January 16, 2004
Broaden the Base
The Wall Street Journal's Alan Murray beats up on Democratic candidates who want to raise the top income-tax rate. That's a mistake, he says. They should broaden the base, he says:
Alan Murray: The Democrats call their fiscal gymnastics "tax reform," but it's almost the antithesis of the tax reform of 1986. That was a bipartisan effort, based on the notion that there was some good (and some bad) in what both parties were peddling. Republicans, concerned about growth, wanted to lower marginal tax rates; Democrats, concerned about fairness, wanted to eliminate special-interest loopholes and tax shelters. The result was a law that did both.... If Democrats want to adopt the reform label again, they should follow the same path. Instead of raising tax rates, they could focus on eliminating loopholes for the affluent and broadening the tax base. A few suggestions:
- Crack down on corporate tax shelters. There is still a yawning gap between the profits that companies report to their shareholders and the profits they pay taxes on. Closing that gap would raise a chunk of money.
- Eliminate tax breaks for high-end perks. While many low-income Americans lack health insurance, the nation's most affluent get subsidies for designer eyeglasses and designer smiles.
- Rein in the rules on charitable giving. High-income individuals cut their tax bills by giving artworks to local museums or real estate to universities, then write off gifts at inflated rates.
- Limit the tax break for mortgages. Interest payments on mortgages to as much as a million dollars remain tax deductible. Should taxpayers really be subsidizing construction of minimansions?
- Corporate welfare. Speaking of Iowa, how about the ethanol-tax break? Its main benefit goes to agribusiness, not family farmers. (But save that one until after the caucuses.)
Me? There's nothing wrong with raising the top rate, IMHO. (Although I have always thought that simply uncapping FICA is the way to make the tax system more progressive.) But Alan Murray is smart. And broadening the base is definitely one of the, if not the principal way to go.
Posted by DeLong at January 16, 2004 12:27 AM
Just wondering: lets say that we had a tax system in which there was a category of expenditure (x, say) that is deductable, and a category of expenditure y. Say that people, with no taxes, spend 70% of their MARGINAL income on y, and 30% on x. The marginal tax rate is, say, 30%. After taxes, incentives are are shifted a bit, so people spend 60% of marginal income on y, and 40% on x.
Given that deductions are made on the margin, I'd think that they would "effectively" act like lower rates, albeit changing incentives in ways that lower rates would not. I'm not sure about this, though, and I keep hearing that a broader tax base with lower rates is better than a narrower tax base with higher rates (though I always thought of this as being due to the fact that deductions and exemptions generally are NOT marginal, so they reduce tax collections while still reducing incentives for work, investment, etc.).
Anyway, back to the hypothetical example, would the tax, in terms of incentive distortions, and such, be equivalent to a 30% marginal income tax with no deductions, a 21% marginal income tax with no deductions, or an 18% marginal income tax with no deductions? I would guess 21%, but I'm mediocrily informed on such matters.
The obvious reason the Democrats don't crack down on corporate and affluent tax shelters and loopholes -- they probably get quite a bit of money from those groups.
History says that tax cuts are followed by spending increases. Reagan and Bush grew government in relative and absolute terms while cutting taxes, while Clinton did the opposite.
Their might be some logic to this in that if government seems cheaper, so we buy more of it. If we have to pay more for it we want less of it.
So, broadening the tax base should bring a demand for greater spending cuts. I would like to see if the demand for benefit reduction in social security increases when the FICA taxes are increased. In 1983 when the FICA rax approached 11%, retirement age was increased and benefits taxed.
I would like to see the response of the rich if we were to just raise the upper end tax rate to something hefty, like 50%. My theory assumes that there would be a very determined effort on the rich to get federal spending way down.
Alan Murray IS smart, and he may turn out to be the fair-minded conservative that David Brooks was supposed to be.
I don't want to sound stupid, but I don't think I know exactly what you mean by "uncapping" FICA. I just want to be sure that what I am thinking is right. So...
Which is why so many Dems are either excited about Dean, or jonesing for full-on public campaign financing.
And how much would uncapping FICA contribute to the long-term solvency of Social Security?
