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Virginia’s Falling Tax Revenues: Cuccinelli Would Cut Them Further

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Virginia State Taxes as share of Virginia GDP, FY 1972-2012

A.  Virginia’s Falling State Tax Share

Virginia state tax revenues have been falling as a share of Virginia GDP for decades, as the graph above shows.  Yet predictably, a major plank in the proposals of the Republican candidate for governor, Ken Cuccinelli, is that Virginia state taxes should be cut further.

The line in the graph was calculated from figures on state tax revenues from the US Census Bureau (which collects such data on a consistent basis for all fifty states), with the figures on Virginia state GDP from the Bureau of Economic Analysis (which publishes state figures with its regular GDP accounts).  The downward trend is clear, and a regression line fitted to those figures (in red) confirms it.

With Virginia taxes lower now as a share of income than they were before, it is hard to see how one can argue, as Cuccinelli does, that they are too high and act as a hindrance to economic performance.  The taxes were higher as a share on income in the past, and economic performance then was good.

But the lower share of state taxes in income, coupled with the implications of Baumol’s Cost Disease (discussed in a previous post on this blog), does explain why Virginia state government services are so much worse now than they used to be.  Sub-national governments must over time limit their public expenditures to what they raise in tax revenues (with a limited ability to shift some of these across time through issuance of state bonds), and Virginia has been a particularly strict adherent to such budgetary rules.  With lower revenues, the state government has no longer been able to provide the public services it once had.

I grew up in Virginia in the 1960s, and at that time Virginia took pride in the quality of its public services.  The state highway system was one of the best in the nation.  State universities such as the University of Virginia and William and Mary were among the best state schools in the country, and also ones where good students graduating from high schools in Virginia could reasonably aspire to getting in as spaces were adequate.  This is no longer true.

B.  The Cuccinelli Tax Plan

Virginia is one of only two states holding gubernatorial elections in this off-year (New Jersey is the other).  The Republicans nominated Ken Cuccinelli, the current Attorney General, as their candidate.  Cuccinelli is best known for his support of a radically conservative social agenda.  His tax plan is similarly a radically conservative proposal which would cut revenues drastically.

The key elements of Cuccinelli’s plan are to:

1)  Eliminate the current top individual income tax bracket in Virginia of 5.75%, replacing it by extending the current 5% second highest bracket;

2)  Cut the Virginia corporate income tax rate from 6% to 4%;

3)  Establish a commission to propose further tax cuts;

4)  Close “loopholes” to raise as much in revenue as would be lost through the cuts in the tax rates;

5)  Cap growth in Virginia state government expenditures to the rate of inflation plus population growth.

But note on each of these proposals:

1)  Eliminating the top tax bracket, and only the top tax bracket, of 5.75%, means that only those households paying the top tax bracket will benefit from lower rates.  By construction, only the richest households will benefit.  The Commonwealth Institute for Fiscal Analysis, a nonpartisan institute based in Richmond, has estimated that fully three-quarters of the benefits from this lower tax rate will accrue to households earning more than $108,000 a year, and that 25% will go to the richest 1%.

2)  The corporate tax rate would be cut by a third, a huge cut, and would bring Virginia’s rate to the lowest of any of the 44 states in the US that have a corporate income tax.  The other six states follow a different tax structure.

3)  The mandate of the proposed commission would be to make even further tax cuts.

4)  It has now become the norm in Republican tax plans that while there is great specificity in the taxes that would be cut, there is no specificity at all on what taxes would be raised (other than that they are all “loopholes”) so that overall tax collections will remain unchanged.  Mitt Romney did this for his presidential campaign last year, and independent analysis showed that his plan was simply not mathematically possible.  Paul Ryan has similarly left undefined what loopholes he would close to raise sufficient revenues to offset his proposed cuts in tax rates, in the budget plans he has set out for the Republicans in Congress.

It would probably not be correct to say that Cuccinelli is keeping secret what tax loopholes he would close.  Keeping them secret would imply that he has looked at the issue and has a plan that he refuses to disclose.  There is no evidence that any such plan exists, much less any assessment of whether the revenues thus raised would offset the losses.  But it may be astute politically to propose sharp reductions in tax rates, while asserting that he will come up with the same in revenues by closing unspecified loopholes that one can believe only others benefit from, and not yourself.

