The Coming Storm: How Business Can Prepare for Federal Income Tax Reform
By Clint Stretch
Illustration By Jonny Mendelsson

When the U.S. government was established under the Constitution, Ben Franklin commented on its apparent stability by observing, “in this world nothing can be said to be certain, except death and taxes.” But the notions of death and taxes held different meanings for Franklin than they do for us. In Franklin’s day, the average adult was lucky to live to age 45. Today, improved health care and a better standard of living have pushed the average life expectancy to 77, and a growing number of adults, like Franklin himself, live well into their 80s and 90s. Similarly, in Franklin’s day, taxes paid for general government and the debts incurred during the Revolutionary War. Today, we have learned how to borrow for more than prior military necessity. While taxes remain certain, they are no longer certain to be paid by the generation doing the current spending.

These demographic changes and mounting federal debt, when combined with a much larger government than even the imaginative Ben Franklin could have conceived, will soon compel dramatic tax and entitlement reforms. Most observers believe that, as with past efforts to address chronic budget shortfalls, the solution will require a combination of spending and tax actions, and that reduced entitlement spending will be necessary. Our focus here is primarily on the tax side of this equation and how business can best prepare for the coming changes.

The window of opportunity for reform is closing, and it is likely that reform needs to occur during the next presidential term. If it does not, the political costs and economic dislocations of making the more dramatic changes necessitated by delay will be extraordinary. Whenever they occur, the reforms will have far-ranging direct and indirect consequences for business.

Simply stated, if left unabated, the combined burden of Medicare and Medicaid benefits, Social Security benefits, and servicing the interest on a staggering accumulation of public debt threatens to bankrupt the federal government during the working careers of those entering the workforce today.

“Many seem to expect that when Congress and a new administration address these pressures on the tax system, they will look to another 1986-style reform in which lower rates were exchanged for a significant broadening of the tax base. We do not think that can happen.”

These problems will become increasingly apparent in stages. First, beginning in FY09, the Social Security surplus, which has masked the true extent of federal deficit spending, will disappear from the last of the 10 years for which the federal budget is projected. After 2017, Social Security expenditures are expected to exceed employer and employee payroll tax collections.

Once the surplus from Social Security has dissipated, the federal budget would quickly deteriorate. Without intervening changes in policy¹, the projected deficit could reach 5.3 percent of gross domestic product (GDP) by 2019 (see Figure 1). Left unaddressed, deficits of this magnitude quickly compound into unsustainable levels of public debt. On the present path, debt held by the public would exceed 100 percent of GDP by 2027 — something that has occurred only twice in our history, when spending during World War II pushed public debt to 106.2 percent of GDP in 1945 and 108.6 percent in 1946 (see Figure 2). Without tax increases or entitlement reforms, the 2027 deficit could only be brought into balance by eliminating discretionary spending — including military spending. By 2047, tax receipts would no longer be sufficient to pay interest on the national debt.

Obviously, Congress and the White House will act to forestall these bleak outcomes. The more salient issues to consider are when they will act and what they will do. Broad agreement exists that the United States cannot grow its way out of these challenges.

Why Tax Reform Is Inevitable

When Congress and the White House turn their attention to our long-term fiscal challenges, they will find that the current U.S. tax system cannot meet their needs. It will require reform for four reasons:

Corporate and individual tax rates cannot be increased significantly. The individual and corporate income taxes, in their current forms, cannot raise sufficient revenue in a sustainable manner. An array of politically popular incentives ranging from mortgage interest deductions and education credits to the research and experimentation credit and the production activity deduction leaves too little that can be taxed at reasonable rates. In addition, the corporate tax rate is too high: at 35 percent, it is higher than that of any of our major trading partners. Most observers agree that the U.S. rate must be reduced substantially to sustain U.S. global competitiveness; however, replacing the lost revenue will not be easy.

On the individual side, the looming expiration of the Bush tax cuts after 2010 seems to offer an automatic tax increase, but it is likely that a substantial portion of those cuts will survive into the next decade. A political consensus appears to support continuation of the Bush tax cuts for middle-class Americans. Even with respect to high-income individuals, few would support a top tax rate significantly above the roughly 40 percent that was in place before the Bush cuts. As a result, efforts to increase revenue from the individual sector would necessarily involve attacking enormously popular incentives such as the mortgage interest deduction, state and local tax deductions, and exclusions for employer-provided medical insurance.

The current individual alternative minimum tax (AMT) is unsustainable. Additionally, the individual income tax is threatened by the AMT, which, if left unreformed, would rapidly become the tax base for the vast majority of middle-class taxpayers over the next decade. The Joint Committee on Taxation estimates that by 2010, over 85 percent of taxpayers with incomes of $100,000, but less than $200,000, would pay AMT. Some would say that this is acceptable as a backdoor approach to a flat tax. In reality, the AMT results almost entirely from two things: having children and paying state and local taxes. A tax that treats children as tax shelters is neither sound policy nor good politics. Unfortunately, repealing the AMT would reduce federal revenues by $1.3 trillion over 10 years, assuming extension of the Bush tax cuts.