United States

Tax reform, even if enacted, may disappoint


Looking at the details of most of the major tax reform proposals under active consideration, the public may be disappointed with the results, even if their main elements are all enacted.

First, there is the issue of the improved economic growth that some hope will result from a reformed tax code. The most recent estimates given by the nonpartisan Congressional Research Service are that comprehensive tax reform modeled after the 1986 tax reform act, which is the prevailing model for most current members of Congress of both parties, will add no more than around two-tenths of 1 percent to our growth rate. Thus, if anyone is hoping to get from 2 percent growth to 4 or 5 percent growth to generate new jobs or enhance economic development, many economists would say that tax reform will only get us a small portion of the way there – from 2 percent to 2.2 percent. 

According to some of the economists of the nonpartisan Congressional Research Service, this includes the effects of proposals to change our system of taxing offshore profits by moving to a territorial tax system, and possibly allowing for tax-free (or tax-favored) repatriation of accumulated offshore profits. In the latter case, the skepticism may be similar to that in recently expressed in Tax Notes by a critic of tax-free repatriation. That critic suggested that many of the large, multi-national corporations that have large amounts of untaxed cash invested in overseas banks or brokerage accounts are able to borrow large amounts of money in the United States at historically low interest rates. As a result, a shortage of available cash may not be the obstacle to more physical investment in the United States. In addition, the Congressional Research Service reported that studies of the most recent repatriation tax holiday concluded that it led to an increase in repatriations, but that the repatriations did not increase domestic investment or employment.

Then there is the issue of tax complexity and the costs of tax compliance. According to IRS statistics, most individuals already have very simple returns, reporting only wages and a small amount of interest or dividends, the information on which is taken directly from information reports provided by banks or brokers. Many do not even itemize deductions. Thus, there may not be much to be gained for such individuals from trying to simplify their tax computations. Even for itemizers, the most common deductions may not create much complexity in terms of tax planning. For example, once you decide to purchase a home, including your mortgage interest and property taxes on your federal return may be a simple, mechanical exercise often done by a personal computer. Even if the purchase of a new home or the refinancing of a mortgage presents tax planning issues, those generally pale in comparison to the complex non-tax financial issues involved in such transactions, such as selecting the ideal fixed or variable rate mortgage, or the preferred school district or neighborhood in which to buy a house. The complexity of dealing with these and similar personal financial issues would not go away even if the income tax were replaced with a flat, national sales tax.  

In theory, a great deal of tax complexity could be eliminated from the taxation of business and investment income. However, very few proposals appear to be calculated to simplify tax computation or tax planning for individuals or corporations with significant amounts of business or investment income. For example, nearly every proposal retains the distinction between capital gains and ordinary income, and retains the complex system of qualified retirement plans and IRAs.

Although tax reform will almost certainly mean that certain assets and industries will enjoy different depreciation rules than under current law (mostly less favorable, some more favorable) the actual application of any new depreciation rules will likely not be significantly more or less complex than current law. It may be more desirable to depreciate property over five years, rather than 10 years, but it is not necessarily any simpler. Even the current rules allowing the expensing property in a single year have their administrative complexities. Of course, most business tax computations are done by computers in any event.

There are some who argue for tax reform because they hope or think it would increase taxes on those making more than $250,000 or more than $1 million, beyond the significant tax increases on those groups that took effect in 2013 when the Bush-era tax cuts were repealed for those groups and the new 3.8 percent tax on net investment income began to take effect. There are some who argue, for example, that individuals earning $1 million should not pay a smaller share of their income in taxes than that paid by middle income taxpayers. This is sometimes referred to as the "Buffett Rule" after famed investor Warren Buffett. However, existing law already contains numerous rules that, nonpartisan experts conclude, accomplish very similar effects as the proposed Buffett rule. According to the staff of the Joint Committee on Taxation, taxpayers earning over a million dollars pay roughly 33 percent of their income in Federal taxes, taxpayers earning $200,000 pay roughly 21 percent, taxpayers earning $75,000 pay roughly 15 percent, and so forth down the income scale. These computations include payroll taxes, even though some argue that payroll taxes are more like mandatory insurance premiums than taxes, because they give rise to a specific personal entitlement in exchange for the amounts paid in. 

There is also the question of whether any of the proposed reforms would last. A good example relates to a series of provisions adopted in 1986 that were similar to the Buffett Rule. In 1986, Congress enacted a series of tax reforms supported by President Reagan and members of Congress from both parties. The law eliminated personal tax shelters (that had allowed many high income individuals to pay taxes at very low rates) and imposed a simple rule taxing the income of high income individuals at a single top marginal rate of 28 percent, without regard to whether it was ordinary income or capital gains.  Lower income individuals had a lower marginal tax rate. 

By providing a uniform marginal tax rate – that may have seemed simpler – the law tended to increase marginal tax rates on some types of investment income, and reduce marginal tax rates on high income individuals earning salaries. But the philosophy of the law – like the Buffett Rule – was that what really mattered was that the average tax rate of higher income individuals (total taxes divided by total income) was higher than the average tax rate of lower income individuals.  Thus, this 1986 reform simplified the rate structure, while preserving the total amount of taxes paid by upper income individuals as a group, and ensuring that they were taxed at an average rate substantially higher than the average rate imposed on middle-income taxpayers. Interestingly, although many said they wanted such an approach at the time, it did not last long.  It took only a few years before Congress began to raise the marginal tax rates on ordinary income of high income individuals while lowering the marginal tax rates on capital gains of high income individuals – even as it kept the overall distribution of the tax burden among the income classes relatively constant.

In other words, people seemed to agree with the idea that certain types of investment income should get preferential rates, as long as high income individuals as a group still end up paying a higher rate on average on their overall income than lower income individuals. As the Joint Committee on Taxation has found, that is how the system works today. Capital gains earned by some high income individuals are indeed, in isolation, subject to a lower marginal tax rate than some salaries earned by lower income individuals. But when you add up all of the taxes paid by lower, middle, and upper income Americans, taking into account all of their tax breaks, and divide the total taxes paid by the total income earned by each group to produce the average tax rate, the average tax rate consistently increases, up as the income of the group increases. For example, as mentioned above, they found that taxpayers earning over a million dollars pay roughly 33 percent of their income in Federal taxes, taxpayers earning $200,000 pay roughly 21 percent, taxpayers earning $75,000 pay roughly 15 percent, and so forth down the income scale.  

Of course, tax reform, if enacted, will certainly have some "winners and losers." For example, the mining industry may end up paying higher taxes while the retail industry may end up paying lower taxes. And residents of low-taxed states, individuals with small families, individuals who live in rental housing, or individuals who make fewer charitable donations may be helped by tax reform that lowers rates and reduces deductions – while residents of high-tax states, individuals with large mortgages, individuals with large families, and individuals who make larger charitable donations may be hurt by the same reforms.  While such changes may, as a matter of academic theory, make for a more economically efficient tax code, the overall effects such changes on the economy and economic growth, are likely to be quite small, according to many of the economists who have studied these issues.


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