StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between



How To Clean Up the Tax Code

26 Feb 2010
Posted by Bruce Bartlett

 My Forbes column this morning looks at the Wyden-Gregg plan for tax reform. BB

 

On Feb. 23 Senators Ron Wyden (D-Oregon) and Judd Gregg (R-New Hampshire) introduced S. 3018, a bill to reform the federal income tax. Unlike utopian reform ideas such as the flat tax, which would tear the existing tax system out by its roots and replace it with something completely different, the Wyden-Gregg plan has a more modest goal of just trying to make the tax system work a little better.
 
The problem historically with utopian plans is that they need to be implemented in totality for them to work. This means taking on every vested interest in any section of the tax code simultaneously. It was a simple matter for those opposed to touching the mortgage interest deduction to join forces with churches concerned about the deduction for charitable contributions and big corporations anxious to keep the research and development credit and all the other special deals that businesses have inserted into the code over the years.
 
Against this sort of opposition the benefits to individual taxpayers from a flattening of tax rates would be relatively small. Because we have progressive rates, the wealthy would benefit disproportionately while many of the poor would be devastated by elimination of refundable tax credits that give those with low incomes a negative tax liability--they get checks from the government rather than paying taxes to the government. Many in the middle class would benefit only modestly or would even pay more under a flat tax.
 
Over the years various tax reformers have tried to tweak the system by raising the personal exemption or continuing the deduction for mortgage interest and charitable contributions. The idea was to buy off the squeakiest wheels. But, in the process, the logic and integrity of the flat tax was lost, and it became harder and harder to make further exceptions lest we end up right back where we started.
 
More importantly, the flat tax always required a trade off between the exemption level and the rate. The higher the exemption, the greater the number of people paying no income taxes at all, which broadened support. But that required a higher rate to bring in enough revenue, which reduced support. Experience showed that the rate could not be much above 20% or support for the flat tax simply evaporated. This greatly constrained how high the exemption could go--which had to be high enough at least to cover everyone in the 10% and 15% tax brackets, or they would see a tax rate increase.
 
Finding a rate and an exemption that fully satisfied every political requirement proved to be impossible if the flat tax were to be implemented in a revenue-neutral manner--neither raising nor lowering the overall tax burden. Tax cuts for the rich in effect led to big tax increases on the poor and middle class, which was at least politically untenable. The only way out was to combine the flat tax with a huge tax cut so that basically everyone was better off. But with massive federal deficits facing us, the option of a tax reform that would sharply reduce overall revenues is not likely to be viable for some time to come.
 
Some reformers have tried to fudge the issue. They would set up the flat tax as an alternative tax system, and people could choose to either opt in or stay in the existing system. In theory no one could possibly be worse off, because the only people who would opt into the flat tax were those who would pay less. The problem, of course, is that this meant the flat tax would be a guaranteed revenue loser even if it had been designed to be revenue neutral. The only way it could work would be if everyone was eventually forced out of the old system and into the flat tax. But the last ones in would necessarily be those with the most to lose. In the opinion of most tax experts, the idea of allowing people to choose their own tax system was fundamentally ill-conceived.
 
Having exhausted every means of reconfiguring the flat tax to make it politically viable, the idea essentially ran out of steam and died during the George W. Bush years. Those who had previously supported the flat tax instead voted for every tax cut that came down the pike without worrying for a moment whether it was improving the tax code or serving some unmet social need. The only thing that mattered was whether a tax cut would buy votes for Republicans. If so, it was enacted with little if any debate.
 
Sadly, real tax reformers stood mostly by the sidelines while Republicans added one special interest provision after another to the tax code without the slightest concern for coherence, economic efficiency or the government's fiscal needs. Along the way, the whole concept of spending and tax cuts became deeply distorted.
 
Once upon a time there was a clear distinction between spending and taxes. Spending flowed from the government to the people; taxes flowed from the people to the government. But then one day someone invented the refundable tax credit. It was called a tax cut but did much more than just lower one's tax liability. If one had no tax liability, one could still get a "tax cut" in the form of a check from the government, which looked very suspiciously like spending.
 
The invention of the refundable tax credit allowed Republicans to spend just like Democrats while fooling their own followers into thinking that that they were only cutting taxes for the oppressed taxpayer. In fact, there were often cutting taxes for people who paid no taxes at all by sending them government checks that were labeled "tax refund," which made it okay, rather than "welfare," which had to be opposed. It was all very Orwellian.
 
The problem today is that we have gotten to the point where 47% of those who file federal income tax returns pay not one penny of federal income tax. While many of these people are poor, a substantial number can be found in the middle class and even among the wealthy, as the following table illustrates.


