America needs a tax system that supports strong, stable, and broad-based economic growth. Unfortunately, we haven’t had shared growth in recent decades. Since 1980, although after-tax incomes have grown by 61 percent on average, they’ve grown by nearly 200 percent for the top 1 percent of the population and only 21 percent for the bottom 50 percent. Tax reform can help change this.
The tax system should raise more revenues. The United States should be investing more, not less, in children, infrastructure, and public health. On top of these needs, we must maintain and improve the social insurance and safety net programs that help ensure a secure retirement and offer protection against ill health, employment disruptions, and poverty—including by insuring workers against the loss of earnings when they need to care for a loved one. These and other needs require revenues beyond those the government will raise under current law. Reform should also be progressive, raising these additional revenues from relatively more fortunate families, those whose incomes have grown more rapidly than the average in recent decades, and offering targeted benefits to low-income families, such as an expanded Earned Income Tax Credit and a fully refundable child credit.
In addition to raising revenues in a progressive fashion, policymakers should redesign the tax system to increase living standards and boost growth. While there are numerous potentially beneficial changes that could be made to the tax code, three broad areas should be central to this effort.
First, reform should increase the role of corrective taxes in the tax system. Corrective taxes are those designed to discourage activities with harmful effects for which the public and private costs exceed the benefits. As such, they can increase living standards while also raising revenue that can be used to reduce other less efficient taxes. The single most important such tax is a federal carbon tax. This tax, when implemented, should be set based on the best estimates of the economic harm resulting from carbon emissions—what economists term the “social cost of carbon.” The available evidence suggests that a tax of roughly $40 per ton would be appropriate. This tax would deliver gains not only at home but also to the rest of the world, by reducing the accumulation of greenhouse gases and the associated environmental harms.
Second, tax reform should restructure how we tax investment income. The preferential rate for capital gains encourages wasteful tax planning that converts income into this more lightly taxed form. Taxing gains upon realization—meaning when assets are sold rather than as the gains accrue—allows investors to choose when they pay taxes on investment income because they can choose when to sell the assets. And it discourages the sale of assets even when it would be efficient to do so.
Policymakers should address this issue through one of three major approaches: mark-to-market taxation of investment income, deferral charges imposed when assets are sold, or an annual wealth tax. Under all three approaches, the tax rate on investment income should be set equal to the rate on other forms of income (or approximately so). In a system of mark-to-market taxation, investors would pay taxes annually on the increase or decrease in an asset’s market value. Deferral charges are designed to offset the value of the tax deferred in prior years when no gains were realized and thus the investment income was treated as zero by the tax system. They are an additional tax paid on top of capital gains taxes due when assets are sold. Finally, a wealth tax would impose a tax equal to a percentage of the value of all assets held by an individual each year. This last approach is analogous to a tax on an assumed return on investment rather than the actual return on investment. At a 33 percent income tax rate, for example, a 2 percent wealth tax would correspond to the assumption of a roughly 6 percent return on assets. In other words, if an investor owns a bond that yields a 6 percent annual return, taxing the interest income at a 33 percent rate or taxing the value of the bond itself at 2 percent would be roughly equivalent.
Each of these approaches has advantages and disadvantages, but the common thread is that they better align the measurement of investment income with the economic reality. In doing so, they reduce the tax system’s current reliance on asset sales to measure investment income, thus reducing planning opportunities and the financial incentive to postpone sales to save on taxes. As a result, they would promote economic efficiency while also ensuring that those holding more complex assets pay their fair share of taxes on asset income. Interest on a bank savings account, for example, is typically paid monthly and taxed annually. In contrast, appreciation in the value of a stock or a work of art is taxed only when sold, creating opportunities to avoid tax. Indeed, when assets are passed on at death without being sold first, any capital gains taxes that would have been due on increases in value during the decedent’s life are avoided. These three reforms serve to reduce the tax advantages of more complicated assets relative to a simple bank account and, by better aligning the measurement of investment income with the economic reality, result in a more efficient tax system.
Third, reform should aim to tax business income equally regardless of source. The preferential treatment of income from pass-through businesses established in the recently enacted tax legislation should be repealed. This new provision encourages wasteful tax planning and creates substantial compliance challenges for the IRS. It simply lacks any compelling justification.
Reform should also eliminate businesses’ ability to deduct interest payments and instead allow them to deduct the amount spent on new investment in tangible and intangible capital. This change would largely eliminate the tax preference for debt-financed over equity-financed investment at the business level and put an end to the negative tax rates that currently exist for certain types of debt-financed investment. More broadly, reform should aim to shift the taxation of the risk-free return on corporate investment to investors and lenders while taxing returns in excess of the risk-free return at the same rate at which other types of business income are taxed on a separate corporate return, a move in the direction of corporate integration. Taxing all sources of income at the same rate would boost productivity by shifting activity from low-return projects that are more lightly taxed under current law to higher-return projects that are more heavily taxed, while also reducing the costs of tax planning that exploits these disparities.
In sum, redesigning the tax system with a focus on these three areas—corrective taxation, the treatment of investment income, and the treatment of domestic business income—would deliver higher living standards at the same level of revenues. On top of this redesign, policymakers should raise additional revenues in a progressive manner to finance the country’s spending needs. Together, these changes would deliver broad-based increases in Americans’ quality of life.