Congress is setting up for Tax Reform this fall. President Trump is touring the country promoting a plan that has no specifics. No bill is likely forthcoming, so no change is apt to happen. But there is a new critical mind attending all things DC, and it might be useful to take a short look at the real pathologies of the tax system and some real remedies. The catchword is “difficult,” and all concede that competing interests block the way. Indeed, there are intractable differences between big campaign donors and the public welfare. Tax reform is contested much like the battle over health care, where the simple, cost-effective fix of single payer meets the political need to cut in Big Insurance and Big Pharma and reduce taxes for the wealthy. Indeed, tax “reform” is basically code for tax cuts. Tax cuts have traditionally been the focus. The last president to make a tax increase a point of policy was Lyndon Johnson. This focus, of course, misses the real point. After decades of bad tax policy there are real repairs needed to get the tax system back in sync with fairness and economic efficiency. Here are some issues and suggestions.
Repay and Repair Social Security
A strange situation exists in the conversation on social insurance. One side says the trust funds are in sound condition and no crisis is imminent. The other side says the demands of retiring Baby Boomers require “entitlement reform” because unbearable strain is just around the corner. The oddity here is that both sides are correct. The trust funds are internally fundamentally sound, but because the federal operating budget has been borrowing from them for 35 years without a plan on how to repay. Social Security is not an unfunded liability; it is funded by government bonds. But the cash flow to repay those bonds that is absent.
Before getting into how this came about, let’s look at another serious defect bound up in this: The current US tax system is overburdening working Americans. Labor, more than any other sector or activity, bears the burden of funding the federal government.
Personal income taxes and payroll taxes comprise 80% of federal revenues. While income taxes also apply to unearned income (e.g., interest, dividends, profits and rents), the preponderance of revenues flow from earned income, that is, wages and salaries. And while the government is ruthless in itemizing and collecting this right on the paystub, the varieties of unearned income are diluted by a panoply of tax dodges and opportunities for avoidance and evasion.
It is a principle in economics that if you want less of something, you raise the price. Taxes effectively raise the price of labor. (Labor also bears the weight of financing much of the health care system.) Consequently good jobs are in short supply. When it comes to trade, for example, the establishment understands this principle. Tariffs are decried for their effect of reducing the free flow of trade and the benefits of comparative advantage, notwithstanding the fact that the major beneficiaries more often look like the Walton family than the average American. Financial transactions are another activity that is virtually untaxed. Consequently we have trillions of dollars of hot money rushing around the world creating instability for precious little benefit. A microscopic tax on financial transactions would generate enormous revenues with relatively little pain for the citizenry. An example more broadly supported by the establishment is consumption. One suspects the motives. In any event, there are alternatives to the obsession on earned income, i.e., jobs.
Payroll taxes comprise one-third of federal revenue. Nominally they are paid by both employers and employees. In fact, as is accepted by the great majority of economists, they fall almost entirely on labor. In the US system, this is predominantly on middle- and lower-class workers. Why? Because there is a cap on the earned income subject to the tax, currently just below $120,000. This is kind of an upside-down open-ended deduction available only to those who need it least. A professional in the top 5% of income often pays one-third or less the rate of a bus driver earning $50,000 per year. This overtly regressive taxation was concocted in the early 1980’s and is a con perpetrated on the working middle class.
At the beginning of his first term, Ronald Reagan pushed through the so-called Supply Side tax cuts, basically tax cuts for the rich, on the promise it would unleash a massive economic boom. That boom failed to materialize, and the economic recovery of the Reagan years stemmed from the deficit spending, largely as a result of a military build-up. At the same time, concern arose over Social Security. Even then it was apparent there were Baby Boomers and they were eventually going to retire and ask for their benefits. Prior to that time Social Security benefits had been funded on a pay-as-you-go basis. But the alarm was that the surge in retirees in the second decade of the 21st Century would make pay-as-you-go unworkable.
A commission headed by none other than Alan Greenspan, later chair of the Federal Reserve, set to work. Greenspan’s idea was to start setting aside excess amounts in trust funds. It seemed to make sense, and soon workers began paying sharply higher payroll taxes. The commission congratulated itself on its prudence and responsibility.