If it's at all significant, that would be a double-win.
As of 2003, FICA is not deducted from any income over $87,000. So, that's a nice tax break for those with incomes above that level. Medicare deductions are not capped however.
I like all of these suggestions. I think corporations should report all of the differences between GAAP and taxable income.
Uncapping FICA means that it would apply to all wage income. It is currently capped at something less than $100K (I think). The impact on marginal tax rates for high wage earners would be spectacular. However, many high earners usually do not receive the bulk of their income in wages. It comes as distributions from partnerships, corporations, LLCs etc. For folks like this (generally self employed), FICA is a $15.3% flat tax until it hits the cap.
However, it would fall squarely on overpaid corporate executives (at $7.65%) and I like it for just that reason.
So we have this situation where middle class wage earners have higher marginal tax rates than high wage earners.
Thanks, Joe Bob. I was thinking of something like that.
A return to bipartisanship, now there's an idea.
I like all of Murray's suggestions. On the other hand, I doubt that they by themselves will eliminate the deficit. So other things still have to come onto the table.
Speaking of broadening the tax base:
How come nobody here is giving any thought to abusive tax shelters?
As far as I know, there are several bills (e.g. S.1937) on the floor of both Houses, there is a bi-partisan initiative (senators Grassley, Rep., chairman of the Senate finance committee, and Baucus, ranking member, Dem.), based on a recent GAO report on abusive tax shelters (see http://finance.senate.gov/), all aiming at closing loopholes in the tax code, and the IRS is giving a lot of thought (since 1999: Revenue Ruling 99/14) to determining which schemes lack "real economic substance", i.e. "a transaction has economic substance only if-- `(I) the transaction changes in a meaningful way (apart from Federal tax effects) the taxpayer's economic position, and `(II) the taxpayer has a substantial nontax purpose for entering into such transaction and the transaction is a reasonable means of accomplishing such purpose." (n the words of S.1937).
In Europe, especially Austria and Germany, there are many cities involved - for reasons of severe budget problems - in LiLo schemes, "selling" properties such as sewage systems, power lines, even tram and metro systems (Frankfurt was close to to selling the Metro, until the City Council was stopped by a popular initiative calling for a referendum on the deal) to US based trusts and leasing them back. Right now, Sen. Chuck Grassley seems to be better known (and even less popular) than President Bush, with City Halls here. German "Stadtkaemmerer" (Aldermen responsible for city budgets) are very concerned - which they should have been before closing those deals, anyway.
The point is that a European city gets cash on the spot (really, only about 5 % of the total "value" of the transaction - which, however, still may be a few hundred millions, which is a lot for ailing city budgets), whereas the investors behind the trust get 30 year tax deductions amounting to hundreds of billions. (Which is why Grassley speaks of tax evasion tout court).
The whole thing is based on legal fiction, or rather, on different notions of "property rights" in US and European law. While the IRS is supposed to believe that the US investors really do own the infrastructure they "bought" in Europe, local tax authorities and city councils are supposed to believe the stuff is still, for all practical purposes, "our" property. What this could mean in terms of judicial disputes on improper maintenance of the asset in question, so far nobody knows, since there is no case law yet. The contracts, as a rule, consist of millions of words (in English legalese), the most important of which are the "non-disclosure" clauses, and no city councillour ever read all of them, let alone understood the terms.
Apparently though, US corporate taxes being as low as they are, it is not prevalently US corporations "investing" in the Delaware based trust funds (run by Alabama banks whose corporate balance is smaller than a German medium city Sparkasse = municipal savings bank). Apparently, it is "European" money transferred from countries with more severe corporate taxation to the US to reap US tax benefits. So in the end, the cities "profiting" from LiLo schemes are eroding their own tax-base. And should be grateful to Sen. Grassley, if they only had the sense to understand what is going on.
Maybe the whole thing is much more of a European issue and nobody in the US gives a damn about cross border leasing, and Grassley is just a busibody secretely laughed at by the Bushies.
Still, it would be interesting to read some thoughts of Prof. DeLong and his illustrious friends on the subject.
