We're Going to Need More Tax Revenue. Here's How to Raise It.

We're Going to Need More Tax Revenue. Here's How to Raise It.

More tax dollars will be essential to improve our infrastructure, push back on global warming, fight poverty and inequality, and improve health and retirement security. 

June 13, 2016

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Trickle-down is nonsense and “revenue neutrality” is insufficient.

I recently testified before the House Committee on Ways and Means, the people who write tax law. The alleged topic of the hearing was how to generate faster economic growth, but what they really wanted to talk about was “tax reform.”

As you might expect, those two words mean different things to different people. To many Republicans, tax reform means cutting taxes. Despite reams of evidence to the contrary, they’re still deeply enthralled by supply-side, trickle-down economics.

So the Republicans had their witnesses testify about the growth-inducing impacts of tax cuts. One witness argued that anyone who didn’t get this was a “science denier.” I half expected the climate-change deniers on the panel to take umbrage at that accusation (“Hey, you’re talking to actual science deniers!”).

Most of the Democrats on the committee rightly and soundly objected to the supply-side fairy dust, pointing out that no evidence exists to support that case. As nonpartisan tax economist Bill Gale and colleagues recently wrote, “At the federal level, there is virtually no evidence that broad-based tax cuts have had a positive effect on growth. … That has been amply demonstrated at the national level, where tax cuts have eroded revenue without discernable effect on economic activity.”

To the extent that most Democrats on the committee wanted to reform taxes, it was to “lower the rates and broaden the base”—a mantra in Washington. The idea is to collect the same amount of revenues—to maintain “revenue neutrality”—by closing some of the loopholes and wasteful subsidies in the tax code. Once the taxable income base is larger, you can get the same amount of revenue with lower tax rates.

Sources: Treasury Greenbook, Tax Policy Center (FTT), CRFB (gas tax increase). Note that the gas tax increase and oil fee should be considered as mutually exclusive options.

While I applaud the Democrats’ realism on the folly of trickle-down, revenue neutrality is the wrong goal. Based on demographic pressures alone, we need more tax dollars. And if we want to improve our infrastructure, push back on global warming, fight poverty and inequality, and improve health and retirement security, we’re going to need still more revenue. As the table to the right shows, I identify almost $2 trillion in new tax revenues that could be collected over the next decade, based on a subset of ideas that progressives should consider.

 

Two criteria for raising more tax revenues

Broadly speaking, two things matter when it comes to the tax system: First, as just noted, the system needs to raise enough revenues to cover the fiscal obligations and economic challenges we face. Second, our tax system should reduce, not exacerbate, market-driven inequality. Those with the highest incomes should face the highest tax rates, and the public tax collection infrastructure should protect the code’s progressivity by blocking tax avoidance and prosecuting tax evasion.

How does the U.S. stack up on these criteria? Our federal system is moderately progressive, while state taxes tend to be pretty flat. Changes to the federal code under President Barack Obama have made it somewhat more progressive. Marginal rates on high income earners went up in 2013, as did rates on capital gains. But the system is less progressive than it first appears because of the code’s numerous credits, deductions, and exemptions—loopholes that mostly favor the wealthy. Outright illegal tax evasion, when last checked, amounted to some $385 billion a year, or about 10 percent of the federal budget and 2 percent of today’s GDP.

Thus, we need to raise more revenues in a way that is progressive and reduces tax avoidance and evasion. What changes might be made that are consistent with these criteria? While most tax increases should be directed at the top, it’s a mistake to limit tax hikes to the very wealthy.

However, Democratic presidential candidate Hillary Clinton has pledged not to raise taxes on the 97 percent of households below $250,000. Obama, in his re-election, made the same promise. But in the subsequent negotiations, the $250,000 cap got bumped up to $450,000.

No question, in an economy where so much of pretax growth has gone to those at the top of the income scale, the high end is the right place to start collecting the revenue we need. But it’s not the right place to end. For instance, it violates no sacred, progressive principle to ask people of all income levels to pay a more realistic price for fossil fuels (e.g., a carbon tax).

In fact, one reason our tax debate is so cramped is because Democrats have bought too far into Republican anti-tax ideology. The right won’t raise taxes on anyone. But the left won’t raise taxes on anyone other than the top 3 percent (households with incomes over $250,000). Again, the high end is absolutely the right target to start with. But it’s ultimately bad politics and bad policy to believe we can raise the revenues we need exclusively from the top few percent.

