Fixing Taxes


Fixing Taxes

The personal income tax, the corporate income tax and the estate and gift tax all harm our economy on a daily basis by reducing our incentives to work, reducing incentives to invest in our country and distorting decisions about how to invest and what to produce. Each is riddled with loopholes, which let the rich, particularly the super rich, off the hook. And each comes with major compliance costs.

In 1913, when first instituted, the personal income tax ran 400 pages. Today the code is almost 75,000 pages long! All those pages are there for three reasons: to provide loopholes for special interest groups who have bribed our politicians with explicit and implicit campaign contributions, to keep tax lawyers, accountants and government bureaucrats fully employed, and to drive us crazy.

The personal income tax is horribly complex because it’s actually multiple tax systems disguised as one. Yes, it includes basic income taxation with eight progressive tax brackets. But there’s also the Alternative Minimum Tax, the Earned Income Tax Credit, the Child Tax Credit, the taxation of Social Security benefits, the Medicare high-income premium tax, PEP (the phase out of personal exemptions), PEASE (the phase-out of itemized deductions), the separate taxation of capital gains, the separate taxation of dividends, the high-income Medicare asset-income surcharge tax, the high-income Medicare labor-income surcharge tax, the taxation of retirement account contributions and withdrawals, the treatment of health savings accounts, the tax treatment of 529 educational saving plans, carried-interest taxation, and, well, I’ll stop now to preserve your digestion.

The corporate income tax, meanwhile, collects less than 2 percent of GDP but is very successful in getting companies to headquarter offshore. Examples include Burger King, which is now Canadian, Medtronic, which is now Irish, and Tyco International, which is now Bermudian. These corporate inversions garner most of the press, but the far bigger story is that large international corporations, whether headquartered in the U.S. or abroad, face a 35 percent effective marginal corporate tax on the return to their U.S. investments. If they invest in any other developed country in the world, they face, on average, a 19 percent corporate tax. As should be obvious, our 84 percent higher corporate tax rate makes our country uncompetitive. And much of the fallout lands on America’s workers, who find far less demand for their services.

The estate and gift tax is also a very bad joke. The top marginal rate is 40 percent, but only 1 percent of the $1 trillion or so bequeathed each year by the super rich is actually paid in taxes. This comes thanks to a range of trust and life-insurance gimmicks that the rich use on a routine basis. One tax expert, George Cooper, wrote a book about the estate tax that he appropriately titled “The Voluntary Tax.”

My Tax Reform

I’ve examined a host of tax reform proposals over the years, such as the FairTax, the Flat Tax, the USA Tax, the Value Added Tax (VAT), the Rubio-Lee Tax Plan, the Sanders Tax Plan, the Trump Tax Plan, the Clinton Tax Plan, the Modern Corporate Tax, the Competitive Tax Plan, the X-Tax, the Growth and Investment Tax Plan, and several others. I’ve done and continue to do research on the economic effects, work incentives and fairness of different tax reforms. Indeed, together with several co-authors, I’ve done most of the basic research on the FairTax and testified to the House Ways & Means Committee about its merits. I’ve also worked up two tax ideas of my own: the Purple Tax and the Common Sense Tax.

Almost all of these proposed reforms have great merit compared with what we now have. But none strikes me as achieving the right balance among our significant revenue needs, the requirement to maintain tax fairness/progressivity and the provision of far better work incentives. Consequently, I’ve combined what I think are the best elements of many of the above-listed plans in my own tax plan, which I’ve formulated in consultation with a number of public finance experts.

When it comes to targeting revenue, my goal is to generate about 5 percent more revenue as a share of GDP. This is essential to help close the fiscal gap. My plans for fixing Social Security and healthcare will, over time, produce significant spending cuts without undermining retirement income or healthcare coverage. These reforms will, in conjunction with the higher revenue, suffice to fully eliminate the fiscal gap.

To repeat, my tax reform eliminates the personal income tax, the corporate income tax and the estate and gift tax entirely. (I would include transition rules to make sure unpaid taxes are collected.) In their stead, I would introduce four new taxes, significantly modify the existing FICA payroll tax, replace the Earned Income and Child Tax Credits with a direct payment to all Americans and eliminate the Food Stamp program in favor of direct food provision.

