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The last major tax reform — personal and corporate — came some 30 years ago. Despite much tweaking in the interim, “everybody agrees that something needs to be done” to modernize the tax code, says Kent Smetters, a Wharton professor of business economics and public policy. What’s more, Congress looks likely to take up the issue soon. To help understand the best approaches to reform, Smetters and co-editor Alan Auerbach “went to about a dozen of the leading authorities in tax analysis” to get their views on taxes affecting business, the environment, retirement, capital gains and estates, college attendance and other areas.
The result: their just-published book, The Economics of Tax Policy, a collection of articles by those tax experts. The book also looks at the effects of various tax approaches on economic growth, income distribution and low-income families, as well as compliance and enforcement. Auerbach is a professor of economics and law at the University of California, Berkeley, and former head of the economics department at the University of Pennsylvania.
Knowledge@Wharton spoke with Smetters about some highlights of the book. An edited transcript of the conversation follows.
Knowledge@Wharton: Kent, thank you for joining us today. Please give us an overview of the book.
Kent Smetters: The idea was very simple. We haven’t had a major tax reform since the 1986 Tax Reform Act, and so everybody agrees that something needs to be done. We simply went to about a dozen of the leading authorities in tax analysis, to cover everything from looking at the corporate tax rate to environmental taxes, to lots of other things that taxes interact with.
And we said: Ok, what do we really know about the impact of taxes on things like the environment or how businesses operate, or how people save or not save for retirement. Each author surveyed the literature, they really brought their attention to what is it that we really know about that particular area of taxation.
Knowledge@Wharton: Before the Tax Reform Act of 1986, individual tax rates were relatively high. But there were so many loopholes that the effective rate was really low. You said earlier that that 1986 law closed most of those loopholes. A lot has changed and that seems to be the thrust of the book.
Kent Smetters: Some of those loopholes have come back, but at the same time, 1986 [marked] … the last big, bipartisan major policy change in Washington. [Since then,] the biggest thing that has changed is globalization. In particular, before 1986 people really didn’t talk about locating income offshore. We didn’t have the $3 trillion of earnings located offshore because of the corporate tax rate being so high. Globalization has really changed the algebra. Our U.S. tax system is still very much old-school. It thinks of the U.S. as the economy, rather than it being a large, open economy in a global system.
“We haven’t had a major tax reform since the 1986 Tax.”
Knowledge@Wharton: On page two of your book, you jump right into what are the corporate tax rates for various countries. And the United States is right at the top — at 35%.
Kent Smetters: Even higher than France.
Knowledge@Wharton: We often hear that the 15 top Fortune 500 companies didn’t pay anything in taxes, or we will hear 35% — that’s the official rate, but what companies actually pay, the real effective rate, is much less. And you have an explanation for that. One reason it is less is that people are keeping their money overseas.
Kent Smetters: Yes. We really have to figure out the cause and the effect. In other words, it’s not right to say, well, 35% is kind of a funny number, because the effective rate, what people are actually paying is maybe half of that amount, depending on what city you look at. The way to really think about it is, that’s a very high statutory rate, especially in today’s world. And so what happens is companies like Apple, Microsoft, Google and Oracle and others are able to figure out how to shift a lot of their earnings offshore to avoid that very high corporate tax rate.
The corporate tax rate is very high, and the fact is that we don’t have this border adjustment that’s currently being debated in Washington. There’s all this distortion [that leads companies] to locate income offshore. Now, in some cases, we also have rewards for investing in new capital. So that’s sometimes called bonus depreciation or expensing. That’s already part of the existing corporate tax rate: The House GOP plan and the Trump plan would increase that even more. That’s one reason why the effective rate is a little bit lower. But the cases you’re talking about, of large companies not paying anything, that’s mainly income shifting.
Knowledge@Wharton: It is interesting, because you’re discussing the concept of lowering the rate in order to encourage investment and so forth. But in I think the second chapter, you start talking about how tax cuts in recent years — whether individual tax cuts or corporate or both — even though there have been cuts to encourage investment or savings, they’ve actually not done that very much.
Kent Smetters: That’s probably the most controversial chapter, written by one of the more liberal economists [William G. Gale, senior fellow] from Brookings and one of the more conservative, Andrew Samwick at Dartmouth. And what they showed is that a lot of tax cuts in the past don’t seem like they have led to stimulus.
Knowledge@Wharton: So is that corporate or individual or both?
Kent Smetters: It’s both. They look right across the series of them — so they look at a lot of tax cuts where both the individual and the corporate were reduced at the same time. The main reason that they find [for why the tax cuts did not lead to stimulus] is that the tax cuts are often not funded, and so the government loses a bunch of revenue, it has to float out a bunch of debt, and that increase in debt actually has the opposite effect. It competes with private capital for international capital flows and household saving, and so it works in the opposite direction to offset a lot of the gains.
