Tax Rates, Loopholes, Taxes, Revenues, and Fairness

There are still optimists in Washington.  Many of them probably lean on the old adage attributed (probably wrongly) to Winston Churchill about “…after all of the other possibilities.”  But we are running out of time, so we had better begin to discard those other possibilities at a faster rate.

One of the “other possibilities” would be the President’s insistence on increasing tax rates in the highest brackets of the income tax schedule.  The President isn’t alone in this focus on tax rates; Nate Silver of the New York Times, who earned plaudits for the accuracy of his analysis of the presidential race this year, weighed in along the same lines on a rumored congressional proposal.

The President (and Silver) believe that this position is driven by fairness.  But very few tax economists, including among the most principled supporters of the progressive income tax, believe that the statutory – or “marginal” – tax rates determine fairness.  Most would judge fairness from the average – or “effective” – tax rates – that is, the taxes paid as a percentage of appropriately measured income.  The statutory rates influence instead the distortions induced by the tax system – including, but not limited to, possible attenuation of incentives to engage in productive behavior.

So in other words, if those with the greatest ability to pay in fact pay a fair amount to support the Republic, it doesn’t matter for fairness what their marginal tax rate is.  In fact, in the interests of economic efficiency, the lower that statutory tax rate, the better – all else (including fairness and fiscal responsibility) equal.  On that basis, the President’s headline negotiating position is off base.

To be sure, the President says that his position is totally logical, and that “It’s just a matter of math.”  (See the President’s Bloomberg interview on this issue)  The premise of the argument is that the people with the greatest ability to pay do not have enough “loopholes and deductions” to close to raise the revenue needed (in addition to sound spending cuts) to solve the budget problem.  Therefore, unless we increase top-bracket tax rates, hitting the revenue target will require putting an excessive additional tax burden on others with less ability to pay.

For example, in the interview, the President cites and then discards a cutback in the deduction for charitable contributions, and the media otherwise jumps immediately to the deduction for mortgage interest.  The charitable deduction is taken to be the bedrock of the American voluntary sector, and the mortgage interest deduction is taken to be the bedrock of the American middle class.

Arguably, however, the President’s vision of “loopholes and deductions” is too narrow.  Three of the very largest preferences in the tax code are highly concentrated on the very most well-off taxpayers, and putting those preferences on the list would shift the President’s calculus significantly.

The Administration’s annual budget presentation estimates that the tax preference for capital gains (including the forgiveness of taxation upon death) will cost the Treasury more than $85 billion in 2013.  The exclusions for pensions and other forms of retirement saving exceed $160 billion.  And the preferential rates for dividends cost over $20 billion.  All of these provisions favor mostly upper-income taxpayers.  The tax reform proposal of the bipartisan Domenici-Rivlin Debt Reduction Task Force (convened by the Bipartisan Policy Center) would eliminate the tax preferences for capital gains and dividends, and reduce the maximum size of tax-preferred pension contributions.  It achieves sufficient deficit reduction to reverse the growth of the public debt relative to the size of the economy (the “debt-to-GDP ratio,” in the language of the Wonkish people), with a top-bracket income tax rate of 28 percent (for corporations as well as individuals.

Each of these steps – elimination of tax preferences for capital gains and dividends, cutbacks of maximum contributions under retirement plans, and reduction of the top-bracket individual income tax rate to 28 percent – was included in the Tax Reform Act of 1986, hailed by then-President Ronald Reagan as a victory for the American people.

Now, everyone has his own view of what is attainable in our political system today.  The Center for American Progress released its own tax plan yesterday, including the increases in top-bracket income tax rates espoused by President Obama (but with many other features that are different from what the President has put forward.). They favor Obama’s proposed increase in tax rates substantially on the grounds that the elimination of tax preferences in the Bipartisan Policy Center is not politically feasible.  Others might say that the increase in tax rates in the Center for American Progress plan is not politically feasible.  (The Bipartisan Policy Center panel was evenly divided between Republicans and Democrats.)  Only a seer can know for sure.

But we do know that the status quo is not feasible – or at least not sustainable.  And we know also that a system with lower tax rates and lesser tax preferences is more conducive to economic growth (see here for a previous discussion in this space about the sensitive issue of small business and capital gains), as well as less conducive to economic distortions, tax planning and manipulation – and therefore arguably fairer as it reduces the budget deficit. So if we must make a political stretch in any event, why not the best?

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