Tax Tradeoffs

Hitherto, the standard position on both sides of the aisle with respect to taxes as a part of deficit reduction has leaned strongly toward tax “reform.”  The word “reform” can mean anything that anyone wants it to mean, of course.  But if the word has borne any content at all with respect to taxation, it has meant “broaden the base, and lower the rates” — in other words, close or narrow selective tax preferences, and use the resulting additional revenue to reduce tax rates for everyone.

Tax reform for deficit reduction, however, could reduce tax rates to give back only some, not all, of the revenue gained by cutting back tax preferences.  The rest of the revenue gained would be kept by the federal government to reduce the deficit.  (Some would assert that the rate reductions could return all of the revenue gain using static scoring, but that taxpayers would work harder and invest more, which would result in more revenue being collected at the end of the day — the classic argument for dynamic scoring.  Large deficits in the 1980s and in the decade of the 2000s make that proposition suspect.)

But earlier this week, Senator Charles Schumer (D-NY), who has become involved in the “Gang of Six (or Eight, depending on who is counting)” budget discussions in the Congress, made a contrary speech. Senator Schumer says that Congress should give up on reducing tax rates, and instead use any tax-preference cutbacks purely to raise more revenue.  He concludes that this path will be more likely to reduce the deficit, and will be better for the middle class.

In a nutshell, Senator Schumer’s argument is that reducing the top tax-rate bracket would give away so much revenue that it would force reductions of still more tax preferences — including some that are important to middle-income taxpayers.  Instead, Senator Schumer says that he would restrict his tax-base broadening to provisions important to the well-off, and simply keep that money to cut the deficit; and he would increase the top-bracket rate to “Clinton-era levels” of about 39.6 percent rather than the current 35.  He is optimistic on the basis of the historical record that economic growth and efficiency would survive rate increases on the order of such a rollback of the 2001 and 2003 tax cuts.

This issue is highly consequential to the prospects for success of deficit reduction, which we at CED believe is one of the most important public policy issues of the day.  It also has implications for the state of the tax system, and the performance of the economy.

Senator Schumer’s speech addresses all of the major considerations surrounding tax reform.  However, I believe that he has come down on the wrong side on each score.  Let me go through each step of his argument and explain why I disagree.

“Using tax reform to produce revenue departs from the 1986 model.”  Senator Schumer acknowledges the success of the Tax Reform Act of 1986, the most recent successful attempt at tax “reform” as defined here at the outset.  But he says that the 1986 model, which was explicitly revenue neutral (i.e., the tax preference reductions and the tax rate cuts were precisely equal), would not work in the current effort at deficit reduction.

In answer to the Senator’s assertion:  Well, yes.  Tax reform today would be significantly different.  However, to say that the 1986 model was different is not to say that it is inapplicable.  Consider Senator Schumer’s proposed alternative, which is to cut tax preferences and use all of the money for deficit reduction.  It is difficult to argue that taxpayers should give up tax preferences that they have enjoyed for years, and have built into their personal financial plans.  It is even harder without offering those taxpayers any compensation.  A major part of the logic of the 1986 Act was that much of the population shared in the loss of tax preferences, but that as a result they shared in tax rate reduction.  Some taxpayers came out as net winners, some as net losers.  But at least there was some benefit even for the losers — and that benefit improved economic incentives.  In Senator Schumer’s approach, those who are singled out to lose their tax preferences get pure pain.  Why just me?  Why not the other guy?  The politics would be much more difficult.

Having a net gain in revenue does not render this straightforward political calculus irrelevant.  In fact, it may be even more important to have something to offer taxpayers who are called upon to pay more.

“…a 1986-style approach that promises upfront rate cuts to the wealthy is almost guaranteed to give middle-income earners the short end of the stick… you would need to slash deductions and credits on a far greater scale than we ever did in 1986.  Middle-income earners would not be spared.”  The answer to this argument has multiple parts.  First, and more painful, contrary to President Obama’s promise from his 2008 campaign, the nation cannot solve its budget and debt problem with tax increases only on taxpayers with incomes above $250,000.  The numbers simply do not work.  We need a broader increase in revenues, and restraint on both domestic and defense spending, to cut debt growth back below the growth rate of our economy.