And the few cases that we have a revenue-neutral change, those seem to be working in a positive direction, especially over time. But when it’s just a tax cut and you haven’t cut government spending at the same time, you’re just increasing the debt and that’s a lot less effective.
Knowledge@Wharton: On tax enforcement — these are taxes that people should be paying, but they’re skirting the law in some way. And they’re not paying them. It’s an enormous amount of money. This isn’t closing loopholes. This is just money that maybe if the IRS knew how to find people, they’d be able to question it?
Kent Smetters: It’s hundreds of billions of dollars a year in revenue that’s lost.
Knowledge@Wharton: So it is tax evasion — $450 billion was lost to noncompliance. This is 2006 numbers. And $385 billion after they went after a few people and got some of that money back. If that money were fully captured, the book notes, it could finance half of all Social Security benefits paid in 2015. What do we do about that?
Kent Smetters: Yes, that’s a commentary [suggesting] that it’s a lot of money that’s lost, and it’s also the fact that our Social Security program is very big, and it’s paying a lot of money. That’s one reason why it’s also in trouble. But in any case, most of the tax evasion, it’s not just people just not filing their tax returns. Yes, you have some of those, but IRS can usually figure those out and hunt you down. And it’s not the small things that people are doing that quite frankly the IRS threatens about but they don’t waste their time on.
Knowledge@Wharton: For instance, if you take a home office deduction?
Kent Smetters: Oh, yes. The home office deduction, do you really have a separate door to your office? Or you take out a HELOC [home equity line of credit] loan, and you deduct the interest. You’re really only supposed to do that if you do home improvements with the money. A lot of people don’t.
The big one is sole proprietors. That’s the one for the electrician, the plumber, the small shopkeeper — you go out to a restaurant and they give you a deduction if you pay cash. Those are the main sources of losses, and the reason why is that you don’t have the tracking that you would normally have like on wages. If you or I don’t file, they’re going to catch us pretty quickly. You just don’t have that counterpart, that tracking of information. And a lot of it is that people have judged in the past that it seems for sole proprietors, which is a very large part of the economy, [income] tax is almost a voluntary exercise. And that’s why IRS does a lot of spot-checking, a lot of randomization when it comes to looking at sole proprietors.
Knowledge@Wharton: You could almost call it a black market?
“… Apple, Microsoft, Google and Oracle and others, are able to figure out how to shift a lot of their earnings offshore to avoid that very high corporate tax rate.”
Kent Smetters: Yes. It’s certainly the case that the IRS has very limited resources and they’re going to really try to concentrate on the things that really matter. Yes, they’re going to look at your Schedule C … and all that type of stuff, but what they’re really pounding is the sole proprietor.
Knowledge@Wharton: It’s interesting when sometimes people talk about other people’s businesses, and you might hear a comment like, “It’s a cash business,” and everyone sort of nods knowingly. That’s what that means, right?
Kent Smetters: Yes, that’s what that means. And the U.S. is not the only country. If you look at China and India, there are huge problems with small businesses.
Knowledge@Wharton: So those are the rules that are getting skirted. Then there are the legal deductions, which is interesting because the term of art for economists is “tax expenditure,” which is very confusing. These are deductions — and they might be what have changed since 1986 more than anything else.
Kent Smetters: Like you say, it’s a term of art. You have to almost be an economist to appreciate the idea, which is that this is tax revenue that we could have brought in, but we’re expending it by essentially giving you a tax break.
I’ll give you some examples, like your home interest deduction. That’s a very big one. You get to deduct your interest payments on your home. That reduces your tax bill. That’s a tax expenditure. Charitable giving is another one. State and local taxes that you get to deduct at the federal level, yet another. And if in fact you didn’t have these tax expenditures, these reductions, the U.S. would have more tax revenue. But economists have known for a long time that if you actually just collected the money, then you had a separate program that said we’re going to subsidize your interest payments, that’s mathematically the same thing. The difference is that the tax expenditure approach looks more like we’re giving you a tax break that’s Republican friendly — the more explicit approach of we’ll collect the taxes, then give it back to you as a subsidy program.
Knowledge@Wharton: That refund check you get back from the IRS?
Kent Smetters: Yes. That looks more like a Democrat-type program. This is a way of expanding the government in a way that was more politically palatable for those on the right.
Knowledge@Wharton: Is there a big number to be saved in other things?