5)  Capping growth in Virginia government expenditures at inflation plus population growth implies absolutely zero growth in real per capita terms.  But for an economy to grow, you need to grow supportive public services.  Hindrances such as a totally inadequate road and public transportation network result when you do not.

Cuccinelli’s tax plan is radically right wing, with sharp cuts in tax rates focussed on the rich and the corporate sector, while asserting with no evidence that it will be made revenue neutral by closing unspecified “loopholes”.  But this is consistent with Cuccinelli’s history of radically right wing policies, although in the past on social issues.  Cuccinelli has been strongly opposed to equal rights for homosexuals; believes that the police powers of the state should be used against couples for engaging in certain sexual acts in what most thought would be the privacy of their bedrooms; has insisted, as Attorney General, that new regulations be applied retroactively to shut down clinics providing health care services to women, in particular poor and minority women, since these clinics have provided also fully legal (and constitutionally protected) abortion services to women in need; has attacked basic academic freedoms by insisting that the University of Virginia turn over to him materials, including private emails, of a scientist doing research on global warming (he lost the case); co-sponsored a bill which would have declared that human life begins at the moment of conception under Virginia law, and hence women using certain forms of birth control (and presumably also their doctors) would be guilty of murder; within five minutes of Obama signing into law the Affordable Care Act to extend health care to the currently uninsured, Cuccinelli filed a case in court to block the act (he lost the case, and well before the Supreme Court ruling on the law); sponsored legislation which would not allow children of undocumented immigrants to become citizens, despite the US Constitution saying that they are; and more.

The one point on which all agree, liberal and conservative, is that Cuccinelli would radically change Virginia, if he has the chance.

Taxes on Corporate Profits – Low, Falling for Decades, And Now Close to a Voluntary Tax

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Corporate Profit Taxes as Share of Corp Profits, 1950-2013Q1

Conservatives bemoan the US corporate profit tax rate, which at 35% for the statutory rate  is the highest among OECD members.  They insist the tax, which they consider to be high, is both unfair and harms US competitiveness.  While they acknowledge that the rates the US corporates actually pay are less, due to legal deductions and other mechanisms, what might not be clear is how low US corporate profit taxes have become.

The US Government Accountability Office (GAO, the audit and investigating agency that  works for the US Congress) released on July 1 a report on what US corporations in fact pay in corporate profit taxes.  Using tax return data (but aggregated to preserve confidentiality), the GAO found that profitable US corporations in 2010 paid federal corporate profit (also called income) taxes at a rate of just 13%, despite the statutory rate of 35%.

If one includes corporations that reported a loss in 2010 (and hence had zero or only little profit taxes due, leaving the numerator the same but whose losses then reduce the denominator in the ratio), the average federal tax rate came to only 17%.  Furthermore, the total tax including not just US federal taxes, but also US state and sometimes local taxes as well as profit taxes paid abroad, came to only 17% in 2010 for the corporations reporting profits, and 22% when one includes the loss-makers.

All these rates are far below the statutory federal corporate profit tax rate of 35%, which has been in place since 1993.  There are state and sometimes local corporate profit taxes on top of this, with rates that vary from zero in certain states (such as Nevada), up to 12% for the top marginal rate (in Iowa).  The state taxes average about 6 1/2%.   Taking account of just federal and state taxes, the corporate profit tax rate on average should be over 41%.

The GAO investigation was carefully done, and has raised again the point that while the US corporate profits tax rate might appear to be high, it bears little relationship to what corporations actually pay.  And the trend over time is decidedly downward.  The graph above uses data from the National Income and Product (GDP) Accounts, produced by the BEA of the US Department of Commerce to show what corporate profit taxes have been as a share of corporate profits since 1950.  While these figures will not be exactly the same as what actual tax return data will show (due to definitional differences in what is included in taxes and especially in how corporate profit is defined, as well as due to timing differences arising from the distinction between when tax obligations are accrued and when they are paid), the trend is clear.  Corporate profit taxes as a share of corporate profits have been falling steadily, from over 50% in 1951 to only 20% recently.  These estimates from the GDP accounts are consistent with the recent GAO figures based on tax return data, where one should note that the BEA estimates will include loss-making firms as well as profitable ones in their averages.

