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Three Simple Truths About What Needs to Be Done in Tax Reform

September 2nd, 2010 . by economistmom

During this last week of summer, I am barely keeping up with the August-recess fiscal policy news.  Luckily there’s not much to keep up with.  But last week the President’s Economic Recovery Advisory Board (sometimes affectionately(?) referred to as “pee-rab” (PERAB)) issued their long-overdue tax reform report.  I was on a long drive to visit family in Michigan, but fortunately Dan Shaviro and Howard Gleckman, two of my favorite experts/commentators on tax policy, got right on the case and blogged on the report, right through their yawns.  Both were disappointed as well as bored.

In my mind this report was always doomed to be a boring disappointment–a pretty useless rehashing of academically-noncontroversial tax reform ideas that would do little to advance the political debate in the direction it desperately needs to go.  That’s because the effort began with the implicit premise that tax revenues don’t need to be raised–that what we need is revenue-neutral tax reform (raising the same level of revenue but more efficiently), when in fact the fiscal outlook makes it clear that we need revenue-gaining tax reform.  Then on top of that, the PERAB was told they not only couldn’t raise taxes on average, they couldn’t raise taxes on any households with incomes under $250,000–i.e., all but the top 2-3 percent of households.  This latter restriction makes it hard to do anything to address the major sources of economic inefficiency/distortions in the tax system, because people all over the income distribution currently benefit from the various and very expensive tax expenditures (”holes” in the tax base) under the current system.

As a result, the PERAB tax reform report is like the tax-side equivalent to a no-pain, “cut (only) waste, fraud, and abuse” report.  It doesn’t tell it like it is in terms of what really needs to be done via tax reform to help our nation fiscally and economically.  What we need to do isn’t complicated at all; it’s just kind of painful to hear.  Here’s my list that is simple if not sweet:

  1. Raise More Money. Raise revenues as a share of our economy above its “historical average” of 18 percent. The 18 percent figure is not the “right” number just because it’s been the average one.  In fact, we need to raise it above where current-policy extended would take us (just read the CBO reports to understand why), which means we have to start thinking of tax reform as how to raise more revenue, not just the same amount of revenue, in the most economically efficient and equitable way possible.
  2. Even Things Out. Raise revenues more efficiently by broadening and “leveling the playing field” called the federal income tax base. Revenue-increasing tax reform necessarily implies the overall, economy-wide average tax rate will go up–no matter how the reform is structured.  But raising revenues by filling in the “holes” in the income tax base (reducing tax preferences or “tax expenditures”) keeps overall marginal tax rates low by raising marginal rates only on those forms of income that currently face very low or even zero tax rates.  Raising effective marginal rates on those forms of income that are currently under-taxed would reduce rather than increase the distortionary effects of the income tax.  (There are also fairness concerns that motivate such “leveling” of effective tax rates.)
  3. Act European. Not in the way conservatives who oppose raising revenues/GDP warn about:  those “European level (marginal) tax rates” necessary to close the fiscal gap using increases in marginal tax rates alone.  I mean engage in more “European-style” taxation by taxing more things that are–if not more pleasant to tax–at least less economically harmful to tax than the things we tax now.  The two prime examples I’m thinking of:  (i) environmentally-harmful activities (e.g., carbon-based energy via a carbon tax), and (ii) consumption (via a value-added tax).  This is really a corollary to the “even things out” directive: by adding tax bases that are more efficient to tax (in addition to broadening our existing income tax base), we can raise more revenue by leveling effective marginal tax rates across different sources and uses of income rather than simply raising marginal tax rates on the types of income or consumption that are already taxed most heavily.

The President’s tax reform panel was prohibited from uttering any of these three simple truths.  I hope the President’s fiscal commission will be less constrained, because tackling the much broader task of achieving fiscal sustainability makes tax reform according to these truths even more critical to the overall mission.

6 Responses to “Three Simple Truths About What Needs to Be Done in Tax Reform”

  1. comment number 1 by: Curt Doolittle

    How about we worry less about raising taxes, and worry more about cutting the cost of running the overseas empire, and policing the world?

  2. comment number 2 by: AMTbuff

    I can see the wisdom of raising revenue to 20% or even 21% of GDP, but NOT UNTIL AFTER the spending problem is fully addressed. That means explicitly breaking all long-term entitlement promises. It means ending Medicare as we know it, severely curtailing Medicaid and its scope of eligibility, raising the retirement age, and repealing Obama’s health care reform.

    Once all that is in place, tax increases will not kill the economy, because investors will see that the nation is no longer headed for a fiscal crash.

  3. comment number 3 by: SteveinCH

    The good news is that taxes will rise that high without us doing anything AMT. In fact, if you allow the Bush and Obama tax cuts to end, taxes will be in that range or higher by 2020 and up to between 23 and 24 percent by 2035.

