05 September 2006

Progressive Tax Reforms

Sebastian Mallaby at the Washington Post, takes up the issue of income inequality in the United States in the form of progressive tax reforms:

Take mortgage-interest relief, a policy that's supposed to boost home ownership. More than half of this subsidy flows to the top 12 percent of households with incomes over $100,000; the poor get very little. This absurdly regressive policy doesn't even promote its objective, since affluent families would own their own homes anyway. The U.S. home ownership rate is no higher than Britain's or Australia's, two countries that have no mortgage-interest tax relief. . . .

Half of the subsidies for IRAs, 401(k)s and other retirement accounts are pocketed by the richest tenth of households; the bottom two-fifths get only 3 percent of the benefits. Again, this absurdly unfair system doesn't even promote its objective, since the rich tend to save anyway, whether or not they get tax subsidies. . . .

The same argument holds for tax incentives to buy health insurance. Just over a quarter of this subsidy is swallowed by households in the $100,000-plus bracket; far from promoting the wider dissemination of health insurance, it may even reduce it. Affluent Americans use the subsidy to buy all-inclusive health plans, which in turn causes them to throw money at health services; health inflation goes up, making insurance too expensive for poor families. The Treasury estimates that the ranks of the uninsured could be reduced by at least 1 million if the tax deduction for health insurance were capped at a reasonable level. . . .

[R]aising the minimum wage might transfer $10 billion a year to poor workers; call it $20 billion if you want to stretch the assumptions generously. But if you eliminated just a quarter of the subsidies in the tax code, you would liberate about $180 billion a year -- enough to finance a big expansion in the earned-income tax credit plus a cut in the regressive payroll tax.

Mallaby is brave to take on these sacred cows.

It doesn't make sense from first principals of have a mortgage interest deduction, although transition issues are significant. At the very least, one could end the deduction for second homes and cap the mortgage interest deduction at a much smaller loan amount (perhaps the Fannie Mae/Freddie Mac jumbo loan cutoff of $417,000) and/or a fixed or fomula dollar amount (perhaps the lesser of 30% of AGI or $30,000), for new loans.

One could also significantly restructure the tax benefits for new retirement savings, for example, limiting defined contribution limits to the limits now applied to traditional and Roth IRAs to all defined contribution plans combined, and creating a federal matching program similar to employer based contribution matching programs with some of the tax savings. This would be a reduction from about $15,000 a year to about $3,000 a year for most beneficiaries. The defined benefit program limits could be limited to a comparable amount. Post-mortem payout periods could also be limited, perhaps with the beneficiary deemed to be no younger than the beneficiary at death of death, for distribution purposes.

I'm deeply skeptical of the proposal to limit the deduction for health insurance. There are real virtues to keeping this simple. Many employers cover their employees precisely because they themselves want coverage. Very high rates are more closely tied to business size and health profile of the beneficiary than the affluence of the beneficiary. Giving small businesses affordable options is more important than reining in excesses of the fat cats in this case.

I'm also no fan of the structure of the current earned income tax credit, which is so complex that it accounts for half of the audits conducted by the IRS each year, and imposes crushing marginal tax rates on work class taxpayers in the phase out range trying to better themselves. I'd prefer scrapping that too and replacing it with a credit that offsets employer and employee FICA (or self-employment taxes) on the first $6,000 of income per taxpayer and dependent with a refundable income tax credit -- leaving the incomes of people in poverty federal tax free.

While I'm at it, I'll mention a few of my suggestions for progressive tax reform:

Revenue Raisers:

1. End all favorable tax rates for capital gains (other than gain on the sale of a principal residence). Rates might be capped at the greater of the individual's top ordinary income tax rate in the year or the highest rate that would apply to the gain divided by the number of years in the holding period for the asset, whichever was greater, to address the concern that an individual might be bumped into an artifically high tax bracket.

2. End the 1031 like-kind exchange (a capital gains tax deferral device), at least for real estate, which would be deemed never to be of like kind with any other real estate.

3. Tax accrued capital gains upon gifts and inheritances, based on a deemed transfer at fair market value, to the donor. Currently gifts are not taxed and receive a carryover basis, while inheritances are not taxed and receive a step up in basis to fair market value. (Similar treatment currently exists for 401(k)s and IRAs).

4. Eliminate graduated marginal tax rates for C corporations, trusts and estates. Tax all at the maximum individual tax rate.

5. Eliminate favorable tax rates on dividends received, and the dividends received deduction of existing tax law, as well as the accumulated income tax and the personal holding company tax. These would be replaced by a simple dividend paid deduction for corporations.

6. Lengthen depreciation schedules to reflect actual useful lives of the class sizes in the current schedules, without changing asset class definitions.