The fall in the actual rate paid to just 20% in recent years also undermines the argument that a high US corporate profits tax rate has undermined the incentive to produce.  Economic performance was better when the profits tax rate paid was much higher than now.  The US corporate profits tax rate averaged 44% in the 1950s and 1960s, yet economic growth was strong then.  As an earlier post on this blog discussed, economic growth performance in the US was substantially better in the 30 years before 1980 than in the 30 years after.

Furthermore, there is little support in the figures that the US corporate profits tax rate at 35% puts the US at a competitive disadvantage vis-a-vis the other OECD members.  While the 35% rate is indeed the highest, the second highest is 34.4% and the third is 33.99% (see the OECD source cited above).  Fifteen of the 33 OECD members covered had rates of 25% or above, and a further 10 had rates of 20 to 24.9%.  More importantly, all of these OECD members, other than the US, imposed a value-added tax on top of their corporate profits tax (and other taxes).  These additional value-added taxes were as high as 27%, and 23 of the 33 OECD members (including essentially all of Europe) had value-added tax rates of 18% or more.  Value-added taxes will be taxes on corporate profits (as well as on labor income), and should not be ignored when one is looking at the overall rate of tax on corporate profits.

The ability to avoid taxes on corporate profits has been receiving increasing attention in recent months.  Historically, much of this avoidance has been achieved through explicit provisions written into the tax code by Congress for certain subsidies or other government expenditures, which the Congress did not want to explicitly provide for or acknowledge in the budget.  Examples include credits for investing in certain locations or for certain purposes (such as R&D), or accelerated depreciation allowances as a mechanism to spur investment.  The objectives might well be worthwhile, but by hiding in the tax code what are in reality subsidies, and then keeping them secret due to the privacy of tax return data, such subsidies are likely to be both inefficient and misguided.  If subsidies are warranted, it would be better to provide them openly and transparently through the budget.

More recently, large corporations have learned how to use international operations as a means of hiding profits from jurisdictions where they would be subject to tax.  Some examples of what US firms have done in the UK to avoid paying taxes there have been recently in the news, and provide good examples of what modern firms can do anywhere, including in the US.

Transfer pricing, while technically illegal, has historically been one mechanism to do this.  This appears to have been one of the ways (among others) that Starbucks was able to run highly profitable coffee shops in the UK, but pay nothing in UK profit taxes.  Starbucks of the UK would “purchase” coffee beans from a Starbucks subsidiary legally based in Switzerland, which would in turn purchase the coffee beans from around the world.  Since commodity trading in Switzerland pays very little tax on the corporate profits generated in such trading, Starbucks could pay the international price for coffee beans through its Swiss subsidiary (even though the beans would never pass physically through Switzerland), and then charge the UK subsidiary a higher price for the beans.  This would increase the costs (and hence reduce the profits) of the UK subsidiary, while generating high profits on coffee bean trading in its Swiss subsidiary, where little or no tax was due on such operations.  And this could be done in essentially any jurisdiction which does not tax corporate profits.

There were other mechanisms as well that Starbucks appears to have used, including intra-company loans from one subsidiary (based in a low tax jurisdiction) to a subsidiary in a jurisdiction (such as the UK) where corporate profit taxes would be due.  This is very similar to transfer pricing on supplies, although here it would be for the supply of capital.

Through these and other mechanisms, Starbucks has been able to avoid, probably legally given the tax code as written, most corporate profit taxes on its UK operations, even though it had consistently reported to analysts on Wall Street that its UK operations were highly profitable.  This became such a public relations disaster that in June the company announced that it would voluntarily pay UK profit taxes of £10 million in 2013 and a second £10 million in 2014.  Starbucks has shown how corporate profit taxes have become in reality voluntary taxes, paid only to avoid image problems.