With that said, here’s what I’d recommend to progressively raise more revenue, both on the individual and business side of the tax code. My goal is not to be exhaustive—there are many good ideas I don’t explore, some of which are contained in the recent Obama budget—but to set forth more of a modular framework (as opposed to all-out “tax reform,” a recipe for an endless, fruitless, muddled debate) and provide numerous examples of the type of ideas that fit neatly into it.

 

Tom Williams/CQ Roll Call via AP Images

From left, Senators Debbie Stabenow, Elizabeth Warren, Charles Schumer, and Mark Warner, prepare for a news conference in the Capitol's senate studio to call on Congressional Republicans to "support tax loophole closures that have been embraced by GOP presidential candidates to help finance a budget agreement this fall," September 17, 2015. 

Progressive ideas to raise more revenue, reduce tax avoidance, and reduce the tax gap

1. Raise high-end tax rates. The current top rate on earned income is about 40 percent for filers with incomes over $400,000. According to recent research on “optimal taxation”—which in our context means maximizing revenues while minimizing distortions (like tax avoidance or reduced labor supply)—income tax rates could be raised significantly, by as much as half again (to around 60 percent) or more.

Surely that would hurt growth, no? Not according to this research, which not only documents responses to high-end tax changes, but also provides evidence of what actually happens when you lower top rates: It isn’t more growth, it’s more inequality.

The Congressional Budget Office tells us that raising rates by 1 percentage point on the top tax brackets would return about $100 billion in revenues over a decade. You can’t multiply that by ten and get a cool trillion because these things aren’t linear. That’s partially because the more you tax ordinary income, the more the wealthy taxpayers reduce their liabilities by redefining their income to avoid the new, higher rates.

Unless our goal is to create a lot more work for crafty tax lawyers, we’ll have to close a boatload of loopholes and avoidance opportunities before we’ll see the desired impact of higher rates on the wealthy. As you’ll see, that boatload is where I think the revenue-raising action should start.

2. Stop favoring one type of income over another. Allow me to formally define J.B.’s first law of tax avoidance: When the tax code favors one type of income over another, every rich person with a tax lawyer all of a sudden discovers that—who knew?—that’s the very type of income they have gobs of.

Investment income is the most obvious culprit. Capital gains and most stock dividends are taxed at a rate far below that of the top rate for earned income (generally speaking, capital income is taxed at 24 percent instead of 40 percent). So, under JB’s first law, you’d expect wealthy people to be going through lots of machinations to define their income as deriving from investments, not earnings. Which is precisely what they’re doing.

You’re probably wondering why anyone would want to privilege asset-based income in the first place. Since such holdings are concentrated among the wealthy, this practice violates the criterion above regarding tax policy not exacerbating inequality. The ostensible justification is that investment is highly “elastic” (i.e., responsive) to tax changes, so you’ve got to tax it gingerly or it will flee the country (or hide under a rock or whatever). There’s some evidence to support that claim, but small changes of a few percentage points either way have never been found to amount to much. I’m down with Warren Buffett on this one:

“I have worked with investors for 60 years and I have yet to see anyone—not even when capital gains rates were 39.9 percent in 1976-77—shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”

Equalizing these rates would thus raise revenue and dampen the incentive for tax avoidance.

3. Raise the estate tax. When it comes to wealth and death, they say “you can’t take it with you.” But because our current estate-tax base is so extremely narrow, the IRS doesn’t get hardly any of it, either. Thus, a great place to start broadening the base is with the estate tax, which right now reaches only 0.2 percent of estates (that’s about 2 of every 1,000 people who die). The Obama administration’s new budget would lower the estate-tax exemption threshold from $10.9 million to $7 million for couples (and from $5.4 million to $3.5 million for individuals); increase the top rate of the estate tax from 40 percent to 45 percent; and close a few estate and gift-tax loopholes, one of which allows an estate to put an investment in a trust to avoid paying capital gains (the Grantor Retained Annuity Trust loophole). Under these changes, which would raise $226 billion over 10 years, the estate tax would still affect only about 0.3 percent of decedents.

Note that this tax is not only a progressive revenue-raiser; because it reduces the size of intergenerational wealth transfers, it can also push back on economic immobility. There are a lot of people out there who were born on third yet think they hit a triple.

