No Gimmicks, No Shenanigans
Our present tax system presents many tempting opportunities for tax avoidance, particularly for high earners and businesses. Some types of income are taxed more lightly than others, and this creates both inefficiencies and avenues for tax avoidance, eroding the tax base and raising the relative burden on other taxpayers. Indeed, the famous investor and third richest man in the world, Warren Buffett, has drawn attention to this problem, lamenting the fact that his secretary pays a higher tax rate than he does (see box on p. 249).
Innovative Ways to Help American Workers through the Tax System
Some have suggested other innovative ways to help the tax system adjust to changes in the world economy. For instance, Burman, Shiller, Leiserson, and Rohaly have suggested a “rising-tide” tax system, where the tax brackets of the income tax would automatically adjust in response to changes in the nationwide income distribution, to counter increases in income inequality.1
Leonard Burman has also suggested a reform that would couple a negative income tax, at a rate of 100 percent on the first $14,000 of earnings, with a new revenue source in the form of a value-added tax (VAT). This would be a strongly progressive change for those in the lower parts of the income distribution. Over time, the proposal indexes the amount of income subject to the tax benefit (the $14,000) to GDP increases. This ensures that economic growth automatically increases the tax benefit, sharing the benefits of growth more widely.2
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1. Leonard E. Burman, Robert J. Shiller, Gregory Leiserson, and Jeffery Rohaly, “The Rising Tide Tax System: Indexing the Tax System for Changes in Inequality,” Tax Policy Center, 2006.
2. Leonard E. Burman, “A Tax Credit to Give Middle-Class Workers a Raise,” Tax Policy Center, August 2, 2017.
Here I suggest a simple tax reform that would tax all income of top taxpayers at the same rate, regardless of source. Importantly, labor income and capital income would face the same top tax rate, so there would be no distortion favoring capital income over labor income. There would also be no incentive to mischaracterize labor income as capital income to reduce tax burdens, so the wastefulness of our tax planning industry would be curtailed.
At present, capital gains (the difference between the selling price of a capital asset and its original cost) and dividends (issued by corporations to shareholders) receive generous tax preferences relative to labor income, with top capital gains and dividend tax rates of 20 percent (or 23.8 percent including the net investment income tax). These tax rates are about half the top rate on labor income, 39.6 percent. (The TCJA temporarily lowers the top rate to 37 percent from 2018 to 2025.)
Several tax preferences make capital gains tax burdens even lower than these tax rates reflect. Income from capital gains has the benefit of tax-free deferral; you do not pay tax on capital gains until the asset is sold, and gains grow tax-free in the meantime. Second, some capital gains escape taxation entirely, since the capital gain is zeroed out when a capital asset is inherited at death. (This is referred to as a step-up in basis. The new “cost” of the asset becomes its market value when the asset is transferred.) Third, capital income held in tax-free retirement accounts is untaxed, as is capital income in tax-free college savings accounts. Finally, capital gains in the form of real estate appreciation often go untaxed as well, since the first $250,000 or $500,000 of home sales capital gains are excluded from tax, depending on filing status.
Warren Buffett on Tax Policy
Warren Buffett is known for his brilliant investing, his philanthropy, and a tax policy idea that bears his name. The Buffett Rule is simple: raise effective tax rates on households making more than one million, raise them even higher for households making ten million or more, and cut employee contributions to the payroll tax. In 2012, the US Senate considered a bill inspired by these principles; it would have required taxpayers earning over a million dollars to pay income taxes of at least 30 percent. Buffett himself faced a rate of only 17.4 percent in 2010.
Tax rates on the wealthy are often low because investment is a much higher proportion of top incomes, and capital income is taxed at highly favorable rates. (Payroll taxes also do not apply above a certain cap.) Yet moves to increase tax rates on investment income are frequently met by claims that higher rates will discourage investment. Buffett’s response is a verbal eye-roll: “I have worked with investors for 60 years and have yet to see anyone … shy away from a sensible investment because of the tax rate on the potential gain.”1 The plan is popular with the American public. A CNN survey about the Buffett-inspired legislation found 72 percent of respondents in favor of its adoption.
