• The economy is increasingly globalized, and capital has become more mobile. About half of U.S. corporate taxes are now paid by multinational corporations, many of which are truly global in reach. To an increasing extent, the assets of these global businesses are intangible and can be located anywhere in the world with relative ease. These trends pose competitive challenges to the U.S. economy—affecting both U.S. companies and U.S. workers—and threaten to undermine our corporate tax revenue base.
• New business forms such as limited-liability companies and S corporations have exploded in scope. These “pass-through” entities now benefit from nearly all the privileges of corporate status but are exempt from corporate tax. The prevalence of these entities has grown to the point where they account for nearly half of all business income, further eroding the corporate tax base.
• Excessive leverage in the financial sector contributed to the financial crisis of 2008, and the many economic dislocations caused by the last recession were worsened by leverage throughout the economy. While the tax code did not cause the financial crisis or the recession, its bias toward debt financing may have worsened them. At the same time, Wall Street has developed new financial products that blur the traditional lines between debt and equity, thereby complicating the application of a distinction that is important to the corporate tax system.
• Congress has created numerous new loopholes and subsidies in the corporate and individual tax codes, while preserving some that have become obsolete.
• The United States is confronting major long-term fiscal challenges, yet the corporate tax provides a smaller and declining share of revenue.
• Income and wealth inequality has greatly increased in the United States, while the overall tax system has become less progressive. In particular, corporate effective rates have declined and income from capital gains and corporate dividends are taxed at rates that are low by historical standards.

The failure of the U.S. corporate tax to respond to these challenges is an impediment to the nation’s long-term economic prospects. Our corporate tax provides incentives for multinationals to invest overseas rather than in the United States. It continues to subsidize companies taking on high levels of debt. And it distorts corporate decision making in ways that are harmful to long-run economic growth. While some existing tax code incentives are helpful and important for the economy, as a group they need streamlining and improvement. In sum, a broad reform is needed to ensure that the corporate tax code enables, rather than impedes, our nation’s economic success.

Given these challenges, a progressive vision for corporate tax reform would include the following priorities:

1. Reforming the international tax system to find a more appropriate balance between the important goals of leveling the playing field for domestic job creation, maintaining the competitiveness of U.S.-based companies, reversing the revenue drain from profit shifting, and exercising U.S. leadership to prevent a global “race to the bottom”
2. Reducing the subsidy for corporate debt
3. Leveling the playing field among competing businesses and ending outdated and ineffective subsidies
4. Maintaining and strengthening investments in innovation
5. Raising additional revenue

Reforming the international tax system

The international aspects of the corporate tax code greatly need reform. Our existing code encourages U.S. companies to invest overseas rather than in the United States, and it allows corporations to exploit offshore tax havens to avoid tens of billions of dollars in taxes every year. Many U.S. multinationals say that its method of taxing international income and its high statutory rate put U.S. companies at a competitive disadvantage and deter them from bringing substantial earnings back home.

The U.S. tax code subsidizes foreign investment

Profits are generally taxed in the year they are earned. But the existing tax code, by allowing U.S. companies to defer paying taxes on their foreign profits until those profits are returned to the United States (see box), contains a perverse incentive for U.S. companies to locate investment, and ultimately jobs, overseas. The Congressional Budget Office explains how this differential treatment of foreign and domestic profits affects incentives:

The current tax system provides incentives for U.S. firms to locate their production facilities in countries with low taxes as a way to reduce their tax liability at home. Those responses to the tax system reduce economic efficiency because the firms are not allocating resources to their most productive use. Those responses also reduce the income of shareholders and employees in the United States and they lead to a loss of federal tax revenue. In addition, those investment decisions may initially result in more unemployment in this country. Over time, however, as the economy adjusts, other jobs are created and total employment would not be significantly affected. But as a result of such decisions, in the long run, total compensation for U.S. workers is lower, and employment may be concentrated in different industries and regions.

Because deferral often allows U.S. multinationals to avoid taxes on foreign profits for extended periods or indefinitely, the effective tax rate that U.S. corporations pay on their foreign profits is by one measure about a third lower than the tax rate on their domestic profits. (see figure)

The differential treatment of domestic and foreign profits “encourage[s] firms to locate physical assets, production, and jobs in [low-tax foreign] countries,” according to the nonpartisan Tax Policy Center. Our existing system even encourages companies to invest in high-tax foreign countries instead of the United States: Once they have established operations in a foreign country, U.S. corporations can arbitrage international tax rules to shift profits on paper from that country to other countries, including tax havens. In sum, the U.S. tax code subsidizes overseas investment—a policy that violates economic neutrality and does not serve our national interest.

The U.S. tax code results in billions of dollars being lost to tax havens

The existing international tax system fails to protect the corporate tax base. Enticed by the ability to defer taxes and enabled by porous tax rules and ineffective enforcement, multinational companies have developed elaborate techniques to shift their profits from the United States to low-tax countries around the globe. U.S. multinationals consistently report their largest profits in a handful of relatively small countries that impose little or no corporate tax. American companies reported 43 percent of their overseas profits in Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland in 2008, even though only 4 percent of these companies’ foreign workforces were employed there and only 7 percent of their foreign investments were made there.

Techniques to shift profits include aggressive “transfer pricing,” accounting for internal transactions within a multinational-corporate group in ways that, on paper, maximize the profits of affiliates in low-tax countries—such as Ireland or Bermuda—and minimize them in higher-tax countries. The techniques include the increasingly common practice of transferring valuable intangible property such as patents or brand names—things that exist only on paper but can be worth billions—to affiliates in tax-haven countries and then having the affiliates in high-tax countries pay tax-deductible royalties for their use. Profit-shifting techniques also include the strategic use of debt to maximize interest deductions in the United States.

The evidence of rampant profit shifting is overwhelming. By one estimate, the U.S. government lost about $90 billion in revenue in 2008 from corporate income shifting, up from $60 billion in 2004. To put that figure in perspective, the corporate income tax raised an average of $300 billion per year during the 2004–2008 period. Some companies are able to virtually wipe out their federal tax obligations. Clearly, the current tax code is failing on this score.

Some U.S. firms face a heavier tax rate than foreign rivals but there is little evidence that the U.S. tax system puts U.S. multinationals at a competitive disadvantage in the aggregate

The United States has one of the highest statutory corporate tax rates in the world—a federal rate of 35 percent—and, unlike most other countries, has a form of worldwide tax system that stakes a tax claim on all global profits of domestically based multinationals. As a result, some U.S. firms face a heavier tax burden on profits earned in foreign countries than do their foreign rivals.

But there is little empirical evidence that on the whole the U.S. tax system impedes the competitiveness of U.S. firms. Of course, U.S. companies still drive global commerce and are by far the most successful in global markets. And studies of the tax burden on U.S.-based companies relative to their foreign rivals have not found that the U.S. companies face any tax disadvantage in the aggregate. The ability to defer taxes on foreign earnings, coupled with the United States’ relatively weak anti-profit-shifting rules and other features of the U.S. system, mean that many U.S. companies have avenues available to reduce their tax costs and offset any disadvantages of the tax system. For some companies, the current tax rules are even more favorable than a pure “exemption” or territorial system, which is discussed in the next section.

This isn’t to say that the current system doesn’t create challenges for U.S. companies. One consequence of corporations taking advantage of the deferral of tax until repatriation and the opportunities to avoid foreign tax has been the massive buildup of earnings in foreign subsidiaries. The “stranding” of these earnings is not, however, the barrier to U.S. parent corporations that it might appear to be. In the event of cash needs—for investment, operational expenses, dividend payments, or share buy-backs—a parent corporation is in a strong balance-sheet position to borrow at very low interest rates in order to finance such outlays. And it is worth noting that the foreign profits of U.S. multinationals are allowed to be held in U.S. banks under an exception to the rules requiring tax upon repatriation; and a large share are in fact held in the United States.

Nevertheless, the existing U.S. tax system undoubtedly distorts corporate capital structures. The complexity of the tax and accounting structures needed to make deferral work also impose additional costs on firms that would be better invested in their actual businesses. The billions of dollars spent establishing byzantine corporate structures and determining how to meet financing needs without triggering repatriation tax is a deadweight loss for society. In addition, notwithstanding the lack of evidence of an overall negative impact on the competitiveness of U.S. corporations, some companies do appear to be disadvantaged in their competitive dealings and are paying relatively high taxes on their foreign subsidiaries earnings.

