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Tax reform twist? Think King Solomon

By Charles Krauthammer
The Washington Post

WASHINGTON The proposition that entitlement curbs are the key to maintaining national solvency is widely accepted, though not by many congressional Democrats. President Obama, however, has endorsed it on various occasions. And he could make it happen.

If he wants. National solvency is important enough to test this proposition at least once more. The obstacle is Obama’s current position that entitlement cuts must be “balanced” with new revenue from closing loopholes.

Republicans are opposed.

Is there a solution? Yes: tax reform with a twist.

The problem begins with definitions. By tax reform, Obama means eliminating deductions, exclusions, various credits with all the money going to the Treasury. That’s new. The 1986 Reagan-O’Neill tax reform closed loopholes with no extra money going to the Treasury. The new revenue went directly back to the citizenry in the form of lower tax rates.

This is called revenue neutrality. The idea is that tax reform is a way not to fatten the Treasury but to clean the tax code. It means eliminating special-interest favors and behavior-altering deductions that create waste by inducing tax-preferred rather than market-oriented economic activity. It introduces fairness by removing breaks and payoffs for which only the rich can afford to lobby.

As a final bonus, tax reform’s lower rates spur economic growth. A unique win-win-win: efficiency, fairness, growth.

Obama’s Simpson-Bowles deficit-reduction commission offered a variant. First, it identified $1.1 trillion per year of these “tax expenditures.” That’s more than $11 trillion in a decade. In one scenario, it knocked them all out and lowered marginal tax rates to just three brackets of 8 percent, 14 percent and 23 percent.

But here’s the twist. Using the full $1.1 trillion annually of newly redeemed “loophole” revenue, Simpson-Bowles could have dropped the rates below 23 percent. But instead it left some of that money in the Treasury, an average of almost $100 billion a year, or about $1 trillion over a decade. It was a reasonable compromise, so reasonable that even the Senate’s most fierce spending hawk, commission member Tom Coburn, signed on.

Now, Simpson-Bowles is not on the table but it could be a model. Obama’s “tax reform” would send 100 percent of the revenue to the Treasury. Reagan-O’Neill sent zero. Simpson-Bowles fell somewhere in between. So should any grand compromise.

But before deciding exactly where to locate that compromise we have to decide which deductions to cut, yielding how much revenue. The bad news is that, given all the lobbying and haggling this would occasion, it could take years to work out. The good news is the formula proposed by Harvard economist Martin Feldstein. Before deciding which deductions should remain permissible, it allows no one to reduce his tax bill by more than 2 percent by using any or all of the deductions and loopholes in the current tax code (except charitable donations).

There should be separate negotiations over which of the hundreds, thousands, of loopholes/deductions should be tossed out as corrupt or counterproductive rent-seeking. But the 2 percent ceiling means that we don’t have to wait until full tax reform – because the Feldstein formula significantly and immediately reduces the impact of all the loopholes.

Feldstein calculates that his tax reform would yield $2.1 trillion in new revenue over a decade. Now we can cut the pie. Obama wants the government to keep it all. The GOP wants to give it all back to reduce tax rates. Let’s be Solomonic. Divide the revenue in half – 50 percent to the Treasury for reducing debt, 50 percent to the citizenry for reducing rates.

That’s roughly $1 trillion each. Everybody gets something. Republicans get a rate cut, minor but symbolic after the fiscal-cliff rate hike. The country gets the first significant tax reform in a quarter century. Obama gets $1 trillion worth of “balance,” his price for real entitlement reform. And if he turns out to be serious about that, we get the Holy Grail – tax and entitlement reform all at once.

Which means a deal that manages to simultaneously promote efficiency, fairness, growth, debt reduction and a return to national solvency. In other words, the best deal since the Louisiana Purchase.

Email: letters@charleskrauthammer.com.
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