The latter two policies in conjunction with my healthcare reform are meant to help eliminate the poverty trap that confronts the poor with a terrible choice: Stay unemployed or go to work for little or no net income after we’ve made you pay more taxes and taken away some or all of your tax credits, Food Stamps and healthcare benefits.

Under my complete set of fiscal reforms, every American, with no exception, gets to keep 70 cents of every dollar he or she earns. That may seem low. But for most Americans, it’s actually higher or far higher, especially in the case of far too many poor households, than what they now get to keep. 

Another significant benefit of my plan is that the vast majority of Americans – roughly 80 percent – won’t need to file any tax returns or deal with any government bureaucrats in meeting their tax obligations, receiving basic health insurance and receiving income in old age.

Criteria for Tax Reform

Fixing our tax-transfer system is imperative. But the fixes must obey three constraints: they can’t worsen inequality, they must dramatically improve work incentives and, in conjunction with other fiscal reforms, they must raise enough revenue to ensure Uncle Sam can pay all his bills over time, leaving no fiscal gap for our descendants to cover.

The Business Cash Flow Tax or VAT

The business cash flow tax rate would be 20 percent. It will collect far more revenue than the corporate income tax it replaces. The tax will be very easy for any business to calculate. A company simply has to pay 20 percent of its annual total cash receipts, less its total purchases of goods and services, including investments.

Rather than taxing profits from new investment at 35 percent, the business cash flow tax effectively taxes profits at zero percent. The reason is that while the additional sales revenue generated from investing will be taxed at 20 percent, the initial investment is deductible at the same 20 percent rate. The present value of the initial deduction exactly offsets the present value of the future taxes, leaving the effective tax on the investment at zero. This well-known means of making America the most tax-advantageous place to invest in the developed world (called immediate expensing), is part of most of the above-referenced tax reforms.

Republicans have long been opposed to the business cash flow tax because they didn’t want to add yet another tax system on top of those we now have. That’s clearly not part of my tax plan, which eliminates three federal taxes that are, when examined closely, a true disgrace to all Americans — whether Democrat, Republican or, like me, aligned with neither party.

Interestingly, Republican opposition to the VAT appears to have lessened considerably after the apparent runner-up for the Republican Presidential nomination, Senator Cruz, included the VAT as part of his tax reform proposal. Just to be clear, the fact that Senator Cruz is calling for a VAT, which is used throughout the developed world, and that I’m calling for a VAT, albeit at a higher rate, does not make me a fan of the senator, let alone of his other policy positions. It does make me someone who can listen and learn from a Senator Cruz or a Senator Sanders with open ears.

Subjecting All Wages and Self-Employment Income to the FICA Tax

Removing the ceiling on payroll taxes makes high earners do what everyone else does, namely pay payroll taxes on all their earnings. This increase in progressivity will not, however, be offset by higher Social Security benefits. As described in Chapter 9, I’m proposing a modern, personalized version of Social Security, whose benefits are independent of future Social Security payroll tax contributions.

Future Social Security payroll tax contributions will be used, over time, to pay off the Social Security benefits we now owe. But, under my plan, no one will accrue additional benefits under the old system. Instead, they will get everything they are due under the old system as they proceed through retirement. But they will also receive benefits under the new system, which I call the Personal Security System. This is one of my bipartisan purple plans that I’ve worked out in recent years. Purple is, of course, the combination of red and blue.

Chapter 9 has the details, but let me hasten to say that my Purple Social Security plan, while it features personal accounts, government matching contributions, contribution sharing (between spouses) and collective investment in the market, involves no involvement whatsoever by Wall Street and, therefore, provides no income whatsoever to Wall Street. Everything is done by a computer, and the government guarantees that the value of our Personal Security Accounts (PSAs) never falls below the sum of our contributions, adjusted for inflation.