Unfortunately, and almost immediately, the funds were tapped by the operating budget, comingled in what was called the Unified Budget This was an exercise of sending special bonds to the trust funds and reducing the official deficit by that amount, essentially hiding the serious shortfall that attended the Reagan tax cut scheme. Payroll tax revenues were, of course, registered in the accounts of the trust funds, and officials did not see any particular necessity of making it clear that official accounting of the deficit also included those funds, even though the bonds represented obligations that would require increased taxes. So the time did arrive and the Boomers did retire. The trust funds began paying out more than they took in, and rather than hiding the size of the deficit, the scheme now amplified it..
It is no exaggeration to say that Social Security was always pay-as-you-go and that the Greenspan Commission effectively shifted the tax burden down. They were more willing than they might have been otherwise to pay the taxes because they assumed it was money they were going to get back later. In other words, it was a fraud. Reagan’s tax reductions for the upper end were financed by tax increases on the lower end. Alarm over the inability to pay benefits is alarm over having the fraud unravel. None of this can be admitted, of course, and as mentioned, it is addressed in a conversation about “entitlement reform.” But the situation is what it is, and we need a means of raising revenues to make good on the Social Security promises. Thus,
1. Eliminate the cap on payroll taxes.
Eliminating the cap recognizes the fraud of the Greenspan arrangement and begins to repair the damage to the system. It taxes those (at least the class of those) who benefited from the fraud. Unearned income still escapes the payroll tax, but it’s a start.
It is a shame that generations of workers got conned, but at least we can have some fiscal security and let the wealthy pay their fair share. The effect is to extend the payroll tax rates – about 15% -- to incomes over $120,000. The overall tax system will become progressive in fact as well as theory. And and there would be no tax increase for those earning less than $120,000.
Stop Subsidizing Millionaires and Banks
The mortgage interest deduction is a sacred cow that is not likely to be sacrificed. Other, more reasonable methods can be imagined. Jerry Brown, now governor of California, ran for president in the 1992 primary and proposed the solution of a standard housing deduction, say $10,000 per year, in lieu of the mortgage deduction. This would accept the principle of a subsidy for basic shelter, but would stop well short of the immense subsidy in the current law. The great mass of the current payouts go not to basic shelter, but to lavish homes. The advantage of Brown’s proposal is that it would also have included renters, who get no subsidy for housing now. While Brown’s idea is likely not going to happen, the same idea can be approached by capping the current mortgage interest deduction at some reasonable limit, thus removing the absurdity of a benefit that gets bigger the more expensive the home.
2. Cap the mortgage interest deduction at level generous enough to cover most mortgages.
Such a change would need to be phased in to avoid complicating the plans of households. When fully implemented it would take another step toward making the theory of a progressive income tax true in practice as well.
End the complexity that hides favoritism to the rich
Many deductions and credits in both the personal income and corporate income taxes are payments for specific and often idiosyncratic activities. These are subsidies. They are in the tax system to avoid scrutiny. The code is then mined by creative and ambitious people, some of whom make enormous salaries for their imagination. These tax subsidies (the technical term) could continue outside the tax code as overt subsidies. The country would then avoid the completely unproductive accountancy and get the help to the intended activity with much less stress on the beleaguered IRS. Data on the effectiveness of the subsidy would be easily available, rather than buried in an obscure attachment. On the personal income tax, some subsidies, such as deductions for interest on college loans would be better included on financial aid forms. On the corporate tax, the opportunity to distort business activity or disguise one activity as another, or just manipulate and complicate, would be eliminated.
3. Eliminate tax subsidy deductions and credits in favor of direct subsidies to useful enterprises.
If robots are going to take the jobs, let them pay the taxes.
As mentioned above, labor bears an inordinate share of the tax burden. Labor is also charged with the funding of most of American health care. This increases the cost of labor and reduces good jobs. At the present time, more and more middle-class jobs are lost to automation and robotics. When a business sheds a job in favor of a robot, the revenue that is the basis of the tax system is also lost. The tax code should be adjusted to reflect this fact. Ironically, in converting to automated processes, many businesses are in line for investment tax incentives.
