September 2012

Going Beyond Tax Expenditures

When we talk about tax reform which lowers the rate and broadens the base, the base-broadening portion of the equation usally focuses on tax expenditures. These deductions, exclusions, credits, and special rates are considered a departure from the normal tax code, and so a number of proposals have focused on reducing or eliminating them. However, not all base-broadening need come from tax expenditures; there are changes which can be made beyond the normal tax expenditure list which could raise revenue and improve efficiency.

Our recent paper on corporate tax reform and our fun, interactive tax calculator both include focus on "non-tax expenditure base-broadening." This type of base broadening involves looking at deductions and other provisions considered to be a "normal" part of the tax code  and finding ways to reduce or modify them. On the corporate side, there is almost an unlimited number of these provisions -- since normal business expenses are deductible in the calculation of net (taxable) income. In many cases, the best policy decision is to leave these provisions as they are; but in some cases, reform may be helpful. We looked at three potential areas for reform in our tax calculator:

  • The Deduction for Interest Expenses: Business interest is generally deductible, as long as total interest expenses do not exceed 150 percent of a business's equity or 50 percent of its taxable income. However, the deduction may distort corporate financing decisions by making debt a much more attractive option than equity, which is taxed at both the corporate level and the shareholder level. This encouragement of overleveraging could be problematic, as we have seen in recent years. One way of dealing with this distortion, which the Wyden-Coats plan uses, is to disallow the portion of interest expenses that is attributable to inflation. Another way would be to lower the limits of the current disallowances or to make interest only partially deductible.
  • Meals and Entertainment Expenses: Meals and entertainment expenses incurred during discussions of business would be fully deductible in a "normal tax code," since they are a cost of doing business. However, in part because this provision is abused and because individuals receive personal gain from meals and entertainment, current law allows only 50 percent of the costs to be deductibled and does not allow the deduction for extravagant expenses and expenses incurred at places that are clearly not conducive to business discussions. One option would be to further reduce the deductibility of meals and entertainment; or perhaps eliminate it altogether.
  • Advertising Costs: Normally, if businesses incur costs for assets that will produce income in future years, they are required to write that asset off over a number of years, reflecting the useful life of that asset. Advertising costs may be written off in the year they are incurred, reflecting the belief that they increase sales in the short term. However, a single advertisement may produce income in future years by building a company's reputation or by creating brand loyalty. An option in our tax calculator would require that 15 percent of advertising costs be written off over a 15-year period, with the remaining 85 percent still being deductible immediately.

These are just a few of the possibilities for non-tax expenditure base-broadeners. As with requiring businesses to capitalize advertising costs, one could apply the same rationale to employee training costs. The taxation (or lack thereof) of non-profit organizations could be reformed. Large pass-through businesses, business-like non-profits, and government-sponsored businesses could all be subjected to the corporate income tax. Or regular deductions could be disallowed on certain types of activities (for example, cigarette advertisements). 

As this blog demonstrates, tax reform is not just about getting rid of or reducing tax expenditures. It requires careful and thoughtful examination of what a better tax code should look like.

Third Way: Both Revenue Increases and Spending Cuts Are Needed

Two new Third Way papers by David Brown, Gabe Horwitz, David Kendall together present an arguement that we have been making for a while now—that the only way to fix our deficit is with a plan that looks at both revenue increases and spending cuts. Third Way explores both relying on a revenue-only approach (specifically taxing the rich), and then a spending only approach, with the results being not so good.

The first paper "Neccessary but Not Sufficient: Why Taxing the Wealthy Can't Fix the Deficit" explores three different tax scenarios and the effect on the deficit.

