Playing Favorites in the Corporate Tax Code

The President’s new Framework for Business Tax Reform is two documents in one. The first diagnoses the many flaws in America’s business tax system, and the second offers a framework for fixing them.

Much of the resulting commentary has focused on the policy recommendations. But I’d like to give a shout out to the diagnosis. The White House and Treasury have done an outstanding job of documenting the problems in our business tax system.

As the Framework notes, our corporate tax system pairs a high statutory tax rate with numerous tax subsidies, loopholes, and tax planning opportunities. Our 39.2 percent corporate tax rate (including state and local taxes) is the second-highest in the developed world, and will take over the lead in April when Japan cuts its rate. But our tax breaks are more generous than the norm.

That leaves us with the worst possible system – one that maximizes the degree to which corporate managers have to worry about taxes when making business decisions but limits the revenue that the government actually collects. It’s a great system for tax lawyers, accountants, and creative financial engineers, and a lousy system for business leaders and ordinary Americans. Far better would be to fill in the Swiss cheese of the tax base and move to a lower statutory rate, just as the President proposes (albeit with much more clarity about the rate-cutting than the cheese-filling and with proposals that would make some of the holes bigger).

A related problem is that our corporate tax system plays favorites among different businesses and activities, often with no good reason. To illustrate, Treasury’s Office of Tax Analysis calculated the average tax rates faced by corporations in different industries. As you can see, the corporate tax really tilts the playing field:

I am at a loss to understand why the tax system should favor utilities, mining (which includes energy extraction), and leasing, while hitting services, construction, and wholesale and retail trade so hard. Why should the average retailer pay 31%, while the average utility pays only 14%?

These disparities are unfair and economically costly. Investors recognize these differences and allocate their capital accordingly. More capital flows to industries on the left side of the chart and less to those on the right. Far better would be a system in which investors deployed their capital based on economic fundamentals, not the distortions of the tax system.

The chart highlights one of the key battlegrounds in corporate tax reform. Leveling the playing field (while maintaining revenues) will require that some companies pay more so others can pay less. The U.S. Chamber of Commerce announced Wednesday that it “will be forced to vigorously oppose pay-fors that pit one industry against another.” But such pitting is exactly what will be necessary to enact comprehensive corporate tax reform.

P.S. The full names of the sector names I abbreviated in the chart are: Transportation and Warehousing; Agriculture, Forestry, Fishing, and Hunting; Finance and Holding Companies; and Wholesale and Retail Trade.

Five Principles for Fixing America’s Tax System

The International Economy recently invited me to contribute to a forum on how best to fix America’s tax system. Here’s my piece; for eleven other views, check out the complete forum.

America’s tax system is a mess. It’s needlessly complicated, economically harmful, and often unfair. And it doesn’t raise enough money to pay our bills. That’s why almost everyone agrees that tax reform should be a top priority. Democrats, Republicans, and independents. Accountants, lawyers, and economists. Elected officials and ordinary citizens. All know our tax system is deeply flawed.

Unfortunately, they don’t agree on how to fix it. Some want revenue-neutral tax reform, while others want higher revenues to cut deficits and pay for rising entitlement spending. Some want to fix the income tax, while others want to tax consumption. Some want to cut tax rates across the board, while others would lift rates for high earners.

Public discourse, meanwhile, is hung up on the idea of attacking “loopholes” when the real action is in tax breaks that benefit millions of taxpayers. Tax reform isn’t just about corporate jets or carried interest. It’s about the mortgage interest deduction, the tax exemption for employer provided health insurance, and generous tax incentives for debt-financed corporate investment. Those policies have major flaws, but they are not loopholes. They reflect fundamental economic and social choices, and they benefit well-defined constituencies.

Tax reform will thus involve a prolonged political struggle, as reformers seek some compromise that can attract enough support to overcome the inevitable inertia against change. That won’t be easy, but given our sky-rocketing debt, weak recovery, and flawed tax system, it’s clearly worth the effort.

Even as they seek a reasonable compromise, reformers should continue to articulate their visions of an ideal tax system. Mine would reflect five principles. First, the government should raise enough money to pay its bills. That likely means higher revenues, relative to GDP, than we’ve had historically. Second, it’s better to tax bads rather than goods. That means greater reliance on energy and environmental taxes. Third, it’s better to tax consumption than income; policymakers should thus limit how much they tax saving and investment. Fourth, the tax burden should be shared equitably both across income levels and among people of similar means who make different choices (for example, renting versus owning a home).

