Taxation of Interest On The National Debt
Interest on the national debt should be exempt from federal income taxes.
Why? The experience from the municipal bond market shows that interest rates on tax free bonds are very close to those of corporate bonds of comparable risk reduced by the top federal income tax rate.
So, for bond purchasers who are subject to federal income taxes, the proposal would be revenue neutral, reducing the interest on the national debt and the the tax revenues from those payments by almost identical amounts.
But, in the current regime, a large share of federal bonds are purchased by tax exempt entities in the U.S., and by foreign public and private investors, who don't pay income taxes on this passive U.S. source income. The after tax return that these investors receive from federal bonds is much better than the return that domestic investors in the taxable sector pay.
The tax incentive for foreign investors to continue to hold their gains from exports to the United States in the form of Treasury bonds, rather than repatriating their earnings by importing goods with their U.S. earnings, is also the single biggest factor driving the trade deficit.
If Treasury bonds were tax free, the interest rates paid to tax free investors would be reduced by amounts comparable to the taxes that would be due on those bonds if they were subject to federal income taxes, even though these investors now pay no federal income taxes. And, a larger share of the federal debt would be owned domestically, reducing the U.S. trade deficit.
While this looks like a tax cut, from a public finance perspective, it is actually a back door tax increase on tax free Treasury bond owners who are overwhelmingly foreign governments and banking institutions.
This is a particular good step to take now, when interest rates on Treasury bonds are low, so the impact will be modest, so that it takes effect seemlessly when interest rates on Treasury bonds increase.
There are a variety of tax breaks that don't have solid policy justifications that could be implemented. A few of the low profile, high cost deductions that come to mind as set forth below. Many not only deprive the federal government of revenue but also harm the efficiency of the U.S. economy by distorting economic decision making. I've omitted changes to tax policy which simplify the tax laws but don't have a major revenue impact.
* End the mortgage interest deduction on new debt for second homes, on new debt in excess of 90% of the purchase price of a primary residence, and on new loans to the extent that they exceed the jumbo loan cutoffs.
This respects reliance interests of existing mortgage holders, retains regional balance between high cost of living and low cost of living areas, retains an incentive for home ownership, and ends room for tax subsidized loans against paper increases in home values.
* End Section 1031 exchange tax deferrals for investment real estate.
Current law allows investors who use proceeds from the sale of investment real estate that sell the real estate to reinvest the proceeds into different real estate, tax free. This requires elaborate and expensive compliance costs, and makes very old transaction records unreasonably relevant, while not furthering strong policy goals. Also, while this does allow for capital investments within the investment real estate sector to be traded with "less friction" caused by taxes, it locks investment capital into the real estate sector even when a market not burdened by these tax biases would move capital out of commercial real estate and into other investments. The lock in to the investment real estate market created by Section 1031 was part of the fule for the housing bubble that created the financial crisis.
* End the tax exemption for increases in cash value inside life insurance company products.
There is no good tax policy reason why someone with a whole life insurance policy should pay lower income taxes on their investment returns that someone who has an economically equivalent term life insurance policy and income oriented investment portfolio. Calculations of the taxable income arising in whole life insurance policies could be easily calculated for customers by the insurance companies and reported on Form 1099, just as mutual funds and REITs do.
* Disallow a current depreciation deduction on purchases for which there is unpaid purchase money debt.
The classic structure of a tax shelter is to create positive cash flow while reporting a tax loss in early years, which effectively defers income taxation. If the entity is sold to a tax exempt organization in the years of the investment when taxes start to come due, the tax deferral can even be turned into legal tax avoidance. Often this is done by borrowing money (revenue from borrowing money is tax free), purchasing a capital asset with the borrowed money, and taking depreciation deductions more quickly than principal payments on the loan used to purchase the asset are paid. Disallowing depreciation deductions to the extent that there is unpaid purchase money debt principal makese these kinds of tax shelters far less attractive. Ending this incentive would prevent tax incentives designed to encourage investments in capital assets from become abusive and encouraging purchases of capital assets that wouldn't make sense from a non-tax perspective, leading to economic inefficiency.
