Pressure Points: Where Tax Reform Can Be Most EffectivePublished: February 13, 2013 in Knowledge@Wharton
The deficit deal that averted the fiscal cliff crisis at the start of the year raised taxes on the wealthiest and postponed -- for two months -- government spending cuts that threatened to derail the economic recovery. But the bulk of the problem remains: This year, the government will likely spend about $845 billion more than it takes in.
Without further agreement on how to deal with the deficit, spending cuts set up in the summer of 2011 to encourage compromise will begin in the spring. That could force layoffs or furloughs of employees of the federal government and its contractors, undermining the economy. While a robust economic recovery could add hundreds of billions to annual tax revenues, few experts think that alone will erase deficits over the next few years. And in the long term, the United States faces an even larger revenue shortfall as the population ages and expenses soar for Social Security, Medicare and Medicaid.
So what's to be done? Five Wharton faculty members offer a variety of tax measures that could help to some extent. They caution, however, that there is no painless way out of this mess.
"Unfortunately, there is no silver bullet with tax policy," says Wharton accounting professor Stephanie Sikes. She and other faculty members warn that President Obama's push for higher tax rates on the well-to-do cannot, by itself, produce enough additional revenue to solve the problem. "The government needs to figure out how to control spending," Sikes states. "But if it is not willing to do so, then I think everyone needs to share the cost of the spending increases. The burden should not be borne solely by top income earners."
"I don't know of any tax increases that won't create pain," notes Wharton accounting professor Jennifer Blouin, adding: "The U.S. is in desperate need of revenue, and we cannot rely on the 'rich,' whatever that means, to cover the growing deficit. Rather, taxes across all individuals should be increased."
Though taxing the rich cannot solve the problem, Sikes and Blouin cite one measure as a no-brainer: taxing carried interest earned by private equity fund managers as income rather than capital gains. Carried interest is the managers' share of gains in the PE fund. The industry argues it is entitled to the 15% rate applied to capital gains, rather than the much higher income tax rate. But critics say these profits come from money put at risk by the fund's investors, not the managers. "No one can explain to me why this isn't management fee income," notes Blouin. Management fees are taxed as income.
Sikes and Blouin also agree that taxes on corporate profits should be changed to encourage U.S. companies to bring home money earned overseas. "Currently, with the worldwide tax system, a company has to pay additional taxes on earnings earned abroad when it repatriates those earnings -- assuming that the U.S. tax rate exceeds the tax rate of the country where the earnings are earned," Sikes says. "This has resulted in companies leaving cash abroad in order to avoid the additional taxes owed upon repatriation."
That, in turn, leads to behaviors that otherwise seem nonsensical, she adds. "An example of the cost that companies are willing to incur to avoid the tax upon repatriation is the fact that both Costco and Microsoft have borrowed rather than repatriated earnings in order to pay dividends."
Dividends and Deductions
Kent Smetters, Wharton professor of business economics and public policy, suggests further modifying corporate taxation to encourage more capital investment, which can create economic growth. "I favor moving to full expensing of capital investments, where capital expenses are fully written off against income when they are [incurred] rather than depreciated over time," Smetters says. "This policy would encourage additional business investment without producing windfalls for past investments."
Corporate profits are returned to investors in two ways: as dividends and through rising share prices. Both methods receive favorable tax treatment -- lower rates than individuals pay for ordinary income. Some critics argue for eliminating this benefit, but Wharton finance professor Jeremy Siegel thinks that would go too far.
For most investors, for instance, dividends are taxed at 15%, while the maximum income tax rate is 39.6%. Siegel, writing in Kiplinger's Personal Finance, says this makes sense because the profits that produce dividends are also taxed at the corporate level, "and taxing them again at the full rates for ordinary income would be double taxation." The preferential 15% rate on capital gains -- profit from selling an investment for more than it cost -- encourages needed investment, Siegel adds.
"Some preference should be given to risk-takers," he writes, "so capital gains should also qualify for lower tax rates. The tax code greatly restricts the ability of investors to deduct capital losses in excess of gains. As a result, risk taking would be reduced if some break isn't given to an investor who turns up on the winning side of an investment."
He suggests a 17.5% tax rate on dividends and capital gains, splitting the difference between the current 15% rate favored by Republicans and the 20% proposed by many Democrats. That would still be below the 28% rate in effect when Bill Clinton was president, Siegel notes.