Kent Smetters: The big three are the mortgage interest deduction, it’s the health expenditure, where, for example, through [the University of Pennsylvania], you get your health care and you pay some of that for your health care and you pay for that through pre-tax dollars. So that’s number two. And the third one is the state and local deductions. The fact of the matter is those three, the big three, are most of the tax expenditures.
One way you can try to deal with some of those big ones, is to do it more subtly. And in particular, what you do is with something like the mortgage interest deduction, you put a cap, and say, “Okay, you can only do this on a house that’s worth [up to] $1 million, but we’re not going to index that for inflation over time.” Your current house is probably okay, but as inflation creeps up over time, the real value of that $1 million is becoming smaller and smaller. We’ve actually done that in the past with some Medicare tax expenditures.
“The issue with the consumption tax — something like a simple national sales tax or VAT — is how do you maintain the progressivity of the tax system?”
Knowledge@Wharton: Those deductions we’re talking about in 2016 were somewhere between $282 billion and $366 billion.
Kent Smetters: Put that and the [amount of tax] evasion together, and now you can fully fund Social Security, almost.
Knowledge@Wharton: We’ve talked a little bit about corporate taxes and what’s really involved there. Estate taxes is an interesting one because we’ve all heard about the death tax and so forth.
Kent Smetters: It’s not based on income. It’s based on assets that are passed to one’s heirs. And so roughly speaking, a married couple under current U.S. tax law can pass a little shy of $11 million to their heirs or anybody else without it being a taxable event.
On top of that, what’s amazing about the current law is that, suppose that you’ve been holding GM stock for 50 years. When you bought that, it might have been $1 a share. Now it’s worth a lot more than that. If you were to sell that, before you died, you’d pay large capital gains [on the profit]. If you bequeath that money, it gets valued at the current market price — your heirs inherit that stock at the current market price. All of those capital gains are wiped out.
The Trump idea, which has actually a fair amount of economists’ backing to it, is to basically just get rid of the estate tax. But when you die, the capital gains is owed at that point. And depending on how you configure, you can actually raise as much money as the current estate tax. You could actually raise more money. You could raise a little less money. It just depends on how aggressive you’re willing to go with it. For example, you probably would not do that forever, but you’d still have some exemption there.
Knowledge@Wharton: Would that cause those affluent families to simply move their money into something that doesn’t have capital gains?
Kent Smetters: It could. But that’s fine, too. They’re not going to get the same kind of longer-term reward on their investment, but the advantage of it is that we think that the current system with what’s called the step-up in basis … where the cost basis gets reset at death, that potentially has some distortions associated with it. So just the fact that the estate tax only hits about 5,000 people — just getting rid of that, it’s not a huge money loser and you could probably just make it up or [collect] even more just by saying: When people die there’s a built-in capital gains. They pay the taxes on that but then you can leave the rest tax-free.
Knowledge@Wharton: Another interesting point made in the book, in Chapter 11, is the trade-offs between personal tax rates and, say, a consumption tax. The authors talk about how a consumption tax could possibly be fairer and so forth. Could you discuss that idea?
Kent Smetters: It’s not clear if it’s more fair or not, but a lot of people who like the idea of a consumption tax are proponents of it because they say, right now we have an income tax system that really discourages savings and capital investment. Household saving is very, very low in the United States. It’s literally about one tenth of the level that we see in Japan.
How do we encourage more saving, more productive capital and so forth? The consumption tax is usually the favored idea. But what people don’t realize is that you can actually go to a consumption tax without getting rid of the regular income tax, simply by rewarding investments made at the margin. That is this idea of full expensing — when a company can immediately write off a new piece of capital equipment in that year, that is going to ultimately translate to higher returns to households, and you can show that that is the same thing as not taxing savings at the margin, but still having that progressive income tax.
The issue with the consumption tax — something like a simple national sales tax or VAT — is how do you maintain the progressivity of the tax system? Now, here’s the ironic twist. In the old days, it used to be conservatives loved the idea of the consumption tax, the VAT, and so forth — a flat tax. And it’s very simple — didn’t hit household saving. Today, it’s switched. The reason why is that conservatives, people like [Nobel laureate economist] Milton Friedman some years ago noticed that countries that added the VAT actually weren’t replacing their income tax. They were just adding on top of their income tax — countries like France and so forth. And so he felt, practically speaking, what would happen is that we wouldn’t really replace the income tax with a VAT, it would just be an add-on.
Basically, I think he won the argument, because that’s why a lot of liberals today like the idea of a VAT. They don’t really think it’s going to replace an income tax. It’s going to be an additional revenue to save things that are greatly underfunded right now, like Social Security, Medicare, Medicaid.
Knowledge@Wharton: They want to maintain some kind of a lever to have progressivity in the tax code, too?