Finally, the best tax systems have a broad base and low rates. Policymakers should thus emphasize cutting tax breaks rather than raising tax rates. Indeed, some rates, like the 35 percent rate on corporate profits, should come down.

To afford such cuts, policymakers should go after the dozens of deductions, credits, exclusions, and exemptions that complicate the code and narrow the tax base, often with little economic or social gain. Many of these provisions have been sold as tax cuts, but are really spending in disguise. They should get the same scrutiny that policymakers devote to traditional spending programs.

How Would the Buffett Rule Affect Marginal Tax Rates?

President Obama’s latest budget endorses a “Buffett rule” — a new floor on taxes paid by folks with very high incomes. His rule would require that “those making over $1 million should pay no less than 30 percent of their income in taxes.”

The president didn’t offer many specifics about how the rule would actually work. Up on Capitol Hill, however, Senator Sheldon Whitehouse and Representative Tammy Baldwin have  introduced legislation that would implement a 30% minimum tax. That legislation addresses key technical issues such as which taxes to include, what measure of income to use, and how to phase-in the tax so that there isn’t a giant spike when someone’s income rises from $999,999 to $1 million. For more information, including TPC’s estimates of the distributional impacts, please see this post by TPC’s Roberton Williams.

TPC”s Daniel Baneman has examined how the PFSA would affect marginal tax rates — i.e., the effective tax rate that would apply if a person earned an additional dollar. Here’s his chart comparing the PFSA to current policy (i.e., the taxes that would be in effect if all the expiring tax cuts get extended at the end of the year, except for the payroll tax holiday):

As you can see, the Buffett rule would have little effect on the tax rate on wages and salaries. The real action is in capital gains:

Effective marginal tax rates on capital gains would nearly double from 18 percent (under current policy) to 34 percent for taxpayers with incomes between $1 million and $2 million, and would climb to 29 percent for taxpayers with incomes over $2 million. That jump shouldn’t come as a surprise. As Warren Buffett has been telling us, high-income taxpayers who face low tax rates tend to have lots of capital gains, which are currently taxed far below the fair share tax rate of 30 percent. (If you’re wondering, taxpayers with incomes between $1 million and $2 million face a higher effective marginal rate than taxpayers with incomes over $2 million because the fair share tax phases in over that range.)

If investors ever expect that the Buffett rule will actually go into effect, expect them to realize lots of capital gains early. Update (I forgot to include the second half of that thought): After that, realizations will be significantly lower than they would be under current tax rules. That cuts into the potential revenue from the Buffett rule.

The 102% Tax Rate and Other Perils Measuring Tax Rates

Over at the Tax Policy Center’s blog, TaxVox, my colleague Roberton Williams examines the pitfalls that afflict some efforts to measure a person’s tax rate:

Investment manager James Ross last week told New York Times columnist James Stewart that his combined federal, state, and local tax rate was 102 percent.  No doubt, Ross did pay a lot of tax to the feds and the two New Yorks, city and state. But did he really pay more than all of his income in tax?

No, he did not.

As Stewart made clear past the wildly misleading headline (“At 102%, His Tax Rate Takes the Cake”), Ross’s tax bills totaled 102 percent of his taxable income, a measure that omits all exclusions, exemptions, and deductions. Using that reduced measure of income inflates Ross’s effective tax rate far above the share of his total income he paid in taxes.

Deeper into his column, Stewart explains that Ross’s tax bill was just 20 percent of his adjusted gross income (AGI), a more inclusive measure that does not subtract out exemptions and deductions. Because he took advantage of many preferences, Ross’s taxable income was only a fifth of his AGI, resulting in that inflated 102 percent tax rate. But even AGI doesn’t include all income. Among other things, it leaves out tax-exempt interest on municipal bonds, contributions to retirement accounts, and the earnings of those accounts. Ross almost surely paid less than 20 percent of his total income in taxes

Stewart’s article demonstrates the common confusion about effective tax rates, or ETRs. There are many ETRs, depending on which taxes you count and against what income you measure them. Including more taxes drives up ETRs. Using a broader measure of income drives them down. And interpreting what a specific ETR means requires a clear understanding of both the tax and income measures used.