The issue of double taxation elsewhere causes much gnashing of teeth when it comes to the corporate sector. It is seen as unfair when owners pay once with the corporate income tax and then again when they fill out their personal taxes. The move to reduce the rate of corporate income taxation advances behind this flimsy shield. Then it is pointed out that the corporate tax rate itself is among the highest in the world. The argument is rarely applied to earned income, but it is even more applicable. Both payroll and personal income taxes are assessed against the same gross amount of earned income, while the unearned income of business owners and stockholders escapes the payroll tax altogether. The claim of a high corporate tax rate wilts in the light of the facts. Since the code is riven with the wormholes of special interest favors, the actual effective tax rate is not high compared to other nations. The apparently high nominal rate is at best hypothetical. For evidence, look first at the share of revenues, and how it has deteriorated over time, even as corporate profits have ballooned.
The two most obvious issues in this chart are the expansion of the payroll tax and the shrinking of the corporate income tax. You can probably even make out an inflection point in the early 1980’s. Corporate profits are booming and stock markets are setting record highs. There is little evidence that the corporate tax is booming alongside.
Corroboration comes every day on the pages of the business section with a drumbeat of reports of one or another company paying little, none, or a negative amount.
4. Establish a firm corporate tax rate.
5. Eliminate special interest deductions and credits in favor of direct, public subsidies.
The US economy and its corporations did quite well in the 1950’s and 1960’s when the corporate tax was a more substantial revenue source, prior to the virtue of the corporate sector becoming so hallowed in the halls of Congress.
Level the playing field between Capitalists and working people
Income from capital gains is taxed at a lower rate than income, earned or unearned. Much economic policy, even outside the tax code, stems from this kind of back door Keynesianism. Taxpayers in the 10 and 15 percent tax brackets pay no tax on long-term gains on most assets; taxpayers in the 25-, 28-, 33-, or 35- percent income tax brackets face a 15 percent rate on long-term capital gains. For those in the top 39.6 percent bracket for ordinary income, the rate is 20 percent. This bias has little support from history. The theory that this encourages investment, grows the economy and creates jobs has little support from history.
In fact, the level of capital gains tax has no correlation with investment and growth. And there is certainly no moral justification to favor the buying and selling of assets over wages, salaries, interest income and dividends. Standardizing rates would also eliminate various tax dodges such as the much-publicized carried interest that is the income of hedge fund managers.
6. Standardize all forms of income on the same schedule.
Investment is important. This has been understood by economists since the time of Keynes. But investment is undertaken for the prospect of profit, not for reasons of the tax code. The prospect of profit is a function of demand, which is mostly a matter of working class incomes. Again, it is official that Supply Side, trickle-down economics does not work. The economics profession has moved on. It is time politicians and the tax code caught up.
Begin to deflate the private debt bubble
Equity capital is not the favored instrument for business investment. Debt financing does not dilute ownership andinterest expense is deductible. Banks have been empowered to create money in exchange for debt instruments. Their business model is to create as much debt as possible in order to collect as much rent, or interest, as possible. Banks’ creation of debt is incentivized all the more for the fact that – like mortgage debt, but unlike personal or household debt – the interest on business loans is tax deductible. The result is that an ocean of non-government private sector debt has flooded the economy, suffocating the present and the future.
Debt bubbles are dangerous. Witness the 2008 financial crisis and compare it to the Dot Com bust of 2000. The latter was indeed dramatic, and devastating for some, but it did not threaten the entire economic system. The reason is the difference between equity and debt. With stocks, the loss is more or less limited to the amount of investment. Loans and mortgages are a different matter. Putting 10% down on a house would have been thought to be prudent, absolutely Puritan, during the housing bubble of the 2000’s. But even that down payment was wiped out overnight, and millions of homeowners found themselves on the hook for many times their out-of-pocket investment. An additional level of debt was added by mortgage providers, who leveraged their side up to 40-to-one. The matter became systemic because loans were spread and interlocked throughout the international financial system. Derivatives floated on top. When one section of mortgage holders defaulted, the dominoes began to fall.
