Certain Tax Increases and Fixes Needed for Equity and Fairness

Tax reform discussions in Congress for the week of October 17 have included possibly not including tax increases. Are taxes too high already? Perhaps. But they are also quite uneven in their application.  Here are a few examples:

• Vastly different rates exist for capital gain versus ordinary income for very high income individuals. A wage earner with over $400,000 of earned income will enter a 37% marginal rate today (39.6% after 2025). In contrast, a person with capital gain and dividend income will be in a marginal rate of 23.8%. This is a frequent question I get from both students and practitioners - why are capital gains taxed lower than ordinary income. There are reasons, but I don't think it supports a difference once income passes the $500,000 level.* Tax it all the same after some high level such as $400,000 or more.  And that high income wage earner will have 2.9% Medicare tax on income above $147,000 (figure for 2022) and an additional 0.9% on income above $200,000 ($250,000 if MFJ).  So a capital gain rate of 37% (or 39.6% once AGI exceeds $1 million as President Biden proposes (see page 8 of this table)), causes the high wage earner and high capital gain recipient to both be at a marginal rate of 43.4%. Note that I am only talking about very high income individuals (less than half of the top 1% of individuals).
  
  Yet, 43.4% is a high rate. I think it would be good to include with Biden's plan, repeal of the extra 3.8% net investment income tax (NIIT) which would also simplify the tax system.  That though would cause the wage earner to still be paying an extra 2.9% on all of their wage income, so perhaps add that to the high capital gain person. Or, keep the top rate at 37% + the 2.9% extra to equalize the high wage earner and high capital gain person. Or even a lower rate could be used along with reduction in some of the tax breaks for high income individuals, such as capping the tax benefit of itemized deductions and exclusions at 28%.
  
  We are talking about far fewer than 1% of individuals. But these few thousands of individuals have lots of income which for some is in the hundreds of millions of dollars annually.
  
  
• A big income tax break for those who die with millions or billions of gains (and their heirs). Tax reform should include a provision to tax all income including gains that exist at date of death for those with assets above a specified amount. Biden uses $1 million (see page 8 of this table). If that were $3 million, there would be far fewer affected by the tax or some of the complexity.  And a good portion of this untaxed income today are appreciated stock gains of multi-billionaires such as Zuckerberg, Musk and Bezos. I think few people can justify why their unrealized gains should disappear and never be taxed under our current income tax system. President Biden's proposal with backstops to prevent having to sell a family business to pay the tax should be discussed in Congress. While that is a tax increase compared to today's system of letting these gains be untaxed, it should be viewed as fixing a longstanding, inequitable flaw in the system.**
  
  
• Tax breaks are worth a lot more to high income taxpayers. Let's raise taxes by reducing some tax breaks that don't make sense and are inequitable. Today, less than 10% claim a mortgage interest deduction. Perhaps this is the time to repeal this tax subsidy that primarily helps a higher income person buy a more expensive home. Reduce the exclusion for employer provided health insurance. Perhaps make some percentage of it taxable with that percentage higher as income goes up. This subsidy benefits about 65% of employees and reduces tax collections by about $200 billion annually. 
  
  And let's rationalize tax deductions. In a personal income tax, deductions should be allowed to remove some income from taxation (standard deduction and personal exemptions enable this) and for the costs of generating income.  And some would argue that the state and local income tax should also be deductible as that money is not available to pay federal taxes (but note that states don't allow a deduction for federal taxes) [see my 2008 article on reasons for and against state tax deduction]. But, some taxes are more in the voluntary category. For example, personal property taxes on more than one vehicle per person. And real property taxes on more than one home and when that home exceeds the median home value in the region.  Tax reform should include discussion of all these tax reductions (credits, exclusions and deductions) to be sure they make sense and are not providing breaks to people who don't need them or much larger ones to the highest income individuals.

#letsfixthis

What do you think?

*I'll cover pros and cons of lower taxes on capital gain income in my blog post for November 23, 2021 which is the 100th anniversary of the Revenue Act of 1921 that created a preference for capital gain income.

**There is a good deal of support for taxing gains at date of death and removing this odd and very large exclusion, usually with some threshold, such as President Biden's $1 million of assets per decedent.  That likely should be $2 or $3 million to be sure step up repeal is aimed at those holding the types of assets that might great appreciate providing significant income tax breaks to multimillionaires and multibillionaires. Think about the founder's stock that several billionaires have.

One of the founders of Facebook, Chris Hughes, a multimillionaire and author of Fair Shot, explaining and supporting universal basic income (UBI) states in this book: "we should adjust our tax code so that the wealthy ay the same tax rates on their investment income as hardworking Americans do on their wages. ... Second, we should cap deductions at 28 percent for the wealthiest Americans and close tax loopholes, like the one that allows for the gains on inherited assets to be be excluded from taxable income."