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1. Warren E. Buffett, “Stop Coddling the Super-Rich,” New York Times, August 14, 2011.
Following the Tax Reform Act of 1986, capital and labor income were taxed uniformly, at the same top rate. Lighter taxation of capital income is difficult to justify. For example, capital income is much more concentrated in the hands of the rich than labor income; the top 5 percent of taxpayers earn 37 percent of all income (including both labor and capital), but a whopping 68 percent of dividend income and 87 percent of long-term capital gains income.3
Also, there is little efficiency rationale for lighter tax burdens on capital income. Modern economic theory suggests that the optimal burden on capital income is likely at least as high as that on labor income, especially if we account for the fact that much of capital income may be “excess” profits due to monopoly power.4
Business income should be also be taxed similarly regardless of what form it takes. For example, corporate and noncorporate businesses should be treated similarly for tax purposes.5 The treatment of debt-financed and equity-financed investments should also be harmonized.6
Business taxes also need updating for today’s global economy, to help governments tax business incomes despite the increasing mobility of the business tax base. Business income should be treated the same regardless of where it is booked.7 At present, we have a large profit shifting problem, as multinational corporations move their profits to tax havens, sometimes creating “stateless income” that goes untaxed by any jurisdiction. In recent years, this problem has cost the US federal government more than $100 billion a year, and tax revenues lost due to profit shifting have increased substantially over the previous two decades.8
Our corporate tax system can be modernized to better suit the reality of the world economy. There are simple reforms that would be highly effective at curtailing profit shifting. In the spirit of taxing all income at the same rate, I suggest simply taxing foreign income currently at the same rate as domestic income, allowing a foreign tax credit to avoid double-taxation when such income is taxed abroad. While some worry that this reform would encourage corporations to incorporate abroad, or undertake corporate inversions, there are easy legislative solutions to this concern.9 In Chapter 7, I also discuss some other, more fundamental corporate tax reform options that would address this problem.10
At what tax rate should high-income taxpayers and businesses be taxed? Of course, this depends on the revenue needs of the country. But, by taxing all forms of income at the same rate, there will be greater revenue at any choice of top tax rates, since revenue will not leak out as taxpayers shift their income into tax-favored forms. This should keep top tax rates lower than they would be in the counterfactual.
Just How Special Are Tax Havens?
By almost any plausible metric, the affiliates of multinational firms book too much income in tax havens, relative to the true economic activity that occurs there. In 2010, affiliates of US multinational firms reported profits in Bermuda that were sixteen times the size of the entire Bermuda economy, and reported profits in the Cayman Islands that were twenty times the size of that economy.1 US multinational firms have accumulated over $2.6 trillion in permanently reinvested earnings in low-tax locations, over $1 trillion of which is held in cash. Seven tax havens are res
ponsible for over half the foreign profits of US multinational firms, and these seven havens have a combined population that is less than that of California. I estimate that most of the income booked in these tax havens is there artificially; absent profit shifting, reported profits would be much lower in tax havens and much higher in non-havens.2
Figure 10.3: Seven Key Profit Shifting Locations of US Multinational Companies
Note: Figure shows results of data analysis of the underlying BEA data from Kimberly Clausing, “The Effect of Profit Shifting on the Corporate Tax Base in the United States and Beyond,” National Tax Journal 69:4 (2016), 905–934. Data source: US Bureau of Economic Analysis.
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1. Even these figures underestimate the size of the problem, since tax haven GDPs are also distorted upwards by artificial profit shifting.