 

AP Photo/Jacquelyn Martin

Protesters hold signs supporting a financial transaction tax by the U.S. Treasury during a march organized by National Nurses United in Washington, on Thursday, November 3, 2011. 

4. End “step-up basis.” This one’s very much in the same spirit of the estate-tax recommendation, but is more narrowly targeted at a particularly egregious tax avoidance loophole that allows the wealthy to pass capital gains on to their heirs, tax-free. Suppose I were to expire and leave one of my kids a property that I bought for $10,000 that’s now worth $100,000. If I had sold it before I croaked, I’d pay capital gains taxes on the $90,000 of the property’s appreciation. But because I passed it on to an heir, the appreciation is untaxed; for tax purposes, the property is treated as if my heir bought it for $100,000. There is no good economic rationale for this loophole. Worse, it creates a “lock-in” effect, an incentive to hold onto such assets until death even if the capital gains from selling the asset might be more productively deployed somewhere else in the economy. Obama’s recent budget proposes to close this loophole (while leaving in significant exemptions so that the change only affects wealthy heirs). Combined with his proposal to raise the capital gains rate from its current 23.8 percent to 28 percent (consistent with my recommendation above about equalizing rates), ending step-up basis raises $235 billion over ten years.

5. Cap deductions on high-income taxpayers. There’s a very simple reason why even revenue-neutral, broaden-the-base/lower-the-rate tax reform is so hard to pull off: It creates losers (winners, too, of course, but they’re not the problem). That is, somebody’s effective tax rate (their tax liability as a share of their income) will go up when you end a subsidy or close a loophole, and behind every loophole is a lobbyist whose salary depends on defending that tax break as a treasured “job creation” program. Well, here’s an idea that cuts through myriad fights engendered if we try to go after these loopholes one at a time: For everyone over a certain income level, limit deductions to 28 percent instead of the top income tax rate of almost 40 percent. It avoids picking winners and losers, and it would boost economic efficiency by reducing the extent to which we subsidize behaviors that would occur anyway among the wealthy, like saving for retirement or buying a home. Applied to incomes of $250,000 or more, this cap would generate savings of more than $640 billion over ten years. Even in D.C., that’s real money.

6. Minimum foreign earnings tax. Multinational companies avoid U.S. taxation on their foreign profits though an avoidance method called “deferral.” That is, as long as they “book” their profits in far-off lands—not actually keep them there, but make it look like they’re there—they don’t have to pay U.S. taxes on them. There are all kinds of schemes to shut down deferral (or conversely, to give up on it), but the simplest one is a minimum tax that multinationals must pay on their foreign earnings when they earn them, after which they could repatriate their earnings without further taxation. And trust me on this one: when it comes to international taxation, “simple” is very, very good. The Obama administration plugs in 19 percent for this tax, which raises $350 billion over ten years.

7. Financial transactions tax. Much of the above is designed to close loopholes or minimize avoidance, typically by tweaking the existing system. But here’s an idea for something new: a very small tax on securities trades, also known as a financial transaction tax (FTTs exist in numerous other countries). Because the base is so large here—literally hundreds of trillions worth of securities are traded every year—a tiny FTT, say, just a few hundredths of a percent, could raise real money for the Treasury. A one-basis-point tax on $1,000 worth of stock would cost the stock trader a dime; a $100,000 trade would generate a tax of only $10. Yet an FTT of this magnitude could raise $185 billion over ten years.

In a world of mobile capital, won’t traders just find offshore exchanges by which to avoid the FTT? Surely some will, which is why it would be good to “hold hands and jump together” on this tax by enacting it in concert with other advanced economies. The European Union has been seriously considering an FTT for a few years now, but continues to delay implementation. As you can imagine, the politics of this are rough, as its opponents have awfully deep pockets. However, the Congressional Budget Office points out that with adequate international coordination, offshore transactions by United States taxpayers could still be captured by a transaction tax, just as an out-of-state Internet purchase can face the sales tax that prevails in the purchaser’s state. Moreover, many busy exchanges exist today with small FTTs, in large part because they remain safe and liquid exchanges.

However, research suggests that the response to a small FTT is more likely to come through fewer trades on domestic markets than shifting to offshore markets. Even so, I suspect even a small FTT would reduce trading volumes somewhat, but that could actually be a good thing. Thanks to high-speed, computer-driven trading, financial markets today suffer from too much trading, not too little. The turnover volumes have grown enormously over the past four decades, with no evidence of more efficient capital allocation (to the contrary, I worry about increased misallocation). An FTT could increase economic efficiency and even produce an increase in average investor returns.

