'Tomorrow' is Always a Good Day to Totally Transform the Economy

If you're looking at America's grand economic policy, it's important to wear bifocals -- not literally (unless you really want to), but figuratively. You need to keep your eyes on both the recession under our noses and the looming debt crisis off in the distance -- and to be prepared to respond to both. In the short-term, you'll want to see low taxes, high spending and strong entitlement benefits to keep seniors buying goods. In the long-term, however, you'll want to see higher taxes, lower spending, and entitlements reformed, or on a inflation-adjusted budget. So that's the central challenge of designing an effective fiscal policy. We'll have to dramatically change the way we tax and spend, but not ... just ... yet.

In Part One of my interview with Brookings senior fellow William Gale, we discussed why paying taxes should be more like paying credit cards. In this second installment, we break out the bifocals. What should tax reform look like today, and what should we do when we reach that crisis we can spot off in the distance?

[To learn more about the Wyden-Gregg tax reform plans, see my interview with Roberton Williams of the Tax Policy Center]

One of the key features of the Wyden-Gregg tax reform plan is that it triples the standard deduction for taxpayers. This is huge, and an obvious blow to itemized deductions like mortgage interest and charitable donations. Is this an opening bid to dramatically change tax benefits? [Read more about tax expenditures here.]

Let's step back. There are three features of the Wyden-Gregg bill that are really, really important. First, this is a tax reform, not a tax cut. They're willing to say, let's close off some loopholes, which will raise revenue. That's the kind of decision that's been lacking in DC. Second, it's bipartisan. Three, it's comprehensive. It aims at the system as a whole, broadening the base and reducing the rates. It gets rid of exemptions and loopholes in two ways. It specifically eliminates some of them and by tripling the standard deduction it takes a big chunk out of the mortgage and charitable deduction benefit. because a lot of people are just going to take the standard deduction. The problem with it is it's an enormous cut into the tax base.

How would you like to see comprehensive tax reform go deeper?

I would like them to see the mortgage deduction replaced with a home buyers' tax credit, one payment of $10K. It would be less expensive for the government. It would be less regressive. And it would be much more effective at stimulating home ownership. It would stop encouraging highly leveraged house purchases.

Just to push back a little on points one and three. I can see critics saying, "When the government says 'This would be less expensive,' home owners will respond, 'But you're taking money from me, and reducing the value of my home.'" Also the subprime crash triggered a backlash against home ownership. Some people would argue it's more financially responsible for some people to rent. How would you respond?

The problem with the sub-prime crisis was the encouragement to take on debt. Moving away from subsidizing debt toward subsidizing ownership would be a good thing. If we want to avoid the type of things that just happened, we should move away from the mortgage deduction and the subsidy of debt.

To be clear, I don't favor this change right now because you're right it would be less valuable for homeowners even though we'd still be subsidizing home ownership. This change could weaken the housing market and reduce home values. That's the difference between tax reform we need now and tax reform we need in general. Another example: States and localities are in horrible state. Raising the cost for them to raise taxes by eliminating the state and local tax deduction [what the heck is that? Full explanation here] is good in general, but it would be bad right now. State and local governments, like the housing market, are under water. There are a lot of things that make sense to do in the long run that don't happen to make sense in a time like this.

That's an interesting way to frame it: There's a difference between the tax reform we can have now, and the tax reform we need later. Once we're out of the recession, what else has to change?

Right, so tax reform in general is necessary, but we're constrained in what we can do now, because these sectors are weak. In the long run, we to fix the employer deduction for health insurance, the non-taxation of carbon, the lack of a federal tax on consumption. Those are the big moving parts in the federal revenue picture. And the biggest is levying a tax on consumption.