This diary started out as a comment – but I quickly realized this topic was too long and complex for a pithy comment. Given that it gets into the weeds of income tax policy, I assume the audience is limited, but I’ll try to keep it as non-technical as possible.
There are many things wrong about or current U.S. income tax system, particularly after the changes made by the misnamed 2017 “Tax Cuts and Jobs Act” that was passed in the dead of night by Republicans desperate to appease their political contributors; too many to cover in this diary. Therefore, this is not a comprehensive critique, but I offer some proposals with respect to what I see as the main problems with the Republican tax bill.
For individuals
1. Eliminate the preferential rate for capital gains and qualified dividends: This isn’t new, it was in the law even before the 2017 legislation. Capital gains – that is, the profits on sales of capital assets like stocks and bonds, real estate, or collectibles – are taxed at a preferential rate, capped at 15% or 20% depending on the amount of income. Qualified dividends, basically income from investments in stock or mutual funds, enjoy the same preferential treatment. What this means is that people who work for a living pay the full rate of tax, while investors get a big tax break. (As Warren Buffet has stated, he pays a lower tax rate than his secretary.) In addition to promoting income inequality and preferring upper income taxpayers, the capital gains/qualified dividends preference also adds complexity to the tax code; and it provides an incentive for taxpayers and their advisors to devise transactions that can be claimed to produce capital gains rather than ordinary income. There’s an easy fix for this: do away with the preferential rate. (Note: this would also eliminate the “carried interest” abuse.)
The objection would be that the capital gains preference is a rough justice attempt to ameliorate the impact of inflation, but that argument doesn’t hold water. If you hold a stock for one year, during which inflation is 3%, you get the 15% rate on all gain, even if the stock triples in price. There are already indexing mechanisms in the tax code to deal with inflation in other contexts. While they would be preferable to the rate preference, I would not be in favor of adopting them for capital gains, and certainly not for qualified dividends, due to the complexity. There is a legitimate equity argument with respect to one type of capital gain: the increase in value of a taxpayer’s principle residence. It could be viewed as unfair that someone who purchased and lived in their home for 30 years has to pay a big tax bill when they get old and downsize. There are already mechanisms in the tax code to deal with this situation, but I propose a simpler solution: exempt all gain on the sale of a principal residence held for more than five years, with additional exceptions (if held less than five years) for involuntary sale situations like transfers, illness, etc.
2. Restore full deductibility of state and local taxes: The 2017 Act put a $10,000 cap on deduction of state and local taxes by filers who itemize deductions. This could actually be seen as promoting income equality, as it primarily hits upper income taxpayers, who have high incomes and own valuable real estate. But the Republicans had an ulterior motive in passing this legislation: they wanted to punish blue states, which tend to have better government services paid for by higher tax rates. In addition, the change hits even middle class taxpayers located in those states, not just the wealthy. Finally, there is a good argument that capping the deduction violates the concept of federalism, as the federal government is in effect taxing the state taxes, thereby interfering with the state’s right to collect tax revenue.
3. Impose higher rates on upper-income taxpayers: This is the big one. In the fifties and sixties, taxpayers in the highest brackets paid marginal rates of 70% or even 90%. The economy hummed along just fine. I would go AOC one better – I’d start imposing the 70% rate on all taxable income in excess of $4 million. (If you can’t get by on $4 million, I’d like to know why.)
Opponents argue that rich people would just figure out ways not to pay the higher taxes. That sounds like tax blackmail to me – “You keep my rate low or I won’t pay anything.” Beefing up IRS tax enforcement should take care of that issue really quickly. The better argument is that such a high marginal rate is unfair to people who have only a short window of high earnings, or to those who experience a once-in-a-lifetime windfall – think, respectively, an NFL player whose career lasts an average of 6 years, or a one-hit wonder musician. I’m sympathetic to this – but the solution would be to adopt an income averaging provision such as existed under tax law in the seventies.
For corporations
1. Restore rates: This is a big one. The 2017 law cut the U.S. corporate tax rate from 35% to 21%. This was based on propaganda that U.S. rates were the highest in the world, that the high rates made it impossible for U.S. companies to compete, and therefore they just had to outsource and move jobs offshore to survive. Supposedly, cutting the corporate tax rate to 21% would solve all these problems. I can tell you, from personal experience as a tax lawyer, that it’s all nonsense. First, due to all the corporate-friendly preferences in the tax code, not to mention all the elaborate schemes U.S. companies use to avoid taxes (legally), few if any major U.S. companies paid anything close to a 35% tax rate. U.S. companies have been competing very nicely, thank you, even with the high nominal rate – corporate profits were at or near all-time highs, even before the tax law changed. As for moving jobs offshore and outsourcing, it’s a sad fact of life that U.S. companies would continue to move jobs offshore even if there were a 0% corporate tax rate; the main incentive to offshore jobs is labor costs. U.S. companies, which after all are profit-seeking enterprises, are understandably reluctant to keep manufacturing operations in the U.S. and pay workers $50,000 a year or more, when workers in Mexico or Vietnam or Singapore are available to do the job for $5000 a year. (No, these aren’t accurate statistics, I didn’t bother to research comparable labor rates, but that’s not important –- there’s no question that labor costs are substantially lower in other countries, and that’s a primary driver to sending jobs offshore.)
