Tag: Taxes

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).

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.)

Sign Your Tax Return in Blue Ink

Esther and I got a scary piece of mail yesterday. The fine folks at the Internal Revenue Service sent our entire tax return back to us. Minus the accompanying check, of course.

A cover sheet said we had failed to sign the return, which we filed on a timely basis in October.

That sounds easy to fix, except for one thing: we did sign the return. If you turn to the second page of the return where it says “SIGN HERE,” you will see fine examples of both of our signatures. (You’ll just have to trust me on this – somehow I don’t feel like posting a scanned image of our tax return.)

So what happened? Our best guess, echoed by several others, is that the IRS thinks one of our signatures is photocopied.

They are not. Esther and I make a point of signing the tax form together. But this year we used a fine black pen (the Uniball Deluxe Micro, usually highly-recommended). It’s an excellent writing instrument but, to be fair to the IRS, the resulting signatures could be mistaken as photocopied. (Dear IRS: It would be nice if you mentioned this on the cover sheet.)

But, let me repeat again, they are not. Our signatures are originals. Part of me is tempted to go all CSI and find a lab to confirm that. But I think we will settle for a friendly note to the IRS.

And we will sign the returns again, this time in blue ink. Maybe with a Paper Mate Flair.

What Should We Do With Higher Gas Tax Revenues?

Most of the economics bloggers I know favor higher gasoline taxes. Not immediately, of course, given our economic weakness. But eventually because of environmental and national security concerns.

As noted yesterday, Tim Kane of the Kauffman Foundation does a quarterly survey of economics bloggers. This time around, Tim included a question from me about the federal gas tax. Specifically, what would economics bloggers do with the money from a higher gasoline tax? (While allowing for the possibility that some don’t want it to go up.)

Here are their responses:

(Note: The federal gas tax is 18.4 cents per gallon; state gas taxes average another 30 cents, according to the American Petroleum Institute.)

As Tim notes in the full survey, “bloggers seem to love the gas tax.” Almost 85% of respondents supported a higher gasoline tax of which fully half would use the money for infrastructure spending. The remainder would use the money for deficit reduction or to reduce other taxes.

Happy Anniversary, Tax Reform

Twenty-five years ago today, President Ronald Reagan signed the Tax Reform Act of 1986 into law.

Happy silver anniversary, tax reform!

Over at the Tax Policy Center, Len Burman and Gene Steuerle, both Treasury staffers at the time, and Howard Gleckman, who covered the proceedings for BusinessWeek, offer personal reflections on how TRA86 happened and what that means for today’s efforts.

Gene offers a recipe for increasing the odds of productive tax reform:

If there is any lesson from TRA86, it is that  real reform requires channeling forces and information in the right  direction.

Put more broadly, it isn’t helpful to  try to recreate  historical circumstances to get the same outcome.   It is far more useful to understand how to  convert luck into serendipity to increase the odds that good things will happen.

In a recent testimony and a Tax Notes article, I outlined ten steps that increased the chances of reform in 1986 and for the most part are repeatable today.  These include;  seize today’s, not yesterday’s opportunities; rely on principles like equal justice under the law to determine what should be done; make reform comprehensive, in part, because the political cost is likely to be the same in any case; shift the burden of proof to those opposing the better system; form liberal-conservative coalitions in areas where both sides can gain something;  plan strategies in advance for  how to best present the proposals and their effects  to the public; empower nonpartisan staffs like Treasury’s Office of Tax Policy and the Joint Committee on Taxation (who really assembled the ’86  reform); establish leadership on a variety of fronts;  insure accountability so that very specific political leaders bear a significant cost if reform fails; and empower someone to run with the ball and strategize on how to make reform happen.

In 1984 through 1986, much of the political leadership came late to  the game.  And some of the lessons of 1986  were learned, not planned. For example, one key to passage was that at each step in the process, first Treasury Secretary Don Regan, then House Ways & Means Committee Chair Dan Rostenkowski, and finally Senate Finance Committee Chair Bob Packwood feared they would be blamed if the bill failed. As a result, each worked extremely hard to  make sure that tax reform did not die on their watch.

Len agrees on the need, but is feeling a bit more gloomy:

Tax reform has never been more necessary, it’s hard to see a solution to our budget problems without it, and it’s just impossible.

