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Fixing the Tax System
Support Fairer, Simpler, and More Adequate Taxation
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A good tax system raises the revenues needed to finance government spending in a manner that is as simple, equitable, stable, and conducive to economic growth as possible. But the challenge for the next President will be to make reform work not just in the abstract, but in the real world, where special interests often rule the roost. The next President should support reforms that would tax all income once (only) at the full tax rate, simplify and streamline the tax code, and, of course, raise sufficient revenues. This paper proposes a package of specific reforms to achieve these goals.
In the next few years, several factors will push tax issues to the forefront of policy discussions. First, under current law, almost all of the Bush administration’s tax cuts will expire at the end of 2010. The loss in revenues from making the tax cuts permanent would be enormous—equal to several times the resources needed to repair Social Security—and economic growth is unlikely to come anywhere close to covering that loss. As a result, the required spending reductions would be enormous, too. For example, if certain key programs—Social Security, Medicare, Medicaid, defense, homeland security, and net interest—were off-limits, all other federal spending would have to be cut by almost half.
A second factor is the rapid growth in the alternative minimum tax (AMT), which will increase the inequity and complexity of the tax system. Tax filers pay the AMT when their AMT liability exceeds their regular income tax liability. Designed in the late 1960s and strengthened in 1986, the AMT operates parallel to the regular tax system and was originally intended to capture tax on excessive sheltering activity. The tax has evolved, however, so that it does not tax many shelters and it does tax a variety of items—like having children, being married, or paying state taxes—that most people do not consider shelters. Moreover, the number of taxpayers facing the AMT is slated to grow exponentially, from about 3 million today to 30 million by 2010, because, the AMT is not indexed for inflation and because some temporary AMT tax cuts are about to expire.
A third issue—which may not require immediate action, but should nevertheless help frame the current debate—is the expected increase in government spending over the next several decades. Since 1950, tax revenues have hovered between 16 and 20 percent of GDP. Under current projections, however, government spending is projected to rise to about 27 percent of GDP by 2030. This increase is fueled mainly by increased entitlement spending for Social Security and especially Medicare and Medicaid. Unless candidates are willing to suggest truly massive cuts in such programs, they will have to come to terms with the need for an increase in revenues to above 20 percent of GDP.
Despite these pressures on the system, tax changes are not inevitable, and achieving meaningful reform—that is, with substantial design improvements—will require strong political leadership.
(End of excerpt. The entire paper is available in PDF format.)