Proposals for reform

The impact of our international tax system on competitiveness is multifaceted and nuanced. Taxes affect the relative attractiveness of the United States as a location for investments—such as factories and research labs, among others—and therefore the competitiveness of U.S. workers. Taxes can also affect the cost of capital for U.S.-based firms as they compete in global markets against foreign rivals. Tax considerations may also influence the choice of where new companies choose to incorporate or where the global headquarters of multinationals are situated. And the U.S. tax system’s ability to raise adequate revenue advances U.S. competitiveness by allowing investments in the economy through infrastructure, education, and innovation. All of these aspects of competitiveness are important, and progressive international tax reform will seek to balance all of them.

Next we will consider some major proposals and how they balance the critical policy goals of international tax reform.

The United States should not adopt a ‘territorial’ tax system

The policy debate over U.S. international taxation is often dominated by buzzwords that obscure rather than illuminate the most important issues at stake. It is often said, for example, that the United States is one of few remaining countries with a “worldwide” tax system—in which the profits of U.S.-based companies are subject to U.S. tax wherever in the world they are earned—and that, to maintain our competitiveness, we need to move to a “territorial” system, in which we tax profits earned on U.S. soil, not outside our borders.

In reality, our system is a hybrid. It is “worldwide” in that the profits of U.S.-based companies are subject to U.S. tax wherever they are earned. The U.S. system, however, gives a credit for foreign taxes paid, and, as described above, it allows multinationals to defer U.S. tax on their foreign profits. Since taxes are deferred for long periods and even indefinitely, the U.S. system operates in practice somewhat like a “territorial” system, which in a pure theoretical form exempts foreign profits from tax.

At the same time, many of our trading partners’ systems of taxing global income are said to be “territorial,” while in fact they too are territorial/worldwide hybrids. For example, many of these countries tax the profits attributable to subsidiaries in tax-haven countries. These “controlled foreign corporation” rules often go further than U.S. rules in ensuring that corporate profits are not shifted on paper to tax havens.

Many multinational corporations and some policymakers support moving the United States toward a territorial system, also called an exemption system because it would amount to an exemption from U.S. tax for U.S. corporations’ overseas profits.

Adopting a territorial system carries substantial risks for the United States because it could exacerbate the worst features of our existing tax system. Allowing U.S. corporations not only to defer taxes on foreign profits but avoid them forever without any consequences would further widen the gap in treatment between foreign and domestic profits. That larger foreign bias could cause U.S. corporations to shift investment overseas; one study estimated that as many as 800,000 jobs would be created elsewhere, potentially at the expense of U.S. jobs.

Moving to a territorial system could also worsen the problem of profit shifting by enhancing its rewards. Currently, the tax upon repatriation provides something of a backstop against profit shifting abroad: Tax is ultimately owed even if that tax can be delayed and there are costs for companies to leaving income in foreign subsidiaries. A complete exemption for foreign profits would remove that backstop, enhancing the rewards for the kinds of accounting tricks that make domestic income appear as foreign income. Countries that have moved to territorial systems are finding that profit shifting is undermining their domestic tax base. Adoption of a territorial system, without adequate safeguards, would “eviscerate the U.S. corporate tax base by eliminating any constraints to shifting income abroad,” in the words of one tax economist.

In fact, the concept of a territorial tax system is increasingly difficult to apply in today’s economy, where global commerce is driven by multinational corporations that are integrated across borders and whose assets are largely intangible (brand names, goodwill, patents, and knowhow). Given the global nature of commerce, the lines between “domestic” and “foreign” profits are difficult to draw. Without safeguards ensuring that corporate profits are taxed somewhere, a shift to “territorial” could simply mean that an increasing share of corporate profits would be taxed nowhere, as they end up reported in tax-haven jurisdictions.

A territorial system makes U.S. firms more “competitive” in the sense that it lowers the tax rate they would face on foreign profits, specifically by removing the cost of repatriating those profits. But a shift to a territorial system would make U.S. workers less competitive by driving capital away, and could further harm U.S. competitiveness by undermining the tax base needed for public investments and sustainable budgets.

A corporate minimum tax would forestall the race to tax havens

In his 2012 State of the Union address, President Barack Obama proposed a “corporate minimum tax” on overseas earnings, which would be similar in purpose and effect as provisions of the corporate tax systems of our trading partners. Under the proposal, if a U.S. corporation is paying taxes in a foreign jurisdiction at a rate lower than the minimum rate (which was not specified), it would have to pay a current tax on the difference. For example, if a subsidiary of a U.S. multinational is reporting profits in Bermuda on which it pays zero (or negligible) corporate tax, it would be required to pay the U.S. minimum tax on a current basis, with the remainder of the regular U.S. tax imposed when those profits were returned home—for example, as dividends to the U.S. corporate parent. As under current rules, companies would still be entitled to a foreign tax credit for any foreign taxes paid.

A corporate minimum tax would help level the playing field between foreign and domestic investment by providing a backstop ensuring that all corporate profits, wherever they are reported, are subject to at least a minimum level of tax in the year they are earned. In so doing, the minimum tax helps narrow the differential between tax rates on foreign investment and on domestic investment. The minimum tax also deters the shifting of profits into tax havens, thus protecting the U.S. revenue base. With a robust minimum tax, there is no reason to set up a tax-haven subsidiary and stuff profits into it. Corporate resources would be freed for more productive uses than finding and exploiting tax havens.

Also, a minimum tax would exert U.S. influence to prevent an international “race to the bottom” on corporate tax rates. Foreign countries—below a point—would not be able to underbid each other to attract U.S. corporations to locate their paper profits there.

A corporate minimum tax is unlikely to put many U.S. firms at a competitive disadvantage. In fact, it would bring the United States’ corporate tax antiabuse rules closer in line with those of our major trading partners. Many European countries and Japan have somewhat similar anti-profit-shifting rules that take into account the tax rate paid in the foreign jurisdiction in determining whether to tax a corporation’s income on a current basis. For example, under Japan’s rule, if a corporate subsidiary in another country is paying an effective tax rate of less than 20 percent, that subsidiary’s income is essentially treated as Japanese income and taxed currently at Japanese rates.

The drain of revenue to tax havens creates an urgent need for a U.S. corporate minimum tax. And there is no policy reason why such a critical antiabuse mechanism should only be considered in an overarching corporate tax reform. It would vastly improve the international tax system on its own, while raising needed revenues.

Political reality, however, may mean that a minimum tax will only be considered in the context of a broader tax reform. It has been noted that a corporate minimum tax is not incompatible with a limited exemption for foreign profits. If the minimum tax, coupled with other antiabuse rules, is robust enough to stop tax-haven abuse and limit the rewards for shifting investments overseas, then a shift toward a limited exemption for overseas profits would not run the same risks as a shift toward a pure territorial system that exempted foreign profits with no safeguards.

Measures needed to complement a minimum tax

A minimum tax mechanism is not the only necessary safeguard to protect the domestic tax base. Others include:

• Thin capitalization/interest allocation rules: Other countries in the Organisation for Economic Co-operation and Development, or OECD, have adopted rules to prevent the income-stripping strategy of directing the members of a global corporate group in high-tax countries to take on disproportionate leverage, and therefore take advantage of tax deductions for interest expenses in high-tax countries.
• Greater use of formulary methods: Transfer pricing, as discussed above, is generally governed by the “arm’s length” method. Under the arm’s length method, multinational corporate groups are required to set hypothetical “prices” for intragroup transactions as if each of their affiliates were independent entities dealing at arm’s length with each other. That standard makes sense in a world of trading in common tangible goods, where it is possible to determine the correct arm’s-length price by looking at comparable transactions among third parties. But today, many of the most important intercompany transactions aren’t done between unrelatedparties in widely traded goods, so comparable transactions provide a reliable reference point less and less often (for example, a software company licensing its brand name and core technology to its own foreign affiliate; a pharmaceutical company and its own, controlled, overseas affiliate entering a “cost-sharing” agreement to develop a potentially lucrative drug). Sometimes the assets themselves are so unique (brand names, know-how, formulas, business opportunities, etc.) that it is all but impossible to put a price on them.U.S. tax treaties and the network of international tax treaties generally require the arm’s-length standard. But even if arm’s length remains the basic standard, tax authorities can and should resort to using “formulary” methods where there exist no good comparable transactions to provide a reliable benchmark. Under such a system, instead of apportioning profits among countries based on a hypothetical arm’s-length price, profits are apportioned by a formula of business measures—typically some combination of revenues, payroll, and fixed business assets.