In short, you need to be careful with both the numerator and the denominator when measuring someone’s tax rate. And you need to be doubly careful when comparing tax rates across individuals or groups.

TPC released a short report today that illustrates that point for taxpayers of different income levels. Rachel Johnson, Joe Rosenberg, and Bob Williams show how including different taxes and using different income measures (AGI versus a broader measure of cash income) can have big effects on ETRs.

As Bob concludes his blog post:

The bottom line is you can use these numbers to tell many different stories, some more valid than others, depending on the taxes you include and the income measure you use. The broadest measure of income provides the most meaningful gauge of the relative impact of taxes on households. Narrower measures can yield absurd results—James Ross didn’t pay 102 percent of his income in taxes—and ignore important differences in households’ ability to pay.

Capital Gains Taxes Are Going Up

The top tax rate on long-term capital gains is currently 15%. That’s why Mitt Romney is spending so much time talking about his tax returns.

That revelation has set off a familiar debate about whether that low rate is appropriate. Often overlooked in these discussions, however, is the fact that the days of the 15% tax rate are numbered. As of this posting, it has only 342 left.

On January 1, 2013, capital gains taxes are scheduled to go up sharply:

First, the 2001 and 2003 tax cuts are scheduled to expire. If that happens, the regular top rate on capital gains will rise to 20%. In addition, an obscure provision of the tax code, the limitation on itemized deductions, will return in full force. That provision, known as Pease, increases effective tax rates on high-income taxpayers by reducing the value of their itemized deductions. On net, it will add another 1.2 percentage points to the effective capital gains tax rate for high-income taxpayers.

And that’s not all. The health reform legislation enacted in 2010 imposed a new tax on the net investment income of high-income taxpayers, including capital gains. That adds another 3.8 percentage points to the tax rate.

Put it all together, and the top tax rate on capital gains is scheduled to increase from 15% today to 25% on January 1. That’s a big jump. If taxpayers really believe this will happen, expect a torrent of asset selling in November and December as wealthy taxpayers take final advantage of the lower rate.

Of course, the tax cuts might get extended for all Americans, including high-income taxpayers. That’s what happened in 2010. In that case, the increase in the capital gains rate will be smaller. Because of the health reform tax, the top capital gains tax rate will increase from 15% to 18.8%. That’s still a notable increase, but would likely set off much less tax-oriented selling this year.

The only way that the top capital gains tax rate remains at 15% will be if the tax cuts are extended for high-income taxpayers and the new health reform tax gets repealed. That’s a key distinction in the election: President Barack Obama opposes those steps, while the GOP presidential candidates favor them (and some candidates would cut the capital gains tax rate even further).

A Great Introduction to Economic Inequality

Over at the Browser, Sophie Roell interviews MIT economist Daron Acemoglu on the economics of inequality. In the course of discussing five books on the topic (one of which is actually a research paper), Acemoglu hits many of the high points — technology, skills, and education; the increase in income at the tippy-top of the wage distribution in the United States (and elsewhere); and the importance of politics, power, and rent-seeking.

Well worth your time.

Even More Expiring Provisions

Two follow ups on the nice Pew chart of many federal laws that expire at year-end.

First, commenter rjs reminds us that “the whole [darn] [continuing resolution] expires Friday.” In short, almost all discretionary agencies of the federal government run out of money at the end of the week. The one exception? Agriculture, whose 2012 appropriations managed to get enacted as part of the last continuing resolution. (Track the status of appropriations bill here.) Another CR will, I presume, pass later this week.

Second, reader JP points us to a new report by the Committee for a Responsible Federal Budget about the expiring provisions. They found a few more (e.g., some additional Medicare ones) and then toted up the costs for one-year extensions and ten-year extensions (except for the payroll tax cut and extended unemployment benefits):

Time’s Almost Up for $152 Billion in Expiring Provisions

America is increasingly governed by temporary policies. The 2001/2003/2010 tax cuts get most of the attention, but they are hardly the only ones. There are also a host of other semi-permanent provisions like patching the alternative minimum tax (AMT), avoiding big cuts to what Medicare pays doctors (the “doc fix”), and a plethora of miscellaneous tax cuts that get extended every year or two (the “extenders”).

