Holtz-Eakin: U.S. Tax Code a “Basic Impediment”

The House Ways and Means Committee, chaired by Rep. Charles Rangel of NY, held hearings over the past several days on the fairness of the U.S. tax code. We share the concern that the legislation to come out of these hearings will be focused solely on a redistribution of the tax burden in the name of fairness, to the exclusion of making our tax code more efficient and our economy more competitive. If so, this will place yet another straw on the camel’s back of domestic output, a reality that is critically linked to the current state of financial markets, signs of domestic sluggishness, and pressure on the Federal Reserve Open Market Committee (FOMC) to cut interest rates.

As we continue to point out, the U.S. dollar is still the world’s primary reserve currency, meaning that it can be used to finance economic activity in most of the world. In order to stabilize the value of the USD, the FOMC has to influence interest rates towards a level that approximates the expected return on marginal investment–not just investment opportunities in the U.S., but anywhere that dollars (and eurodollars, to be technically correct) can be used to finance investment.

In other words, the effectiveness of U.S. monetary policy is dictated by global economic realities, a fact that most policymakers, especially the current Congress, as well as many market pundits and participants, seem oblivious to. And as long as the marginal cost of a dollar falls below the marginal return on expected investment in the global dollar economy, persistent inflation will result. That means that the value of the USD steadily declines in real terms, i.e., in purchasing power. Congress and markets must realize that the FOMC cannot do anything about the relative quality of investment opportunities versus the rest of the world. As such, a cheaper dollar in the current global environment will mean a return of stagflation as we experienced in the 1970s–probably not to the same extent, but demoralizing nonetheless.

In this context, the U.S. tax code is defective in two important ways–neither of which were given much attention by Congressman Rangel’s committee. First, it is rendering our economy less competitive globally than it would otherwise be. And second, because it is not indexed for inflation, greater "fairness" in the form of steeper progressivity will impose ever larger penalties on people in terms of real wealth. For these reasons, we think that the testimony of Douglas Holtz-Eakin is worth a read, as it illuminates some of the important flaws in the federal tax code. While distribution of the tax burden is an important issue, the flaws pointed out in Holtz-Eakin’s testimony are far more important to our future economic performance:

The tax code is a basic impediment to the United States’ ability to grow robustly and compete in global markets…At present, the federal tax system is roughly achieving its goal of providing financing for federal spending.  However, there is little else to defend in the current tax code.  It is overly complex and burdensome, interferes too much with commerce and economic competitiveness, and is riddled with uneven treatment.  Far-reaching reforms are merited; more modest efforts will not succeed in raising federal revenues in a pro-growth and fair fashion.