• Country-by-country reporting: The magnitude of the overall corporate income-shifting problem is clear from Bureau of Economic Analysis data. Yet investors and government authorities do not have sufficient country-by-country information about public companies’ offshore activities. As Sen. Carl Levin (D-MI) has found through several investigations of offshore tax abuses, the lack of country-specific information “impedes efficient tax administration, leaving tax authorities unable to effectively analyze transfer pricing arrangements, foreign tax credits, business arrangements that attempt to play one country off another to avoid taxation, and illicit tactics to move profits to tax havens.” Sen. Levin’s Stop Tax Haven Abuse Act would require all multinational corporations that file financial reports with the Securities and Exchange Commission to report employees, sales, financing, tax obligations, and tax payments on a country-by-country basis. This provision will aid tax enforcement and also give policymakers critically needed information about how the tax system is functioning.

Multilateral solutions to global tax problems

Because the United States’ international corporate tax system is so ineffective in protecting our national interests, Congress should act to reform it. But many of the pressures bearing on the U.S. corporate tax system are global in nature and demand global coordination and cooperation.

The loss of corporate tax revenues to profit-shifting strategies is hardly unique to the United States. Many of our trading partners experience the same drain of corporate revenues as foreign multinationals shift profits from home countries to tax havens. And often, differences in countries’ tax rules can result in corporate income falling between the cracks and being taxed nowhere. As the OECD explains:

Most tax rules are still grounded in an economic environment characterized by fixed assets, plant and machinery and a lower degree of economic integration across borders, rather than today’s environment where much of the profit lies in risk taking and intangibles. Some rules and their underlying policies were built on the assumption that one country would cede taxation as the other would then be able to exercise it. With movements to global supply chains, and aggressive corporate tax structures, that assumption may often not be accurate and profits may often end up in a third, low or no tax, country.

[T]he strategies used to shift profits and erode the taxable base put increased pressure on the rules and on the governments that designed them. [Tax avoidance] strategies take advantage of a combination of features of tax systems which have been put in place by home and host countries. Accordingly, it may be impossible for any single country, acting alone, to fully address the issue.

In February, as part of a new focus on corporate tax base erosion issues, the OECD delivered a report to the G-20 on corporate tax base erosion, calling it a “serious risk to tax revenues, tax sovereignty, and tax fairness for OECD member countries and non-members alike.” The OECD report was an urgent call for multilateral action. The finance ministers of Britain, Germany, and France have issued a joint statement calling for greater international coordination and backing the OECD’s Base Erosion and Profit Shifting, or BEPS, efforts. The United States should support and indeed lead these efforts to ensure that they bear fruit. It should also exercise leadership within the OECD to ensure that the OECD’s influential guidelines on transfer pricing adapt to current economic realities and address the shared problem of income shifting. Specifically, we should use our influence to push the OECD to reduce reliance on the increasingly obsolete arm’s-length standard, and embrace formulary apportionment in the transfer pricing guidelines and model tax treaty.

The European Commission has already proposed a Common Consolidated Corporate Tax Base, or CCCTB, for the European Union. If adopted, the CCCTB would introduce a common European tax base to allow firms to calculate their aggregate EU-wide profits. Profits would then be apportioned among member states according to a formula, with tax rates determined by each country according to its policies. The CCCTB’s formula would be based on three equally weighted factors: (1) payroll and number of employees in each country; (2) sales in each country; and (3) the value of fixed tangible assets in each country. The CCCTB is a pioneering cross-border approach, but it has strong precedents: The United States and Canada apportion income in a similar fashion among states and provinces. The European CCCTB would be adopted on a voluntary basis, at least at first. But it illustrates the European Union’s recognition that territorial tax systems are vulnerable to income shifting from transfer pricing; that the most effective approach to the challenge of defining the corporate tax base is multilateral; and that, given the complexity of cross-border transactions, the arm’s-length method is increasingly unreliable, while formulary apportionment is a viable alternative.

Eliminating the bias toward debt

One of the other serious flaws of the corporate tax code is that it encourages companies to incur debt, and this practice can lead to higher and sometimes unhealthy levels of leverage. The bias toward debt results from the fact that corporations can deduct interest payments to creditors but not dividends to shareholders.

This differential treatment is rooted in the outdated economic notion that creditors are third-party outsiders lending funds to the corporation while shareholders are insiders playing an active role in managing the corporation. In today’s business world, however, it is difficult to draw such a clear line. Rank-and-file shareholders exercise little control over the corporations they invest in, while creditors might closely monitor and influence their borrowers. And new financial instruments have arisen, blurring the traditional lines between debt and equity, and making the stark differential in tax treatment increasingly arbitrary.

This differential treatment results in an enormous gap between the effective tax rates on investments financed with debt and those financed with equity. The Treasury’s Office of Tax Analysis found that debt-financed corporate investment faces an effective marginal tax rate of negative 2.2 percent, while equity-financed corporate investment faces a rate more than 40 percentage points higher, including both corporate- and shareholder-level taxes. Many countries’ corporate tax systems are biased toward debt in a similar manner, but the disparity between debt and equity in the United States is the highest among OECD nations. In short, our tax code subsidizes corporate debt.

Unfortunately, the tax code’s bias in favor of debt financing has far-reaching consequences. The code encourages firms to have more debt in their capital structure than they otherwise would, increasing their vulnerability to business downturns. And when firms fail, it results in disruptions and bankruptcies that impose social costs on employees, vendors, and the wider economy. According to a recent report by the International Monetary Fund, “The general view of experts has been that the bias was not a major cause of the financial crisis. … Yet by contributing to the excessive leverage of firms, it might well have deepened the crisis.” The debt bias also creates competitive distortions: It favors corporations that have access to debt financing over those that do not, and it subsidizes firms that purchase companies using debt, as through leveraged buyouts.

The deductibility of interest also enables corporations to shift their taxable profits outside of the United States to minimize their tax bills here, and this shift diminishes the U.S. tax base. Without limits on interest deductions, U.S. corporations can borrow funds in the United States, deduct the interest payments against their U.S. tax bills, and then use the proceeds to make investments overseas, where the resulting profits will be tax deferred.

Corporate tax reform can address the bias toward debt by limiting corporate interest deductions. Using some of the resulting revenue to pay for a reduction in corporate rates would further reduce the debt bias. Both President Obama and House Ways and Means Committee Chairman Rep. Dave Camp (R-MI) have identified interest deductions as a potential area for reform.

There are several ways to limit interest deductions that warrant deeper consideration by policymakers:

• The president’s Economic Recovery Advisory Board’s August 2010 report on tax reform options offered an illustrative proposal to limit the deductibility of net interest expense to 90 percent of expense in excess of $5 million per year. So, for example, if a corporation has $15 million of net interest expense, it could deduct all of the first $5 million and then $9 million of the next $10 million. The Treasury Department estimated roughly that the revenue effect of the proposal would allow for a 0.7 percent reduction in the corporate rate. Other analysts have estimated that a stricter limit on interest expense would allow for an even greater reduction in the corporate rate.
• Germany recently enacted an innovative limit on corporate interest deductions, with the resulting revenue helping to offset a reduction in the corporate rate. Under Germany’s rule, interest is deductible only up to 30 percent of annual earnings before interest, taxes, depreciation, and amortization, or EBITDA. The rule applies only when net interest (interest expense minus interest income) is higher than €3 million (about $4 million), thereby exempting smaller businesses.
• Another approach is to deny deductions for the portion of interest expense attributable to inflation. Such a proposal is included in the bipartisan tax reform legislation submitted by Sens. Ron Wyden (D-OR) and Dan Coats (R-IN), and is estimated to raise $163 billion in revenue over 10 years.