* Limit the application of net operating losses from one entity to another entity until an interest in that entity is terminated.
A trait generic to tax shelters is their tendency to generate net operating losses in one entity that can offset operating profits in another business. For businesses organized as C corporations, the requirement that losses be realized and the worthless stock rule have this effect. But, for businesses organized as limited liability corporations, S corporations or partnerships, the kind of trafficing in net operating losses that isn't forbidden in C corporations is possible. A prohibition against applying net operating losses from one tax entity to other income would shut down a significant share of tax shelter activity.
* End graduated tax rates for C corporations, trusts and estates, taxing all of them at a flat rate equal to the top income tax rate applicable to natural persons.
The tax policy justifications for progressive income taxation are based on the notion that high income people receive less marginal utility from an additional dollar of income than lower income people. These justifications have no application to corporations, trusts and estates whose ultimate economic beneficiary may be high or low in income. Instead, these tax rates exist to prevent undue accumulation of income in entities. This would end the need for a variety of complex tax rules designed to prevent abuse of graduated rates by affiliated groups of taxpayers, rules preventing S corporations from being owned by trusts, personal service corporation rules, and so on.
* Apply the self-employment tax to the distributive share of S corporation profits of shareholders who are active in the business and dividends paid to C corporation shareholders who are active in the business.
A large share of all S corporations are formed to reduce the amount of FICA taxes paid by owner-employees of small businesses. This undermines the health of the Social Security tax system and promotes ongoing expensive compliance efforts by taxpayers and collection efforts by tax authorities over whether owner-employee salary compensation is unreasonably low in order to reduce FICA taxes. A simple change in the tax laws would dramatically reduce the cost of administering these provisions, by elminating the tax bias in the dividend v. compensation debate, and it strengthens the long term soundness of the Social Security system.
* End the tax deduction for business meals and entertainment.
Food and entertainment provide consumption benefit to individuals whether they are consumed on or off the job. It is administratively complex to tax this to the person who actually benefits, however, particularly when members of different businesses share meals. Allowing the true beneficiaries of the meals and entertainment to enjoy this tax fee, while disallowing a deduction for these expenses for businesses, effectively taxing the benefit in the business that pays for it, is a good rough justice compromise. The tax enforcement effort that goes into policing this deduction is also great compared to the dollar amounts involved, because it is highly prone to abuse. The government should not have to be in the business of subsidizing the expensive account meals and entertainment of business people.
* Impose a place holding tax on foreign income that is not repatriated.
U.S. companies can defer income taxation on foreign activities until the funds are repatriated to the United States. This reduces U.S. income tax revenues, due to the time value of money, and creates an incentive for multinational companies to refrain from investing funds in the United States, which would strengthen the U.S. economy. But, the mechanics of looking through foreign investments to determine how much money actually goes untaxed would impose very high compliance costs on all involved.
An easier to administer approach would to be impute and tax income on foreign investments of multinational companies each year based upon an IRS determined market interest rate times the value of the foreign funds invested, which may be offset to the extent that income from foreign investments is actually repatriated, and settled finally when the investment is closed out. This wouldn't end tax deferral for companies with very profitable investments in low tax countries, but it would greatly reduce the amount of abuse and reduce the amount of tax deferral that companies obtain from failing to repatriate foreign earnings.
* Replace reduced tax rates on dividends received and capital gains on C corporation stock with a deduction for C corporations for dividends paid.
One way to understand preferrential tax rates on capital gains from C corporation stock and dividends received from C corporations is as a way to mitigate the fact that income owned by C corporations is taxed first at the corporate level, and again when realized by shareholders either in the form of dividends or capital gains, which is called "double taxation."
Double taxation, in addition to imposing an excessive tax burden on owners of C corporations, also has a number of negative effects on our economy. First, it encourages corporations to overleverage themselves increasing systemic risk, because the tax code favors debt over equity. Second, it encourages corporations to retain income to build their businesses up even when the profits would produce higher returns if invested in some other business, something that discouraged entrapreneurship and weakens the efficiency of U.S. capital markets. Third, it encourages corporations to "go private" even when it would be more efficient from a non-tax perspective to finance businesses in the public U.S. capital markets.
