Kudlow: Tax Reform Is the Fix for IRS

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Apart from criminal prosecution, the best way to strip the power of politics and corruption from the IRS is to initiate broad-based, pro-growth tax reform and simplification. It's the complexity of the tax code that nurtures IRS corruption.

There's a buzz in Washington about this possibility, where both Democrats and Republicans are interested in reform. We need a simpler and flatter tax code. We need to get rid of the crony-capitalism insider deductions and exemptions, which have given the IRS so much power. These deductions and exemptions are precisely what nurtured the political corruption that led to a major scandal.

Some conservatives—like my great pal Jim Pethokoukis—don't believe tax reform can be done. Old habits die hard, he believes. And the budget numbers from a pure flat tax never add up.

Well, Pethokoukis may be right in his concerns. But that's no reason to give up the fight.

(Watch: Pethokoukis and Kudlow Face Off on Flat Tax)

I'm going to argue for a modified flat tax in the personal code, and a single-rate flat tax—or a sales tax net of investment—for large and small businesses. Here's a quick example of the need for this reform.

The Wall Street Journal editorial page just ran a tax-exempt IRS primer surrounding the 501(c), which unbelievably covers 28 categories of organizations. The 501(c)3s include charities, the (c)4s cover social-welfare groups, the (c)6s include business groups, and the (c)5s cover labor unions.

That's a gigantic mess. And I say scrap the whole thing. Take the IRS's power away.

If people want to give to political campaigns, fine. Give as much as you want to whomever. But post it on the Internet for all to see right away. No secret donors. No tax deductions. And no IRS interpretations.

(Watch: Tax Reform to Curb IRS Power)

I don't know how many other examples of tax-exempt craziness exist in the IRS code. The Journal itself says, "The tax code would be cleaner, and our politics fairer, if no one enjoyed any tax-exempt advantages." Right on. That's where the simplicity comes from.

And then let's put a limit on numerous other tax deductions. Trillions of revenue dollars are lost from mortgages, charitable contributions, health care, and state and local spending deductions. We don't need them.

But to make the tax-reform transition easier, and promote economic growth, let's go the way of Reagan in 1986 and slam down the marginal tax rates.

For example, we have six brackets today: 10, 15, 25, 28, 33, and 40 percent. How about two brackets? One at 10 percent would have a high-income threshold, and one at 28 percent would take over from there.

And you know what happens because of these lower tax rates? The remaining deductions become far less valuable, even unnecessary. And the low tax rates spur economic growth by providing new incentives to work, save and invest. Housing and charitable deductions went through the roof during the prosperity years that followed the 1986 reform.

Really, why should Warren Buffett enjoy a $15 billion tax-free charitable loophole merely by donating his fortune to the Bill Gates Foundation? And why should the tax code stimulate a proliferation of nonprofits when the economy actually needs the encouragement of profitable job-creating start-ups and companies?

(Read More: So You're Not Saving Enough for Your Retirement...)

Middle-income folks would benefit enormously form a flatter approach. Right now, a middle earner pays roughly a 15 percent payroll tax and a 28 percent income tax. That's a 43 percent tax rate, which is actually higher than the 40 percent top rate. This is wrong. At a 10 percent income tax, the total burden for a middle-income family would drop to 25 percent. That's a major tax cut and a great increase in take-home pay.

Lower rates, fewer brackets and a major cutback in cronyist deductions and exemptions won't end the IRS. But these measures surely will cut back on its arrogant power to make political judgments. That's the point of the exercise.

Budget cuts also will be necessary to make the deficit numbers work. That's as it should be. But dynamic scoring will show a burst of economic activity that will reduce the short-term cost of tax-rate reduction while increasing the long-run growth of the American economy.

Coming out of this deep recession, we need 4 percent to 5 percent growth over the next 10 years, not 2 percent. Tax incentives are not the only instrument, but taxes change behavior. Taxes matter.

Of course, Team Obama wants to limit tax deductions, raise taxes on the wealthy and then spend the revenues. They think the IRS problem is just a few bad apples. They're completely wrong.

The institutional corruption of the IRS has been enabled and encouraged by one of the craziest tax codes in the world. Tax reform can solve this. Now is the time.

—By CNBC's Larry Kudlow. Follow him on Twitter @larry_kudlow