2. Clausing, “The Effect of Profit Shifting.”
Taxing Death or Taxing Patrimonial Capitalism? The Estate Tax
Prior to the TCJA, the federal estate tax applied to the portion of estates that are in excess of about $5.5 million; any estate worth less than the threshold amount is untaxed. The TCJA temporarily increases that threshold to $11 million for the period 2018 to 2025.
The federal estate tax generates significant tax revenue, but 99.8 percent of estates were tax exempt. (Even more estates will be tax exempt from 2018 to 2025.) There is little risk to family businesses from the tax; of the 5,200 estates taxed in 2017, estimates show that only about fifty include small farms and businesses, and they typically owe less than 6 percent of their value.1
The estate tax’s top rate is 40 percent, but effective rates are often significantly lower due to loopholes and exemptions. Furthermore, capital gains (on assets like real estate or stock) go untaxed upon death. Any increase in the value of a capital gain over the course of its owner’s life is ignored when capital assets are given to descendants. These unrealized capital gains are 56 percent of the value of estates over $10 million. Many have suggested reforming estate taxation to eliminate this “step-up” in basis at death, preventing capital gains from escaping taxation.
Opponents of the estate tax argue that it is unfair to tax death, and the estate tax deters the incentive to save to leave bequests. It is important to note, however, that receiving an inheritance, or anticipating an inheritance, can also deter savings and work by heirs. More important, an estate tax can limit the passing of inherited wealth across generations, reducing the economic power of dynastic families living solely off the work effort of prior generations and investment returns. A robust estate tax helps counter the worries of patrimonial capitalism raised in Thomas Piketty’s best-selling book, Capital in the Twenty-First Century. The masterful data collection efforts of this book documented worrisome trends in the role of capital in the economy.2 Left unchecked, high capital-to-income ratios risk creating societies where wealth and political power are too concentrated.
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1. Center on Budget and Policy Priorities, “Policy Basics: The Estate Tax,” Report, August 14, 2017.
2. Thomas Piketty, Capital in the Twentyb-First Century (Cambridge, MA: Belknap Press of Harvard University Press, 2014).
Saving the Planet: An Essential Part of the Grand Bargain
Economic inequality and middle-class stagnation are the essential economic problems of our time. But a larger concern, beyond economics, is the problem of climate change, which threatens the future of humanity if left unchecked. Even if climate change is slowed, the world will suffer from substantial costs associated with damage and mitigation efforts.11
Without government intervention, the market provides little incentive to solve this problem, as individuals and businesses have no reason (aside from public-spiritedness) to consider the spillover effects of their actions on the planet as a whole. For most people, decisions about where to fly, what car to buy, and where and how to live are usually made on the basis of other factors.
A carbon tax is perhaps the most wonderful economic policy of them all. Economists of all political stripes offer full-throated endorsements of carbon taxation for three reasons. First, a carbon tax helps save the planet. By making the use of carbon more expensive, it creates an incentive for people to conserve on their carbon use. Everyday decisions about how warm to heat the house, whether to drive or walk to the store, and whether to fly to see a cousin’s wedding are profoundly influenced by prices; the more expensive it is to generate carbon dioxide emissions, the less people will chose to generate them.
More expensive carbon also encourages businesses to reduce the carbon footprint of their products, since doing so reduces carbon-tax inclusive energy costs. There is a built-in incentive to make products more energy-efficient. As a consequence, cumbersome regulations like the corporate average fuel economy (CAFE) standards would be unnecessary; both automakers and consumers would already have strong economic incentives to choose fuel-efficient cars. Tax credits for green appliances would be similarly unnecessary. Further, the pace of energy innovation and reform would accelerate, as there would be an ever-present reason to reduce carbon emissions.
Inefficiency at the CAFE
The Corporate Average Fuel Economy (CAFE) program was established in 1975 as part of an effort to reduce dependence on foreign oil. It seeks to raise the average miles per gallon (MPG) of the cars on America’s roads by setting minimum standards for the fuel efficiency of companies’ fleets, fining companies that fall short. CAFE can boast some success: the average MPG rose from 18 to 27.5 after its implementation, and estimates suggest that Americans would consume 2.8 million more barrels of oil each day without these CAFE standards. Standards were frozen between 1985 and 2007, but President Obama increased the required MPG of new cars to 54.5 in 2012 (to be realized by 2025).
