As the 112th Congress settles in and looks for ways to address our $14 trillion national debt, the case for tax reform has never been stronger.
Major tax reform must address the two fundamental structural problems that plague the existing tax code -- high tax rates and a narrow tax base caused by excessive tax expenditures.
The extension of the rate reductions in the 2001 and 2003 tax cuts partially and temporarily addressed the first problem, but actually made the second problem worse. The combined legislation includes a significant amount of tax spending in the form of tax credits and increased deductions.
In December, as part of a larger plan to put the United States on the path to fiscal responsibility, the National Commission on Fiscal Responsibility and Reform put forth a tax reform proposal that provides a fix. Their report proposed reducing the top individual income tax rate to between 23 percent and 28 percent -- a substantial reduction from the current top rate of 35 percent. Importantly, the commission also proposed slashing tax expenditures (e.g. the mortgage interest deduction and state and local tax deductions) by at least $785 billion.
While that plan failed to gain the votes needed to send it to Congress, it still deserves serious consideration.
Consider: While lowering tax rates will increase everyone's incentives to work and save, the federal government still needs to maintain the tax base. Lowering marginal tax rates, but continuing to spend tax dollars on a myriad of expenditures, is a recipe for an even larger national debt.
Given the enormity of the budget crisis facing the United States, policymakers should also have a serious discussion about moving toward a consumption-based tax system. Such a system offers the greatest efficiency gains and reduces the huge burdens being passed on to future generations. It can also be accomplished while maintaining the progressive nature of our current tax system.
Whatever pathway we choose, it's critical we implement a broad-based, low-rate tax system designed to increase economic growth -- before the next debate about extending the current marginal tax rates is upon us. Neither a drastic increase in tax rates nor the cost of political bargaining is good for long-term economic growth.
Equally important is spending reform and restraint. We must reduce expenditures and reform entitlements to limit the size of government.
Lastly, we should implement these reforms, including significant expenditure reductions, in a timely manner (after accounting for the fragile state of the economy) so as to reap the potential positive effects of fiscal prudence while avoiding the negative effects of passing on massive debts to future generations.
John W. Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the James A. Baker III Institute for Public Policy and an adjunct professor of economics at Rice University.