But equally important, any combination of tax-preference cutbacks that comes close to what is needed to solve the problem will have consequences up and down the income scale.  Most tax preferences are used at least to some degree by middle-income taxpayers.  Those preferences that are the most concentrated at the top of the income scale are not large enough (but see the next point).

And furthermore, in a significant tax reform, tax rates can be changed selectively up and down the income scale to yield a distribution of the tax burden that the public and the Congress agree is fair — taking into account that total taxes must go up to cut the deficit.  The 1986 Act went even further and increased the personal exemption, the standard deduction (for taxpayers who do not itemize their deductions), and the earned income tax credit to help not only middle-income taxpayers but also those at the bottom of the scale.  In fact, Senator Schumer’s predecessor Daniel Patrick Moynihan (D-NY) called the Tax Reform Act of 1986 the greatest anti-poverty legislation of all time.  If the 1986 model can reach that standard, it can protect the middle class.

But to ice his argument, Senator Schumer touches on what may be the crucial, and perhaps the most politically sensitive, part of the tax reform puzzle.  He shows some flexibility, but I believe he needs to go farther:

“It’s time to reduce the sizable differential in the tax treatment of earned and unearned income…  The reduction in the capital gains rate to 15 percent under President Bush was a major contributor to the growth in wealth disparity we see today…  As part of the 1986 reform, Reagan raised it to 28 percent…  Now, if you are returning the top income rate to Clinton-era levels, as I have proposed, I do think it is too much to treat capital gains the same as ordinary income.  We don’t need a 39.6 percent rate on capital gains.”  The capital gains preference is in fact the sticky wicket of true tax reform.  It is the one tax preference that is most concentrated on taxpayers with substantial income and wealth.  Eliminating it would be perhaps the biggest step toward reducing after-tax income inequality, as Senator Schumer wants to do.  (CED recommends that step in our tax reform proposal).  So why start by choosing a top-bracket rate for ordinary income, and then conclude that progress on the capital gains rate must be limited?  Why not take on the issue holistically, and come up with the best overall system?  Why confuse the level of the top ordinary-income rate with the amount of revenue collected from those top-bracket taxpayers, when the capital gains rate can be even more important — especially for the spectacularly wealthy?

There are plenty of reasons to try to get the top-bracket ordinary-income tax rate down, and as close to the capital-gains rate as possible.  One of the most important facilitators of tax avoidance is the gap between the tax rates on capital gains and ordinary income.  The dean of American tax reformers, the late Harvard Law Professor Stanley Surrey, used to say the 95 percent of the practice of tax law was converting ordinary income into tax-preferred capital gain, and capital loss into ordinary loss.  Raising the ordinary-income rate a little and capital-gains rate a little might increase revenue, but it will not stop such abuse.

Some see the capital gains tax preference as an incentive for the formation of businesses.  The effectiveness of that incentive, however, is on the order of scale of that to buy lottery tickets.  There is a widely repeated estimate that there are 27 million small businesses in the United States.  However, in 2009, the latest year for which data are available, only about 588,000 — or about two in 100 — reported capital gains from sales of businesses.  (A roughly equal number sold businesses at capital losses.)  The rest of those small businesses — the mom and pop stores, and others that create jobs but are not likely salable for large sums — are being operated for ordinary income.  Maintaining a large capital gains exclusion at the cost of a higher tax rate on those 98 in 100 “job creators” is arguably neither equitable nor efficient tax policy.  (Even considering that this two in100 sales ratio is a one-year number, those entrepreneurs who plan to earn ordinary income from running a business and then to sell it upon retirement might be more grateful for a lower rate of tax while they are working.  The prospective purchasers of those businesses might also pay more if they can foresee higher after-tax income over the course of their working careers.)

Senator Schumer’s position is arguably further from the middle ground where Democrats and Republicans might find agreement on deficit reduction — including both higher revenues and reduced entitlement spending.  (Some might say that a tax reform that increases the tax rate on capital gains could not be on the program of Republicans.  But a tax reform that increases both the tax rate on capital gains and that on ordinary income must be even further off the program.  And the combination of a lower ordinary income rate and an equal capital gains rate at least has the seal of approval of the late President Ronald Reagan and of many Members of Congress’s Class of 1986.)  Perhaps Senator Schumer’s move is an attempt to pull the turf more toward one end of the playing field, in the hope of finding a consensus in a different location.  But if it instead lessens the chance of a deal, the potential downside is very deep indeed.

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