Some further points about the Social Security payroll tax. Going forward everyone, including those in state and local government jobs who have been exempt from Social Security taxation, will have to pay the Social Security FICA tax. On the other hand, I would ask Congress to limit the Windfall Elimination and Government Pension Offset provisions to reflect only the pre-reform years of uncovered employment. Second, all income from LLC and subchapter S companies will be subject to FICA taxation. Third the current market value of all compensation in the form of stock and employee fringe benefits will be subject to FICA taxation. Finally, when exercised, the value of stock and stock options realized in excess of their market value at issuance will be subject to FICA taxation.

The Progressive Personal Consumption Tax

The progressive personal consumption tax would exempt the first $100,000 in consumption. Consequently, the great majority of households, roughly 80 percent, won’t need to worry about this tax. It would also exempt consumption paid out of labor earnings. Its rate would start at 5 percent and rise to 30 percent. All consumption, including the imputed consumption services, called imputed rent, derived from ownership of personal wealth (e.g., homes, yachts, planes, jewelry, and art, whether those durables are located in the U.S. or abroad) above $5 million, would be included in the tax base.

This tax would also be very easy to calculate. Households subject to the tax would simply add up all their inflow of funds (receipts), including borrowing and imputed rent but excluding labor earnings, over the course of the year and subtract out funds they invest. The difference is their consumption apart from imputed rent, which would be added in. Investment would be defined to include investment in homes, yachts, etc. because those durables could be rented out.

Investment would also be defined to include expenditures on higher education for oneself or one’s children, including tuition, special fees and room and board. And it would include charitable contributions, since I want to retain incentives for the rich to continue to make their enormous contribution to our country in funding private charities, including those sponsoring the arts, which are sorely underfunded in our country.

Warren Buffett is an example of an extremely rich person whose pockets are lined with gold. But his heart appears to be filled with gold as well. The same can be said of Bill and Melinda Gates and many other super-rich Americans who care intensely about others, particularly the poor. In Buffett’s case, he is contributing his wealth to the Gates Foundation, which is dedicated to eliminating global poverty and improving education at home and abroad. I’m not a religious person, but this is God’s work by anyone’s definition and shouldn’t be penalized by the tax system.

Ensuring the Rich Meet Their Tax Obligations

The personal consumption tax as well as the inheritance tax is the only way we will get all of the rich to pay their fair share of taxes. Under the current tax system, a billionaire (and we have close to 2,000 of them) can, if he or she so chooses, spend his or her entire life paying little or no personal income taxes. Let me review the simple method. They can and routinely do simply borrow money, pledging their assets as collateral, to pay for their spending. Consequently, they don’t sell their assets, which means they don’t pay capital gains taxes. Instead, they leave their assets to appreciate in value, which will happen on average. When they die, they can convey these assets to their heirs with no capital gains tax levied on the increase in value (appreciation). Furthermore, in conveying their estates to their heirs, they use irrevocable trusts and other means to avoid the estate and gift tax. Meanwhile, the rich are consuming whatever they want and making the rest of us pay for their public services, including the protection affordable by our military, that they enjoy.

This problem goes away under my tax plan. The rich pay taxes each year on every dollar they consume in excess of $5 million. Supporters of Senator Sanders who are particularly concerned, as am I, about inequality, may think that a top rate of 30 percent on the consumption by the rich is too low. But this ignores my 20 percent business cash flow tax or VAT. The VAT is also a tax on consumption, just collected in an indirect manner.

Here’s why. When all of the business tax returns are combined, the VAT ends up taxing all of national income less investment, which equals national income less savings (since savings equals investment), and income minus savings is consumption. The VAT excludes imputed rent on homes and other durables, which constitute about 25 percent of total U.S. consumption. Hence, and I apologize for all the wonky numbers, but a 20 percent VAT is effectively a 15 percent consumption tax. Consequently, the richest people in our country will pay 30 percent plus 15 percent on their spending, apart from charitable contributions and expenditures on higher education, for a combined 45 percent tax rate. 

What if the rich continue to borrow to consume? No problem. That borrowing is taxable, as are all inflows of cash that are not invested. What if the rich invest all their money, live on the streets and don’t spend a penny? That’s a great thing for the economy and for workers in particular. It means we all get to work with their assets. But won’t that worsen the concentration of wealth and its associated political? This is where the inheritance tax comes in.