  • The first scenario assumes the 2001/2003/2010 tax cuts expire for the top two tax brackets (along with cuts in capital gains and dividends rates), the Buffet Rule is passed, itemized deductions and exclusions are limited for upper-income taxpayers, and the estate tax reverts to 2009 levels—but even with these tax increases the national debt would still double by 2035.
  • The second scenario assumes all the changes above and raise marginal rates for the top bracket and capital gains rate by 15 percentage points, resulting in 50 and 39 percent top rates, respectively. Also, the next two brackets (the 33 and 36 percent brackets) are raised by 5 percentage points and the Social Security payroll tax cap is increased from $110,100 to $170,000.
  • The third scenario raises income tax rates by 5 percentage points across the board, raises the Medicare payroll tax rate by one percentage point, raises capital gains rates by 10 percentage points, and enacts a 10 percent value-added tax (VAT).

As the graph below shows, neither of the first two scenarios are able to halt the rise in debt. In the third scenario, debt would be stabilized, but the median family's after-tax income would go down by 8 percent compared to current policy due to the tax changes.

Just as a Tax Policy Center paper earlier this year showed, there are clear limits to taxing the rich, so spending will have to be addressed or taxes will have to be raised on the non-rich.

In "Death by a Thousand Cuts: Why Spending Cuts Alone Won't Fix the Deficit," the authors explore the alternative approach of trying to eliminate the deficit with only spending cuts. An across-the-board cuts approach to spending would require cuts as high as 25%, and as the graph below shows, when lawmakers beging to protect some programs the level of cuts are even higher. The real key cost driver is health care: if policymakers are able to contain health care costs, the solution becomes a bit easier but the paper, along with similiar findings from the Center for American Progress, shows that trying to tackle the deficit without any increase in revenue would be very difficult.

Both parties will have to give up something in a debt deal, whether its Republicans with more revenue or Democrats with entitlement reforms. This is not only to ensure that a bill will receive the needed bipartisan support but also due to the fact that our fiscal issues are so large, it is unreasonable to think a solution can come from only one side of the ledger. Through a comprehensive plan, we can minimize the burden for either side, whether it is using base broadening to raise more revenue or making sure changes to entitlement programs protect the most vulnerable. Policymakers will need to put everything on the table and think creatively if we are going to be able to come up with a solution.

The Third Way papers can be found here and here.

Millennials Weigh in on Simpson-Bowles

Fix the Debt co-founders and Fiscal Commission co-chairs Al Simpson and Erskine Bowles have been busy traveling around the country speaking with Americans about the dangers posed by rising debt and deficits. Yesterday at Wake Forest University, Erskine and Al laid out our fiscal math and the simple message that comes from it -- that future deficit and debt levels are unsustainable. Bowles summed up the problem by saying, "These deficits of over a trillion dollars a year, they are like a cancer. A cancer that’s going to destroy this country from within."

We were especially pleased to hear how young people reacted at the event. Kicking the can down the road will only leave a much larger problem for the next generation, and those in the audience recognized it. Here are a few of their reactions in the Winston-Salem Journal:

India Prather, a senior political science major at Wake Forest, said she was surprised how much health care, Medicare and Medicaid contributed to the national debt. She said listening to Simpson and Bowles will help her decide who to vote for in the presidential election.

"I'll be thinking about which political party and which person is removing the polarization as far as Democrats and Republicans and trying to get down to actually solving the problem," she said.

Steve Kelley of Winston-Salem, who attended the event, said he liked the plan Simpson and Bowles recommended and thinks it was a shame that Congress and Obama didn't fully embrace it.

"It's beyond me why we can't come to grips with this debt," he said.

After speaking at Wake Forest, the duo traveled to The George Washington University to speak today at an all-day event on the budget. In an interview with Aaron Harber, they laid out the problems facing us, and how all areas of the budget could be improved and needed to contribute to the solution. Simpson added that lawmakers who promised they could make the budget sustainable with only minor changes or without touching major categories in the budget was not serious.

It is good to hear young voters care about this issue, as no generation will be affected more by rising debt than this one--the one that will end up having to pay it all off. The Can Kicks Back is a millennial-driven campaign that is urging lawmakers to adopt a debt-reduction deal for the good of their younger constituents. We encourage our readers to check out their blog and follow them on Twitter at @TheCanKicksBack.