Percentage of Tax Units With Zero or Negative Tax Liability, 2009 (thousands of dollars)
Cash Income
Percent
Cash Income
Percent
Under 10
99.8
75 - 100
9.2
10 - 20
83.6
100 - 200
3.5
20 - 30
61.8
200 - 500
2
30 - 40
47.5
500 - 1,000
2
40 - 50
35.7
Over 1,000
1.5
50 - 75
21.5
All
46.8
 
Furthermore, even within income classes of people with roughly similar incomes there is now a crazy quilt of effective rates that vary enormously depending on things like whether one owns a house or rents, whether one has children, how much of one's income is derived from wages or capital, and various other factors. As one can see in the table below, for those in the middle quintile (20%) of income, 25% had no tax liability or a negative liability while the rest paid between 3.2% and 9% of their income in federal income taxes. Even among the ultra-wealthy, the top 1% of tax filers, effective tax rates vary 10-fold between 2.6% and 26.9%.

Effective Federal Income Tax Rates Within Income Quintiles, 2010
 
- - - - - - - - - Percentiles - - - - - - - - -
Quintiles of Cash Income
10th
25th
Median
75th
90th
Lowest
-39.4
-12.2
-4.2
0
0
Second
-20.8
-6
0
3.2
5.9
Middle
-4.5
-0.1
3.2
7.5
9
Fourth
0.5
3.3
6.4
9.3
13
Top
3.8
7.1
10.8
14.1
18.6
Top 1%
2.6
10.7
18.8
24.4
26.9
All
-12.8
-2.3
1.5
7.1
11.4
 
At a minimum this violates what was once an important principle of taxation--that those with similar incomes ought to pay roughly similar taxes. Economists call this horizontal equity. No one likes thinking that their next-door neighbor, who has a similar job and makes about the same annual income, is paying significantly less in taxes. That encourages people to cheat on their taxes and make bad investment decisions designed more to lower their taxes than increase their income. For example, I often hear of people in low tax brackets buying tax-free municipal bonds just because they hate paying taxes, even though they would be much better off financially buying taxable bonds with a higher return and paying the tax.
 
For these reasons, it would be highly desirable to clean up the tax code, eliminate special tax provisions, and try to establish more uniform effective tax rates across income classes. That is what Sens. Wyden and Gregg propose. Here is a list of the credits, deductions, exclusions and other tax preferences they would abolish. A key benefit would be abolition of the Alternative Minimum tax in return.
 
It's too soon to say whether the Wyden-Gregg proposal is a viable vehicle for tax reform, but it's a good start. It's realistic in its assumptions and goals and strives to be a 21st-century version of the Tax Reform Act of 1986. At a minimum it deserves serious consideration.
 
Addendum
 
Bob Williams of the Tax Policy Center comments here.

 

"47% pay no income tax" It's

"47% pay no income tax"

It's simply not true.

1. They pay payroll taxes which make the budget picture look rosier than it is, allowing federal tax rates to be artificially low. When it comes time to pay back this debt, the lower class will pay through reduced benefits.

2. A very high percentage of lower class income is consumption: When they buy a cheeseburger, a certain percentage of the price of that cheeseburger is the income tax of an executive with an obscene salary, taxes on dividends to shareholders, taxes on exercised options, taxes on company profits etc.


All federal taxes: income, payroll, corporate ...

"47% pay no income tax"

It's simply not true.

1. They pay payroll taxes

Social Security and Medicare are supposedly "progressive" by definition. If so, how can the taxes that pay for them not be?

which make the budget picture look rosier than it is, allowing federal tax rates to be artificially low.

Not any more. SS is back into deficit.

When it comes time to pay back this debt, the lower class will pay through reduced benefits.

This debt is to be paid by redeeming US bonds, financed by the progressive income tax. You believe the US will default on the trust fund bonds?

Well, if benefits are reduced you can bet it will be largely via progressive means-testing, from Bill Gates on down -- sticking it to the richest. After all, we already started this in 1983 by making SS benefits subject to income tax rates and remitting the tax back to the SSA, effectively a "progressive" benefit payment reduction, disguised to look otherwise. As there is no inflation-indexation for taxable SS benefits, they have steadily become more heavily progressively taxed year-by-year.

How can the Democrats permit anything else but such progressive benefit cuts? For that matter, how can the Republicans? It's a no-brainer that "the rich" would prefer to see their benefits cut rather than have tax on all their income rise -- and everyone else will want to see the rich's benefits cut first too, you can bet. (Check the incentives.)

2. A very high percentage of lower class income is consumption: When they buy a cheeseburger, a certain percentage of the price of that cheeseburger is the income tax of an executive with an obscene salary, taxes on dividends to shareholders, taxes on exercised options, taxes on company profits etc.