Taxing Inheritance

As we all know, the rich, particularly the super rich, are incredibly adept at transferring their wealth to their offspring without paying any or much in taxes. But my proposed inheritance tax will tax all cumulative net inheritances received in excess of $5 million at a 20 percent rate. This threshold will be adjusted for inflation. Cumulative inheritances will be calculated as the sum of all past inheritances and gifts (valued in today’s dollars) received in excess of a $20,000 annual exempt amount, which would be indexed to inflation. Before the annual net excess inheritances are added together to see if the individual has exceeded his or her lifetime exemption, each year’s excess (of the $20,000) inheritance will be measured in current year dollars to keep the inheritance tax neutral to inflation.

In addition, to the extent the children of the rich don’t invest their inheritances, i.e., to the extent they spend them on their often-lavish lifestyles they will pay progressive consumption taxes on those inheritances.

Taxing inheritance is far more sensible than taxing bequests. A billionaire who dies and leaves her fortune to every American in the country in equal measure is mitigating inequality. But a billionaire who leaves all her wealth to a single person who is already very rich is exacerbating inequality. The progressive nature of my proposed inheritance tax (zero taxation on the first $5 million of inheritances and 20 percent taxation thereafter) provides strong incentives to share the wealth.

Taxing Carbon

The evidence for global warming and climate change is overwhelming. Here are some of the distressing facts provided by NASA, the National Academy of Sciences, the Royal Academy and the scientific journal Nature.

Carbon dioxide in the air is at its highest level in 650,000 years. Humans have raised CO2 levels by 40 percent since the industrial revolution, with more than half of this increase occurring in the last four decades. Since 1900, the planet’s average temperature has risen by 1.4o Fahrenheit. Nine of the 10 warmest years on record have occurred since 2000. In 2012, the Arctic summer sea ice shrank to its lowest level on record. Greenland is experiencing accelerating ice loss. The melting of the West Antarctica ice sheet in conjunction with other ice melting could raise the sea level by 6 feet by the end of this century. This would largely put New York, Boston, Miami, New Orleans and other major U.S. cities under water.

In the 2015 Paris Accord, 195 nations affirmed that the time for debate on climate change is over and that immediate action is needed. Those who claim that this is manufactured hysteria by politically correct scientists need to ask themselves the following questions.

“What if I am wrong? What if the climate is indeed changing? What if we actually do have only a very short window to reverse global warming before the planet passes a grave tipping point?” The melting of the West Antarctica ice sheet is an example of such a tipping point. Once the ice sheet melts, there is no refreezing it.

These “What If?” questions do not allow a response of “Sorry, I was wrong.” We cannot simply sit back and leave ourselves, but primarily our children, at severe risk. We cannot play dice with their physical lives anymore than we can play dice with their economic lives.

Our country is second only to China in CO2 emissions. Historically, we have done the most to raise the planet’s temperature. It is our responsibility to do the most to lower it. Development of hydropower, wind, solar, wave, hydrogen, biofuels and geothermal clean-energy sources is imperative.

A carbon tax is the straightforward means by which we can control emissions and coordinate federal and state emissions policies. But it’s important to understand the dynamics of carbon taxation. If we set a low tax rate now and a higher one in the future, producers of dirty energy will produce more, not less, in the short run. The reason is simple. They’ll seek to profit from their stocks of oil, natural gas and coal when they can make the most money, net of tax.

In this regard, the 2015 Paris Accord may actually be backfiring. The Accord asks its 195 national signatories to specify their contributions to reducing CO2 emissions and to raise those contributions over time. But there is no legal enforcement of these pledges and no hard deadlines. The one sure thing the Accord does is to put dirty-energy producers on notice that their days are numbered. Unfortunately, this greatly incentivizes them to accelerate their extraction of fossil fuels and, thereby, increase the planet’s temperature. The current extremely low price of oil is striking testimony to the “use it or lose it” calculus underlying today’s oil production.

My proposed carbon tax would be set at $50 per metric ton. This will raise the price of gasoline by roughly 50 cents per gallon. This is twice the initial tax rate considered by the JCT and the CBO in their 2014 study of carbon taxation. I’d keep this absolute tax (the $50) fixed over time, so that the carbon tax rate would fall over time due to inflation as well as projected fossil fuel price rises. This would give fossil fuel producers what the planet needs: a strong incentive to delay their production and sale of dirty energy to the future when the tax rate is lower and the climate will be less at risk. A low, steady burn of fossil fuels is safer for the planet than a high, rapid burn.

