Presidents often trade imperfect policy for political expediency, and the tax proposals in President Barack Obama’s fiscal 2013 budget are a good example. In stitching new bits and pieces to an already Frankenstein-like income-tax code, the budget is a showcase for muddled aims producing bad policy, especially when it comes to taxing investment income.
Beyond higher levies on millionaires, the president’s plan makes only modest progress toward goals we applaud, including raising more money and making the tax system fairer. The president does too little to broaden the tax base, which is the best way to combine the goals of greater simplicity, more revenue and less tax avoidance. As Obama prepares to offer a corporate-tax reform measure, he should keep these first principles in mind.
First, the good news. The administration wants to tax dividends and so-called carried interest (the share of profits that hedge-fund managers and private-equity partners receive) as ordinary income, a change that’s long overdue. It also proposes to cap tax deductions for those earning more than $1 million, which broadens the base -- a smart move, albeit an unduly timid one.
Unfortunately, Obama’s plan also includes a host of new tax breaks and preferences for activities the administration wants to encourage. It leaves the treatment of capital gains (apart from carried interest) largely unreformed. And it pushes top marginal rates to 39.6 percent, higher than they need to be to achieve the administration’s revenue and fairness goals.
It’s not hard to envision a better plan. Several smarter blueprints already exist, including one by the president’s own fiscal commission. The Simpson-Bowles proposal achieves roughly the same revenue gains and deficit reduction as the Obama budget but in a way that simplifies the system, makes it fairer, and dramatically lowers marginal rates for almost all taxpayers.
It’s worth remembering that many tax experts regard even the Simpson-Bowles plan as too cautious. Most public-finance economists think a more radical overhaul is needed to shift the burden of taxation from income to consumption, so as to encourage savings and economic growth. We’re for that, too, but it’s too ambitious for a Congress that struggles to agree on anything, let alone a plan as far-reaching as that.
If root-and-branch reform is out, the focus needs to be on incremental improvement, the scope for which is almost unlimited. Taxes on capital gains are a notable instance. At the moment, gains realized a year or more after an investment is made are taxed at just 15 percent. The case for this preferential rate is that profits have already been taxed once at the corporate level and that gains realized after many years have been boosted by inflation, so that in real terms the income is less than it looks.
In principle, both points are valid. In practice, though, effective rates of corporate tax vary widely from company to company. With smart planning, profits can escape some, if not all, corporate tax. Notice, too, that this is another case of a tax base being hollowed out by exemptions and preferences, so that higher rates are needed to collect even modest amounts of revenue.
As for taxing gains due to inflation, that may seem unfair. But the same issue arises for interest payments (nominal rather than inflation-adjusted interest payments are taxed), and the deferral of any tax liability until capital gains are realized is an important offsetting benefit.
Lower and Flatter
Lower, flatter corporate taxes plus lower, more uniform taxes on income, including capital gains, are the fairest, most efficient approach -- with a side benefit of minimizing avoidance tactics. Apply a lower rate of tax to a broader base of corporate income; then tax capital gains (perhaps with an allowance for inflation) at the ordinary rate of income tax. Simplicity wins every time.
Another promising avenue for base broadening is the deductibility of corporate interest expense. Dividends are a cost of capital just as interest payments are a cost of capital, except that interest is tax-deductible while dividends aren’t. This creates a bias in favor of debt to finance new investment, and an excessive reliance on leverage.
The 2008 crash shows the dangers of too much leverage. Another commission appointed by Obama, this one led by former Federal Reserve Chairman Paul Volcker, discussed a cap on interest deductibility, which would allow a further offsetting cut in the corporate tax rate. That’s also in the spirit of the approach we are recommending.
Considering the toxic state of politics today, it’s understandable that Obama would go for what’s politically easy, but the excuse doesn’t really work in this case. The tax changes in the president’s budget have no chance of passing this year, and he knows it. The White House should have taken the opportunity to advance a longer-term agenda by championing a plan that was better, bolder and more fully thought-through.
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