My only issue is with the mortgage deduction. In some areas of the country (Brad, you should know all about his) the median price of a home is quite high. My brother had an identical house to his (3 bedroom, 2 bath calif. ranch) sell for over a million two years ago. That was in Palo Alto. By no means is it a minimansion. Perhaps some other mechanism to gauge house value relative to regional markets? Too complex?
A million dollar home is a million dollar home - you are either paying for a big house or a desirable location. (Palo Alto is a desirable location.) You can't find anything in California in your price range? All of coastal California may be a desirable location. Try moving to the midwest or south - lower taxes, lower property costs, maybe lower wages, but the income tax rate structure doesn't ream you in low-cost of living states like it does in the high cost of living states.
I wonder when people are going to realize that property costs are high in overregulated places and places that everyone wants to live - they aren't random. And that both overregulation and desirable weather are luxuries, not birthrights.
I consider myself conservative and I don't mind any of his suggestions. I don't think the gap between reported earnings and tax earnings indicates any kind of tax loophole, however. What are you going after? Accelerated depreciation and stock options.
Income tax relief on mortgage interest payments has been removed in the UK. It was done gradually; initially with a cap on the capital amount borrowed (~$50 000 in 1986), then only allowing relief at the middle rate of tax, then total abandonment. The world has failed to end and house price inflation is still at ludicrous levels. We still have an upper cap on employee NI contributions, which I imagine are equivalent to your "FICA" but that's slowly eroding too. I can remember when it was a flat rate.
Murray is right but does he not know that the Bush, Forbes, et al. agenda is to whittle away at all forms of taxing capital income? In other words, it is those who have highjacked the Republican party that are narrowing the base.
Can someone explain for me, please, the terms "margin" and "marginal"? I've been reading about taxes for a while now and sort of just passing over the terms without quite understanding. I appreciate it.
On the FICA question. If the cap- taxes levied on only the first $87,000 of wage earnings annually- were removed without increasing benefits accordingly between 70 and 80% of the projected gap is gone. If the cap is merely raised or the benefits ceiling is partially increased the contribution to balance slips accordingly.
None of this touches non-earnings income- capital gains, rents, dividends, etc.
The worst charitable deduction abuse: being able to deduct the full appreciated value of a security.
To my mind, there should be no difference between selling an asset then donating the money to charity, and donating the asset directly. But being able to deduct the appreciated value of a security means that you are deducting income you never earned!
Example: I have $130K worth of stock that I paid $30K for. If I sell the stock, and donate the money to charity, I get a $100K capital gain (which I must pay taxes on), but get to deduct $130K from my income -- so the *net* effect on my taxable income is a $30K deduction, which is just what I paid for the stock in the first place. On the other hand, if I donate the stock to charity, I get to take a $130K deduction *even though $100K of that was never included in my taxable income*.
For any asset like stock, or valuable collectables (art, etc.) you should only be able to deduct your basis -- the amount you paid for it.
Jeremy: "Marginal" tax rate is the tax rate you pay on the last dollar you earned. The effect of some policy "at the margin" refers to how it affects small changes in income/spending/whatever, rather than how it affects total income/spending/whatever.
On the mortgage deduction in general, has anybody done a study on the effects of interest rates on tax revenue? (on a federal as well as a state income tax level) To explain, back in the early 80s, mortgage rates were in the low teens; hence mortgage deductions were higher and therefore actual taxes paid lower. With rates close to an average of 5%, the interest rate deduction should be lower too.
IOW, with the Clinton administration's [or Alan Greenspan if you are a GOPer who can't give the Clinton admin. any credit whatsoever] sound fiscal policy of getting interest rates down, they created higher tax revenue by reducing mortgage interest rate deductions.
On a political level, eliminating the FICA cap has the same effect of raising tax revenues without the usual suspects braying about how their taxes were raised.
Am I missing something here?
I couldn't agree more about increasing the base. No it won't solve the deficit by itself, but neither will cancelling Bush's tax cuts (there are the two little matters of runaway spending and the continued lack of big capital gains to be taxed.)