And then there are the policies that really are supposed to be temporary, but likely won’t be retired until the economy strengthens. They include the 2% payroll tax holiday and extended unemployment insurance, both of which Congress is debating this week.

Over at the Pew Fiscal Analysis Initiative, Carla Uriona, Evan Potler, and Ernie Tedeschi have put together a nice infographic of all the provisions scheduled to expire at the end of the month. The 2001/2003/2010 tax cuts aren’t included, since they expire at the end of 2012, but there is still plenty of action:

In the near-term, the big money is in the payroll tax cut and unemployment insurance. Extending those provisions for one year would add about $164 billion to the deficit, not including interest costs. Over the next decade, however, the really big money among these provisions comes from patching the AMT ($690 billion) and the extenders ($356 billion). (Extending the 2001/2003/2010 tax cuts, in comparison, comes in around $4 trillion.)

Flat-tax Simplicity with a Progressive Twist

My latest column for the Christian Science Monitor. One of the perils of writing a monthly column is the multi-week lag between writing and publication. Rick Perry and Herman Cain were near the top of GOP contenders when I wrote this. Today? Not so much. But the ideas are still worth analysis. And Newt Gingrich is promoting a flat tax, although it hasn’t been a central part of his campaign thus far.

Tax reform has emerged as a key issue for GOP presidential hopefuls. Texas Gov. Rick Perry wants to scrap our current system and replace it with a 20 percent flat tax on individual and corporate incomes. Former Speaker of the House Newt Gingrich wants to do the same, but with even lower rates.

Then there’s pizza magnate Herman Cain. His “9-9-9” plan would replace today’s income and payroll taxes with a trio of levies: a 9 percent flat tax on individuals, another on businesses, and a 9 percent retail sales tax. But Mr. Cain’s ultimate vision is to eliminate anything remotely resembling today’s tax system in favor of a national retail sales tax, which proponents call the FairTax.

These three plans have much in common. Catchy names, for one. More important, they all focus on taxing consumption – what people spend – rather than income.

The flat tax is most famous, of course, for applying a single rate to all corporate earnings and to all individual earnings above some exemption. It’s also famous for allowing taxpayers to file their returns on a postcard by eliminating all the special deductions, credits, and other rules that complicate today’s tax code. (It also proved too radical for Governor Perry and Mr. Gingrich; their modified flat taxes keep some select deductions, including for charity and mortgage interest, and they also allow individuals to choose to remain in the current system.)

Equally important, however, is the way the flat tax handles investment income. Individuals would pay taxes on their labor income but not on capital gains, dividends, or interest.

That doesn’t mean capital income would escape taxation. Instead, the taxes would be collected at the business level. Businesses would pay taxes on all their income, regardless of whether it’s paid out as dividends or interest. They would also be allowed to write off the entire cost of new investments when they are made.

The net result of these rules is that people would be taxed only to the extent that they consume. In the words of Robert Hall and Alvin Rabushka, the economists who invented the flat tax 30 years ago, “people are taxed on what they take out of the economy, not on what they put in.”

The flat tax is thus a very close cousin to the FairTax and other retail sales taxes (which many Republicans like) and to value-added taxes (which they don’t). The logistics differ: A sales tax is collected on retail purchases, a VAT from businesses at each stage of the supply chain, and a flat tax from individuals and businesses. But the underlying economics work out the same: People get taxed only on their consumption.

There are good reasons to favor a simpler tax system that emphasizes taxes on consumption over income. Some policy experts across the political spectrum embrace exactly that approach to tax reform. But all these plans would be much less progressive than our current income tax, and that’s neither appropriate nor politically viable.

What we need are tax-reform proposals that would maintain progressivity while harvesting many of the benefits of simplicity and consumption taxation. The late Princeton economist David Bradford offered one simple approach: Add progressive rates to a flat tax. Columbia Law School Prof. Michael Graetz offered another: Pair a broad-based VAT with an income tax for folks with high incomes. These ideas might not have much traction among GOP primary voters. But they offer a much better starting point for reform than the plans on the table today.