When we talked with Republicans and Democrats at the recent conventions, we noticed how many young people were interested in this issue and recognized that it would greatly affect their generation. A few even appeared in our video reactions, which you should check out if you haven't seen them already. With organizations like the Can Kicks Back and others we have met at universities, we think that millennials are an important voice for fiscal responsibility.

We cannot leave this problem to be solved entirely by future generations. We have a prime opportunity to replace the fiscal cliff with a bipartisan deal in the upcoming months. With leadership and compromise, we can give the next generation a secure fiscal future.

Event Recap: The Challenge of Pro-Growth Tax Reform

Today, the third forum of the "Strengthening of America—Our Children's Future" series was held in New York City on "The Challenges of Pro-Growth Tax Reform." Commenting on taxes as well as our unsustainable debt path were two panels; the first featuring notable economists Martin Feldstein and Lawrence Summers, while the second made up of business leaders—Honeywell CEO and Fiscal Commission member David Cote, CEO of SEI and Chairman of the American Business Conference Alfred West, and COO of Qwiki Navin Thukkaram. The takeaway? Tax reform may be politically difficult, but there would be economic payoffs for doing so.

On the first panel, both economists saw our fiscal outlook as unsustainable. Feldstein noted that the low interest rates that we are seeing today will not be permanent with both the Federal Reserve and foreign countries like China are buying much of our debt, the latter of which declared in its recent 5-year plan that it will look to boost domestic consumption (leading China to purchase less U.S.. Treasuries). "We don't know how long the financial markets will be tolerant of our enormous deficits and debt." Feldstein said. Summers agreed, clarifying that while it is difficult to know when a fiscal crisis could happen, "every day we delay is a day we increase the risk." The way to think of borrowing, Summers said, was not as financing government but as delaying the tax burden that we would inevitably face to future generations.

But they both saw tax reform as an opportunity. Feldstein said that broadening the base and lowering marginal tax rates would "have a direct effect on growth." Summers agreed that tax expenditures needed to be reduced, calling them "entitlements" that often help the most wealthy taxpayers. Tax reform would be best done as part of a comprehensive plan that addressed entitlements and the deficit in a thoughtful way. While the two may differ on some of the details, it seemed that both agreed with the tax reform principles behind bipartisan plans like Domenici-Rivlin and Simpson-Bowles and the need for fiscal responsibility.

The business leaders on the panel also recognized the need for addressing our deficit. For Cote, the combination of both rising debt and the fiscal cliff were a concern, with the fiscal cliff likely to have an even larger effect on the markets than last August's debt ceiling debate. "If the debt ceiling was like playing with fire, the fiscal cliff is like playing with nitroglycerin." West and Thukkaram agreed, both noting that businesses can create growth but they need the confidence in a stable tax environment. Cote said he "loved the concept of Simpson-Bowles," as shown by his vote for the plan, and its approach to tax reform of eliminating tax expenditures and lowering rates.

For Cote, the next important step is to convince lawmakers the price of doing nothing is far greater than the price of doing something, and the support behind the Campaign to Fix the Debt, of which he is a steering committee member, may make that a reality. Whether you are a CEO, a small business owner, or even an average American worker, we could all benefit from getting our deficits under control and finding ways to make our tax code more efficient. Sign the Fix the Debt petition and tell Congress that inaction is not an option.

The event was the third of a four "Strengthening of America–Our Children's Future" forums of former senators and representatives that are seeking to raise awareness of our growing and unsustainable debt. You can read summaries of the first event here and the second event here. More information on the forum can be found here.

CRS: Carbon Tax Would Take a Chunk Out of the Deficit

Efforts to curb greenhouse gas emissions have fallen out of favor since the attempted passage of a cap-and-trade program in 2009 and 2010. Still, the idea of a carbon tax or cap-and-trade remains out there as a way to both curb GHGs and raise revenue. A new Congressional Research Service (CRS) report discusses the pros and cons of a carbon tax and how it would impact households, the economy, and the debt.