And Howard points to the president–whoever that might be–as the key to the Tax Reform Act of 2013:

Tax reform will make nearly everyone mad. Big-bucks subsidies will be slashed or killed. Political demagoguery will run wild. The Reagan Administration saw that reform would only work if it began with a very specific plan that the White House owned. And President Reagan eventually became its best salesman. My Tax Policy Center colleague Gene Steuerle—who helped write TRA 86—always says the secret to success in Washington is writing the first draft. Put it this way: President Obama’s health reform strategy, which left the dirty work to Congress, is not the way to go.

Taxes and Energy Policy

Last week I had the opportunity to testify before two Ways and Means subcommittees–Select Revenue Measures and Oversight–about the way our tax system is used as a tool of energy policy. Here are my opening remarks. You can find my full testimony here.

As you know, our tax system is desperately in need of reform. It’s needlessly complex, economically harmful, and often unfair. Because of a plethora of temporary tax cuts, it’s also increasingly unpredictable.

We can and should do better.

The most promising path to reform is to reexamine the many tax preferences in our code. For decades, lawmakers have used the tax system not only to raise revenues to pay for government activities, but also to pursue a broad range of social and economic policies. These policies touch many aspects of life, including health insurance, home ownership, retirement saving, and the topic of today’s hearing, energy production and use.

These preferences often support important policy goals, but they have a downside. They narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates to be higher than they otherwise would be, and are often unfair. Those concerns have prompted policymakers and analysts across the political spectrum—including, most notably, the Bowles-Simpson commission—to recommend that tax preferences be cut back. The resulting revenue could then be used to lower tax rates, reduce future deficits, or some combination of the two.

In considering such proposals, lawmakers should consider how tax reform, fiscal concerns, and energy policy interact.  Six factors are particularly important.

  • Our tax system needs a fundamental overhaul. Every tax provision, including those related to energy, deserves close scrutiny to determine whether its benefits exceed its costs. Such a review will reveal that many tax preferences should be reduced, redesigned, or eliminated.
  • The code includes numerous energy tax preferences. The Treasury Department, for example, recently identified 25 types of energy preferences worth about $16 billion in 2011. These include incentives for renewable energy sources, traditional fossil fuel sources, and energy efficiency. In addition, energy companies are also eligible for several tax preferences that are available more broadly, such as the domestic production credit.
  • Tax subsidies are an imperfect way of pursuing energy and environmental policy goals. Such subsidies do encourage greater use of targeted energy resources. But, as I discuss in greater detail in my written testimony, they do so in an economically wasteful manner. Subsidies require, for example, that the government play a substantial role in picking winners and losers among energy technologies. The associated revenue losses also require higher taxes or larger deficits.
  • A key political challenge for reform is that energy tax subsidies are often viewed as tax cuts. It makes more sense, however, to view them as spending through the tax code. Reducing such subsidies would make the government smaller even though tax revenues, as conventionally measured, would increase.
  • Tax subsidies are not created equal. Production incentives reward businesses for producing desired energy and are agnostic about what mix of capital, labor, and materials firms use to accomplish that. Investment incentives, in contrast, reward businesses merely for making qualifying investments and encourage firms to use relatively more capital than labor. For both reasons, production incentives tend to be more efficient than investment incentives.
  • Well-designed taxes can typically address the negative effects of energy use more effectively and at lower cost than can tax subsidies. I understand that higher gasoline taxes or a new carbon tax are not popular ideas in many circles, but please bear with me. As I explain at length in my written testimony, well-designed energy taxes are a much more pro-market way of addressing energy concerns than are tax subsidies. Taxes take full advantage of market forces and, in so doing, can accomplish policy goals at least cost and with minimal government intervention. Subsidies, in contrast, make much less use of market forces and inevitably require the government to pick winners and losers. Energy taxes also generate revenue that lawmakers can use to cut other taxes or to reduce deficits.

P.S. Not surprisingly, that last point wasn’t picked up by anyone else, at least during my panel (one of three at the hearing). New energy taxes would, of course, be problematic for the macroeconomy if enacted immediately. And we’d have to make some adjustment, either in the tax code or in benefit programs, to offset the impact on low-income families. In the long-run, however, I think that would be a much better way to address many energy concerns, including carbon emissions and oil dependence. But that’s not the way our system works. Instead, as noted, it’s much more popular to use tax preferences, whose benefits are visible and whose costs are obscure, to pursue energy and environmental goals. Other participants discussed the particular incentives, existing and proposed, in greater detail; their testimony is available here.