All of these approaches would improve our tax system by reducing the debt bias. Of the three, the percentage limit suggested by the president’s Economic Recovery Advisory Board might be the most workable, although a more aggressive version might be even better. It would apply fairly consistently across larger firms rather than affecting only firms that have high-interest expenses in certain years, as with the German approach. It is also a more direct method to limiting interest deductions than the Wyden-Coats approach.

Broadening the tax base and leveling the playing field to reduce distortions and enhance growth

Tax expenditures—subsidies delivered through the tax code in the form of tax deductions, deferrals, and credits—reduce corporate tax revenues by more than $100 billion per year. While some of these provisions are incentives backed by solid economic rationales, many are simply preferences for politically favored industries or relics of the tax code that have existed for decades with little scrutiny. There are also unjustified loopholes that are not technically counted as tax expenditures in the official accounting, but should be. Reforming tax expenditures and closing loopholes could help boost federal revenues and pay for a lower corporate rate. Perhaps as importantly, reducing the number of unjustified subsidies in the tax code reduces harmful economic distortions and thereby improves the prospects for growth. Here is a partial list of tax breaks that should be addressed:

• Oil and gas: The tax code provides more than $4 billion per year in tax subsidies for fossil fuels. Big Oil companies, among the most profitable companies in the world, are among the primary beneficiaries. Several of these subsidies are relics of the tax code, originated nearly 100 years ago and continued because of concerted lobbying efforts. Taxpayer subsidies are simply not needed for a mature and profitable industry, especially at a time of high gas prices. Eliminating them is a long-overdue priority.
• Timber and agriculture: Timber companies and agribusinesses benefit from a number of special tax preferences, including special expensing provisions and capital gains treatment of certain items. Eliminating these provisions would save about $1 billion per year.
• LIFO/LCM: Special tax provisions allow companies to choose the most favorable methods for valuing their inventory and cost of goods sold. The “last-in-first-out,” or LIFO, and the lower-cost-or-market, or LCM, methods amount to subsidies for holding inefficient amounts of inventory. The Treasury Department estimates that eliminating these tax subsidies would gain $88 billion in revenue over 10 years, allowing for a 10-year phase-out period. The revenue gain from disallowing LIFO, however, would be less over the long term.
• Offshore reinsurance loophole: The tax code includes provisions intended to prevent “interest stripping” by foreign-owned corporations operating in the United States. But similar rules do not exist for foreign-owned insurance companies that deduct reinsurance premiums paid to affiliates in Bermuda and Switzerland to reduce their U.S. taxable income. This loophole, which costs $1.7 billion per year, puts domestic reinsurers at a competitive disadvantage. Legislation introduced by Rep. Richard Neal (D-MA) and a similar Obama administration proposal would close this loophole.

• Like-kind exchanges: Originally intended to help farmers exchange land, livestock, or farm equipment, a special rule in the tax code allows corporations and real-estate investors to defer paying taxes on realized gains. As The New York Times recently reported, some major corporations “have routinely pushed the boundaries [of the like-kind exchange rules] while claiming lucrative tax savings.” In all, like-kind exchanges cost the Treasury $3 billion per year. Congress should consider eliminating like-kind exchanges or strongly limiting their use.

• Tax-exempt organizations providing commercial services: Certain organizations, including fraternal-benefit societies and credit unions, are exempt from corporate income taxes even though many are large institutions that compete with taxable rivals to provide financial services. Congress should examine whether the largest of these organizations should receive a special subsidy if the scale of their operations rivals for-profit competitors.
• Business meals and entertainment: Food and entertainment are personal expenses. If people take their families out to dinner, they cannot deduct the cost of that meal from their taxable income. If, however, they take someone out to lunch and claim it is for a business purpose, then they can deduct half of the cost of the meal. This special exception, which costs the Treasury up to $14 billion per year, acts as an unnecessary subsidy for people benefiting from expense accounts as well as their guests. Allowing deductions for business meals and entertainment also results in an unknown quantity of abuse and fraud, with personal expenses classified as “business” expenses and the IRS ill-equipped to police the legitimacy of the deductions.

• Advertising deductions: Businesses can generally deduct their advertising costs in the year they are incurred. But advertising can have long-lasting rewards for a business, increasing its income over many years. Therefore, policymakers should consider requiring businesses to “capitalize” a portion of their advertising costs under a wider range of circumstances than currently required, which would mean that they would take deductions over a period of time rather than all at once.

• Distinctions between corporate and noncorporate businesses:Another area where base broadening is needed to ensure a level playing field among businesses involves the increased use of pass-through businesses that avoid corporate-level taxes. C corporations pay corporate taxes, and their owners (i.e., shareholders) pay taxes on dividends distributed out of post-tax profits. But pass-through entities do not pay entity-level tax; rather, profits are attributed and taxed directly to owners. The use of pass-through business forms has been rising, both because states have created more noncorporate business forms that confer limited liability and other corporate attributes, and because of the relaxation of federal rules regarding “subchapter S” corporations. Currently, whether or not a business is subject to the corporate tax often depends on whether it is publicly traded. But some extremely large businesses that are not publicly traded compete with those that are without paying corporate-level tax. For example, the engineering firm Bechtel, with $33 billion in revenues in 2012, is structured as an S corporation and is thus exempt from corporate taxes.Redrawing the line between corporate and noncorporate businesses, and adding business size as a criteria, would be a good step in broadening the corporate tax base while ensuring that at least large businesses compete on a level playing field within the same tax framework. Congress should also reconsider the special exceptions from the general rule that publicly traded entities must pay corporate tax, including those for investment partnerships and “master limited partnerships” in the oil and gas field.

• Accelerated depreciation and the domestic production deduction:These tax expenditures, the two largest, will reduce revenues by a combined $900 billion over the next 10 years.Corporate tax reform is an opportunity to review how current depreciation schedules produce uneven tax rates, potentially slowing growth by distorting investments. One recent study found that effective tax rates vary widely by investment type. For example, mining structures and oil and gas structures are taxed at a mere 7 percent rate, while other structures can face a 35 percent to 40 percent effective tax rate. Similarly, the effective tax rate on investments in ships and boats was found to be about half that for autos.The domestic production deduction (section 199) should also be reviewed. It is clearly overbroad: Intended as an incentive for U.S. manufacturing, it applies to oil extraction and software development, among myriad other areas. Congress should reform the deduction to better target it toward its core purpose of encouraging domestic manufacturing.Yet while reforms to these two incentives should be on the table in corporate tax reform, Congress should balance several concerns in wringing budget savings from them to pay for a lower rate.Reducingaccelerated depreciation to pay for a lower corporate rate runs the risk of providing a tax windfall for past corporate investments while removing an incentive for future ones. That is because a significant share of the benefits from a lower corporate rate flow to “old capital”—in other words, investments made before the change in tax policies—whereas accelerated depreciation exclusively encourages future investment. Economists at the Joint Committee on Taxation have found that trading reductions in accelerated depreciation for a lower corporate rate “results in a macroeconomic outlook that is worse by several measures than the current law baseline, with potentially lower consumption, employment, real GDP, and capital stock [particularly in the medium term].”Accelerated depreciation and the domestic production deduction also serve to mitigate the bias against domestic investment created by the tax deferral of foreign profits. They also act as a balance to incentives that other countries offer in their tax codes or in other forms of support and subsidies.

Corporate tax reform should contribute to increased federal revenue

Corporate tax reform will not happen in a vacuum. Policymakers must consider the overall economic challenges facing the country, including the problem of unsustainable deficits over the long term and shortfalls in needed public investments.

The corporate sector in the United States has a strong stake in our country’s fiscal sustainability and growth. As they invest, innovate, hire, and earn returns for shareholders, U.S. corporations benefit greatly from government services, from law enforcement to product safety, patent protection, education, and workforce development. Given the need to address vital national priorities at a time of unsustainable budget deficits, the corporate sector cannot be exempted from contributing to the solution.

The corporate income tax is a significant revenue source, but it contributes a smaller share of federal revenues than it used to and a smaller share of revenues than corporate taxes in most other advanced economies. In 1953 corporate tax revenues were 5.6 percent of GDP and 30 percent of federal tax revenues. Over the past decade, corporate tax revenues averaged 1.8 percent of GDP and 10.3 percent of federal revenues, notwithstanding the fact that corporate profits constitute a growing share of the economy. Corporate tax revenues in the United States are about 25 percent lower than the OECD average. The diminishing corporate tax has worsened budget deficits and has caused the United States to rely more on other taxes, especially payroll and individual income taxes.