Taking CBO's estimate of a cap-and-trade program that would price CO2 emissions at $20 per metric ton ($1.2 trillion over ten years), CRS estimates that it would cut CBO's estimated current law 2013-2022 deficit from $2.3 trillion to $1.1 trillion (1.1 percent of GDP to 0.5 percent) and the estimated Alternative Fiscal Scenario 2013-2022 deficit from $10 trillion to $8.8 trillion (4.9 percent of GDP to 4.4 percent). We should note that this may underestimate the deficit reduction since it does not seem to count reductions in interest on the debt.

Of course, these estimates would only hold if the carbon tax was enacted in isolation. That may not be the case. Given the impact of a carbon tax on energy costs and carbon-intensive industries, carbon taxes are often pared with deficit-increasing measures. These could include rebates to low-income households, allowances to affected energy producers, or the trading of a carbon tax for reductions in payroll or other taxes (the latter was suggested here and here). Obviously, any of these policies would reduce the deficit impact of the carbon tax, but also the effect on the economy and households.

Many economists on the left and right advocate taxing more of what is bad and less of what is good, such as taxing carbon or congestion. Policymakers looking to raise revenue may find such taxes palatable alongside a comprehensive reform of the tax code.

How Does Our Corporate Code Compare to Other Countries?

In our newest paper, "Reforming the Corporate Tax Code," CRFB makes the case for why the U.S. needs to reform the corporate tax code, discussing its high marginal rates, its incredible complexity, and its relative inefficiency. Using data from the OECD highlighted in our paper, we can see how the U.S. stacks up with other countries.

In 2010, when data were last available for revenue, the U.S. had the highest statutory corporate tax rate of any central government of the Organization for Economic Co-operation and Development (OECD) at 35 percent. At the same time, the corporate tax raised 2.7 percent of GDP, compared to the OECD unweighted average of 2.9 percent of GDP. In 2007, the last pre-crisis year, the U.S. raised 3.0 percent of GDP, while the OECD average was 3.8 percent. According to CBO, the corporate tax will raise only 2.2 percent over the next decade. This relatively low revenue is partially due to the fact that the effective corporate tax rate is well below the 35 percent rate, but it also due to the fact that the U.S. is less restrictive on which businesses -- especially businesses with higher receipts -- can be classified as pass-through entities, which are not subject to the corporate tax.

Another area where the U.S. sticks out is in how they tax the foreign income of domestic multinational companies. The U.S. currently has a deferral system, in which companies are not taxed on foreign income by the U.S. until it is repatriated to the U.S. (although certain passive income is taxed as it is earned under Subpart F). This system simultaneously encourages countries to move resources abroad and discourages them from bringing resources back.

By contrast, many of our trading partners, particularly developed countries, have territorial systems, where income is only taxed by the country where it is earned. These countries also have put in regimes to tax passive income and prevent artificial profit-shifting to tax havens. Some tax reform plans would shift to a territorial system, while others would shift to a worldwide system, where U.S. multinationals are taxed by the U.S. on their worldwide income as it is earned.

It is clear that many other developed countries' corporate tax systems outperform the U.S.'s in terms of efficiency. There is definitely room for improvement. As our paper said:

By combining all the potential benefits of corporate tax reform done right, a fiscally responsible remake of the tax code can improve the strength of the economy, fueling job creation and wage growth in the future. However, corporate tax reform would be most successful if enacted as part of a broader effort to reform the entire tax code and put the national on a sustainable, downward path over the medium and long term.

Click here to read our corporate tax reform paper and click here to design your own corporate tax plan.

Design Your Own Corporate Tax Plan!

If you've ever wanted to design your own corporate tax reform, now you can with our new Interactive Tax Reform Calculator.