While CAFE standards encourage the development of more fuel-efficient vehicles, the scheme itself is inefficient. Setting a single value for a manufacturer’s entire fleet can incentivize the over-production of less-desirable, fuel-friendly vehicles, to compensate for the popularity of gas-guzzling favorites in the company fleet calculations. It would likely be far simpler to simply rely on a carbon tax, which would align consumer and company interests in more fuel-efficient cars.
The CAFE standards may not weather the current political climate. President Trump deemed CAFE an “assault on the American auto industry” and promised to work to eliminate them. Still, thanks to global markets, strict standards in Europe and Asia (and in large US states such as California) will keep car manufacturers focused on fuel efficiency.
Second, a carbon tax would generate government revenue in a highly efficient manner. A carbon tax of $25 per metric ton is estimated by the Congressional Budget Office to generate about a trillion dollars in revenue over ten years.12 And, unlike most sources of revenue, a carbon tax makes the economy more efficient by discouraging something that the market, left to its own devices, overproduces. In contrast, most other taxes discourage things we would rather encourage, like labor effort, savings, and entrepreneurial effort.
Third, a carbon tax is an essential part of a tax policy grand bargain, since revenue raised from the carbon tax will help pay for the needs of government without resorting to higher tax rates on individuals or businesses.13 While individuals and businesses will, of course, pay the carbon tax implicitly in the form of higher prices on energy consumption, that tax will not be as salient as the tax that is removed from a worker’s paycheck. And a carbon tax rewards virtues (conserving on carbon emissions), whereas most taxes discourage virtues, such as working or savings.
The Politics of the Grand Bargain
There are several aspects of these proposed changes in tax policy that should bring people together to make a better tax system. First, there are big carrots for both those on the left and the right of the political spectrum. Most on the left wish for a more progressive tax system and more urgent responses to environmental challenges. The incre
ased negative tax rates for low-wage workers and the tax relief for middle-class workers help ensure that tax burdens are lower for Americans who have not benefited from changes in the economy. And the carbon tax is a highly effective response to climate change.
On the right, the inefficiency and distortions of the tax code (and the high tax rates on some types of economic activity) are constant sources of frustration. The tax changes above will require global “winners” to pay their fair share, but tax rates will be reasonable. The top corporate rate and the top personal income tax rate will be the same, and slightly lower than they were prior to the TCJA. All income will be treated similarly, so the tax code with generate less frustration and distortion. The revenue raised from the carbon tax will reduce the need for higher top marginal rates. People will pay their fair share, but the tax code will not unduly hinder entrepreneurial drive or distort investment decisions.
These tax policy changes are grounded in the art of the possible, not abstract notions of optimal tax theory. They aspire to “rough justice” and to rules of thumb that people can easily understand. A progressive tax system has widespread political support, as does the notion that the tax system should be simple and non-distortionary.
The tax system can do a better job raising the revenue needs of the country if it is relatively modest in its aims. While it is tempting to pursue all sorts of social policy goals through the tax system (providing additional tax credits for savings, health care expenses, education, and so forth), the tax system can be both fairer and more effective if these temptations are resisted. Every time we try to encourage something “good” through the tax system, we raise less revenue—putting us in a position of having to increase tax rates on other activities or cut government spending. (A third option would be for the government to issue more debt, but that simply shifts tax burdens onto future generations.) A simple and fair tax code should be progressive at its root, taxing a lower percentage of the income of the poor than of the rich, but it should also tax all forms of income similarly for particular people or businesses. This principle keeps the tax code simple, efficiently raising the revenue that we need for the goals of civilized society.
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