Starbucks provides a good example of what modern corporates can do, even though it operates just a simple business of selling coffee.  High-tech firms such as Apple are more often in the news since they have generated high profits yet have legally been able to avoid paying taxes on these profits at anything close to the 35% statutory rate.  For example, and as reported in a recent Senate investigation, Apple was able to exploit a difference in how corporations are defined in terms of their tax liability in a country, in order to generate profits in an Irish subsidiary which would not be subject to tax in either Ireland or the US.

More generally, US corporates do not have to pay US corporate income tax on profits generated in overseas operations until these profits are brought back to their US companies.  This is unlike the case for US citizens, who must pay each year income taxes on income generated everywhere in the world, and not just the US.  Because of this provision in the US tax code, Apple and other US corporates have kept accumulated profits legally overseas, so as to avoid paying US profit taxes on them.   The total for large US corporates reached an estimated $1.9 trillion as of the end of 2012, with Apple alone accounting for $102 billion.  Republicans have pushed for a tax amnesty on the repatriation of such funds, as was done once during the presidency of George W. Bush.  But such tax amnesties of course then generate the incentive to hold such profits in untaxed offshore accounts again, in the expectation that an administration in the future will once again grant such an amnesty.

And it has now become straightforward to structure a system of corporate subsidiaries so that almost any company can, if it wishes, make it appear that profits in the US (or indeed any other country, where corporate profit taxes would be due) are close to zero, and instead are high in some low tax or even untaxed jurisdiction such as the Cayman Islands.  Transfer pricing is one such mechanism, although technically illegal as prices between corporate subsidiaries are supposed to be “arms-length” market prices.  But these are effectively impossible to enforce.  How does a tax-audit determine what the price should have been for some specialized input (such as a component going into an iPad), for which no market exists?

But there are other means as well.  High tech firms such as Apple can, for example, transfer ownership of some patent to an Apple subsidiary in the Cayman Islands, and then require the Apple US firm to pay a royalty to the Apple Cayman Islands firm.  Or Starbucks can transfer ownership to the Starbucks brand name similarly to a subsidiary in some low tax or no tax off-shore jurisdiction, and then have the US subsidiaries pay that off-shore subsidiary for the use of that brand name.

The legal “technology” for corporate tax avoidance has therefore come to the point where what is in fact paid in corporate profit taxes can be close to voluntary.  Starbucks in the UK is the most clear case so far.  Governments are concerned, as these mechanisms can now undermine, quite legally, collections on what was at one point an important tax.  The OECD now has a working group looking at possible reforms to address the currently legal ability of modern corporates to avoid taxes through their international operations, with a report scheduled to be released in July.  But it remains to be seen whether politically possible changes in the tax code will be able to ensure such loopholes are closed.

Three Reforms to Make the Income Tax System Simpler, Fairer, and More Progressive

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Introduction

The main tax filing season is now recently over.  With the frustrations of an absurdly complex system still fresh, it is perhaps a good time to consider reforms which would simplify the system while improving its progressivity.

Conservatives have asserted that the only way to make the tax system simpler is to end its progressivity, with the poor then required to pay the same tax rate as the rich.  This is simply not correct.  The complexity in the system does not comes from the calculation of how much is due in taxes once taxable income is determined.  That is easy to do.  Rather, the complexity comes from the many different rules for determining what is included in and deducted from taxable income, and then taxing different types of income at different rates.  Tax all income, whether from wages or from wealth, at the same progressive rates, and the system would be far simpler as well as fairer.

This blog post will set out three basic reforms that would lead to a simpler, fairer, and more progressive personal income tax system.  It will focus on broader issues, and not go into the specifics of the many special interest loop-holes that clutter the system.  These loop-holes lead to tax breaks for a few while not only forcing everyone else to pay higher taxes to make up for this (in order to meet any given overall revenue need), but also forces us all to determine in each case whether the special provision applies to us (usually not, but you do not know until you investigate the details).  One can find many discussions elsewhere on the pros and cons of these many different special provisions.

Nor will this blog post focus on the corporate income tax system, which is also cluttered with an enormous number of unwarranted special provisions.  But the corporate income tax system raises a very different set of issues.