The decline of corporate tax revenue has been principally driven by two trends. First, corporations are paying lower taxes on their profits. The U.S. statutory corporate tax rate, at 35 percent, has remained nearly constant since the 1986 tax reform, and is the highest among OECD countries. Yet the effective rate paid by corporations—what they actually pay as a percentage of their profits—has declined. According to the Congressional Research Service, “Despite concerns expressed about the size of the corporate tax rate, current corporate taxes are extremely low by historical standards, whether measured as a share of output or based on the effective tax rate on income.”

And though the U.S. tax rate stands at 35 percent, effective tax rates put U.S. companies squarely in line with companies in other major economies:

• A survey of 280 Fortune 500 companies, each of which was profitable in all years from 2008 through 2010, found that they paid 18.5 percent of their profits in U.S. federal corporate income tax—slightly more than half of the statutory rate.
• The Congressional Research Service found that corporate effective rates are lower than average for OECD countries (weighted by the size of their economies).
• A comprehensive study of the 100 largest U.S. multinationals and the 100 largest EU multinationals found that the U.S. companies paid lower effective rates, in the aggregate, over a 10-year period.

The reason that the United States collects relatively little in corporate tax revenue despite having the highest statutory rate in the world is the narrowness of its corporate tax base. As a 2007 Treasury report concluded, “The contrast between [the United States’] high statutory corporate income tax rate and low average corporate tax rate implies a relatively narrow corporate tax base, due to accelerated depreciation allowances, corporate tax preferences, and tax-planning incentives created by [the] high statutory rate.”

The tattered state of the U.S. corporate tax base means that U.S. corporations can, on the whole, contribute a greater share of revenues without jeopardizing their competitiveness or the overall competitiveness of our economy. Given the huge potential savings from broadening the corporate tax base, it is possible to achieve deficit reduction from the corporate tax while also lowering the statutory rate. A lower corporate rate would reduce economic distortions caused by the corporate tax, including the disparities in tax rates among industries and the bias toward debt. Both goals—deficit reduction and a lower corporate rate—are desirable, and whether they are achievable depends on Congress’s willingness to broaden and repair the corporate tax base.

Rehabilitating the corporate tax base is also important for ensuring a progressive overall tax system. By preventing tax sheltering by high-income individuals, the corporate tax provides a needed backstop to the individual income tax, and it is itself a strongly progressive tax.

Conclusion

Corporate tax reform is complicated and involves many moving and interacting parts. Special preferences and loopholes in the code have created an extremely narrow tax base. Clearly, obsolete preferences and those that divert economic activity into less-productive pursuits should be eliminated. On the other hand, though not otherwise discussed here, measures such as the Research Credit can, if appropriately designed, encourage innovations that are beneficial to long-term economic health. Meanwhile, the deduction for interest payments on debt encourages companies to take on excessive leverage to minimize tax payments. Eliminating inefficient corporate tax expenditures and limiting deductions for interest payments on debt could raise significant revenue for investments in our future, and potentially allow for some rate reduction, which would, in turn, alleviate some of the concerns expressed by corporations about the current tax system.

With respect to the treatment of international income, reform efforts must deal with the rampant tax avoidance that the current system allows, encourage job creation in the United States, and address the legitimate concerns of multinational corporations. Moving to a pure territorial system would exacerbate many of the current problems with the tax system, and, while eliminating deferral is attractive, in the long run it could have adverse, unintended consequences and is unrealistic. A more likely and helpful approach would be to put in place a new hybrid model that includes a robust minimum tax that would immediately apply to all income (i.e., no deferral), thereby diminishing the incentive to shift income to low-tax countries or move jobs overseas. Most countries that ostensibly have territorial systems actually follow this kind of model, but the revised U.S. system should be more aggressive and include the full range of anti-tax-avoidance measures. Concerns expressed by multinational corporations could be addressed by adjusting the corporate tax rate overall or with a modestly differentiated rate for repatriated earnings—consistent with an overall increase in revenues.

Finally, the United States should work with its trading partners to address these issues. International cooperation is necessary for meeting all of the challenges in fair ways that benefit both U.S. and global economic growth.

SOURCE: AP/J. Scott Applewhite

House Budget Committee Chairman Paul Ryan (R-WI) checks notes as he appears before the House Rules Committee to advance his party'€™s FY 2014 budget proposal, at the Capitol in Washington, Monday, March 18, 2013.

Endnotes and citations are available in the PDF version of this issue brief.

As Americans across the country filed their tax returns over the past few months, two competing approaches to improving our federal tax code have emerged. One approach is to offer specific proposals to reform, eliminate, or otherwise cut back on the unfair and inefficient tax breaks—known as tax expenditures—that clutter the current code. The other approach is to offer specific proposals to cut tax rates, promise to pay for them with tax-expenditure reforms, but stay silent on exactly how to do that.

Tax expenditures are spending programs hidden in the tax code that allow individuals and corporations to reduce their tax bill through deductions and exemptions, credits, or preferential rates for certain types of income. They include broadly utilized tax breaks such as charitable gift deductions and state and local tax deductions, and lower capital-gains tax rates, but they also include obscure and narrowly defined tax breaks such as those that benefit only hedge-fund managers, oil companies, or corporate-jet owners.

Both President Barack Obama and House Budget Committee Chairman Paul Ryan (R-WI) agree on the need to reform these tax expenditures. But that is about all they agree on.

President Obama’s budget for fiscal year 2014 identified the specific tax preferences he wishes to reform and detailed proposals to do so. Rep. Ryan’s tax-expenditure reform proposals, however, must be deduced from his larger tax proposals and targeted revenue level. He is specific about tax cuts, and he is specific about how much overall revenue he wants to raise, but he fails to offer any details whatsoever on the exact tax-expenditure reforms he would prefer.

Comparing these two plans for tax reform side by side, it is apparent which approach is more realistic and more committed to actual reform. Where the president offers a well-defined path forward that eliminates unfair or unnecessary tax expenditures to generate a modest amount of new revenue, Rep. Ryan’s approach depends on unrealistic levels of new revenue from tax-expenditure reforms that he declines to identify. In fact, any plan to actually meet Rep. Ryan’s tax rates and tax-revenue specifications would inevitably entail a large tax increase for the middle class and lower-income households, while bestowing a large tax cut on those earners at the top.

In this issue brief we describe the details provided by President Obama and Rep. Ryan on tax reform generally and on tax expenditures specifically; evaluate whether the policy targets of each are realistic; and then analyze the effect these competing reforms would have on middle-class taxpayers.

What reforms to taxes and tax expenditures does each budget call for, and are the targets realistic?

In his 2014 budget President Obama calls for the elimination or reform of a variety of tax expenditures. These include proposals that put a large dent in yearly deficits as well as proposals that would eliminate much smaller loopholes that, nevertheless, are simply unfair. Some of the president’s proposed reforms would:

• Limit itemized deductions taken by high-income earners to 28 percent tax credits ($529 billion)
• Enact the Buffett Rule, which would ensure that millionaires pay at least 30 percent of their income in taxes after charitable contributions ($53 billion with other reforms, $99 billion alone)
• Place a ceiling on the total amount that can be accrued in tax-preferred retirement accounts ($9 billion)
• Eliminate the unfair tax classification that allows hedge-fund managers to pay tax rates lower than middle-class Americans ($15.9 billion)
• End the special depreciation allowance given to corporate jets beyond what is given to an identical commercial airliner ($2.7 billion)

These changes, along with several others in his budget, offer a complete picture of the president’s tax-expenditure reform. The president’s changes could pay for lowering corporate tax rates, new job incentives, and increased investment in American infrastructure. What’s more, even after carrying out all of those options, there would still be enough revenue left to reduce deficits by an estimated $583 billion over 10 years.