There is no question that the U.S. corporate tax system is badly in need of reform, and leaders in both parties have been pursuing this goal. President Obama has put forward a framework to reduce the corporate tax rate from 35 percent today (among the highest rates internationally) to 28 percent while broadening the corporate tax base to ensure revenue neutrality. Meanwhile, Republican Ways & Means chairman Dave Camp (R-MI) has proposed a revenue neutral reduction to a 25 percent rate, and a number of bipartisan plans, including Simpson-Bowles, Domenici-Rivlin, and Wyden-Coats, have proposed similar reforms. Today, CRFB discusses these issues and various proposals in a new paper, Reforming the Corporate Tax Code, which makes the case for fiscally responsible corporate tax reform.

The Corporate Tax Reform Calculator, however, lets users write their own corporate tax reform. Options range from eliminating very small preferences such as those for corporate jets, to scaling back very large preferences like accelerated depreciation schedules, to changing the way we treat certain business expense deductions, such as advertising.

Based on the revenue target a user sets and the options they choose, the corporate tax rate will go up or down automatically. It's a very fun tool and sheds light on what needs to be done to reach different revenue and rate combinations. The calculator has already been featured on Ezra Klein's Wonkblog.

To see how the calculator works, we've  shown a few examples below based on actual plans out there.

Simpson-Bowles Illustrative Plan

In their illustrative plan, the  Simpson-Bowles Commission calls for eliminating all corporate tax expenditures, moving to a competitive territorial system, and reducing the corporate tax rate to 28 percent.

Sure enough, running those options yields a rate very close to that. We focused only on reforms aimed at C-Corps, presuming that "pass-through entities" (businesses that pay taxes on the individual side) would be dealt with through individual reforms. By eliminating accelerated depreciation and the domestic production deduction for C-corps, having a flat corporate tax rate, moving to a competitive territorial system, and eliminating all other tax expenditures, we were able to get the rate down to 27.9 percent.

 

President Obama's Business Tax Reform Framework

Though President Obama hasn't offered all the details of his plan, his framework gives us a good starting point. We know he raises revenue on the international side by moving in some ways toward a worldwide system. We know he eliminates the domestic production deduction for oil and gas companies as well as other preferences for those companies, repeals preferences for corporate jets, taxes carried interest as ordinary income, eliminates last-in first-out (LIFO) accounting, eliminates insurance company preferences, and extends the R&E tax credit and clean energy provisions. We also know he wants to raise revenue from reducing the interest deduction and reducing accelerated depreciation, though we don't know how exactly. When we combine these options with the elimination of many of the tax expenditures he hasn't specified, such as the exclusion for private activity bonds and the exemption of credit union income, we get the rate down 27.7 percent -- compared to his target of 28 percent.

Chairman Camp's Discussion Draft

Chairman Camp's plan still has a lot of details to be worked out, but we know that he would move to a revenue-neutral territorial system and reduce the corporate rate to 25 percent. To achieve those goals with the options available -- presuming he wants to raise all the money from C-Corps, the Camp proposals would have to be quite aggressive. As an example, if he were to eliminate accelerated depreciation and the domestic production deduction for C-corps, cut all other tax expenditures listed, reduce the interest deduction by the amount of inflation, reduce deductibility of meals and entertainment expenses to 25 percent, and capitalizing 15 percent of advertising costs the rate could be reduced to 25.1 percent.

 

We encourage our readers to design their own plans. Descriptions of each option are available in the question mark boxes to the right of each option.

In addition, our latest tax reform paper can be a helpful guide. The paper makes the case for corporate tax reform, discusses options for reform, and compares the major reform plans that are out there currently. It is a very informative primer for anyone who wants to know the basics of how the corporate tax code works now and what is being considered to change it.

Check out the Corporate Tax Reform Calculator and the analysis at http://crfb/corporate.

Only One Week Left Until the Presidential Debates

The first presidential debate is now only one week away on October 3 at the University of Denver. With much of the first debate focusing on the economy, we look forward to hearing about how the candidates will tackle one of the most important economic issues: our rising debt.

