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“There has been increasingly widespread dissatisfaction in the United States with the Federal tax system. Numerous special features of the current law, adopted over the years, have led to extreme complexity and have raised questions about the law’s basic fairness.” Sound familiar? Those are the opening sentences of a 1977 U.S. Treasury study, “Blueprints for Basic Tax Reform.” Sad to say, the income tax code’s complexity and basic unfairness have worsened since then.
The latest reminder is the dust-up over Mitt Romney’s 2010 tax return, which showed him to have an effective tax rate of 13.9 percent on his 2010 income of $21.6 million (and which was accompanied by an estimate of an effective rate of 15.4 percent on 2011 income of $20.9 million). Former Republican Presidential candidate Herman Cain got a lot of attention with his proposed 9-9-9 tax overhaul. Tax reform is a key change in the various blue chip proposals for reducing the long-term federal debt and deficit, such as the Dec. 1, 2010, plan from Erskine Bowles, the former Clinton chief of staff, and Alan Simpson, former Republican senator from Wyoming. President Obama joined the fray in his State of the Union address on Jan. 24, when he called for anyone with an annual income of more than $1 million to pay a minimum effective tax rate of 30 percent.
There’s good reason to throw a spotlight on capital gains—specifically, the lower tax rate on capital gains investments vs. ordinary income. Long-term capital gains (assets owned for at least a year) are taxed at 15 percent, compared with a top rate of 35 percent for wage earners. Romney’s multimillion-dollar income comes from investments, and therefore he pays the same effective tax rate as a wage earner pocketing $80,000 a year.
Why stop at capital gains? Since at least the 1930s, tax reformers have pushed for a much simpler system that is more equitable and efficient. Simplicity requires broadening the tax base by eliminating as many credits and deductions, phase-ins and phase-outs as possible. A simpler tax code is more equitable because those with equal incomes—no matter what the source—would pay the same tax. And since filling out the form would be so easy, it could be dubbed the Tax Lawyer and Accountant Unemployment Act. The political debate could then focus on how progressive to keep the system and how high rates should go to pay the government’s current and future liabilities.
Like it or not, some form of major tax change is coming over the next several years. The reason is well-known: The federal government’s dire long-term fiscal situation. The real question is what kind of tax overhaul. The major bipartisan deficit reduction plans rely on broadening the tax base. For example, both Bowles-Simpson and the Bipartisan Policy Center’s sweeping budget overhaul, sponsored by former Republican Senate Budget Committee Chairman Pete Domenici and former Clinton budget director Alice Rivlin, would tax capital gains at the same rate as ordinary income. They also want a bunch of well-known, economy-distorting tax expenditures to be eliminated or slashed.
One of those is the cherished mortgage interest deduction. It’s a classic case of government spending masquerading as a tax break to subsidize home ownership. (Yet Canada’s homeownership rate is comparable to the U.S. without the deductibility of mortgage interest). The exclusion for employer-provided health insurance is a tax expenditure that badly distorts the market for health insurance. Getting rid of these two tax breaks alone would shrink the size of government’s footprint on the ordinary household, says Daniel N. Shaviro, professor of taxation at New York University School of Law.
The biggest loophole of all, though, is capital gains. There are a number of economic arguments used to justify a lower capital gains tax rate, particularly the belief that it boosts savings, investment, and economic growth. Problem is, the economic studies are ambiguous at best. Louis Johnston, economist at College of Saint Benedict/St. John’s University, notes that when capital gains taxes were cut in 1998 and in 2003, savings rates did not pick up and the GDP growth rate declined. “Nobody has been able to show any relationship across countries and within countries over time between capital gains taxes and economic growth,” says Joel Slemrod, economist at the Stephen M. Ross School of Business at the University of Michigan. “It’s one of a million things that affect economic growth, and if it were huge, we’d be able to pick it up out of the data.”
There are a number of other economic arguments behind giving capital gains a tax edge over ordinary income. The income is already taxed once at the corporate rate of 35 percent and then again when it is passed through to the individual. While some corporations pay a lot of tax, most take advantage of tax law to reduce their effective corporate rate sharply. The corporate tax rate doesn’t affect approximately 90 percent of businesses anyway. They’re partnerships, sole proprietorships, and S corporations whose tax is paid on the individual tax form. The capital gains tax break includes residential real estate, paintings, gold coins, and other noncorporate investable assets, too. Much of the capital that fuels new investment comes from foreigners, pension funds, and similar pools of money that don’t pay capital gains. “The economic efficiency arguments are debatable,” says Joseph J. Thorndike, director of the tax history project at Tax Analysts. “The fairness arguments are more compelling.”
Fairness matters. There’s no good reason for treating labor income and capital income differently, especially not since the share of total income going to the top 1 percent has risen from around 8 percent in the late 1970s, when “Blueprints for Basic Tax Reform” was published, to 24.5 percent in 2007. There is precedent for reform. In 1986, President Reagan, House Democrat Dan Rostenkowski, and Senate Republican Robert Packwood combined forces to simplify the tax code by eliminating the distinction between income tax rates and capital gains. Tax reform won’t get beyond sound bites in an election year, but the 1986 model is as good a talking point as any.