On FICA, I agree that eliminating the cap could make sense. However, remember why its there. SS benefits are linked to the amount you pay in. Limiting contributions limits the eventual benefits. If Bill Gates paid 15% of all his income, he'd qualify for a million dollar social security check (I know, his income is mostly capital gains, not wages, but the point is still valid even if applied to a $1MM/year wage earner.) I would advocate breaking the link, but this would involve admitting that social security is a tax-financed government transfer payment, and not a saving scheme. This would make it hard to justify paying full, untaxed SS benefits to non-poor retirees. OTOH, try facing the AARP lobby if you proposed to cut benefits to current and/or soon to be retirees. I don't mind paying more in FICA to ensure that no-one will have to eat dog food in thier old age; I do mind if much of the money will go to those who are only marginally less well off than myself.
Alan Murray's readers did splendidly well in the 1990's with the higher marginal tax rate set by Clinton. This rate has little effect on their behavior, but a lot to do with the deficits. Aren't his readers smart enough to know that their long-term interest lies with the rate set at whatever value is needed to ensure fiscal balance given whatever spending priorities like Iraq, war on terror, prescription drugs, Mars, etc. are set by their president?
I was thinking about the uncapping FICA option recently too. It would undo the Bush income tax breaks to the wealthy, and sort out much of SS deficit, and would appear to have considerable potential for popular support both by the link with SS and by ending the position where the rich pay this tax only on part of their income, while you, the average voter, pay it on all of yours.
My question: Does anyone have a better idea of the politics of this proposal? Is there polling on this issue? What about previous votes in Congress when it has been proposed, or previous Presidential candidates who have floated it?
Brad-- my memory is not what it use to be, but wasn't eliminating many tax shelters part of the original deal with the Reagan tax cut. Part of the trade off was lower rates, but eliminate many of the tax shelters.
It is part of the problem with any rule or regulation. Whatever one person is smart enough to dream up as a tax rule or regulation someone else is smart enough to figure out a way around it. There is a massive industry out there of very smart tax lawyers, etc, that all they do is try to figure out how to game, or beat the IRS regulations. If you eliminate one set of shelters before long these people will come up with a new set of tax avoidance schemes.
The inherent problem is that we use our tax system to do many things. As long as the tax system is this way it will remain extremely complex and some people will be able to game the system. People do not want to trade off their individual tax breaks for a simple but better
Re uncapping SS.
While I am an favor, it does not "undo" the tax breaks to the wealthy (in most cases). This is because the wealthy (and non-wealthy) small business owners, partners etc. have non-wage methods to take money out of our businesses. Full disclosure: I am a small business owner who will make money in 2004 for the first time since 9/11.
"Alan Murray's readers did splendidly well in the 1990's with the higher marginal tax rate set by Clinton. This rate has little effect on their behavior, but a lot to do with the deficits. Aren't his readers smart enough to know that their long-term interest lies with the rate set at whatever value is needed to ensure fiscal balance given whatever spending priorities like Iraq, war on terror, prescription drugs, Mars, etc. are set by their president?"
You cannnot ignore the low level of federal spending. Remember the "era of big government is over" speech? I don't see any political party out there interested in keeping spending down.
Clint Stretch of Deloitte - whose job it is to explain the implications of proposed tax changes to clients(which he does very well and with a lot of candor) - is quoted in Daily Tax Report as saying repealing the Bush tax cuts will have its most substantial impact on high income groups. This is precisely the same as what Brookings has said when they note that high income groups received the most benefit from the Bush tax cuts. And Mr. Stretch is not exactly a flaming liberal. I wonder if Howard Dean reads the Daily Tax Report?
FICA, as it stands, is a flat tax on the poor and middle class. The money goes directly to the general fund. It is in no way, shape or form any different from monies paid in other forms of tax.
Which leads me to this: America, we already have a flat tax system. It only applies to poor and middle class folks, though. Rich people don't pay it.
When you add the 15.8% of FICA(employee and employer) to the 15-20% our low/average income workers are paying already, they're up over 30% in tax, as a percentage of income.
High income folks making 500k+ a year pay around the same amount, as a percentage, because FICA is a dramatically lower percentage of their overall income, due to the caps.
It's a great scam.