Kent Smetters: Essentially what the liberal side is saying is that there’s a compromise here. Let’s keep the current progressive income tax. We need to get more revenue. We don’t want to replace that whole thing with a flat income tax that reduces progressivity. If we’re talking about additional revenue, I’m willing to get that through a flat tax, provided that’s truly additional.
Knowledge@Wharton: The interesting thing that you talk about was that there’s this business-friendly side of this, which is doing away with [lengthy] depreciation, or rather, you can depreciate immediately, in one year, instead of dragging it out over 10 years.
And so a company is going to be much more likely to buy a new piece of equipment or build a new wing on their factory [if it can expense or depreciate the first year]. That’s the idea?
Kent Smetters: That’s right. And both the House GOP plan as well as the Trump tax plan had that element in there. The Trump plan on top of it also reduces the corporate income tax rate. And when you do both together, what’s actually happening is that when you go to full expense [immediately] and you’re not taxing new investment at the margin, and then you lower the corporate tax rate on top of all that, you actually are now only rewarding capital that’s already been invested in, capital that’s already been installed.
“The top 10% of the population pays about 60% of the taxes. The top 1% pays 25% of the taxes. It’s a very progressive system….”
That’s not going to be a stimulant. If you’re already doing full expensing, you’re not going to get much stimulus by reducing the corporate tax rate on top of it. It’s really, [either] you reduce the corporate tax rate, and don’t go to full expensing, or you go the full expensing and maybe change the corporate tax rate just to deal with some of the international issues.
Knowledge@Wharton: Was that a problem with some past corporate tax changes? They were hoping to provide stimulus, but it turned out that it didn’t really work out that way?
Kent Smetters: That’s right. It mainly rewarded existing investments, and it also was greatly underfunded. One reason why if you go to the Penn Wharton Budget Model website, you can simulate and look at how the Trump plan works as well as the House GOP plan. And you’ll notice the Trump plan has an initial boost, but then over time, the economy actually shrinks relative to the current law. And it’s simply because such a massive amount of debt is built up, that it eventually reduces the size of the economy.
Knowledge@Wharton: Tell us more about the model, because you started out with a model that was looking at the costs and benefits of immigration and Social Security, and then not long ago, you added one that looks at taxes, which has to be a lot more complicated.
Kent Smetters: It is. So, before the election, we released the presidential candidates’ — Clinton, Trump and House GOP — three plans. And anyone can go onto the Penn Wharton Budget Model and play with those plans, and change different assumptions to see what the impact in the economy and lots of different economic variables would be. [You can look at that] both from a static basis of the type [of economic models] that you would see normally in Washington, or from a dynamic basis that includes economic feedback effects.
The big takeaway from there was that the Clinton plan really didn’t do much. It wasn’t super-positive or negative. The House GOP plan was the one that performed basically the best. And then the Trump plan performed basically the worst. And essentially, even though the Trump plan did okay in the short run, it was just so underfunded, because they’re not cutting government spending at the same time, that it basically just leads to a substantial amount of debt.
Knowledge@Wharton: What else should people know about your new book?
Kent Smetters: I cover a lot more areas than even what we talked about, including another thing that has changed in the last 30 years: Our concern about CO2. What is the economics literature that has looked at things like carbon taxes and tradeable pollution rights — what has that been saying? That’s something that 30 years ago, we weren’t so concerned about. But since then, there’s been lots of literature published on that. We have a great chapter there by Roberton Williams at University of Maryland that dissects that literature in great detail and explains it.
Knowledge@Wharton: Including income inequality?
Kent Smetters: Yes. We have a chapter simply labeled Fundamental Tax Reform. And part of fundamental tax reform is, yes, if you want to just get the GDP as big as possible, then you could probably go with a flat tax — not taxing any sort of saving — just try to be as pro-stimulus as possible.
But of course that is not going to be as progressive as current taxes in the United States. A lot of people don’t realize this: There’s this belief that the middle class pays most of the taxes. It’s actually not true. For the most part, the rich pay most of the non-payroll taxes, the federal income taxes. The top 10% of the population pays about 60% of the taxes. The top 1% pays 25% of the taxes. It’s a very progressive system that we’re starting out with. And when you have that progressive system, and you’re trying to do reform, you’re trying to do something that’s stimulating and at the same time maintain progressivity, it’s a hard nut to crack.
Knowledge@Wharton: But there are some answers here?
Kent Smetters: There are answers, yes. But it’s a fool’s game to say there are no losers. As I pointed out, economists, regarding the 1986 Reform Act — the the last big bipartisan act — believed it was going to be pro-growth as well as revenue neutral, as well as distributionally, kind of neutral. It turns out they fudged the numbers on this. So there was a little bit of fudging that went on in terms of selling that.