[Many specifics of the current tax code will be cited below.  Rather than reference each one, the source for all can be found at the IRS web site.]

Reform 1:  Equal Tax Benefits for Deductions at All Income Levels 

Suppose one had a system that led to the following:  There are three individuals, one from a rich household with an income of a half million dollars a year, one from a middle income household with an income of $100,000 a year, and one from a poorer household with an income of just $25,000 a year.  Each decide to give $100 to the same worthy charity.

To the rich household, the US Government says that was very generous, and due to this generosity, the government will give back $40 (more or less – it will depend on a number of special factors, but will be close), so the net cost of the contribution is only $60.  To the middle income household, the US Government also says that the generosity was welcome, but with their lower income compared to the rich household, will give back to them only $25, making the net cost of the contribution $75.  And to the poor household, making only $25,000 a year, the US Government might say that while it was extremely generous to have contributed $100 to that same charity, we will only give back $10 to you, leading to a net cost of $90.

Most would agree that this is enormously unfair.  But it is how our current system works.  Contributions to charities are counted as deductions from income, so the tax subsidy the government provides back to the household will depend on the tax bracket and whether the household itemizes deductions.  It costs the rich household, in a 40% bracket, only $60 to make a $100 donation; it costs the middle income household, in a 25% bracket, only $75 to make a $100 donation to the exact same charity; and it costs the poor household $90 to make a $100 donation to that charity.  (This assumes, for the sake of illustration, that each of the households are itemizing their deductions, rather than taking the standard deduction.)

Most people understand and recognize this.  It is perverse, but many believe there is no simple way around it.  But in fact there is.  Instead of making such payments a deduction from household income, on which one then determines the tax, one can instead make a percentage of such payments a tax credit, to be subtracted from taxes due household incomes without first taking deductions.

One would do this for all deductions as well as personal exemptions (credits for the number of household members, which will be $3,900 per person in 2013).  For all expenses that one determines should remain as deductions (they should in fact be simplified, but that is a separate issue), one would add up the expenses as one does now on Schedule A, which would not need to be changed.  There would then be a tax credit rate (20% perhaps, but the same for all households, rich or poor) applied to the sum of the former deductions and personal exemptions.  One would determine taxes due on the full income (what the IRS calls the adjusted gross income) with no subtraction for deductions or exemptions, based on the standard tables, and then subtract as a tax credit 20% of the total former deductions and exemptions.  And as is the case now, one could have the equivalent of the standard deduction by applying the 20% rate (or whatever rate is chosen) to the current standard deduction amounts and apply it as a tax credit.

If someone had been in a 20% tax bracket before, then their tax would remain unchanged.  But now all households would receive the same tax benefit from a $100 contribution to some charity regardless of their tax bracket.  Poorer households would receive more (relative to what they are receiving now) while richer households would receive less.  This would not only be fairer, but also simpler and more progressive than is the case under the current system.

Reform 2:  Equal Tax Rates on All Forms of Income

Under the current income tax system in the US, the tax rate you pay depends not only on the level of your income, but also on the type of income.  For so-called “ordinary income”, the tax rate can be as high as 39.6% in 2013 (and in fact somewhat higher, as will be discussed below).  Such ordinary income includes wages, interest income from savings accounts or from long-term bonds, income received as rents, and income from capital gains on sales of assets held less than one year.  But if the exact same asset is held for a day more than one year, the tax rate on any captial gains from its sale drops to only 15%.  Dividends may be taxed at ordinary income rates or at the long-term capital gains rates depending on whether the stock paying the dividend had been held for at least 60 days during a period straddling when the dividend was paid (unless it was a dividend on a preferred stock, in which case the requirement is 90 days).  And for those with lower incomes, the long-term capital gains tax rate might be 0%.

There are additional complications on top.  Different rates apply on “ordinary income” if the household is subject to the Alternative Minimum Tax, with tax rates then (on a different definition of what is taxable income) of 26 or 28% (depending on income).  The long-term capital gains tax rate is 15% on many assets, but is 28% on “Section 1202 qualified small business stock”, 28% on “collectibles” (coins or art, defined somehow), and 25% on “unrecaptured Section 1250 gain from selling Section 1250 real property” (whatever that is).  Even once one determines whether any of these apply to your own situation (normally not), one must still navigate tax forms that have to be complex to allow for each of these options.