Our 12 Principles of Fiscal Responsibility lay out what we expect from the candidates on fiscal issues. While we have no doubt that both candidates will claim that deficit reduction will be a priority of their presidencies, the candidates cannot rely on empty promises and budget gimmicks; rather, they need to propose measures that could realistically reduce the debt. If they adhere to the following 12 Principles, what the candidates propose in the debates could eventually become part of the framework for a bipartisan debt deal that looks at all parts of the budget. The principles are:

  1. Make Deficit Reduction a Top Priority.
  2. Propose Specific Fiscal Targets.
  3. Recommend Specific Policies to Achieve the Targets.
  4. Do No Harm.
  5. Use Honest Numbers and Avoid Budget Gimmicks.
  6. Do Not Perpetuate Budget Myths.
  7. Do Not Attack Someone Else’s Plan Without Putting Forward an Alternative.
  8. Refrain From Pledges That Take Policies Off the Table.
  9. Propose Specific Solutions for Social Security, Health Care Programs, and the Tax Code.
  10. Offer Solutions for Temporary and Expiring Policies.
  11. Encourage Congress to Come Up With a Budget Reform Plan as Quickly as Possible.
  12. Remain Open to Bipartisan Compromise.

To keep the conversation honest, we will be live tweeting from @BudgetHawks and also from @FixtheDebt on our reactions to the fiscal policy discussions as they come. The Fix the Debt team will also be traveling to Denver to make sure fiscal policy is part of the conversation and we hope to see some of our readers there.

Bringing both parties in Congress to the table will take great leadership, including from the executive branch. Moderator Jim Lehrer will likely be serving up many fiscal policy questions in the first debate, and considering the 180,000 plus people who have signed our Fix the Debt petition, that would be good news for citizens. We hope their answers follow our principles and provide a real discussion of policy, not politics, on the national stage.

A more detailed discussion of our 12 Principles on Fiscal Responsibility for the 2012 campaign can be found here.

Geithner Calls for a "Go Smart" Approach

In an interview with Charlie Rose at the Clinton Global Initiative's annual meeting, Treasury Secretary Timothy Geithner endorsed a "Go Smart" approach to the fiscal cliff and deficit reduction more broadly. First, he said that simply waiving all the policies in the fiscal cliff, even for a short amount of time, would not be a viable solution because of the message it would send to the public.

That means Congress is going to put off again any meaningful action to make the economy stronger, any meaningful action to give confidence to people that we're going to go back to living within our means. And why would people be confident...that they're going to negotiate seriously and try to replace this mix of tax increases and spending cuts with something more sensible?

He also said that the fiscal cliff was a great opportunity to enact a plan that tackled both taxes and spending and contained elements to help growth in both the short term and longer term.

I think people look at this fiscal cliff with unease, which is understandable given their lack of confidence in the political system, but it's a really good opportunity for us....The magnitude of the changes we have to undertake as a country...are things we can manage. If you do it right, if it's balanced, if the burden is spread fairly, and again if you're doing things that help growth at the same time like infrastructure or investment in research and development or education, things like that, then these are manageable challenges for the United States and much more modest challenges than what you see countries around the world do to put their fiscal houses in order.

Geithner went on to argue that entitlements on both the spending and tax side were unsustainable, and that dealing with both in the context of entitlement and tax reform was the best way to go. He also said that deficit reduction was more than just about numbers and that policymakers should look to improve programs and the tax code instead of just cutting spending and raising taxes.

Secretary Geithner's endorsement of a Go Smart approach to deficit reduction is encouraging. We hope that the Administration and Congress are able to agree to a plan that takes that to heart.

Armed Services Committee Senators Call For a Deal

Yesterday, a group of six senators from both parties signed a letter to Senator Majority Leader Harry Reid (D-NV) and Minority Leader Mitch McConnell (R-KY) urging them to help replace the sequester with a smart and bipartisan debt reduction plan. The letter, signed by the Senate Armed Services Chairman Sen. Carl Levin (D-MI) along with Committee members Sens. John McCain (R-AZ), Jeanne Shaheen (D-NH), Lindsey Graham (R-SC) and Kelly Ayotte (R-NH) as well as Sen. Sheldon Whitehouse (D-RI), warns of the damage sequestration will cause and the importance of finding a solution in the upcoming months.