The House budget takes an entirely different approach. Though it is vague in many areas, especially regarding tax-expenditure reforms, Rep. Ryan’s main tax proposals are very clear and provide context for what his tax-expenditure reform must do. He aims to drastically lower marginal rates for both corporations and individuals, seeking a historically low top rate of 25 percent, and a full repeal of the alternative minimum tax, or AMT, a tax aimed at preventing wealthy taxpayers from paying extraordinarily low rates. Further, by repealing the Affordable Care Act, the Ryan budget also eliminates the modest revenue obtained from high-income taxpayers through a Medicare and investment income tax.

These changes to the tax code would reduce federal revenues enormously. The nonpartisan Tax Policy Center estimates that the cost of these changes to the federal government would be more than $5.7 trillion over the next 10 years. But despite calling for massive tax cuts, the Ryan budget sets a 10-year revenue level equal to the same $40.24 trillion under the current tax code. This means Rep. Ryan will need to find roughly $5.7 trillion through tax-expenditure reforms to pay for his tax-rate cuts. The House budget is silent on how it would achieve these tax-expenditure savings, and just as he did with his FY 2013 budget last year, Rep. Ryan passes the buck to the House Ways and Means Committee Chairman Rep. Dave Camp (R-MI) to identify the reforms that can raise $5.7 trillion. Although the Center for American Progress has found $1 trillion in savings from expenditure reforms, finding the next $4.7 trillion is another thing entirely.

In order for the Ryan budget to raise $40.24 trillion over the next 10 years, Rep. Camp and Rep. Ryan must find an average of $570 billion a year in tax expenditures to reform or eliminate. But the nonpartisan Congressional Research Service has found that eliminating more than $150 billion in individual tax expenditures per year would be both politically and technically difficult, leaving at least a $420 billion gap in the Ryan budget.

Filling this gap becomes an even more difficult task if the House budget tries to find this revenue without raising taxes on the middle class. In 2015 alone the House budget gives $246 billion of the $445.5 billion tax-rate cut to the top 1 percent of earners. If Rep. Ryan wants to pay for his tax-rate cuts and insulate the middle class from a tax hike, he would need to eliminate $246 billion in tax expenditures used only by the top 1 percent of income earners.

Given the technical complexity involved with eliminating some of these provisions and Rep. Ryan’s continued defense of those provisions that promote savings and investment, it seems unlikely that his overhaul of tax expenditures can raise this much from top income earners. This isn’t just rhetoric: The math clearly shows that the policies outlined in the Ryan budget offer a great deal for the wealthy—at the expense of middle-class Americans or future deficits.

The impact of the tax proposals in the Obama and Ryan budgets on the middle class

The tax cuts, as laid out in the House budget plan, would benefit mostly upper-income taxpayers, with more than 80 percent of Rep. Ryan’s cuts, roughly $4.5 trillion, going toward the highest 20 percent of income earners and 55 percent going solely to the highest 1 percent. To put this number in perspective, all of the austere spending cuts included in the House budget total “only” $4.63 trillion. In other words, the cost of the proposed tax cuts going to the richest fifth of Americans in the Ryan budget almost equals the money saved through his painful spending cuts.

The specified tax changes in the Ryan budget give the top 1 percent a $246 billion tax cut in 2015. But remember, Rep. Ryan claims that revenue in 2015—and every year of his 10-year budget—will be the same as it would be if no tax changes were made at all. This means that Rep. Ryan intends to make up that $246 billion in lost revenue. To do that without raising taxes on the middle class, he would need to get all $246 billion back from that same top 1 percent. Is that even possible?

According to several estimates, all of the individual-income tax expenditures in 2015 will total approximately $1.3 trillion. But there are several reasons why that total dramatically overstates how much is actually available to Reps. Ryan and Camp.

First, this total must be reduced to reflect the effect that the lower tax rates in Rep. Ryan’s plan have on potential revenues gained through tax-expenditure reform. To understand why lower tax rates reduce the potential savings from tax-expenditure reforms, imagine the following: A wealthy taxpayer deducts $1,000 from his taxable income. At the current 39.6 percent marginal tax rate, this deduction saves him or her $396 of tax liability, while at a 25 percent marginal tax rate, this same $1,000 deduction saves only $250 of tax liability. Once rates are lowered, eliminating or reducing this deduction will raise less money than it would have at the higher rates. This helps to explain why President Obama’s tax expenditure reform is more attainable as well; besides needing to raise less revenue from tax expenditure reform, the higher tax rates offer more savings from the elimination and reform of tax preferences.

There are also certain tax expenditures that could not realistically be cut under a conservative base-broadening reform. These include income exclusions that are technically too difficult to tax, such as “imputed rent on owner-occupied housing,” and expenditures that are politically off-limits, such as taxing veterans’ benefits and combat pay. What’s more, many tax expenditures are directed toward encouraging savings and investment, such as the lower tax rate on capital gains and dividends. While Rep. Ryan does not directly defend these provisions in his 2014 budget and could even eliminate them, his 2013 budget made the case for protecting them. And given that Rep. Ryan has supported eliminating these taxes altogether in the past, it is unlikely that he now supports raising them.

After these adjustments, the Tax Policy Center found only $551 billion left for possible revenue increasing tax expenditure reform. Obviously, $551 billion is more than the $246 billion that Rep. Ryan needs to make his plan add up. But not all of that $551 billion goes to the top 1 percent. Of the $551 billion available, only $72 billion can be raised from that group in 2015 through eliminating individual tax expenditures, according to our analysis below. The remaining $174 billion in cuts for the wealthy can only be paid for by cutting corporate tax expenditures or by raising taxes on the middle class.

Paying for some of the remaining $174 billion in cuts for the wealthy could certainly come from closing corporate tax loopholes, but not nearly enough is available to prevent a tax increase on the middle class. First, the Office of Management and Budget projects that in 2015 all corporate income tax expenditures will total approximately $159 billion. Second, there is ample evidence that conservatives are not interested in eliminating the largest corporate tax preferences.

One of the largest corporate tax expenditures is the accelerated depreciation of machinery and equipment, which is estimated to cost $43 billion in 2015. Accelerated depreciation is a set of provisions in the tax code that allow businesses to deduct the cost of equipment before its useful life has run out. Rather than seeking to eliminate accelerated depreciation, Rep. Camp actually supports permanently extending an expensing provision that would increase the cost of accelerated depreciation.

Another equally large corporate tax expenditure is the deferral of taxes paid on the foreign earnings of American companies, which is estimated to cost $43 billion in 2015. Both Reps. Ryan and Camp have expressed support for moving the United States to a territorial tax system. This change would allow foreign-earned profits of American companies to be repatriated to the United States with either no tax or a small tax paid to the federal government.

By expanding depreciation and moving the United States to a territorial tax system, there simply is not enough revenue to be gained from corporate tax reform to prevent a middle-class tax hike on the individual side of the code. Those two provisions are the largest in the corporate tax code and after sparing them, only $73 billion is left to cut through corporate expenditures—about $100 billion less than the $174 billion needed to prevent a middle-class tax hike. This shortfall can only be expected to grow as more details are sketched out, particularly with other expenditures such as the exclusion of municipal bond interest and the expensing of research activities likely to be saved.

Simply put, there aren’t enough tax breaks for the top 1 percent and for corporations to offset their massive tax cut. And it’s not even close. Though Rep. Camp recently asserted that his tax reform will not result in a middle-class tax hike, Rep. Ryan has also declared that his tax cuts will not increase deficits. One of these two men is wrong.

This is in contrast to President Obama’s tax-expenditure reforms, which clearly identify who will pay higher taxes. Taxing the income of hedge-fund managers the same way as other Americans will not raise your taxes if you are not a hedge-fund manager. Likewise, if you do not own a corporate jet, lengthening corporate-jet-depreciation schedules to the same depreciation timeline that commercial airlines use will not raise your taxes. And limiting itemized deductions for the top 3 percent of income earners and tax-preferred retirement accounts for Americans with more than $3 million in those funds, only affects the people who can most afford to pay for deficit reduction.

President Obama’s budget is stronger on tax-expenditure reform and better for the middle class

Both President Obama and Rep. Ryan agree that we should reform the dense thicket of tax breaks that has grown wild and unchecked in the tax code. But their approaches to clearing out this underbrush differ dramatically. The president prefers an approach that targets the provisions that are demonstrably unfair as well as a few used by Americans most able to pay. By reforming the tax code in this manner, President Obama can contribute $583 billion to deficit reduction over the next 10 years without overburdening the middle class with higher taxes.

