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Small Problems with the Tax Code Beg for a Large Solution

Lawmakers should redouble their efforts to pull up the current tax code by its roots and begin anew.

by
Ike Brannon and Eileen J. O’Connor

Bio

June 29, 2012 - 12:00 am

A recent OECD (Organization for Economic Cooperation and Development) study finds that, by taking advantage of countries’ differing treatments of financial instruments, transactions, and business entities, multinational businesses have saved themselves as much as $3.5 billion over the past twenty years. The study concludes that member countries — including the U.S. — should consider modifying their laws to make these “hybrid mismatch arrangements” impossible.

Such a reflexive reaction — fix it! — is the sort of response that, through the decades, has created the ad-hoc and growth-reducing tax laws currently in place. U.S. Tax Code is completely broken. Lawmakers should redouble their efforts to pull up the current tax code by its roots and begin anew, and resist the temptation to clip a few dandelions.

Our tax code is complicated for a whole host of legitimate reasons. At the top on the list for multinational businesses is the their exceedingly complex nature: defining a multinational’s taxable “profits” for a particular time and place is anything but simple.

But the primary reason for the tax code’s complexity is lawmakers’ desire to use it to address every problem under the sun. Under the guise of encouraging or discouraging activities they consider economically or socially productive or harmful, lawmakers have added hundreds of incentives and disincentives into the tax code. Even though many are of little or no economic value, they stay on the books because lawmakers find it easier to leave even questionable tax provisions alone than to risk the wrath of voters and contributors who benefit from them. Besides, as President Reagan wisely observed, the thing coming closest to having eternal life on earth is a government program.

A small-bore “fix” of a tax code flaw often begets a whole range of unintended consequences with far-reaching effects. For instance, when 155 Americans completely avoided taxes in the 1960s by combining various tax incentives, rather than reduce or eliminate the incentives, Congress enacted the Alternative Minimum Tax (AMT). It was a 10 percent tax on alternative minimum taxable income over $30,000. That is $180,000 in today’s dollars. Over the next 40 years, that once-obscure provision has come to affect millions of taxpayers. Instead of a 10% tax on AMT income of more than $180,000, it is now a 26% on incomes of more than about $50,000 (single) and $75,000 (married), and 28% on AMT incomes of more than $175,000. Every year, Congress passes a temporary “patch” to keep the AMT from reaching even more people.

A list of the unintended consequences of well-meaning tax provisions could fill a book. For just one recent example, look at the addition of an “alternative energy credit” to the tax code. Shortly after the credit’s enactment, the IRS determined that the paper industry’s use of “black liquor” — a paper-processing byproduct the industry had already used for decades to generate power — qualified for it. Lawmakers neither intended nor foresaw this application of the credit, and enacted a provision to close this loophole, but not before the industry claimed a few billion dollars in the credits. Rather than merely clarifying the law, however, lawmakers deemed the “fix” a loophole-closer that would “raise” $23 billion in new revenue, thus permitting them to use it to “pay” for $23 billion in new spending.

The amount of tax revenue the U.S. Treasury loses by “hybrid mismatch arrangements” is small in the scheme of things — roughly $175 million per year. Rather than spend a moment of effort to address OECD’s proposal, lawmakers need to resist the temptation to solve every perceived problem of social and economic behavior with a tax incentive or disincentive, and find the fortitude to create a tax code that looks, in the words of a former Treasury secretary, like it was designed on purpose.

Ike Brannon is Director of Economic Policy at the American Action Forum. Eileen J. O’Connor was Assistant Attorney General of the United States from 2001 to 2007
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