This is just confusing. How much of the cost of income tax on "obscene" executive salaries (made selling cheeeseburgers?) really is supposed to not land on them but instead on their employers -- and from there get passed on by their employers not to the business's owners, or suppliers, or other employees, but to the price of cheeseburgers? Not much, I'd wager.

And what's the remedy supposed to be? Cut income taxes on the rich, so they don't incur so much income tax to stick on others? Slash the obscene salaries of McDonald's managers, so they don't owe so much income tax?
....
I was thinking the same thing as the above poster. Is their an equivalant chart to includes payroll taxes?

Sure. From analysis counting all federal taxes: income, payroll, corporate, excise, as per CBO ...

Income quintile & tax rate counting all taxes, 2006:

Lowest: 4.3%
2nd low: 10.2%
Middle: 14.2%
2nd high 17.6%
Highest: 25.8%
Top 1%: 31.2%

Lots of other data at the link. And I've put up another comment pointing to the progressiveness of the spending side, financed by these taxes, which should not be overlooked.


I was thinking the same thing

I was thinking the same thing as the above poster. Is their an equivalant chart to includes payroll taxes?


Total taxes

I think it's worth noting in this context that because state, local, and payroll taxes are so regressive, total taxation in this country is not progressive at all above about $60K a year.

http://graphics8.nytimes.com/images/2009/04/13/business/economy/shares.jpg

That leaves a lot of room for making federal taxes decidedly more progressive.

I note that my home state has the most regressive taxes in the country:

http://www.asymptosis.com/most-regressive-taxes-my-home-state.html


"Payroll Taxes" aren't taxes.

"Payroll Taxes" aren't taxes. They are retirement contributions like those made to a 401K.


Prop it up

About 8% of all government spending comes from the social security "surplus", which has accumulated to about $2.5 trillion. That's $2.5 trillion borrowed from the middle class and working poor to subsidize "low taxes." Of course, the days are fast approaching when that money will have to be paid back. I predict a lot of crying about "soaking the rich."


@Yet another budget wonk

>"Payroll Taxes" aren't taxes. They are retirement contributions like those made to a 401K.

That would be true if the trust funds had anything in them except promises from the U.S. general fund.

The reality is that all Americans are on the hook to pay those liabilities, and they'll have to be paid through taxes--payroll, income, etc.

There's how we choose to tax, and how we choose to spend. Anything in between is smoke and mirrors.


Who pays the tax *and* who collects the benefits

If one wants to know how “progressive” a government's taxing-and-spending truly is, one must look not only at who pays how much in taxes but also who receives how much of the spending and benefits that the taxes pay for.

The Tax Foundation did this (.pdf) a couple years ago by several different measures -- including all federal taxes (income, payroll, etc), and state & local taxes and spending, etc.

For instance, counting both all federal taxes paid and federal spending received by households by income quintile:

(hoping the formatting works out)

quintile .. tax paid .. spending rec'd .. net .. rec'd/tax paid

lowest ...... $1,684 ..... $24,860 .... +$23,176 ... 14.8x
2nd low .... $6,644 ..... $19,889 .... +$13,245 ..... 3.0x
middle .... $13,028 ..... $16,781 .... +$ 3,753 ...... 1.3x
2nd high . $22,718 ..... $15,502 ..... -$ 7,216 ...... 0.7x
highest ... $57,512 ..... $18,573 .... -$38,939 ...... 0.3x

So the lowest-income quintile gets back 14.8 times the tax it pays, while the top gets back 0.3 times.

There are several interesting charts and graphs at the link.


If one wants to know how

If one wants to know how “progressive” a government's taxing-and-spending truly is, one must look not only at who pays how much in taxes but also who receives how much of the spending and benefits that the taxes pay for.

I just want applaud that excellent conceptual point. And it relates to the discussion on "tax expenditures" that's been taking place elsewhere. It's why I referred to the fairness of fiscal policy rather than fairness of the tax code in my response to someone arguing that many/most tax expenditures make the tax code fairer than it would be without them. I replied that, (1) since I'm talking about "tax expenditure subsidies", and there's no substantive, inherent difference between such a subsidy and the same thing done via explicit "spending" subsidy, the questions are whether or not we want a lot of subsidies in general and whether or not we want a particular given subsidy, and (2) yes, one can make a case (perhaps convincing in some cases) that some subsidies make fiscal policy "fairer". But an argument against reducing/eliminating a tax expenditure subsidy on the basis of "fairness" of the tax code is the same as an argument against eliminating an equivalent "spending" subsidy on the basis of "fairness", and is thus really properly viewed more broadly as an argument on the basis of "fairness" of overall fiscal policy (taxation and spending), not just the tax code.