    To my mind, this the dirty little secret that runs against Diane’s point 1. Taxes (as a percentage of GDP) are already going up well above historical norms. In fact, even if the Bush and Obama tax cuts and the AMT patch were extended in perpetuity, taxes as a percentage of GDP would approach 21 percent by 2035.

  4. comment number 4 by: BillSmith

    A one trick pony… Raise taxes, raise taxes, raise taxes.

  5. comment number 5 by: Acetracy

    US personal and corporate tax system needs a complete overhaul and simplification. A true tax discussion can’t just look at what happens on the federal level but also take into account increase and respective burdens of state and local tax levies.

    This article and most others writing about the Bush Tax cuts, Expired Estate Tax in 2010, etc. ignore the increasing tax burden middle class America is pay on the LOCAL level.

    55% of personal income paid in taxes. That’s the effective rate for all federal, state and local taxes combined for American families making between $50,000 to $500,000. By far the biggest chunks for middle income are social security, sales, and real estate taxes.

    At that tax rate, German, Swedish, Dutch, etc. middle class families have universal health care and free higher education!!

    Bush tax cuts is a big misnomer since many income groups did not see a tax breaks because the Republican Congress in 2003-2004 couldn’t find a way to pay for the correction in AMT (now hitting the top 5% of earners, not the 0.5% top earners as it was originally designed for). So it was a trade off, cut dividend tax rats in half or give 2 income families a break from AMT.

    Another big misnomer in the Bush Tax Cut lingo is the -0 Inheritance tax in 2010. Well, Congress only paid for this expiration of the inheritance tax by eliminating stepped up cost basis for inherited assets. So where in 2009 a family could have inherited their grandparents home (original cost in 1950 being $15,000) could have sold the home last year for $500,000 and paid no tax (assuming total inheritance was under $3.0 million), in 2010 the family would pay 15% capital gains tax on the gain of $485,000.

    So there’s been a big tax increase for middle income Americans inheriting assets this year, HUGE!!!

    The other huge issue that the Bush Tax Cut discussions overlook is the affect certain low tax rates on short term capital gains, carried interest, real estate investment, derivative income, etc. has had on the disastrous financial collapse we are experiencing. Speculation rules the NYSE and hedge funds, prop trading desks, etc. have turned the US equity and bond markets into a roulette wheel. This is a direct result of pegging s/t cap gains taxes to marginal income tax rate. The lowest Federal tax rate on a security trade is the 10% tax on derivative income received from writing a broad based index option.

    Think about that. One of the most speculative trades on Wall Street receives the lowest tax. That’s stupid and shows why our economy is not attracting investors but speculators.

    The US economy is so dysfunctional today because the Federal tax code favors certain industries and sectors, and certainly the mega corporation over the small businesses, even though it is businesses with fewer than 100 employees that have been the major source of new jobs. Simplifying the corporate tax code so it can be a one page, online return would save $billions.

    Suggestions for a complete tax overhaul:

    Federal Income tax rate by income bracket: Under $25K: 5%; Under $50K: 10%; under $250K: 20%; under $1.0M: 30% under $10M: 35%; over $10M: 40%. These rates would apply to all earned and investment income. No deductions. Consider giving a 50% credit to income brackets under $100K for state & local taxes. Very, very simple.

    Social Security tax should be cut in half and eliminate the salary cap, now at $103K. If solvency is an issue, pass a 1% intangibles tax on net worths over $10M.

    Federal Corporate Tax rate on Earnings before Interest and Taxes (EBIT) with brackets. EBIT under $1.0M: -0-% tax rate; EBIT under $10M: 10%; EBIT between $100M and $1.0B: 20%; EBIT over $1.0 B: 30%. There is room to debate the use of EBITAD and allow the deduction of depreciation.

    Inheritance Tax rate would be -0-% for estates under $5.0 million. 30% tax rate for estates under $10M; 50% for estates over $10M. Re-install stepped up cost basis. Eliminate the exemption of trusts.

  6. comment number 6 by: JKLaPlante

    One thing most folks on both sides of this issue invariably overlook is the unseen “taxes” that have crept into the “money flows” of all individuals (and other entities). A few examples to consider: HOA’s (pay for many services the local taxes used to cover); the legal profession (lawyers to protect us from other lawyers) and insurance the framework that ties us to the lawyers, all precipitated by laws enacted by congress; fees of all sorts - DMV, communications, utilities, again, all as a result of congressional or local regulation. Throw all of this and more into the “tax” bucket and I bet you are well above 20%. Even a “flat” or “fair” tax ignores these other intrusions. The congress, nearly half of which is made up of attorneys, will find a way to continue degrading your financial freedom. Be careful!