But instead of calling for a repeal of the sequester, the Senators commit themselves to a much more productive goal: a comprehensive debt reduction plan. The Senators argue that the consequences of the fiscal cliff are so severe that all ideas should be on the table.

We face a critical challenge in the next few months:  balancing the need to reduce the deficit with the need to safeguard important priorities, particularly protecting our national security, vital domestic programs, and our economic recovery.  We believe it is imperative to enact a bipartisan deficit reduction package to avoid the severe economic damage that would result from the implementation of sequestration. Any deficit reduction package should be long term and should provide as much certainty as possible for businesses and consumers.

The Congressional Budget Office has already warned sequestration in combination with the expiration of current tax policy could send our fragile economy back into a recession and raise unemployment above 9 percent, and the administration agrees that sequestration “would be deeply destructive to national security, domestic investments, and core government functions.”  Failure to act to address the debt would result in sequestration taking effect in January 2013 with significant detrimental impact on our fragile economic recovery.  According to a report done for the Aerospace Industries Association, if sequestration is allowed to occur in January, the nation will lose approximately 1 million jobs because of defense budget cuts and 1 million jobs because of domestic cuts in 2013....

Sequestration will endanger the lives of America's service members, threaten our national security, and impact vital domestic programs and services.  Meeting this challenge will require real compromise, and we do not believe that Congress and the president can afford to wait until January to begin to develop a short term or long term sequestration alternative.  All ideas should be put on the table and considered.  Accordingly, we urge you to press between now and November the Congressional Budget Office and the Joint Committee on Taxation to score any bipartisan proposals forwarded to them so that Congress may evaluate these plans.

We believe it is important to send a strong signal of our bipartisan determination to avoid or delay sequestration and the resulting major damage to our national security, vital domestic priorities, and our economy.

The letter can be found here. 

More on Capital Gains and Tax Reform

Last week, we featured a piece by CRFB Senior Policy Director Marc Goldwein discussing one option to reduce tax rates while maintaining progressitivity and raising $1 trillion in revenue: eliminating the special rates for capital gains along with other deductions. In theory, a lower tax on capital gains might be preferred in order to incentivize savings. But there are also serious drawbacks to the approach, including the tax arbitrage that preferential rates encourage and the general fact that other rates must be higher to make up for the lost revenue.

We also discussed a joint House Ways and Means Committee/Senate Finance Committee hearing on capital gains, which unsurprisingly produced split opinions. Those in favor of a capital gains preference argued that it would encourage savings and thus help economic growth, and it would help compensate for double taxation of gains through the corporate income tax and illusory gains from inflation. Opponents argued that the preference was very regressive, increased complexity in the tax code, and did little to help economic growth. 

Adding to the discussion on the tax treatment of capital gains are two helpful new papers from the Joint Committee on Taxation (JCT) and the Center on Budget and Policy Priorities (CBPP).  The JCT summarizes the current rules on taxation of capital gains and the end of the year changes under current law. Currently for taxpayers above the 15 percent bracket, the long-term capital gains (assets held for more than a year) tax rate is 15 percent while those in the lower brackets pay no capital gain tax. Under current law, the long-term capital gains tax will increase to 20 percent for the upper brackets and 10 percent for the lower brackets.

The capital gains tax, though, is not that straightforward. There are tax exclusions for assets passed on to heirs ("step-up" basis), portions of gains from home sales, and gains from certain small business stock. Deferral of tax burden exists for exchanges of similar property (like-kind exchanges) until the final property is sold, even if the exchanged properties have different values. Furthermore, some income that would normally be treated as earned income-- from sales of timber, livestock, and ore; coal royalties; and carried interest from partnerships to name a few -- gets capital gains treatment.

