Save the Tax Code, Save the Country

Save the Tax Code, Save the Country 

This week’s Ways and Means hearing adds to the growing conversation focused on “what comes next” for the tax code. Like the residents of a dying planet, the DC tax crowd appears to instinctively understand that something big needs to change if we’re going to survive the decade.

Rumor has it that the hearing was a promise then-Speaker McCarthy made to the Freedom Caucus in exchange for their support of a past effort.  The challenge is consumption taxes – the focus of Wednesday’s hearing – are problematic for everybody. On the left, their center of gravity has moved so far that older ideas like the Cardin sales tax or European VAT taxes now fall into the category of unmentionables.  Meanwhile, conservatives distrust consumption taxes because they raise lots of money and would be additive, not replicative, of the income tax.

That said, as our fiscal outlook continues to deteriorate, we expect to see more talk of tax reform, and frankly we endorse the trend fully. The federal budget will not survive the coming fiscal cliff and pending Social Security bankruptcy without a complete overhaul, and the sooner we get started the sooner the healing can begin. What does reform look like? Maybe not consumption taxes, but there are lots of good ideas out there.  In a previous post, we analyzed some of those ideas.  This week, we put forward some thoughts of our own.

Simplification

You hear lots about simplification in tax reform conversations, but much of the talk is directed at the wrong targets.  For example, tax writers like to brag about the number of tax brackets they’d eliminate, but are tax brackets really that complex?  Does anybody really sweat the fact that we have six brackets as opposed to two or three?  Not really.

But what about tax codes?  We have lots of those and eliminating some of them would offer meaningful simplification.  Exactly how many tax codes do we have, how many do we need, and how many can we eliminate?  If you define a tax code as a distinct set of rates applied to a distinct tax base, then we have at least seven tax codes at the federal level:

• Income
• Dividends
• Capital Gains
• Payroll
• NIIT
• Estate
• AMT

Seven!  That’s too many.  And unlike brackets, taxing the same income multiple times really does contribute to complexity.  The more layers, the more taxpayers change their behavior to avoid them.  And like drug interactions, there’s no way to ensure the net result is not hurting the very thing you’re trying to help.

For example, prior to the TCJA, the income tax allowed businesses to expense research costs.  But the Alternative Minimum Tax disallowed the R&E expensing, so business owners who finance research would often learn, after the fact, that they don’t qualify for the deduction. That was just stupid and it undermined the whole point. To its credit, the TCJA greatly reduced the AMT, but it also eliminated full expensing for R&E. Whoops.

The estate tax is another needless complication.  Advocates argue the estate tax raises needed revenue while reducing income inequality, but it does neither. On the other hand, as a direct tax on capital, it does hurt investment. It also hurts family businesses, who are subject to the estate tax, relative to public companies who are not. And it’s simply bad policy. Taxpayers don’t know when the tax will be due nor do they know how much will be owed. Finally, it’s just mean (let’s tax the crap out of somebody when their relative dies).

Under the best of circumstances, the estate tax drains capital and time from family businesses.  At worst, it results in wasted tax planning that gets discarded as the facts change on the ground.  A simple swap would be to tax the capital gains when the assets are sold.  Such an approach would be more humane and it would eliminate the uncertainty and planning expenses of the estate tax. It might also increase revenue.

The bottom line is real reform would eliminate the number of tax codes we have, eliminate all this waste and uncertainty, and focus instead on collecting the revenues we need as efficiently as possible.

Tax Code Integration

Reducing the layers of tax should be another priority. Income should be taxed once and only once, not two or three times like it is now.  The worst example is how we tax C corporations.  Corporate income is taxed at the business level, and then again when it is distributed to the shareholders. Economic literature is rife with examples of how this double tax reduces hiring and investment by altering taxpayer behavior.  Corporate executives rely on stock buybacks rather than dividends to avoid the double tax while shareholders forgo or delay selling shares for the same reason.  People behave differently and, as a result, the economy suffers.

The recent focus on cutting the corporate rate has increased, not reduced, this distortion. When the corporate tax was 35 percent and the dividends tax was just 15 percent, the relative penalty for paying taxable dividends and capital gains was low.  Today, the corporate rate is 21 percent but the dividend/capital gains rate is 23.8 percent. The penalty for paying out profits now exceeds the initial corporate tax. The result is more taxpayers are using the corporate structure to shelter their income.