And in addition, starting in 2013 there will be complications from a number of additional tax provisions.  These are in effect higher tax rates, and the revenues they will raise could have been achieved by modestly higher tax rates, but since Congress did not want to appear to be approving higher tax rates, they instead “hid” them.  The most clear-cut was a decision to phase out the tax benefits for personal exemptions and itemized deductions for high income households (those with incomes of over $300,000 if married filing jointly).  In effect, this will mean higher effective tax rates for the moderately rich, which will then fall back to lower rates for the extremely rich.  There will also now be a Net Investment Income Tax of 3.8% on investment income of all kinds (including short and long term capital gains, interest, dividends, and more), but only on income on the lesser of net investment income or some “modified adjusted gross income” that is in excess of a some threshold amount.  And there is now a additional 0.9% tax for Medicare that applies to wages and self-employment income above a threshold amount (of $250,000 for those married filing jointly).

This is absurdly complex.  But perhaps even more importantly, these widely varying tax rates on different forms of income create an incentive for firms and individuals to shift the incomes being paid to categories subject to lower tax rates.  This mostly benefits the well-connected insiders of firms.  The biggest gap, and hence the biggest incentive, is to shift what are in fact wages to forms of income that are taxed at the low long-term capital gains rate.  One has therefore seen a shift in recent decades to payments in the form of stock options which, if structured correctly, are subject only to tax at the long-term capital gains rate.

An even more egregious example is the taxation of “carried interest”, which is the payment of the fees to fund managers that are linked to the success of the investment.  The fund managers pay tax at only the low long-term capital gains rates on such fees.  Lawyers or accountants working on the same deals, who might also be paid based on the success or not of the deals, receive income from such deals that is taxed as any wages are.  And these fund managers can earn a lot.  Forbes has estimated that one such manager personally earned $2.2 billion in 2012 alone, while four more earned over $1 billion each in 2012.  How can one justify that such managers pay tax at a rate of only 15% on such earnings, while households with ordinary incomes of $72,500 or more pay from 25% up to over 40%.

The basic principle of taxation should be that a dollar of income is taxed the same whether that dollar is earned as wages, or as capital gains (long or short term), or as interest, or as rental income, or as dividends, or as carried interest, or as whatever.  Widely different rates are not only not fair, but add needless complexity as well as incentives to manipulate the system by shifting incomes from one category to another.

The one adjustment that should be made is for inflation, as one is seeking to treat all dollars in terms of the same prices (that of the current year).  This affects capital gains.  Gains that arise only due to inflation do not reflect any real gain in income.  To illustrate, suppose one purchased a house ten years ago for $100,000.  Suppose inflation averaged 3% a year over those ten years.  If the house were now sold for $134,400, one would be receiving back cash that is the same value now as $100,000 was ten years ago.  There would be no real gain.

Some have argued that the low long-term capital gains tax rate of 15% is warranted to compensate for such inflation.  But if so, it is an absurd way to do this.  In the example above, one would still pay capital gains tax on the $34,400 nominal gain.  And one would pay this same capital gains tax if the asset had been held for a day more than a year, or for ten years, or for thirty years.  Yet the cumulative impact of inflation would be widely different depending on the length of time the asset was held.

Much more rational would be to adjust for inflation directly, rather than assign different tax rates for capital gains than for ordinary income.  It would not be difficult to do.  The IRS would publish each year a table showing for each year (going back 100 years if one wants) the adjustment factor to be applied to the cost basis of the asset that had been sold in the current tax year.  In the house example described above, with inflation averaging 3% a year for the past ten years, the table would indicate that the cost basis of an asset purchased ten years ago should be marked up by a factor of 1.344.  That is, the cost basis  of the house sold now would be $134,400 (in terms of current year dollars).  If the house now sold for $150,000 say, the capital gain (in current dollars) would be $15,600, which would be added to current year wages and all other current year income, and taxed at ordinary income tax rates.