If you think there's a problem with taxes now, just wait a few years. Brookings researchers estimate that by year 2010 one-third of all taxpayers -- 33 million returns -- will be paying alternative minimum tax in addition to regular tax, and that almost everyone in the $100K to $500K income range will pay AMT. See: http://www.taxpolicycenter.org/research/Topic.cfm?PubID=1000505.
The AMT, by the way, was the bastard offspring of 1986 tax reform -- making that legislation appear revenue neutral in the short-term at the price of horrendous permanent complexity.
While uncapping FICA would hit some high earners, it is not the best way to go. It would just increase the share of gov't revenue that comes from EARNED income, continuing the current trend away from taxation of the inherited money class.
Better would be to eliminate FICA and raise the progressive income tax rates enough to make it up. This has two advantages:
1) It recognizes the fact that we are spending SS revenue as general revenue, and
2) It might even generate support in the business community because they could stop paying their 7.65% share, too. (It might require and increased corporate tax to cover that, but at least that would only be paid by profitable corps--entrepreneurial startups would be encouraged because they wouldn't have that tremendous fixed cost during their pre-revenue period.)
Dennis is right. Don't pull the cap off of FICA or the rich will just shift all their income into stock options (15% rate), dividends (15% rate), benefits (0% rate), and subchapter S corp. distributions (35% max rate). Those rates are even lower than current max rates (37.9%).
The way to do it is to create an income surtax of 14.3% (the current total FICA rate) on income over $30 000 and up to infinity. That should be about revenue neutral, flat, and progressive. It would replace FICA totally and not unduly burden wages.
And we might want to adjust the bottom boundary or reduce the rate and make it apply to all income.
Jeremy: "Marginal" in this sense means "on the next unit". So your marginal tax rate is the tax you would pay on the next dollar of income you earn.
In general, in economics, all decisions are assumed to be baby steps. You don't choose to produce 100 widgets - you produce 1, decide if you get more revenue than cost from the next, decide whether to produce another, if yes, repeat. When you get to 100, you compare marginal cost - the cost of that unit, to marginal revenue - the additional revenue from that unit, find marginal cost is greater than/equal to marginal revenue, and stop. Each of those decisions was a marginal step along the way. This is greatly simplified, but it is more or less how it works.
When we add math to all of this, the "marginal" anything becomes the 1st derivative of the function describing that thing - the same relationship as velocity has to location.
Agree that removing the FICA cap is a bad idea because it would just boost the amount of SS that rich retirees get. The solution is to raise the cap to, say $250,000; exempt the first 7,500-10,000 of wages from SS taxes to help low income people; raise the marginal tax rates on the top two brackets back to 35% and 39%, respectively. Then continue to tax SS benefits over an amount appropriate to capture back overpayments to high-income individuals.
"The solution is to raise the cap to, say $250,000; exempt the first 7,500-10,000 of wages from SS taxes to help low income people; raise the marginal tax rates on the top two brackets back to 35% and 39%, respectively."
Pure insanity. Why not just confiscate all income above 80,000?
Regarding tinkering with social security: If I understand the current scheme correctly, it is supposed to implement some notion of "fairness" by way of what I would dub "principle of proportionality". By assigning credits in proportion to the amount of social security tax paid, retirees will roughly get a portion of the total payouts equal to their portion of total contributions. (This is not entirely correct, but the intended principle.) Whether that's fair is arguable, but I have not heard of a fairer system yet, considering that the contributions come from earned income.
To maintain (arguably) some notion of fairness in the entitlement systems, then with a broadened tax base (which I would generally find desirable, and which should not just mean uncapping taxes, but including other income (wealth?) types), the range of entitled persons would have to be broadened accordingly. In regard to the above, a "fair" allocation of benefits has to be devised. It is currently beyond me to come up with a good solution quickly. There are also lots of technical details -- should US income of foreigners be taxed (presumably awarding benefits?) etc.
This calls for administering a benefit allocation system which by the increased tax base would be of much larger proportion than the current system.