Real tax reform would eliminate the double tax on corporate profits and tax all business income once, when it is earned.

A Single, Reasonable Top Rate    

Another complexity is the practice of taxing different forms of income at different rates. In the 1950s, individuals were taxed at rates up to 91 percent while C corporations were taxed at about half that much. In response, wealthy taxpayers paid themselves lower salaries and kept the bulk of their income imbedded in the corporation.

They would push personal costs into the corporation too.  Back then, the IRS was kept busy disallowing “business” expenses such as cars, boats, vacations and apartments.

After the Tax Reform Act of 1986 reduced and largely equalized the top income tax rates, the gaming stopped and taxpayers shifted their focus to making business decisions, not tax decisions.

Real reform would restore this parity so that income would be taxed only once and at a reasonable top rate that applied to all forms of income.

Progressivity

Another challenge is progressivity.  Most people agree wealthy Americans should pay more than lower-income Americans.  But the concept of progressivity fails to define exactly how much.

For example, by most measures, our current tax code is highly progressive, with wealthy Americans paying many times more than their middle-income neighbors, and infinitely more than the poor (you can’t divide by zero).  Despite this, most plans call for making the tax code even more progressive.  How much more?  They don’t say. Just more.

This emphasis on taxing the rich has less to do with raising revenue and more about leveling incomes, so that the wealthiest earn no more than a specified amount more than the poor. But if these policies are successful, who will we tax to pay for government?

More to the point, these policies are never successful. Our tax history is ripe with failed efforts to “tax the rich.”  The 1991 Bush tax hikes imposed a 10-percent “luxury” tax on expensive cars, boats and jewelry.  The tax was quickly repealed after it became apparent the rich had stopped buying expensive cars, boats, and jewelry. Meanwhile, tens of thousands of workers lost their jobs as entire industries disappeared. The New York Times quoted one displaced boat builder as saying, “You had to be an ignoramus to believe the luxury tax was only going to soak the rich.  The only people it hurt was working people like myself.”

Soaking the rich is a policy dead end – inevitably it’s the middle class that ends up getting soaked – and progressivity offers little guidance on exactly how much the wealthy should pay.  Always more is not an operational metric.

We need a different measuring stick. What about proportionality?  Under proportionality, a taxpayer earning ten times more than another would owe ten times the tax.  That seems reasonable, but it will never fly.  The current code already applies a degree of progressivity that goes well beyond proportionality. What about two times proportionality or three times?  We don’t have a specific number in mind but something concrete, measurable, and achievable is needed to ensure the wealthy pay a fair amount of tax while at the same time acting as constraint on the insatiable desire of some for more revenue.

Economic Growth

Finally, a goal for tax reform should be economic growth. To some, that means cutting marginal rates as low as possible and encouraging investment and/or by reducing taxes on workers to increase their after-tax income.

Low rates are great, but focusing on marginal tax rates to the exclusion of effective tax rates is a mistake.  What’s the difference?  Marginal rates measure the tax imposed on the last dollar a taxpayer earns, whereas effective rates measure the total tax they pay on all their income, divided by their income.

So it’s possible to have a tax code with really high marginal rates but really low effective tax rates. That’s literally what we had in the 1950s and 1960s. Those policies hurt economic growth by dramatically altering taxpayer behavior – nobody purposefully earned income above the 91-percent threshold — so little tax was collected at that rate.  The net result was really high marginal rates, but really low effective ones.

The opposite example would be where rates stay low, but the tax code imposes so many layers that the result is a high effective tax that applies unevenly throughout the economy. That’s the code we have now, where lots of income goes untaxed while its neighbor is taxed two or three times.

The best balance is where marginal and effective rates converge, so that the delta between the tax on the last dollar earned and the average tax is as close as possible. We don’t have that now, but we should. Properly constructed, tax reform would impose similar marginal and effective rates on the economy across all industries.

Summary

The tax reform conversation is heating up, but so far it’s been missing the elements necessary to ensure success. This post highlights the elements we think should be included in the next big tax reform bill. In our next post, S-Corp will put forward our own ideas on how Congress can reform the code, raise the necessary revenue, and save the country.

In the past, our mantra was “S Corps for Everybody!” Our new mantra is “Save the Tax Code, Save the Country.”  It’s time for Congress to be a hero. Tee shirts to follow.