Double taxation also produces an arcane set of tax laws that are expensive to administer and apply designed to prevent transactions that avoid double taxation of corporate income. The effort that goes into creating and shutting down these schemes is a dead weight loss to the economy.
Basically, every other industrialized country in the world has some mechanism in its tax code for preventing this form of double taxation. Some countries treat the corporate income tax as a withholding tax on dividends that will ultimately be paid and then allow people who earn dividend incomes to apply their share of corporate taxes paid to their tax bill on the dividends, a system called imputation. But, this is harder in a federal system like that of the United States, where the national government can't require state government tax codes to follow its system of corporate taxation. Some U.S. states have corporate incomes taxes similar to that of the federal government, some U.S. states have comprehensive business income taxes, and some U.S. states have nothing approximating corporate income taxes.
Another way to eliminate corporate double taxation would be to end income taxes on capital gains and dividends of C corporations. But, this undermines the progressive nature of the income tax code, fails to address that fact that states may tax capital gains and dividends even if the federal government does not, and fails to properly tax secondary market gains from stock trading.
The simplest way to end double taxation of C corporation profits in a complex state and federal tax regime like that of the United States is simply to allow corporations to deduct dividend payments to shareholders just as they would interest payments on investments made in the form of debt.
Undue incentives to corporations to be owned by foreign investors thereby avoiding taxes on both corporate income and dividends could be solved by requiring corporations to withhold taxes at a flat rate on dividends rather than simply sending a 1099 to shareholders who are not otherwise subject to U.S. income taxes, since this is U.S. source income.
A dividend deduction is not exactly equivalent to the imputation system used in most developed countries. It leads to some double taxation of corporate income in situations where corporations retain income and realize profits via capital gains rather than dividend payments. But, this difference is modest and can be eliminated if corporations elect to distribute their earnings as dividends and allow their investors to decide where to reinvest those proceeds, which is a good incentive to have in the tax code.
* Impose a low tax on the average fair market value of publicly held securities
The existing corporate income tax serves two purposes. One is to prevent unlimited deferral of taxation on corporate income, for which it must be retained. Another is to tax the privilege of gaining access to the public capital markets. One of the least economically intrusive, hardest to evade, and easiest to enforce ways to do so would be to impose a low quarterly tax on the average fair market value of a corporation's publicly held securities in the quarter. Tax accounting gimmicks would matter only to the extent that they impacted the price of publicly held company securities. Since the total market capitalization of publicly held securities is easily determined from publicly available records, it would be straightforward to simply set the tax rate at whatever level is necessary to raise the revenue required. This would not impose the friction on the financial system that a transfer tax on securities would impose.
* Tax unrealized capital gains in marketable at death (and use a carryover basis for unmarketable capital assets held at death) above a certain dollar threshold.
Prior to 2010 and again in 2011 unless the tax law is changed, if you bought stock at a low price and hold it until your death, the capital gains taxes that would have been due if you sold the stock at fair market value at death are forgiven and your heirs are deemed to have purchased the stock they receive as an inheritance at fair market value on the date of your death.
This tax break is a huge boon to wealthy heirs with no policy justification when the assets are marketable. Something on the order of a quarter to a third of estate taxes simply recoup this tax break, which is not shared by those who inherit balance in retirement plans of the middle and upper middle class who must paid both accrued income taxes and estate taxes (in years other than 2010) on their inheritances.
This also has negative economic effects. It locks older investors into appreciated capital assets, which they hold onto in order to receive the forgiveness of capital gains, thereby reducing the efficiency of the U.S. capital markets. People hold onto bad investments to avoid paying tax on them. Founders of major companies don't diversify their holdings, or enter into systemic risk creating margin loans, because they don't want to trigger taxation on an asset that they can painlessly hold onto until they die and escape taxation upon.