A similar inflation adjustment would be made for interest earned.  Suppose inflation is 2% this year, and you have money in a savings account earning 3% a year.  The real return is only 1%, and taxes (at ordinary income tax rates) should be charged only on this 1% return, not (as now) on the 3%.  A way to see this is to note that in earning a 3% return, one has lent to the bank $100, say, last year, and then received $103 back this year.  But that $100 from last year is now worth $102 this year in today’s dollars, due to the 2% inflation, so one is receiving a net return of just $1 in today’s dollars.

With such adjustments for inflation, which would put all sources of income into terms of today’s dollars, there is then no reason to tax different categories of incomes at different rates.  The special long-term capital gains tax rate of 15% should be ended (as should the 28% and 25% rates on other forms of capital gains).  There is also no reason to create hidden increases in marginal tax rates by introducing phase-outs of exemptions and deductions.  Reform 1, discussed above, presents a fair and simple way on how to handle exemptions and deductions.  Finally, there is no logic in having an Alternative Minimum Tax.  If there are loop-holes that lead rich people to have a legally low level of taxable income, one should get rid of the loop-holes.

Reform 3:  Ensure All Sources of Income Are Taxed Similarly Over a Life-Time 

Even with equalized tax rates on all forms of income (as well as equalized tax credits for deductions and exemptions, regardless of income level), taxes are still assessed only on incomes that can be readily measured each year.  Thus taxes are assessed on wages, dividends, and interest, and on capital gains when assets are sold.  If the assets are not sold, the tax system does not assess taxes on what the gains might have been from an increase in the market value of the assets.  Such gains accumulate tax free until the assets are sold.  And if they are never sold, but instead are passed along to heirs at the time of death, the heirs inherit the asset at a cost basis equal to the value on the date it passed to them.

Furthermore, and as was noted in a column by Larry Summers (former Treasury Secretary and Obama advisor), the really wealthy have developed many mechanisms to receive income and accumulate wealth over their lifetimes and even upon death, without ever paying significant taxes on what can be truly massive accumulations.  The accumulation of unrealized capital gains is only one such mechanism.  And it would require a specialized lawyer (which I am not) to explain many of the tricks.  But in recent decades one has seen massive accumulations of wealth with apparently limited tax consequences.

The principle to follow should be that all income and earnings from accumulation of wealth should be taxed equally at at least one point in a person’s lifetime, or upon death.  Income is taxed generally as it is earned, whether as wages, interest, dividends, rents, or other forms.  Capital gains are taxed if assets have been sold.  All other wealth, in whatever form, should be taxed upon death according to the capital gains that would have been generated based on their valuations on the date of death.

The estate tax (combined with the unified gift tax) can be seen as a poorly designed substitute that tries to make up for this.  While total estate assets are taxed at a relatively high rate (reaching 35% currently), and the tax is based on the gross value of assets upon death and not on the unrealized capital gains on such assets at that time, no estate taxes are due at all until estates reach a sizeable $5,250,000 (as of 2013, and this can effectively be doubled for a married couple though some straightforward legal measures), with the 35% rate applying only to estates over $5,750,000 (which can also effectively be doubled for a married couple).

Both through the high thresholds before any estate taxes are due, and through other mechanisms, little is actually paid in estate and gift taxes each year.  As Larry Summers noted in the column cited above, only about $12 billion in such taxes are paid each year.  A conservative guess would be that at least $1.2 trillion is passed down in inheritances each year, the vast bulk of which is concentrated among a wealthy few.  Thus current estate and gift taxes are generating taxes equal to only 1% of this, and the bulk of estates are being passed along with small or no taxes being paid.

The reform would be to have much lower thresholds (perhaps $1 million per married couple, meaning $0.5 million per person, with unlimited spousal inheritance if the couple so chooses), but taxes then based only on the capital gain as of the date of death instead of the gross value of the assets at that time.  Ordinary income tax rates would be applied for estates above these limits.

