This paper studies the political prospects for reform in a model where the tax base and statutory rate are separate instruments of tax policy. The model suggests that large changes in the tax code may be easier to enact than marginal reforms. The tax base faces a tipping point where even the beneficiaries from tax exemptions support reform. At this tipping point, tax reform is Pareto improving. Politically feasible tax reform occurs when fiscal needs are large, but may nonetheless involve reductions in marginal tax rates. There is strategic complementarity in lobbying for tax exemptions, resulting in multiple equilibria. The model’s main predictions are consistent with recent tax reforms in OECD countries.

Introduction

The politics of tax reform are taking center stage once again, just as public debts are mounting worldwide. Congress passed a substantial change to the U.S. tax code in December 2017; calls for tax reform have also emerged in Spain, Portugal, Italy, and Greece following the debt crisis in Southern Europe. Tax reform was a centerpiece of the legislative agenda of the current Indian parliament. Frequently, tax reform involves changes not only in tax rates, but also in the tax base. Proposals eliminating exemptions or closing loopholes involve a change in the tax base. Indeed, expanding the tax base was central to the most successful reforms in recent history. For example, the landmark 1986 U.S. tax reform eliminated exemptions to both corporate and personal taxes. Reviewing the history of any major tax reform, one sees immediately that broadening the tax base,while often economically desirable, is also politically contentious. (See Birnbaum and Murray, 1987 on the politics of the U.S. Tax Reform Act of 1986). An interest group that was powerful enough to secure a tax exemption is sure to resist attempts to eliminate this exemption when reform is on the table. This paper explores the political determinants of the tax base. To this end, I propose a model where a government meets its revenue needs through a choice of not only the tax rate, but also the tax base. These two policy dimensions appear important in actual reforms and are central to the discussion in this paper. This framework allows us to evaluate individuals’ preferences for tax exemptions and the tradeoff between the two policy dimensions. In the model, all agents and goods are identical ex-ante and there is no economic rationale for tax exemptions. A broader tax base is more efficient, as it removes a wedge between the prices of taxed- and tax-exempt goods. However, in political equilibrium, certain goods may nevertheless be exempt from taxation. The rents from tax exemptions are large and concentrated, while their costs are diffuse. Therefore, a special interest may attempt to secure a tax break despite the inefficiency it creates. This phenomenon is familiar from our understanding of special interest politics. (See Grossman and Helpman, 2002). The novelty here is the study of the budgetary and general equilibrium implications of the inefficient policies that result and their political repercussions. While a tax exemption increases the relative demand for a good, the resulting inefficiencies reduce aggregate demand. The model yields a simple expression that quantifies the general equilibrium losses borne directly by the beneficiaries of tax exemptions. When inefficiencies in the tax code reach a critical point, special interests themselves are willing to forgo their tax breaks in favor of tax reform: the elimination of all tax exemptions. Importantly, no (small) special interest would forgo its tax break in isolation. The rents from a single exemption are large, but the budgetary and general equilibrium gains from its elimination are negligible. At the same time, a broad coalition of special interests may agree collectively to give up their tax breaks for tax reform. I derive the (minimum) coalition size that would collectively forgo its tax exemptions for the enactment of tax reform. I show that the size of this coalition is decreasing in the government’s fiscal needs. Hence, the scope for tax reform is greater when the government wishes to raise more revenues.