There are two ways to solve the problem. One is to treat death as a deemed sale of capital assets at fair market value. The other is to treat the later sale of those assets by heirs as if they were made by the decedent for tax purposes, which is called a carryover basis.
In the case of marketable assets that can be easily sold, the fair market value solution works best, because it avoids the immense amount of ancient paperwork that must be kept track of in a carryover basis regime. In the case of unmarketable assets, like family businesses, the paperwork involved in a carryover basis (which could be streamlined going forward with a document declaring the capital gain tax basis of the property on the date of death filed with the IRS) is worth the trouble since it avoid tax system forced sales of property to pay capital gains taxes.
Allowing decedents to exclude gain on the sale of their principal residences, as they would have been allowed to do if they had sold their residences during life, and exempting a modest amount of capital gains from taxation (perhaps gains on assets with a fair market value on the date of death of up to $1,000,000), would dispense with costly paperwork in most small estates, which this tax break provides only a modest benefit.
If this approach were used, estate tax rates could be reduced to reflect this increased capital gains tax revenue, without increasing the deficit.
* Retain the estate tax at a rate equal to the top individual income tax rate
The gift and estate tax serves two basic purposes. It is a tax in lieu of capital gain taxes that would have been owed by the decedent at death (an issue better dealt with separately), and it is a tax in lieu of an income tax on inherited wealth designed to be easier to administer in that context.
The basic concept of the gift and estate tax should be that it should tax large inheritances received by heirs on a basis comparable to the taxation of lottery winnings and earned income (i.e. at the same rate that applies to large amounts of ordinary income). Charitable gifts are not subject to tax in this situation because their income is tax free, so there is no policy justification for a tax in lieu of an income tax on transfer to charities. Where income is subject to income taxes accrued by the decedent during life in capital gains or retirement accounts, for example, those taxes should be paid first and the estate tax should be due only on the after tax part of those taxes.
Since the vast majority of wealth transferred this way is in very large estates, a substantial exemption makes sense to reduce collection and compliance costs. President Obama's proposal of a $3.5 million exemption per person per lifetime, and various Congressional proposals to allow unused exemptions to be inherited by a surviving spouse are reasonable, but an increase to $5 million, for exmaple, would be a reasonable compromise.
The tax base for this tax should be widened by adopting anti-evasion rules, including rules barring minority interest discounts on interests in closely held companies, rules including life insurance proceeds in the estate of the insured unless none of the premium is directly or indirectly derived from the insured or a family member of the insured and none of the proceeds are payable to the insured or a family member of the insured, and treating trusts with retained interests (e.g. GRATs an GRUTs) as incomplete gifts until termination.
To alleviate concerns about the impact of this tax on closely held businesses and farms, these businesses should be permitted to use a "special use valuation" (i.e. a value based on the income it generates as a business rather than the value of its assets which might include development value in real estate, for example) without a dollar limitations, and should be permitted to pay estate taxes attributable to such closely held businesses or farms in installments at a low interest rate for a long period of time, with the tax debt secured by the inherited closely held business or farm.
* Reform equity based compensation for services
Stock options reward executives if stock prices rise, but don't penalize them if stock prices fall, and if structured according to I.R.S. rules are taxed at capital gains tax rates, despite the fact that the people earning the income have high incomes.
Several executive compensation reforms could solve this problem.
First, penalty taxation on large cash compensation amounts (i.e. in excess of $1,000,000) which are taxed as ordinary income which is taxed immediately and at higher rates and is transparent, should be eliminated.
Second, income from stock for services, carried interests in partnerships, or below market rate stock options for services, should be taxed as ordinary income and subject to self-employment taxation (rather than FICA taxation since the person receiving the stock may no longer be employed with the company), since this is compensation for services. If companies want to give their employees currently taxed cash compensation to buy stock in a publicly traded company at fair market value, or someone wants to lend employees money on a recourse basis to buy stock at fair market value, and the employee does so, then they can be treated like other investor. But, when equity interests come in exchange for services they should be taxed as compensation for services. This also dramatically simplifies the tax compliance issues associated with providing equity based compensation in closely held companies where it is most useful in encouraging investments in start up businesses.