Among the tax issues getting current attention are various deductions for individuals, such as those for charitable contributions and mortgage interest payments. Currently, for example, individuals can deduct from taxable income the interest paid on up to $1 million in mortgage debt, even if all or some of it is on a second home.
Real estate agents and home builders argue the deductions are necessary for a healthy housing market, which is key to the economy, and they say the deduction helps make home ownership affordable, allowing more people to enter the middle class. But critics say the mortgage interest deduction unfairly favors homeowners over renters and is skewed to benefit the wealthy, since tax deductions are more valuable to people with big mortgages and high tax brackets.
Blouin suggests lawmakers find a middle ground by considering a lower cap on the interest deduction, or eliminating the deduction for a second home -- a luxury, not a necessity.
Another approach, says Siegel, would be to cap overall deductions rather than struggle with the decision to keep some and eliminate or trim others. "Instead of trying to decide which deductions are justified, perhaps the best solution is to cap the total amount of deductions taxpayers are allowed, with a five-year phase-out of the mortgage deduction," he writes in Kiplinger. "I would cap total deductions at, say, $20,000, or 10% of adjusted gross income, whichever is higher."
Siegel might make an exception, he adds, for charitable giving, which could diminish if the deduction were slashed. "My recommendation: Allow an additional deduction for charitable contributions equal to 10% of income."
AMT, VAT and Other Issues
The estate tax has long been controversial. Currently, the first $5.25 million of an estate passed to heirs is tax-free, with the remainder taxed at rates as high as 40%. In general, Republicans would like to eliminate the estate tax, or raise the exempted amount, while Democrats feel that would unfairly benefit the wealthy.
"I am not persuaded by arguments calling for the complete elimination of the estate tax on the grounds that income that has already been taxed once should not be taxed again," Siegel writes. In fact, he says, most of the wealth in large estates has not yet been taxed because it comes from capital gains, which are not taxed until an asset is sold.
"I do favor reducing the tax rates and providing an estate-tax exemption of about $4 million," Siegel adds, "but there is a good argument that large amounts of wealth should not be passed down without some of it going to the public coffers, either through taxes or charitable giving."
Blouin suggests several other tax issues that need attention.
One is the alternative minimum tax (AMT). Originally designed to ensure that the wealthy did not use deductions to escape taxes, it has gradually increased the taxes paid by the middle class, whose members are increasingly finding that it disallows deductions for things, like state income taxes, they have paid. "The alternative minimum tax should be abolished," Blouin says. "It unfairly taxes individuals in high state-income-tax locations relative to low state-income-tax locations."
While eliminating the AMT would probably reduce tax revenues, other changes could boost them, Blouin says. Currently, for example, employers get a tax deduction for providing employees with health insurance, but employees are not taxed for this benefit, which can be worth many thousands of dollars a year.
"The government could consider taxing the receipt of health insurance," she says.
And finally, "If we can't figure out how to control our spending, then we need to think about a VAT (value-added tax)," she says. A value-added tax would be a kind of national sales tax. Since everyone buys things, a VAT would be paid by the more than 40% of Americans who currently pay no federal income tax.
Proposals like those mentioned could increase tax revenues and stimulate the economy, but few experts think they would be enough to wipe out the problem of deficits over the long term.
Olivia S. Mitchell, professor of business economics and public policy at Wharton, points to the enormous long-term costs of the key entitlements: Social Security, Medicare and Medicaid. She worries that Obama's recent inaugural address reaffirmed his opposition to significantly reducing those benefits. "His statement was intended to emphasize the benefits of social protection," according to Mitchell. "But the President has yet to acknowledge that our social programs are on the brink of insolvency, and neither party has proposed sensible ways to fix these programs."
Not only are these entitlements expensive, but they also have unintended consequences that damage the economy further, she argues. "For instance, economic research has confirmed that the Medicaid program discourages most people from taking steps to save and insure against long-term care expenses. The structure of the Social Security program discourages private saving, and the program's impending insolvency threatens retirement security for millions." Meanwhile, the disability insurance feature of Social Security has caused many people to leave the work force, she adds.
"In sum, I would like to see both parties -- and the President -- integrate these counterbalancing factors into a proposal to remedy the insolvencies confronting us," Mitchell says.
But that's a tall order. Recent debates, like those before them, show that Washington will have enormous difficulty reaching consensus on closing the gap between spending and revenue.