Also see a March 2021 press release from Senator Van Hollen and others on the rationale for eliminating the tax exclusion of gains at date of death and letting heirs get the assets at FMV.

Also see my September 2020 op ed in The Hill on not using a wealth tax to generate revenue but fixing the big leaks and inequities in our income tax.

New York Times Tax Reform Suggestions

A December 29, 2012 editorial in the New York Times, part of a series of suggestions for President Obama for his second term, makes the following recommendations.

• Tax capital gains at the ordinary income tax rates. They note that the top 1% receive 70% of capital gains while the bottom 80% receive just 6%. Thus, they argue, taxing capital gains at 15% or 20% is "an indefensible giveaway to the richest Americans."
• Cap the benefit of deductions for individuals at 28% or convert them to tax credits.
• Higher rates on individuals with income over $1 million.
• Restore the estate tax (presumably at the 55% rate scheduled to return on 1/1/13).
• Higher corporate tax rates.
• No more deferral of tax for US companies for income earned abroad (presumably they mean by subsidiaries).
• The Treasury Department should "start work on tax reform now" including consideration of a carbon tax, VAT and financial transactions tax.

That is quite a list!

The editorial board notes that our current system is not bringing in enough revenues to cover spending and investment so new revenues are needed.

I have a few comments to offer:

1. Yes, tax reform is needed but not exactly for the reasons noted. The key reason for reform should be that our current system does not meet principles of good tax policy or fully recognize that we are operating in an information-age, global economy. Our tax system has grown complex by the addition of over 100 items after the Tax Reform Act of 1986 and has too many provisions that are temporary and often expired awaiting what often becomes retroactive renewal.  Our tax system is not equitable. Significant deductions and exclusions provide significantly larger benefits to those in higher brackets. There are too many special rules that benefit just a few companies or industries. We have a $450 billion annual tax gap.
2. We have spending problems.  One big one is that significant borrowing, particularly in the past few years has greatly increased the country's interest expense obligations. The GAO has issued a few reports pointing out over 100 areas where there is "evidence of duplication, overlap, or fragmentation among federal government programs." There is significant waste and inefficiencies in the medical care system with much of that paid for by the government (we hear about this often; I have seen this first hand lately with my 80-year old mother who now lives near me). AND, we have significant spending problems in our tax system with its $1.1 trillion dollars of annual tax expenditures (see page 28 of the Deficit Commission's 2010 report). If these could instead be relabeled as direct spending in the appropriate agency's budget, it would likely be easier to get rid of them.  For example, I think that if the HUD budget had a line item - "Subsidy to middle-to upper income individuals to pay mortgage interest on vacation homes," the mortgage interest deduction for second homes would be gone. That is just one example.  But all tax expenditures (special deductions, exclusions, credits and special rates not crucial to the design of an income tax) should be examined to see if they are serving a legitimate purpose, can be improved to better meet equity and simplicity goals, or can be eliminated in exchange for a lowered rate.
3. There are some reasons to tax capital gains at lower rates, particularly long-term capital gains. For example, some portion of a long-term capital gain does represent inflation. But treating all gains on assets held over one year at the same lower rate doesn't make sense. And, the lowered capital gains rate is not tied to inflation. So that theory doesn't work well with the current system. With the Tax Reform Act of 1986, the top rate for both ordinary and capital gain income was 28%.  We managed to live with that. I think there are a variety of reforms needed for capital gains. Certainly, they should not be taxed at rate lower than the payroll tax rate for employees and self-employed (15.3% (other than in 2011 and 2012)) + the lowest individual tax rate.  Why not use an inflation factor rather than a flat lower rate?
4. Given that other countries have lower corporate income tax rates and we are in a very competitive global marketplace, we should not increase the corporate tax rate. We should further examine how to modernize our business tax system (not just corporate tax system) for our new economy.
5. Yes, let's look at a VAT and see if it is something that states could join in on to help modernize their out-dated sales tax systems. The VAT might help with other federal issues. After all, almost all other countries have a VAT and that is likely how OECD countries help funded a lower corporate tax rate (by increasing the VAT rate).
6. Yes, let's look at a carbon tax as a polluter-pays tax to help reduce greenhouse gas emissions. We should see if this needs to be a separate tax or can be accomplished with a higher gasoline excise tax and some type of tax on other fossil fuels and other sources of GHG.
7. We should also be exploring how technology can improve tax compliance.
8. Starting point - let's articulate our economic, societal and environmental goals. Then let's see how our current taxes may work counter to those goals. That would help us in identifying problems along with evaluating our current rules against principles of good tax policy.

What do you think?