Tax Reform Options: Marginal Rates on High Income Taxpayes, Capital Gains and Dividends

Comments for the Record

United States Senate Committee on Finance

Tax Reform Options: Marginal Rates on

High-Income Taxpayers, Capital Gains and Dividends
September 14, 2011, 10:00 AM

By Michael Bindner

Center for Fiscal Equity

Chairman Baucus and Ranking Member Hatch, thank you for the opportunity to address this topic. The Center for Fiscal Equity believes that dealing with marginal rates for high income taxpayers, capital gains taxes and dividends are key issues in constructing tax reform legislation and ultimately in achieving comprehensive deficit reduction. We would also add treatment of the estate tax to the issues which must be discussed in this context.

The key fact of the deficit reduction debate is that the entire exercise is only necessary to fund the extension of the 2001, 2003 and 2010 tax cuts. If these tax cuts were allowed to expire automatically, no further deficit reduction would be required. For the efforts of the Joint Select Committee to succeed, they must not only link cuts to permanent tax reforms, but they must also enact enough cuts and reforms to make extending the Bush cuts a non-issue.

Cutting only $1.5 trillion on top of the previous $900 billion in cuts is inadequate for a master compromise, because no agreement is likely possible on which tax provisions to offset. If cuts are proposed to offset tax savings to preserve the 10%, 25% and 28% rates and the $1000 child tax cut, Republican members will never agree – as this would allow the President to veto any additional tax cut extensions. Democrats will never allow tax cuts at the high end to come to the floor unless low end cuts are enacted first. In order to enact any tax plan, some type of tax simplification is necessary, else gridlock will solve the deficit problem, provided the President refuses to compromise on temporary tax cut extensions.

In the long term, the explosion of the debt comes from the aging of society and the funding of their health care costs. Some thought should be given to ways to reverse a demographic imbalance that produces too few children while life expectancy of the elderly increases.

Unassisted labor markets work against population growth. Given a choice between hiring parents with children and recent college graduates, the smart decision will always be to hire the new graduates, as they will demand less money – especially in the technology area where recent training is often valued over experience.

Separating out pay for families allows society to reverse that trend, with a significant driver to that separation being a more generous tax credit for children. Such a credit could be “paid for” by ending the Mortgage Interest Deduction (MID) without hurting the housing sector, as housing is the biggest area of cost growth when children are added. While lobbyists for lenders and realtors would prefer gridlock on reducing the MID, if forced to chose between transferring this deduction to families and using it for deficit reduction (as both Bowles-Simpson and Rivlin-Domenici suggest), we suspect that they would chose the former over the latter if forced to make a choice. The religious community could also see such a development as a “pro-life” vote, especially among religious liberals.

Enactment of such a credit meets both our nation’s short term needs for consumer liquidity and our long term need for population growth. Adding this issue to the pro-life agenda, at least in some quarters, makes this proposal a win for everyone.

Administration of an expanded child tax credit is an important issue as well. If administered within the context of personal income taxes, filers will continue to need the services of professional (and sometimes very-unprofessional) tax preparation services, which are often tied to predatory refund anticipation schemes because such credits are often seen as found money.

It would be preferable to instead tie this credit to an employer-based Net Business Receipts Tax (NBRT). Such a tax would be similar to a Value Added Tax (VAT), but would not appear on the customer receipt because it would have offsets for both the child credit and employer-provided health insurance (or direct services) for employees and possibly for retirees as well. As importantly, attaching this tax to the employer provides an incentive to adjust base pay downward for non-parents and parents whose children have left the nest – providing an incentive to have children for younger workers and providing an incentive to keep older workers on board, rather than replacing them with younger workers.

A separate VAT would also be established to fund discretionary spending occurring in the United States (both military and civil). This tax would make everyone conscious of supporting the operation of government and provide a direct incentive to save costs, because it could be made visible on the receipt at every level, including retail.

Both the NBRT and VAT would, as consumption taxes, burden both labor costs and profit. Enactment of both taxes would allow repeal of separate corporate income taxation, business income tax collection under personal income taxes, the hospital insurance and disability insurance payroll taxes and low rate personal income taxes on everyone, including higher income individuals.

In other OECD countries, all of whom have consumption taxes, capital gains taxes can be lower, since a portion of the taxation of capital already occurs as part of the VAT. The logic to enact lower capital gains and dividend taxes outside of a consumption tax environment is not as strong.

The Center for Fiscal Equity believes that lower dividend, capital gains and marginal income taxes for the wealthy actually destroys more jobs than they create. This occurs for a very simple reason – management and owners who receive lower tax rates have more an incentive to extract productivity gains from the work force through benefit cuts, lower wages, sending jobs offshore or automating work. As taxes on management and owners go down, the marginal incentives for cost cutting go up. As taxes go up, the marginal benefit for such savings go down. It is no accident that the middle class began losing ground when taxes were cut during the Reagan and recent Bush Administrations, both of which saw huge tax cuts. Keeping these taxes low is also part of why we are experiencing a jobless recovery now.

As long as management and ownership benefit personally from cutting jobs, they will continue to do so. Tax reform must reverse these perverse incentives.

In order to preserve vertical equity in a given tax year in a consumption tax environment, some form of progressive income and inheritance taxation is essential, otherwise the debt crisis cannot be avoided as consumption taxes will never be adequate to replace the lost revenue.

The Center suggests retaining surtaxes on high income earners and heirs. These would replace the Inheritance or Death Tax by instead taxing only cash or in-kind distributions from inheritances but not asset transfers, with distributions remaining tax free they are the result of a sale to a qualified Employee Stock Ownership Plan.

In testimony before the Senate Budget Committee, Lawrence B. Lindsey explored the possibility of including high income taxation as a component of a Net Business Receipts Tax. The tax form could have a line on it to report income to highly paid employees and investors and pay surtaxes on that income.

The Center considered and rejected a similar option in a plan submitted to President Bush’s Tax Reform Task Force, largely because you could not guarantee that the right people pay taxes. If only large dividend payments are reported, then diversified investment income might be under-taxed, as would employment income from individuals with high investment income. Under collection could, of course, be overcome by forcing high income individuals to disclose their income to their employers and investment sources – however this may make some inheritors unemployable if the employer is in charge of paying a higher tax rate. For the sake of privacy, it is preferable to leave filing responsibilities with high income individuals.

Identifying deficit reduction with income and inheritance surtaxes recognizes that attempting to reduce the debt through either higher taxes on or lower benefits to lower income individuals will have a contracting effect on consumer spending, but no such effect when progressive income taxes are used. Indeed, if progressive income taxes lead to debt reduction and lower interest costs, economic growth will occur as a consequence.

Using this tax to fund deficit reduction explicitly shows which economic strata owe the national debt. Only income taxes have the ability to back the national debt with any efficiency. Payroll taxes are designed to create obligation rather than being useful for discharging them. Other taxes are transaction based or obligations to fictitious individuals. Only the personal income tax burden is potentially allocable and only taxes on dividends, capital gains and inheritance are unavoidable in the long run because the income is unavoidable, unlike income from wages.

Even without progressive rate structures, using an income tax to pay the national debt firmly shows that attempts to cut income taxes on the wealthiest taxpayers do not burden the next generation at large. Instead, they burden only those children who will have the ability to pay high income taxes. In an increasingly stratified society, this means that those who demand tax cuts for the wealthy are burdening the children of the top 20% of earners, as well as their children, with the obligation to repay these cuts. That realization should have a healthy impact on the debate on raising income taxes.

Thank you for the opportunity to address the committee. We are, of course, available for direct testimony or to answer questions by members and staff.