Thus the correct and important conceptual point Jim makes above highlights the equivalence of tax expenditure subsidies and explicit "spending" subsidies, and in turn the prevalent (on the right and center) irrationality of viewing the former more favorably than the latter simply by virtue of the label and the inconsequential difference in bookkeeping and in the mechanics of the cash flow.


This leaves out quite a lot

The Tax Foundation study on which this linked report is based is an interesting effort.

But conspicuously missing (see tables 55 and 56) is the broad class of government outlays generally referred to as "corporate welfare." (Admittedly a darned difficult thing to measure.) It is all hidden in the categories shown, and as a result is allocated as income across all households.

This inaccurately represents our country's spending allocations to different income classes.

The current situation, for instance--whereby banks are getting almost interest-free loans supported by government money-printing--would not even appear in this analysis, nor would the benefits of it be allocated to the upper-income households that benefit from it so disproportionately.

Steve


Safety Net

In other words, households who make less than $24,000 and thus pay virtually no tax recieve an additional $6,000 per year in government spending compared to those making more than $100,000 and who do pay tax. Shocking stuff.


Equity and exponential forces

even within income classes of people with roughly similar incomes there is now a crazy quilt of effective rates .... those in the middle quintile (20%) of income, 25% had no tax liability or a negative liability while the rest paid between 3.2% and 9% of their income in federal income taxes. Even among the ultra-wealthy, the top 1% of tax filers, effective tax rates vary 10-fold between 2.6% and 26.9%.

At a minimum this violates what was once an important principle of taxation--that those with similar incomes ought to pay roughly similar taxes. Economists call this horizontal equity....

An important principle in principle, though in practice probably always most honored in the breech -- except for the brief shining moment after TRA '86.

E.g. back in the liberal glory days of the 70% (or higher) top tax bracket that so many on the left pine for today, historical data show the very highest-income level taxpayers paid lower effective rates than did persons at the lower but above-average income levels below them (as did the second-highest, etc.) because of all the tax breaks for investment income plus multitudes of legal tax shelters built into the law. "Tax planning" provided increasing returns to scale (as it does with the estate tax today). That wasn't even vertical equity.

The problem is simple but inexorable: The deadweight cost of taxes rises by the square of the rise in the tax rate -- that is, exponentially. That drives the creation of "loopholes", exemptions, credits, etc., both (a) on the merits to protect important economic activity from the deadweight cost; and (b) in response to the ever bigger payoff to both constituents and politicians from buying and selling tax loopholes, regardless of merit. So much for equity, horizontal or vertical.

Then the new loopholes and tax expenditures narrow the tax base, which requires by arithmetic even higher tax rates to collect any given amount of income, and the higher rates further increase the deadweight cost ... repeat cycle.

An exponentially rising force is tough to resist. And in that light, the unremittingly rising projectived future revenue needs of the govt are not a happy consideration regarding tax equity and efficiency.

TRA '86 was a brief happy moment when the process was reversed in a real left-right bargain, with the left givng up high tax rates and the right giving up scads of corporate tax breaks and rich-person tax shelters. We've been gradually unravelling it ever since.

But hey, it's been done once so at least we know it is possible -- as opposed to so many other pie-in-the-sky miracle reforms, from 90% top tax brackets to flat taxes to the Georgists and all the rest.

So if Wyden-Gregg can start some movement back in that direction, more power to them.

Maybe it could even be a precedent for learning once again how to make left-right bargains on other issues.


Piketty and Saez's work shows

Piketty and Saez's work shows that the top 0.01% of taxpayers paid average federal tax rates of 71.4% and 74.6% in 1960 and 1970 respectively. In 2004, they paid 34.7%.

http://elsa.berkeley.edu/~saez/piketty-saezJEP07taxprog.pdf


Effective tax rates, historically

IRS Statistics of Income, 1965 (the days of the good old 70% top tax bracket).

Effective tax rates by income level (tax actually paid/income, 1965 dollars)...

>$1 million: 30.8%
$500k to $1,000k: 32.8%
$100k to $500k: 36.4%
$50k to 100k: 31.2%

So the people who had income of $50k to $100k paid a higher effective tax rate those who had twenty times more income.

Also note that as in 1970 the top tax bracket rate was 71.75%, it seems unlikely that any income class paid an "average" tax rate of 74.6% -- not only did rates not go that high, but that would also mean receiving no benefit from all the other lower brackets.

Although for 0.01% of taxpayers, who knows what anomaly might apply?

(Also, 34.7% is higher than 30.8%.)




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