7. Eliminate favorable tax treatment for non-qualified deferred compensation.

8. Eliminate the tax exclusion on the non-term component of a whole life insurance policy.

9. Tax all income on stock received in exchange for either services, or for stock options granted in exchange for services, as ordinary income subject to self-employment taxation.

10. Subject S corporation profits (whether or not distributed) and C corporation dividends of active shareholders to self-employment taxation.

11. Narrow the scope of the Section 170 charitable income tax deduction to contributions that truly benefit the needy, as opposed to contributions to all 501(c)(3) organizations. For example, charitable deductions for educational contributions would generally be limited to scholarships, and charitable deductions for churches would be limited to funds specifically ear marked for ministries to the needy. Among the donations that would no longer qualify would be contributions to the general funds of universities and museums. These deductions would still apply for gift and estate tax purposes under the theory that those taxes are taxes in lieu of an income tax on the receipient.

12. Tax the net investment income of non-profits at corporate rates.

13. Set estate tax rates and exclusions at the 2009 level permanently subject to indexing, set the gift tax exclusion at the same level as the estate tax with a tax inclusive rate structure, allow surviving spouses to inherit a decedent's unused unified credit.

14. Close various gift and estate tax loopholes such as those relating to the minority interest discount valuation of closely held entities, those applicable to split interest trusts (like QPRTs, GRATs, GRUTs, CRTs and CLTs, treating them instead as incomplete gifts), and ILITs with an insured or an insured's spouse who is directly or indirectly a source of premium funding.

15. End the manufacturing activity deduction.

16. End the exclusion for state and local bond interest. Use the tax savings to fund a subsidized loan program for state and local governments.

17. End the pastor's housing allowance.

18. Tax business food, clothing, entertainment and lodging expenses as not taxable to the customer or employee, but not deductible by the provider.

19. Disallow vehicle expenses except for the percentage of use documented as business travel.

20. Improve information reporting for brokerage transactions and real estate transactions.

21. Require witholding at a flat 20% rate on personal services payments to natural persons not reported on any Form 1099.

22. End mortgage interest deduction on second homes and cap the mortgage interest deduction at $417,000 of loan (varied with jumbo loan cutoff), 30% of AGI, or $30,000, whichever is least, on new loans, as discussed above.

23. Limit new 401(k) and defined contribution plan contributions (including traditional and Roth IRAs) to $5,000 per year in the aggregate per employee (plus an additional $5,000 for a homemaker spouse). Set comparable limits on defined benefit plan income considerations, as discussed above. Post-mortem payout periods from retirement accounts would also be limited, perhaps with the beneficiary deemed to be no younger than the beneficiary at death of death, for distribution purposes, as discussed above.

24. Repeal the earned income tax credit.

25. Impose a new tax of $1 per hour for hourly employees, or $40 per week for salaried employees who are not provided with health insurance, at least on themselves, and an opportunity to insure dependents.

Tax Cuts:

1. Relax the medical expense deduction % of AGI cutoff (perhaps to 5% of AGI).

2. Allow an itemized deduction for car insurance and homeowner's and renter's insurance (to compliment the casualty loss deduction, up to a flat dollar cap of $2,500 a year or so); ease the threshold for taking a casaulty loss.

3. Allow an itemized deduction for rent paid up to $30,000 a year or 30% of AGI, whichever is smaller. Only a rent deduction or a mortgage interest/property tax deduction would be allowed, not both.

4. Create a refundable income tax credit for employers and employees equal to FICA or self-employment taxes on $12,000 of income per employee per year. Increase the FICA taxation cutoff to create social security system solvency.

5. Repeal volume based federal alcohol taxes.

6. Establish a tax credit providing matching contributions to defined contribution plans or Traditional or Roth IRAs similar to match programs of employers now.

7. Create an unlimited above the line child care tax deduction, replacing the child care tax credit.

8. Create a charitable deduction for direct payments to non-family members/non-employees in need in the form of qualified vouchers.

9. Create a 100% tax credit for evicting landlord who place a tenant's goods in storage rather than throwing them in the street, up to $100 per eviction, for actual storage costs incurred.

10. Treat tip income as self-employment income to the employee rather than wages.

11. Create a self-employment/investment income exclusion of $3,000 per year.

12. End phase outs of the personal exemption and itemized deductions.


Sotosoroto said...

The more money that's kept out of the governments' hands, the better. I don't care who gets it. They'll spend it eventually and it'll pay someone else's paycheck.

Andrew Oh-Willeke said...

I'm more concerned with economic impacts of the structure of the income tax than the actual amount. A 1986 revenue neutral tax deal style change would be just fine.

Sotosoroto said...

The simpler the better, aye.