The JCT and CBO are staffed with many excellent economists. But both are agencies of Congress. When they analyze policies, they are strongly influenced by what they consider politically feasible as opposed to what’s economically needed. They do so because their bosses – members of Congress – are politicians and their job is to keep their bosses happy. In their 2014 study, the two agencies considered a relatively low initial tax, but one that rises over time by 2 percent in real terms (at a rate that is 2 percentage points higher than the rate of inflation). This corresponds to what the Paris Accord promises: higher, not lower, emission penalties over time.

Unfortunately, this is the exact opposite of what the economics of extractable resources, dating back to seminal work in 1931 by Harold Hotelling, recommends. Hotelling’s classic study, which isn’t even referenced by the JCT and CBO, tells us that a rising rate of carbon taxation will accelerate emissions, that a constant rate of carbon taxation will have no impact on emissions and that a declining rate of carbon taxation will slow emissions.

It may be counterintuitive to tell fossil fuel producers that they will be treated badly now but far better in the future. But that’s precisely what’s needed to keep them from focusing on “use it or lose it.”

Replacing Tax Credits With a $2,000 (Inflation-Indexed) Payment per Person

The Earned Income Tax Credit (EITC) and the Child Tax Credit are our most important poverty-alleviation policies. Unfortunately, both are clawed back through the tax system as workers earn more money. In the case of the EITC’s claw back, earning an extra dollar can cost more than 20 cents in lost EITC benefits. This is part of the aforementioned poverty trap.

Let me be clear about this trap. When the poor work they stand not only to pay FICA taxes. They also stand to lose the Earned Income Tax Credit, their Food Stamps, their Medicaid benefits or their Obamacare subsidies. In some cases, the marginal rates of taxation, when combined, put the poor in tax brackets above 100 percent, meaning they lose money from working.

Under my tax reform everyone would face the same 30 percent tax rate on their labor earnings. Part of the means of achieving this is to eliminate the EITC and Child Tax Credit and simply provide a lump-sum payment to each American, regardless of his age or income. This “negative income tax” approach to providing basic support has been endorsed over the years by both conservative and liberal economists, including two now deceased Nobel Laureates – the University of Chicago’s Milton Friedman and Yale University’s James Tobin.

The other two elements needed to eliminate the poverty tax are replacing Food Stamps with direct food distribution and changing the healthcare system so a) everyone has basic health insurance coverage, b) the provision of basic health insurance doesn’t bankrupt our country, and c) the provision of basic health insurance doesn’t dramatically undermine people’s work decisions, which is now the case. Let me tell you now about direct food distribution and leave healthcare reform to Chapter 8.

 

Replacing Food Stamps With Direct Food Distribution

No one in America should go hungry. But providing food assistance in a manner that reduces work incentives by over 20 cents on the dollar earned is no answer. I propose replacing Food Stamps with Food Distribution Assistance. This would be provided to children living in low-income neighborhoods at their schools in the form of three free meals a day. Adults, any adult, could receive basic food for free at food distribution centers, which would also be located in low-income neighborhoods. Food would also be delivered on request to those who cannot travel to the distribution centers.

Summing Up

Under my tax reform, the marginal tax rate on earnings is 30 percent for everyone. It consists of the 15 percent FICA tax plus the 15 percent effective tax on working associated with the VAT. (Yes, my VAT tax rate is 20 percent, but the VAT covers only about 75 percent of total income since it excludes imputed rent on homes and other durables.) Under my plan, no one will lose any federal benefits, be they cash assistance, food assistance, or health insurance, when they work.

My tax plan is designed to increase federal revenues by 5 percent of GDP, dramatically increase the incentive of companies to hire and invest in America, ensure the rich actually pay their fair share of taxes, limit the perpetuation of wealth inequality from generation to generation, provide everyone with the same incentive to work and eliminate the poverty trap, which arises under our tax and benefit system, leaving millions of low-income households with little or no incentive to work.