But then we have computers today.
rvman wrote, "In general, in economics, all decisions are assumed to be baby steps. You don't choose to produce 100 widgets - you produce 1, decide if you get more revenue than cost from the next, decide whether to produce another, if yes, repeat. When you get to 100, you compare marginal cost - the cost of that unit, to marginal revenue - the additional revenue from that unit, find marginal cost is greater than/equal to marginal revenue, and stop. Each of those decisions was a marginal step along the way. This is greatly simplified, but it is more or less how it works."
Do you have any evidence that firms actually work this way?
spencer wrote, "Brad-- my memory is not what it use to be, but wasn't eliminating many tax shelters part of the original deal with the Reagan tax cut. Part of the trade off was lower rates, but eliminate many of the tax shelters."
You're right. The 1986 tax reform cut marginal tax rates quite a bit, but also broadened the tax base by a lot. If I recall correctly, it also resulted in the elimination of differentials between taxes on income and capital gains.
Tax reformers are on the right track. My dream would be some sort of constitutional amendment, enforceable by private action, that says taxes are levied solely for the purpose of funding public expenditures that cannot be covered by user fees and that taxes should be neutral with respect to their economic impact.
Tax loopholes/deductions are political bribes paid for by taxpayers who cannot take them. Tax rates should be mildly progressive in order to reflect the fact that those with higher incomes derive greater value from general government actitivy, as, for example when defense spending protects us from hostile invaders who would disrupt the economy that blesses the rich with high returns on their work and investments; but when that progressivity extends to punishment of the rich or Ponzi schemes to overcome the natural tendency of incomes to be unequal, the effect is counterproductive. Obviously the rich, being few in number, see little hope in mobilizing a majority of voters to agree to lower top marginal rates, instead, they use their resources to bribe politicians into writing loopholes/deductions into the tax codes.
The Social Security Trust Fund is a scam. Government should take care of the elderly and disabled who, through no fault of their own, are left without either income or the ability to work; but call it what it is, welfare or 'income support', and fund it out of general revenue for 70-year old retirees just as it is for 6-year children without working parents.
I admit that a) I'm not an economist, b) I'm not familiar with all the nuances of the tax code with regard to either personal or corporate deductions etc., and c) I don't really care to be. However, it seems to me (in my admitted state of naivety) that reasonable/fair deductions, should relate to what the cost of 'survival' is, and as this varies with geographic location, so should the basis of the deduction. If this were the case in the last decades perhaps we would not have have the mass exodus of silicon valley going forward and transfering the same economic problems (e.g., artificially high real estate etc.) to neighboring states (Portland, Seattle). In general, eliminate FICA and have taxes/deductions based on all income, regardless of source. Have the tax brackets based on % of reasonable cost of living. That is, we now have 30+ tax brackets based on income range; we would instead have brackets based on cost of living ranges (NYC=SF, Topeka = Little Rock etc.). Poverty level would be defined as income less than or = to 'Reasonable Cost of Living". Taxable income would start at some bracket , say 125%-150% of RLC and brackets would continue progressively (e.g., 2-3X RLC, 3-4, 4-5 etc.). A flat (preferrably) or progressive tax rate would apply but your sole, nontaxable amount (deduction) would be the RLC. Determination for RLC would be 1X for singles, 2X for married/civil union, and 3X with one additional dependant (be it child or elderly) and something less than a full-fold increase for additional dependants. I'll save corporate ideas for another post. In this way, if you were a millionare living in inexpensive town, USA, you don't get a write-off for your multimillion dollar mansion and beach home, you get what everyone else does - a reasonable cost of living deduction and pay taxes on everything else. We could put all the people now processing complex forms at the IRS and turn them into auditors. RLC data should be easily ascertained and updated annually. Just a simple fair plan from an economics-challenged taxpayer.
>>spencer wrote, "Brad-- my memory is not what it use to be, but wasn't eliminating many tax shelters part of the original deal with the Reagan tax cut. Part of the trade off was lower rates, but eliminate many of the tax shelters."<<
I prefer to think of it as the Bill Bradley 1986 tax reform: Bradley had been pushing it for a decade, and finally got somewhere when Reagan's Treasury Secretary James Baker decided to sign on. See _Showdown at Gucci Gulch_...