If we close some of the loopholes and particularly, eliminate deferral (see below), we probably don’t need to go all the way back to 35%; the right tax rate would depend on complex revenue effect computations beyond my ability as a lowly tax lawyer. But the corporate tax share of total federal tax revenue has steadily declined, and in my view it should go back up. Without attempting to do the math, I’m guessing that a rate of 28% or so would be sustainable, assuming the items discussed below are adopted.
2. GILTI and deferral: This is going to require a bit of technical background, but you’ve if you’ve come this far, don’t let that deter you; I’ll try to keep it relatively painless. Ever since the corporate tax was adopted, taxation of international income was based on a concept known as “deferral.” This means that a foreign corporate subsidiary of a U.S. parent corporation was not liable for U.S. tax on the income it earned abroad. Nor was the parent, until the foreign profits were sent back to the U.S. parent in the form of dividends. (Sending dividends back is commonly referred to as “repatriation.”) By contrast, if a U.S. corporation was operating directly in the foreign country, through a “branch office” located in the foreign country, the U.S. company was liable for tax when the foreign income was earned (though this was ameliorated through a foreign tax credit mechanism, but that’s too much detail to get into here). For obvious reasons, most U.S. companies with significant foreign operations chose to conduct them through subsidiaries, and to defer paying U.S. tax until the foreign income was repatriated, if ever. To make matters worse for the U.S. fisc, there were a number of ways foreign income could be artificially increased, at the cost of U.S. income; for example, by moving intellectual property (“IP”) such as trademarks or patents to the foreign subsidiary. There were also a number of tools the IRS had to challenge such schemes, but they didn’t always work, so there was a significant amount of “tax leakage.”
In an effort to (at least partially) address this problem, the new tax law made a dramatic change. A routine return on a foreign subsidiary’s foreign income is now exempt from U.S. tax, period; any income earned by the foreign subsidiary in excess of that routine return is no longer eligible for deferral, but instead is taxable to the U.S. parent company in the year earned. This new tax approach is called “GILTI” (for “global intangible low-taxed income”). In effect, Congress threw up its hands, saying “it’s too hard to figure out which IP you moved for tax avoidance purposes, or whether you’re hoarding income overseas instead of repatriating it, so we’re just going to tax all the foreign income over an arbitrary routine return.” So far so good – in concept, this is actually an improvement on prior law, as it would help avoid a lot of the games multinational corporations were playing to defer tax.
The problem is that the Republican Congress couldn’t just take away deferral, without providing some offsetting benefit; so, in effect, they made the GILTI income subject to only half the (new) normal corporate tax rate: instead of paying 21% on GILTI income, U.S. companies only pay 10.5%. Another problem with GILTI is the way routine returns are defined. Basically, a U.S. company pays no tax on income equivalent to 10% of the value of the tangible assets (such as property, plant, and equipment) owned by its foreign subsidiary. Do you see the problem? Because only hard assets qualify, this gives U.S. companies an incentive to move plants (and therefore, it follows, jobs) offshore; the more the better, because the more factories you put offshore, the more income you make that pays no U.S. tax. And even the GILTI income, which is subject U.S. tax, is entitled to a sweetheart rate of 10.5%. Far from discouraging outsourcing and the offshoring of jobs, the GILTI tax thus provides a strong incentive for U.S. companies to do so. And even worse, the new tax law did little if anything to shut down the games companies use to move income offshore, making it relatively easy for them to plan to make GILTI income rather than U.S. income.
So here’s an easy fix to GILTI – eliminate deferral entirely, and make all income earned through a foreign subsidiary of a U.S. company currently subject to U.S. tax at the regular corporate rate. If you really don’t want to go that far, there are two less extreme changes you could make: (i) change the way routine return is calculated to remove the incentive to move hard assets offshore; for example, you could just exempt some arbitrary percentage of the foreign subsidiary’s profits. (ii) and even if you want to provide some preference to foreign income, at least raise the GILTI rate, if not to the full corporate rate, higher than 10.5%. But I’d prefer just eliminating deferral altogether.
3. FDII: “FDII” is an acronym for “foreign derived intangible income.” This is the mirror image of GILTI. It was designed to give U.S. companies an incentive to export goods and services (and to license IP) from the U.S. to foreign customers by providing a preferential rate of tax, 13.125%, on the profits from such exports. (In general, this applies to direct sales, not subsidiary income as covered by GILTI.) There are a few problems with this new rule. First, it is probably an illegal subsidy under international trade rules, and our trading partners have challenged it. Second, it is inherently unfair. Two U.S. companies making exactly the same product and selling it for exactly the same amount will pay vastly different tax bills on those sales. Third, it introduces great complexity into the corporate tax. Although the concept is simple, as in the description above, the rules for implementing it are complicated. I would recommend repealing FDII.