Tax reform -- not just cuts -- needed

By Chris Isidore, senior writer


NEW YORK (CNNMoney.com) -- Want to lower your tax rates, help the economy and make April 15 less of a chore? Tax reform is probably the way to go.

Tax reform is suddenly getting a lot more attention as a way to fix the ailing U.S. economy, as well as address the problems with government deficits. That's because even with the lower tax rates, your tax bill might rise due to closing loopholes and the removal of deductions and credits.

Do you support the tax cut compromise reached between President Obama and Republicans in Congress?
  • Yes
  • Yes, but with revisions
  • No

"The tax code is very inefficient," said Federal Reserve Chairman Ben Bernanke said in an interview with "60 Minutes" this week. "Both the personal tax code and the corporate tax code. By closing loopholes and lowering rates, you could increase the efficiency of the tax code and create more incentives for people to invest."

President Obama also endorsed the idea of some kind of tax reform when answering questions about his deal with Republican leadership on extending the tax cuts, saying he's in favor of reforming the tax system before the end of the proposed two-year extension.

"We've got to start that conversation next year," he told NPR in an interview broadcast Friday. "I think we can get some broad bipartisan agreement that it needs to be done. But it's going to require a lot of hard work to actually make it happen."

And tax reform is a major component of both the proposal from the Bowles-Simpson deficit reduction commission, and a competing proposal from the Bipartisan Policy Center.

What exactly does reforming the tax system mean?

There are as many different ways to simplify the tax code as there are IRS forms. But the basics are likely to revolve around eliminating the huge range of deductions and income that gets special treatment under current law, allowing for lower tax rates across the board.

There is agreement among economists that broad-based reform would make the U.S. economy much more efficient and spur growth.

"The tax system is distorting people's decisions," said Diane Lim Rogers, chief economist of the Concord Coalition, a public interest group that is focused on reducing the federal deficit. "If you do tax reform, resources will get steered to the most productive uses rather than their tax-preferred uses, and we'll see higher growth."

Just the cost of complying with federal tax filing laws by individuals and corporations is estimated to be about $140 billion a year, or about 1% of the total U.S. economy.

"All the money people spend trying to avoid taxes could be spent on useful things," said Len Burman, professor of public affairs at Syracuse University.

Will tax reform save me money?

While lowering income and corporate tax rates sounds like a boon for workers and companies, experts say the loss of breaks and deductions will mean that some people will have higher tax bills, significantly higher in some cases.

Those who don't take advantage of some of the advantages of the current system, such as those who don't itemize, are more likely to have their tax bills cut in the process.

But depending on the level at which the new tax rates are set, there could be an overall increase in taxes paid by individuals and businesses.

In fact, the reason tax reform is an element in various deficit reduction plans is the belief that the best way to increase government revenue is to do so through a more efficient tax system, rather than trying to squeeze out more taxes in a system already riddled with loopholes and ways to avoid taxes.

What tax advantages will I lose?

It's far too early to say which tax breaks and deductions would disappear, and which will survive. Some proposals call for keeping many of the current deductions but simply capping how much they can reduce any individual taxes. Others want a proposal that eliminates most -- if not all -- breaks.

Some big ticket deductions include state and local income taxes, charitable contributions and medical, child care and commuting expenses paid with pre-tax dollars.

But much of the change could come from expanding the definition of what should be counted as taxable income. The largest could be taxing the $131 billion employers spent in 2008 on medical insurance premiums and medical care.

The biggest potential increase in taxes would come from closing the home ownership tax advantages, including the ability to deduct mortgage interest and property taxes and the tax-free treatment for most gains on primary home sales. According to the Tax Policy Institute, those breaks totaled $148 billion in 2008, and are forecast to top $200 billion a year by 2012.

Even those in favor tax reform say eliminating all those benefits would be another blow to the still-struggling real estate market. That's why most of the current proposals call for limits on those real estate deductions, rather than their complete elimination.

Is tax reform likely to happen anytime soon?

One of the best things about tax reform is that it gets support from across the political spectrum. Burman recently served on the committee of the Bipartisan Policy Center that drafted its deficit reduction plan.

"It included pretty conservative people and pretty liberal people, and they all got pretty excited about the tax reform proposal," said Burman. "I thought that was encouraging."

Still, the current political environment, with a divided Congress and the looming presidential election, doesn't lend itself to the kind of compromise needed to accomplish such radical reform, according to most experts.

Liberals won't be happy unless the new system means lower wage earners benefit as much or more than higher earners. And many Republicans would fight any reform which raised the overall amount of money collected.

And while Burman thinks the odds of tax reform passing anytime in the next couple of years are improving, he says it is still a long shot. Each of the items that get special treatment in the tax code has a powerful special interest behind it, willing to fight to have the preference maintained.

"For every special interest, it's worth spending a bundle of money to protect its own interest," said Roberton Williams, senior fellow of the Tax Policy Center, a leading think tank on tax issues, who said lobbying will be the biggest growth industry of any tax reform debate.

"They'll hire K Street lawyers out the wazoo." To top of page

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