Rather than clean out the debt and create a sturdy foundation for the economy, the financial authorities decided to bail out the lenders and leave the mass of debt in place. The Federal Reserve bought literally trillions of bad paper to support debt markets. The Fed created trillions of dollars and became the only buyer of toxic mortgage securities. As Fed chairman in the early 2000’s, Alan Greenspan arguably created, or at least abetted, the housing boom by dropping the federal funds rate to an historically low one percent. Ben Bernanke “solved” the problem by reducing that rate to zero and holding it there for six-plus years. Since zero was deemed not enough, the Fed devised “quantitative easing” to lower the real interest rate even more. This operation was great for financial markets, which were buoyant throughout the Obama years. But it was precious little help for the real economy. Too big and too interconnected banks were made bigger and more interconnected. There is now more than 30% more debt in the world. And we sit again uneasily atop an ocean of private arrangements, each interlinked with another, an interdependent stack of cards.
Furthermore, tax-deductible interest was not typically used to actually invest in tangible, physical capital. There has been only tepid capital investment since the crisis. Instead new, cheap debt was used, as it has often been historically, to take over companies and financially engineer them, loading the new entity up with these obligations and often leaving the workers begging for their pensions. Companies have also borrowed to enrich their owners by buying back stock or increasing dividends, all with tax-exempt interest.
To be clear, the serious debt situation for citizens and the economy can only be resolved by reducing the debt itself, as was done in the New Deal – restructuring loans, closing banks and writing off the bad debts. Instead the debt has been increased, households have been left with the load, and the economy continues to suffer.
7. Eliminate the deductibility of interest on corporate taxes.
While this will not rectify the mattercompletely and much more needs to be done, the tax code should at least not incentivize another crisis. It bears repeating that the major issue with the current sluggish and fragile economy is the immense private debt.
Taxes and Climate
“Externalities” is the term in economics that designates costs that are not born by the buyer or seller in a business transaction. What is external to the transaction, however, is often very intimate to the experience of people. A fine example is the purchase and use of fossil fuels. All the ecological costs of mining, transporting and burning of oil, coal and natural gas are outside the price paid. Enormous costs are left for the society at large, and the future, to pay. One way to bring these costs into the price, to make the price reflect actual costs and thus make the market actually work, is to tax the product.
Revenue from such a tax is not the main benefit. It is the action on supply and demand and use. In fact, the revenue could be rebated entirely to consumers. A brilliant example of this applied to the oil market was proposed by Senators Susan Collins and Maria Cantwell in what they called “cap and dividend.” The revenues collected would be returned in their entirety, divided equally among all households. So the cost of gasoline and heating oil would go up as a result of the tax, but the average household would be given the money to pay that amount. The heavy user would feel the pain and be encouraged to reduce his use. The light user would actually realize a net gain and rewarded for his conservation. The point is that the costs in pollution and climate change are reflected in the price and the world gets to live a little longer.
8. Tax Carbon
Whether on the Cantwell-Collins model or in another form, it is absolutely essential to rectify the market failure of externalities in carbon production and use. Not doing this is an immense subsidy to producers. The future is in the balance. This is one proposal upon which virtually all economists agree.
If “pragmatic” is defined as economically sound, fiscally responsible and useful to the citizenry, the above proposals are imminently pragmatic. If “pragmatic” means “what can get through the Congress,” these are bordering on tinfoil hat. What is practical and desirable for the public is not what is practical and desirable for a political establishment, since campaigns are often funded by bidders for corporate welfare. The arguments are dressed up in myths of trickle down, of economic growth, of “job creators,” of “unleashing the power of the market,” but those tropes are becoming tired and weak, no matter how closely held by prominent members of Congress. Paul Ryan, Speaker of the House, is a veritable factory of them. And though the best that might be hoped for is another iteration of error, debate on true tax reform is amusing, if only as preparation. Real change can make a real difference.