Cost of Capital Gains Tax Preferences (billions)
  2012 2013 2014 2015 2016 2017
Capital Gains Preference* $66.2 $62.0 $48.3 $59.4 $71.2 $80.2
Step-up Basis for Capital Gains at Death $19.9 $23.9 $36.2 $38.4 $40.7 $43.1
Exclusion for Home Sales $16.0 $23.4 $31.6 $34.9 $38.6 $42.6
Exclusion for Small Business Stock  $0.1 $0.3 $0.7 $1.0 $1.1 $0.8
Treatment of Certain Agricultural Income $0.9 $0.8 $0.7 $0.8 $1.0 $1.1
Treatment of Timber Income $0.1 $0.1 $0.1 $0.1 $0.1 $0.1
Treatment of Coal Royalties $0.1 $0.1 $0.1 $0.1 $0.1 $0.1

Source: OMB
*Includes carried interest. Excludes agriculture, timber, ore, and coal.

The JCT background report further reinforces a point brought up by Goldwein, that there is no one tax on capital gains, but rather a complex set of rules. This complexity in turn creates economic inefficiency and encourages efforts to classify or convert ordinary income into preferentially taxed capital gains. JCT itself demonstrated the complexity of capital gains rules for 2012 with a table in the report.

Chye-Ching Huang and Chuck Marr of CBPP argue that the special rates for capital gains and dividends should be reconsidered, claiming that the preference is economically inefficient, regressive, and expensive. Because the capital gains preference overwhelmingly benefits high-income earners, they say, it would be especially hard to both lower rates and raise more revenue while maintaining the code's progressitivity without raising that rate.

Having a lower tax rate for capital gains might be a policy that lawmakers choose to have. But the revenue will likely have to be made up with higher rates, which is why plans like Simpson-Bowles and Domenici-Rivlin chose to eliminate the preference. Lawmakers should put all preferences on the table, including those for capital gains and dividends, so as not to limit themselves as they work to improve the tax code and put the debt on a downward path.

FY 2013 Budget is Settled...For Now

Late last week, the Senate passed a continuing resolution (CR) by a 62-30 vote to keep the government funded for the next six months with only a week to spare before the start of the fiscal year. The government will be funded at a $1.047 trillion annual rate through March 27 of next year, representing a 0.6 percent increase for each of the 12 appropriations bills over last year. Including emergency, disaster and war spending, the bill funds the government at an annual rate of $1.15 trillion, a decline of $26.5 billion from last year, mostly due to the war drawdown. President Obama is expected to sign the bill sometime this week.

Passing the CR will avoid a government shutdown, which has threatened the budget process the past two years. But Congress leaves without addressing the sequester or the rest of the fiscal cliff. As Congress heads home to campaign, much of work is left still to be done, with the next opportunity coming during the lame duck session. The potential economic downturn with the threat of the fiscal cliff and possible downgrades from credit rating agencies ensure that the negotiations during lame duck period will be absolutely critical.

CRFB President Maya MacGuineas reminded us in an op-ed in The Hill last week that while the members of Congress might be allowed to head home, our fiscal challenges will stay on the table until we agree upon a plan to deal with it. As she states:

Such a plan must be bipartisan and comprehensive, addressing all parts of the budget, including cuts in low-priority spending, reforms of entitlement programs to reduce the growth of health care entitlements and make Social Security financially sound, and pro-growth tax reform which broadens the base, lowers rates, raises revenues, and reduces the deficit. It must also be large enough to stabilize and ultimately reduce the debt, but be implemented gradually to protect the fragile economic recovery and to give Americans time to prepare for the changes in the federal budget. Lastly, the plan should be conducive to long-term economic growth, protect the vulnerable, include credible enforcement mechanisms to ensure that the promised deficit reduction is achieved, and leave the next generation better off.

We are running out of time and rhetoric is of little value at this point. We need action.

Passing the CR might have prevented a government shutdown for now, but the hard work of both averting the fiscal cliff and a mountain of debt remains to be done -- preferably far in advance of January 1st.