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How Tax Reform Represents Obama’s Greatest Shot at Hope and Change

Whatever form the final agreement to raise the federal debt ceiling takes, it will surely include some sort of promise that Congress and the president will pursue “tax reform” or a “tax overhaul.” It can’t be called a tax increase, but the purpose will be not just to close tax loopholes and keep basic marginal rates low, but also to bring revenues up from their current level of 14.4 percent of gross domestic product, a level last seen in the Truman administration.

The very words “tax reform” are music to the ears of good-government liberals like me—and Barack Obama. They bear the hope of bipartisan compromise and grand bargains in which everyone wins. Conservatives get lower rates, liberals get a fairer tax code with more revenues for social programs, and fewer giveaways to favored industries. For folks like us, Showdown at Gucci Gulch, the book about the 1986 tax reform, is like a national epic; the moment in the book when then-Senator Bob Packwood drinks a pitcher of beer over lunch and decides to throw out the messy bill his Finance Committee has produced and start over with a clean tax-reformer’s dream bill is like Aeneas’s arrival in Latium.

There are no Packwoods around today (while remembered now for his egregious sexual harassment, he was also a smart moderate Republican of a type long ago banished from the party), and nothing about tax reform is going to be any easier than the debt-limit deal itself. Still, if a budget deal commits Congress to do something, the goal of tax reform can be much more than just moving the long-term revenue line a little closer to the spending line. Because the tax code sets some of the basic parameters of our economic structure, it can also be an opportunity to move the whole country in the direction of greater fairness, growth, and financial stability.

IF AND WHEN the tax reform moment arrives, you’re guaranteed to hear two principles tossed around a lot. One is that we should have a “clean” tax code that doesn’t try to “pick winners” through narrow deductions and credits. The other is that we should “tax what we want less of, and not what we want more of.” That second principle conflicts with the first, since it implies picking winners. But one lesson from past tax reform: There’s no such thing as a purely clean code—taxes always create incentives that change the economic structure and create winners and losers, often in ways that aren’t obvious.

One thing that we want less of, or should want less of, is economic inequality. From the stagnation of wages and opportunity in the middle and low end of the income spectrum, to the staggering gains at the top (the 152,000 people in the top one-tenth of one percent receive more than ten percent of all income), the thirty-year “great divergence,” as the economist Claudia Goldin has called it, represents a profound social change with grave consequences for social cohesion, economic instability, and political polarization.

The most obvious way for the tax code to reduce inequality might seem to be by redistribution—raise rates on the wealthy, then reduce rates and add subsidies, such as the Earned Income Tax Credit, for the working poor and the middle class. But as important as it is for the wealthy to pay their fair share, any politically realistic tax increase, such as Obama’s proposal to let the Bush tax cuts expire for those earning more than $250,000, would hardly yield enough revenue (in this case, we’re talking about approximately $80 billion a year) to make a dent in the conditions of those in the bottom 60 percent who have gained almost nothing over the last 30 years. Enacting Obama’s plan in the hope of reducing inequality would be like dipping into great fortunes with a teaspoon, and sprinkling it over the rest of the country. And, anyway, that revenue isn’t intended for sprinkling; it’s earmarked for deficit reduction.

Further, taxation-as-redistribution treats inequality as if it were a natural fact, and then expects taxes to compensate for it. But inequality is the result of a lot of deliberate choices, especially decisions by companies about how to allocate revenues, and the tax code itself is responsible for many of them. As Jacob Hacker and Paul Pierson show in their acclaimed book, Winner-Take-All Politics, one cause of the sharp widening of economic inequality is the tax changes that began in 1978 and continued through the Reagan years. With individual income tax rates lower than the corporate tax rate, and the rates on capital gains income lower still, there emerged a strong incentive for corporate executives to take money out of the company in the form of salary and, especially, stock options, which enjoy quite favorable tax treatment. As recent data has shown, a significant portion of high-end economic inequality comes from high-end executive pay, which rose 430 percent since the 1970s, while average wages went up just 26 percent. Entire industries, particularly the one in which Mitt Romney made his fortune, private equity, depended on tax rules that let them draw the value out of companies in the form of tax-preferred capital gains.

The recent rise in inequality isn’t a story of superstar athletes running up monster contracts (less than 5 percent of the very top are athletes or actors), or even of hedge fund geniuses manipulating the markets from behind their wall of monitors (less than a fifth of the top earners are in finance). It’s a story of corporate managers making decisions to take more of their company’s income for themselves (forty-one percent of top-earners are corporate managers), decisions that are encouraged by the tax code. Rewarding themselves with stock options that in turn reward short-term performance, they made their companies more vulnerable and their workers poorer.

While far from the only cause of structural inequality, the tax code is a big part of it, and tax reform can change it. The first step is to end the special treatment of capital gains and dividend income—not just because the wealthy get more of their income in that form, but because of the incentives it has created to increase inequality and risk. That’s a reform that would both clean up the code and give us more of what we want more of.

But imagine a tax code that tried to undo its own damage. When so much inequality is created within single companies, why not reward companies that are narrowing the gap and tax companies that widen it? The average CEO now takes home 350 times the pay of the average worker, a difference that’s more than tripled since 1990, and is unknown in any other country. Leo Hindery, a former telecommunications executive, has proposed a tax penalty for companies where executive compensation exceeds a certain level; another proposal, put forward by investor Steve Silberstein, would adjust the corporate tax rate based on the ratio of CEO pay to the average worker. A company with a ratio at the 1980 level of 50:1 would pay tax at the current rate of 35 percent, with the rate rising for companies with a higher ratio and lower for those with a narrower pay gap.

Of course, there’s work to be done to make sure these proposals work—particularly to make sure that overseas employees and suppliers are included in the calculation—but these ideas suggest that “tax reform” can be more than just the next dreary step in the fiscal responsibility project. Taxation provides the basic structure of incentives in our economy, and the Bush and Reagan tax changes got them wrong. If the budget deal does lead to tax reform, it’s a welcome opportunity to get them right this time. 

Mark Schmitt is a senior fellow at the Roosevelt Institute and a former editor of The American Prospect.