When it comes to the epidemic of computer-driven high-speed trading, the FTT is a benefit, not a bug. It’s what economists call a Pigouvian tax (a tax on some economic activity that we want to reduce, like pollution or secondhand smoke, because of negative externalities). This automated, algorithmically driven trading is used to make windfall profits through millisecond price arbitrage (taking advantage of small differences in price), and even a tiny FTT would likely make it unprofitable. As you might imagine, high-speed trading often hurts ordinary investors, can destabilize financial markets, and provides no useful information through price signals. So here’s a chance to do well by doing good.

8. A tax on carbon. This one is obvious and essential. Yes, it would raise taxes on non-rich people (and many such taxes include a rebate to lower-income people who spend more of their income on energy). But it’s a defensible tax increase.

The Obama administration recently proposed a $10-per-barrel tax on oil, which raises $319 billion over ten years. Especially given how cheap oil has recently become, I appreciate their motivation, but I’d rather raise the federal gas tax. This tax is how we fund both highway infrastructure and the federal contribution to public transit, and it has been stuck at 18.4 cents a gallon in nominal terms since 1993. Meanwhile, the costs of maintenance have gone up, as has vehicle mileage, so no wonder the Highway Trust Fund is always broke. We and our politicians have conspired to create a magical world where we can maintain our roads and bridges and support our urban mass transit without paying for it.

AP Photo/Charlie Riedel

A tax on fossil fuels is essential partly because they're socially underpriced. Here, the National Cooperative Refinery Association oil refinery is silhouetted against the setting sun in McPherson, Kansas.

Moreover, and this is of course the other huge reason we need to raise the tax liability on fossil fuels: They’re socially underpriced. This is an opportunity to tax a seriously threatening negative externality, breaking the curse of magical thinking on transportation infrastructure, and raise needed revenues. There’s even been a touch of bipartisan support for the idea. (That’s why I’d go for this over the oil surcharge.) One such plan raises the gas tax by 12 cents a gallon over two years (6 cents per year) and then indexes it to inflation. That would raise $180 billion over ten years.

9. IRS funding. While Republicans would love to do the opposite of pretty much everything you just read about, they’ve consistently been blocked by the White House and congressional Democrats. They have, however, with help from many a Democrat, cut discretionary spending, including the budget of the Internal Revenue Service. As The New York Times explains: “Between 2010, the year before Republicans took control of the House of Representatives, and 2014, the I.R.S. budget dropped by almost $2 billion in real terms, or nearly 15 percent. That has forced it to shed about 5,000 high-level enforcement positions out of about 23,000, according to the agency.” (See companion piece by Martin Lobel.)

What it all amounts to: As the table shows, these ideas (counting the increase in the federal gas tax but not the oil surcharge or new revenues from increased tax enforcement) get you $1.8 trillion over ten years, about 1 percent of GDP. In other words, this is far from a radical reach.

And yet, the politics of all this is anything but forthcoming. To put not too fine a point on it, none of these ideas has any traction in the current Congress, in no small part because many members have pledged never to raise taxes and would block any such legislation. And yet, not that long ago, after his re-election, Obama managed to pass legislation that raised income tax rates on high-income households, as well as the rate on capital gains. How did that happen?

Observation suggests that, somehow, newly elected or even re-elected presidents can sometimes get Congress to make some of the tax changes on which they ran for office. Think Reagan, Clinton, George W. Bush, Obama—and they didn’t all have pliant Congresses by a long shot. The implication is that if there’s any hope to get any of these ideas through, candidates have to run on them.

So, especially given the climate out there in the electorate today, progressives’ best play is to make the other side defend favorable rates for investment income (even Trump has said he wants to close the carried-interest loophole, where hedge fund managers face favorable asset-based rates on their earnings at a cost of $19 billion over ten years), as well as step-up basis, overseas deferral (and the related corporate inversions), other forms of tax avoidance, and fattening up the tax gap by defunding the IRS.

Many members of Congress won’t help because they’re funded by the beneficiaries of the current system. But there are a lot of voters on both sides of the aisle rightfully outraged by the unfairness in the tax code. A good place to start would be to try to tap their energy by picking off some of the ideas above and running with them. 

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