Rep. Ryan works backward in his budget, starting with the huge revenue levels that must be raised and then searching for the tax-expenditure reforms to get there. But by so generously cutting taxes for the wealthy in step one of his process, Rep. Ryan is left with a situation where he must either raise taxes on the middle class or fail to reach his revenue target.

John Craig is a Research Assistant in the Economic Policy department at the Center for American Progress. Michael Linden is the Managing Director for Economic Policy at the Center.

SOURCE: AP/Danny Johnston

A sign promoting loans for instant tax refunds is displayed in a window in Little Rock, Arkansas, Tuesday, January 26, 2010.

Endnotes and citations are available in the PDF version of this issue brief.

For many Americans, tax time is also savings time—whether a family is working with an accountant to maximize deductions or debating how to use a tax refund.

This should not come as a surprise. The tax code encourages people to save through billions of dollars in tax incentives for homeownership, retirement, and other goals, including the Saver’s Credit, which rewards low- and moderate-income families who make contributions to retirement accounts. Yet the vast majority of benefits from retirement-tax incentives—about 80 percent—go to the top 20 percent of income earners. Some have suggested, however, that savings incentives help low- and moderate-income families increase how much they save—which generates net new savings—while higher-income earners are more likely to simply move existing savings into tax-advantaged accounts.

More can be done to help working families build wealth so that they can better deal with emergencies. In 2009 about 27 percent of all American households—more than 80 million Americans—were considered “asset poor” according to the Corporation for Enterprise Development. Asset poverty means that these households lack sufficient resources to get by at the poverty line for three months in case of job loss or other loss of income. Excluding houses, cars, and other types of assets that are not typically liquidated in a crisis, however, this number increases to 43 percent of all households. This is nearly three times the national poverty rate of 15 percent.

Similarly, roughly half of all Americans—at all income levels—would “probably not” or “certainly not” be able to come up with $2,000 in 30 days to deal with an emergency, according to a recent nationwide survey by the market research firm TNS Global. This was true not only for about three-quarters of those with incomes of less than $20,000 per year, but also for about 20 percent of respondents earning more than $100,000 annually.

In short, many Americans who may not technically be considered “in poverty” still run the risk of financial ruin. Having even small amounts of savings, however, can help families weather their crises. Without savings, families may seek out predatory loans and fall deeper into debt, or they may become more dependent on government assistance. Savings are also key to planning for the future, whether buying a house or a car, preparing for college expenses, or thinking about a secure retirement.

Tax refunds can help provide a savings opportunity—a “savable moment”—where refund money can be set aside to meet future financial needs. More than 110 million tax filers—77 percent of all American households who file taxes—received a federal income-tax refund in 2010. This includes 76 million tax filers who earned less than $50,000 a year—an average refund of more than $2,300 per filer in this income group. Many tax filers overwithhold during the year—in other words, they have more money taken out of their paychecks than is actually necessary to meet their tax liability. Some economists suggest that this is because taxpayers have not properly filled out their tax forms at work or do not adjust them as circumstances change. But taxpayers may also be attracted to receiving a refund instead of having to worry about paying their taxes in April.

For about 27 million low- and moderate-income tax filers—mostly families with children—this tax refund moment is made more attractive by policies such as the earned income tax credit, or EITC. The credit, which was first enacted in 1975 and expanded in the 1990s, provides families with modest incomes—less than $36,000 to $50,000 per year, depending on family size—with a credit ranging from $3,000 to more than $5,000. Most importantly, the earned income tax credit is refundable: If the credit is greater than the tax filer’s federal income-tax liability—the filer’s obligation to the Internal Revenue Service—the IRS refunds the difference. Since low-income tax filers may not have an income-tax liability, this can provide a sizable financial boost to these families.

Behaviorally, “mental accounting” suggests that larger, less common payments like bonuses and tax refunds are treated differently from regular, small amounts like paychecks. Tax refunds for EITC filers are a prime case. In one study of EITC recipients in two cities, 84 percent used part of the tax refund to pay off debt or cover bills. Sixty-one percent used a portion of their refunds on child-related expenses, and one-third used at least part of their refunds to purchase or repair a car. But nearly half—47 percent—also put aside part of their refund for goals such as a security deposit on an apartment, a down payment on a home, or to cover emergencies. The tax refund moment is an opportunity to put aside hundreds of dollars that may have been more difficult to save during the year.

But to make the most of tax time, savings is only half the battle. Fees for tax preparation and expensive financial products such as refund-anticipation checks—temporary holding accounts for tax-refund dollars—can take hundreds of dollars out of a working family’s tax refund. The National Consumer Law Center reported that in 2008 more than $1.5 billion in EITC payments went toward tax-preparation and refund-anticipation fees. What’s more, some tax refunds are loaded onto prepaid cards that may charge fees just to access refund dollars.

At the same time, some progress has already been made to make tax time a better wealth-building opportunity for working families. In recent years the Internal Revenue Service has made it possible for consumers to automatically split tax refunds into multiple bank accounts, and it has gone after some of the most nefarious and costly tax-refund loans. Pilot programs across the country have also demonstrated that matching incentives and creative messaging can help increase savings rates.

Congress should build upon these initiatives to help working families save at tax time. First, tax reform should create a stronger savings incentive—a refundable, matching Saver’s Credit—and make it available to more low- and moderate-income families. Congress should also make sure that savings opportunities—such as savings bonds and safe, affordable accounts—are available to all tax filers, and it should support free and low-cost tax-preparation opportunities such as Volunteer Income Tax Assistance sites, which saved families receiving the earned income tax credit an estimated $90 million in tax-preparation fees in 2011.

Other government actors should also take action. The Internal Revenue Service and the Consumer Financial Protection Bureau should continue to monitor financial products targeted to consumers with tax refunds, such as refund-anticipation checks and prepaid cards. And state lawmakers should consider whether asset tests, which force agencies to comb through all financial aspects of potential public beneficiaries’ lives—from bank accounts to the values of used cars to life insurance policies to, in some cases, prepaid burial plots—are discouraging families from saving because saving would threaten their access to public assistance. Encouraging savings could actually reduce dependency.

This issue brief looks at some of the problems low-income families face in building wealth at tax time, the pilot programs and policy developments that have been able to potentially increase savings, and current proposals to make tax-time savings more popular and effective.

Problems

The Saver’s Credit has limited reach

To encourage savings by low-income families, Congress passed the Saver’s Credit in 2001, which rewards saving in employer-sponsored retirement plans like 401(k)s as well as Individual Retirement Accounts, or IRAs. For single filers earning less than $28,750 and joint filers earning less than $57,500 in 2012, the Saver’s Credit is a tax credit of up to 50 percent of the amount saved, with a maximum of up to $2,000 in savings.

In 2010 more than 91 million tax filers reported annual incomes of less than $50,000. Only 6.1 million tax filers claimed the Saver’s Credit—a small fraction of all low- and moderate-income tax filers. One of the main obstacles to broader reach is that the credit is nonrefundable. Unlike the earned income tax credit, the Saver’s Credit cannot exceed the tax filer’s federal tax obligation. As a result, tax filers who pay little or no federal income tax—such as many low-income workers—are generally not able to benefit from it. The credit also only applies to contributions for certain types of retirement accounts, such as 401(k)s and IRAs. Low-income savers may not be familiar with or have access to these accounts. And as income increases, the credit drops off very quickly: It starts at 50 percent for the lowest-income filers, before phasing down to 20 percent for joint filers earning more than $34,500 and 10 percent for joint filers earning more than $37,500. (see Figure 1)

The Office of Management and Budget estimates that the Saver’s Credit cost the government slightly more than $1 billion in foregone revenue in 2011. This is a tiny fraction of an estimated $142 billion in retirement-tax expenditures—dollars that would otherwise be taxed but are not because of credits in the tax code. The vast majority of retirement-tax expenditures help higher-income earners, who also benefit more from tax-advantaged saving because higher tax brackets reduce tax liability more for each dollar saved.

