April 16, 2014

Lawrence Summers Explains How Today's Tax Reform Issues Differ from the Past

At last week’s 105th annual conference of the National Tax Association in Providence, R.I., former Clinton Treasury secretary and Obama economic advisor Lawrence Summers explained that the tax reform needed today is very different from the Tax Reform Act of 1986.
"It seems to me that the tax community will fail the broader economic community if, at this crucial juncture that lies ahead over the next several years, it remains entirely preoccupied with its most traditional concerns," Summers said at the conference, which I attended. "There are a number of aspects about the current context that stand out as quite unique -- very different from where the world was in 1986 and at most other moments when tax reform has been a prominent area of work." Summers sorted these differences into four factors:
(1)    Now our economy is constrained on the demand side, operating below its full productive capacity so that we are looking for policies that can quickly boost the aggregate level of economic activity. That is in contrast to the full-employment economy of the mid-1980s, when the focus was mainly on improving efficiency in the allocation of economic activity to promote more longer-term, supply-side growth.

(2)    In recent years, the income distribution has been changing considerably (becoming more unequal, and tax changes have exacerbated that trend), while in the 1980s it was more stable.

(3)    Now there are several trends implying that the scale of government will increase substantially over the next 20 years: (i) the aging of the population; (ii) rising debt/GDP and the corresponding higher share of the federal budget that will go toward interest; (iii) technology improvements leading to relative price changes tending to make goods cheaper and services more expensive, with the government sector providing more services than goods; and (iv) the expectation that national security spending will grow over time, given rising or continued terrorist threats.

(4)    Now there is not as much “low-hanging fruit” in the tax system for reformers to pick compared with all the inefficiencies in the tax system of the mid-1980s, and with interest rates now near zero, any remaining tax distortions across different types of capital matter less.

Accordingly, Summers urged policymakers to focus their efforts on three areas of tax reform that are not yet a large enough part of the current discussion:

(1)    Tax policies that more effectively promote aggregate demand and employment, such as the payroll tax cut.

(2)    Tax policies known by economists as “corrective” taxes because they reduce behaviors that generate social costs, including a “carbon tax” (which could reduce fossil fuel consumption and hence global warming) and health-related taxes such as those on tobacco or refined sugar (which could reduce cardiovascular disease, obesity and diabetes).

(3)    Tax policies aimed at raising taxes on the financial sector and, in particular, highly leveraged activities that contribute to reduced productivity, increased income inequality, and greater economic instability.

Summers concluded by emphasizing that the pressures on public sector spending pose a critical, and new, question in designing tax reforms: how to design a tax system to generate and sustain adequate revenues. In the 1980s, tax reform could be approached from a revenue-neutral perspective that focused on raising the same amount of revenue in a more economically efficient manner. Now we’ve lived through a prolonged period where revenues were reduced but policymakers failed to bring spending down with it, producing record deficits. Summers stressed that any tax reform will have to raise revenue in order to contribute to the larger fiscal solution and a stronger economy.