Third, compensation in the form of stock or stock options or carried interests should not be subject to taxation, or considered an alternative minimum tax preference, until it is realized. Stock compensation is indeterminate until it is cashed out, and compensating executives with stock as opposed to stock options, which gives them a downside risk as well as an upside risk, should be encouraged since it aligns their interests simply with the shareholders.
Fourth, golden parachute payments should be taxed as ordinary income and subject to self-employment taxation. This too is really compensation for services and should, at the very least, not be taxed more favorably than compensation for services.
Ulimately, compensation arrangements should be left to private parties. But, tax code provisions discouraging cash compensation, and favoring stock option compensation over stock compensation, have proven themselves to be bad policies that have greatly increased systemic risk in our economy.
* Include half of Social Security benefits in income
Social Security benefits are taxed according to a complex formula. There is a more fair and simple approach. Half of FICA and self-employment taxes come from an employee's after tax income. Half of FICA and self-employment taxes come from an employee's before tax income and is paid by the employer in the case of FICA taxes. Simply including half of Social Security benefits in income, while allowing half of them to be exempt from taxation would fairly address this fact without complicated formulas, while replicating the treatment given to other retirement savings such as defined benefit plans, 401(k)s, Traditional IRAs and Roth IRAs.
* Limit determination of tax preferenced retirement benefits to FICA and self-employment income and unify contribution limits
Contributions to tax preferenced defined benefit, defined contribution, IRA and Roth IRA plans are limited by earned income. But, the limits for these plans is often far higher than Social Security tax income. The portion of the tax benefits of these plans attributable to income in excess of the Social Security tax base is a large share of the entire tax benefit from these provisions, but goes to people who there is no need for government to encourage to save for retirement with tax breaks, or provide extra asset protection.
Also, the contribution limit for retirement plans should be unified, so that total tax preferenced contributions from all forms of private sector retirement vehicles combined cannot exceed a certain cap (e.g. 15% of FICA and self-employment income, possibly with additional catch up contributions for people nearing retirement age).
* Limit the exclusion of gain on a principal residence for builder flips.
The exclusion of gain on a principal residence has created a cottage industry of people who build or majorly renovate homes, live in them until they qualify for the exclusion, and then use the exclusion to escape taxation on their construction income. This was not an intended use of the exclusion and it contributed materially to the housing bubble that caused the financial crisis.
It should be mitigated by disallowing the exclusion for gain by someone who built or substantially renovated the house (perhaps defined as investing more than the part of the purchase price attributable to the existing structure to renovations), in excess of real estate appreciation in the county as shown by that county's assessor's records or an IRS approved alternative for measuring real estate appreciation, for properties held less than a full five years.
This wouldn't end the possibility of abuse, but would greatly dampen tax avoidance designed around this exclusion.
* Limit The Section 199 Deduction
The tax code, appropriately, encourages the profitable domestic manufacturing industry, which is troubled, in Section 199 of the Internal Revenue Code by allowing "a deduction an amount equal to 9 percent of the lesser of-- (A) the qualified production activities income of the taxpayer for the taxable year, or (B) taxable income (determined without regard to this section) for the taxable year." The deduction can't be more than half of the business's W-2 wages in the year, however.
But, the law, which is designed to encourage domestic manufacturing which might otherwise be outsourced inappropriately includes lots of activities that can't be partically outsourced. Domestic production activities include:
(i) any lease, rental, license, sale, exchange, or other disposition of--
(I) qualifying production property which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States,
(II) any qualified film produced by the taxpayer, or
(III) electricity, natural gas, or potable water produced by the taxpayer in the United States,
(ii) construction performed in the United States, or
(iii) engineering or architectural services performed in the United States for construction projects in the United States.
Allowing utility companies and construction, which can't be outsourced to any great extent, to benefit from the deduction, is just a waste of taxpayer money, and in the case of construction encourages the activities that lead to the housing bubble.