It has been argued that those gaining the inheritance would not know the cost basis, but this can be easily remedied.  For almost all households except the very rich, the assets to be passed along are either in financial accounts (where the financial firm holding the asset will know the cost basis, which is now being reported to the IRS when assets are sold), or are homes.  The cost basis on homes (and indeed other major property) can be recorded in an annex to the will.  And as was proposed in Reform #2 above, the cost basis would then be adjusted up to reflect inflation between when the asset was first purchased and the date of death.  For the very rich with a diversity of highly valuable assets, the cost basis could be recorded as part of the will or other document in which inheritance decisions are recorded.

IRS enforcement would focus on the extremely large estates.  These are where there would be major losses from underreporting of the value at the time of death of the assets being transferred.  As under the current system, such assets should be reported at their fair market value, but sophisticated operators have often reported much less.  One way to enforce this might be that the value of very expensive assets (say those over $10 million) would have to be publicly declared, where anyone would be able to bid for those assets at a price of at least 10% above the declared price.  A few firms would likely develop that would specialize in valuing such assets and then bidding for those being undervalued.  Such a market mechanism would enforce discipline.

Note also that with this new system, there would no longer need to be the complication of separate gift tax accounting.  Gifts of up to $14,000 (currently) per person per year can be given with no gift tax consequences.  Gifts above this must be recorded and then effectively added to the estate to determine estate tax.  This is needed so that the rich cannot transfer all of their estate to their inheritors tax free prior to their death.  But with an estate tax based on capital gains, one could allow gifts of any amount provided they are made in cash (as there is no capital gain involved).  If assets other than cash are given to inheritors, then one could require that any such gifts above the minimum ($14,000 currently, but it could be adjusted) would be subject to tax at the amount of capital gain involved in that asset, with this tax to be paid by the one providing the gift.  It would be taxed as if the asset were sold, the capital gain tax paid, and then the resulting cash being provided as a gift.

Conclusion

The reforms presented above would lead to a simpler tax system, as well as a fairer and more progressive one.  The focus has been on structure.  Decisions would still need to be made on the specific tax parameters to be applied.  But these would be far fewer in number than is the case under the current system.  In the current system there are different sets of tax rates for ordinary income taxes (which now vary from 10% to 39.6%), for capital gains (15%, 25%, 28%, or the ordinary income tax rates if short term), for the Alternative Minimum Tax (26% and 28%), for estate taxes (0% to 35%), for the new Net Investment Income Tax (3.8%), for phase out rates for deductions and exemptions, and for more, as well as the multiple floors and ceilings which apply to each rate.  In the new system, one would have one set of ordinary income tax rates (and the income ranges to which they would apply), and one rate of uniform tax credit to be applied to what are now tax deductions and personal exemptions.  There would also be thresholds to determine for the new Estate Tax.

A determination would need to be made on what the new income tax rates, tax credit rate, and thresholds would need to be.  This would require data and models that I do not have, but which are readily available at the US Treasury, at the Congress (Joint Committee on Taxation), and at the private non-profit Tax Policy Center.

But I would note that there is no logic in requiring that such a tax reform be revenue neutral, generating only as much revenue as the current convoluted system currently leads to.  Rather, the tax parameters should be set so that over the course of the full business cycle, the tax revenues generated and the government expenditures that are warranted lead to a path of deficits and surpluses such that the public debt to GDP ratio follows some desired path.

Note that what makes no sense is to pre-specify (as was been done in the original Bowles-Simpson proposal, or the budget proposals of Congressman Paul Ryan) that federal tax revenues should be set to some level or share of GDP, with expenditures then cut to whatever extent necessary to match those revenues.  Under such an approach, even Congressman Ryan as well as Bowles and Simpson would agree that it would be nonsense to spend more if revenues surprisingly turned out to be higher than anticipated.  It would be equally nonsensical to say expenditures should necessarily be cut, no matter how worthwhile and efficient the program, if revenues turn out to less than anticipated.

Rather, for long-term budgetary purposes, a determination should first be made of the level of government expenditures that are warranted and worthwhile, and reflect an efficient use of resources.  Revenue targets should then be set to meet these goals.  The specific tax rates of any system, including the one proposed here, would then be determined to reflect this.