Potential savers have a “leaky bucket,” and may have disincentives to save

Having a tax refund is one thing, but committing it toward saving is another. This is known as the “leaky bucket” problem: With a large refund, it may be tempting to spend the money rather than put a portion of it aside. Knowing that a windfall is coming, tax filers may have already decided to use their tax refunds for a specific purpose, such as paying off debt or taking care of pressing household needs. Looking at planned and actual uses of low-income families’ tax refunds, researchers found that 69 percent of tax filers intended to save a portion of their refunds when they filed their taxes, but only 47 percent actually reported doing so six months later. Pressing financial needs may threaten a savings goal.

Moreover, many states create a disincentive to save by disqualifying people from welfare benefits or food assistance if they exceed certain “asset limits.” If a tax refund is saved rather than spent, in some cases it may trigger these limits, which restrict how much public-benefit recipients can have in their bank accounts as well as other types of holdings, including vehicles, property, and even burial plots. This means that while spending a tax refund has no penalty, potentially saving part of it in a bank account for future needs can threaten access to benefits. Policies vary widely across states and programs, but even when these limits do not apply—or are very high—the belief that families are punished for having savings can discourage public-benefit recipients from putting tax refunds into a bank account.

Even maximized refunds can be eroded by fees

The National Consumer Law Center estimated that of the $49 billion in earned income tax credits in 2008, more than $1.5 billion went toward refund-anticipation and tax-preparation fees. In other words, 3 percent of EITC dollars—government funds designed to help cash-strapped families make ends meet—went directly into tax preparers’ pockets, not to the recipients. Nearly $1 billion went to tax-preparation fees alone. Refund-anticipation loans and refund-anticipation checks may give consumers access to their expected tax-refund dollars faster than they would otherwise be available, but at a high cost. In 2008 the typical refund-anticipation loan cost about $65—in addition to tax-preparation fees—to receive cash one to two weeks before the refund would arrive from the Internal Revenue Service. Some, however, could cost more than $100. For tax filers without bank accounts, a refund-anticipation check offers a temporary account for receiving tax refunds that is faster than waiting for a paper check, and automatically deducts tax-preparation fees, at the cost of $30 or more. But for tax filers with bank accounts, refund-anticipation checks deliver refunds no faster than they would otherwise be directly deposited.

In 2010 the average tax refund for filers earning between $10,000 and $50,000 was more than $2,500. Overall, $300 or more of the tax refund could go to these fees—while low-income filers using free options such as Volunteer Income Tax Assistance sites or Free File software could receive their refunds in one to two weeks by direct deposit. Yet roughly 20 million tax filers in 2008 used a refund-anticipation loan or refund-anticipation check, including roughly half of all filers claiming the earned income tax credit. In fact, a 2008 Government Accountability Office report found that the refund-anticipation loan market was so lucrative that in some cases, car dealers and shoe stores would offer tax-preparation services in order to make the loans and encourage the tax filers to use their loan proceeds to buy goods.

Refund-anticipation checks still exist today, but recent actions by banking regulators and the Internal Revenue Service have greatly cracked down on banks offering refund-anticipation loans. But some nonbank actors, such as check cashers and payday lenders, are starting to offer these services. And some tax preparers have found another opportunity to gain revenue from low-income families’ tax refunds—high-cost prepaid cards. Prepaid cards can be a valuable alternative to bank accounts, since they generally cannot be overspent and are an effective substitute for cash. While innovative, some card offers may be far better than others that have high initial opening or monthly maintenance fees.

Progress

The Internal Revenue Service has taken steps to make savings easier

In 2007 the Internal Revenue Service made available a new tool to facilitate savings through Form 8888, which enables a tax refund to be split into multiple accounts. This change addresses the “leaky bucket” issue, in which a taxpayer might intend to save part of a tax refund but end up spending the entire refund instead. A tax filer receiving a $1,000 refund, for example, can have $500 automatically deposited in a checking account and the other $500 deposited in a savings account. Prior to this change, the same taxpayer would have to choose one account or the other in which to deposit the entire amount.

Since 2010 Form 8888 has allowed tax filers to use part of their refund to buy U.S. savings bonds in $50 denominations as well. This is not the first time the IRS has promoted savings bonds: From 1962 to 1968 tax refunds were available either as a check or as a savings bond. As of January 2012 this is the only remaining way to buy paper savings bonds; the U.S. Treasury now almost exclusively sells them electronically. Yet savings bonds remain attractive to some consumers who may not have a bank account or home Internet access, leading to controversy over the move away from paper bonds.

The IRS has also helped rein in high-cost refund-anticipation loans. Tax preparers making these loans face some risk that a portion of the tax refund will be garnished to pay for outstanding federal debts. In the early 1990s and again from 1999 onward, the IRS provided a “debt indicator” that helped tax preparers identify if refunds were likely to be recaptured. Starting in the late 2000s, banking regulators informed sponsoring banks that the loans were too risky, and in 2011 an IRS administrative change eliminating this indicator made it difficult for tax preparers to determine the risk of these loans. As a result, refund-anticipation loans have largely disappeared from mainstream banking actors, although some nonbanks continue to make these loans.

Public and private actors have demonstrated new ways to boost savings

Several pilot programs around the country have looked at the role of matching funds as a behavioral “nudge” and more popular alternative to tax credits. Matching funds are more concrete than credits—and demonstrations have shown that they may help boost savings by low- and moderate-income families at tax time.

In 2005 14,000 low-income tax filers at H&R Block offices in the St. Louis metropolitan area were randomly offered a matching contribution if they opened an Express IRA—the retirement savings account that H&R Block marketed at the time. Of those who were offered no match at all, 3 percent still decided to open an account and save. Of those who were offered a 20 percent match, 8 percent opened an account, and of those who were offered a 50 percent match, 14 percent opened an account. In other words, the match made tax filers between two and five times as likely to save. Amounts saved also increased dramatically in the presence of a match, with savers offered a match contributing four to eight times as much as those not offered a match.

In 2008 New York City launched SaveNYC, a pilot program in collaboration with select free Volunteer Income Tax Assistance sites, which matched 50 cents of every dollar saved, up to a maximum of $500 in matching funds—provided that the savings was not touched for one year. Roughly 9 percent of eligible tax filers participated from 2008 to 2010, even though matching dollars were limited. Over this three-year period, more than 2,200 people chose to open savings accounts through SaveNYC, collectively saving more than $1.7 million. Eighty-one percent kept their savings for the full year, yielding a total of $2.3 million in savings, including matching funds. In 2010, with support from the U.S. Social Innovation Fund, the pilot program was expanded to Newark, New Jersey; Tulsa, Oklahoma; and San Antonio, Texas, under the name SaveUSA. The evaluation is still underway, but during its first year, 73 percent of participants across the four cities were able to open a savings account and keep their savings untouched.

A new savings pilot program called Refund2Savings also looks at the role of messaging and behavioral defaults. Researchers at Duke University and Washington University in St. Louis teamed up with tax preparer Intuit to test the potential for marketing savings through split refunds. Launched in 2012, the Refund2Savings demonstration reached more than 80,000 low-income tax filers who used Intuit’s TurboTax Free File software.

After completing their tax returns, filers saw a motivational prompt, such as “Would you like to save for a rainy day?” After the prompt, they may also have viewed a suggested tax refund divided up into checking and savings amounts, such as 75 percent in checking and 25 percent in savings, or vice versa. Those behind the pilot program hope to reveal how likely tax filers are to save based on different default amounts and savings messages. While official findings have not yet been released, providing a default savings suggestion has shown greater savings than the study’s control group, in which no motivational prompt or savings suggestion was given. In its 2013 pilot, Refund2Savings will also be offering savings bonds as an alternative to accounts.

Tax preparers have an interest in these types of activities because they ultimately add value for clients who have a number of tax filing options. Intuit has expressed interest in the Refund2Savings pilot program because it is “a unique opportunity to build savings while filing a tax return, making saving easier and, in turn, generating customer satisfaction and loyalty.” Helping working families save at tax time can be attractive to both the preparer and the client.

Common-sense Saver’s Credit reforms have been proposed

Recognizing the limitations of the Saver’s Credit, President Barack Obama’s 2011 budget included a proposal to expand the credit to more low- and moderate-income families. The proposal would increase eligibility to joint filers earning as much as $85,000, and would convert the current nonrefundable credit into a refundable credit.

Along similar lines, the Aspen Institute’s Initiative on Financial Security recently proposed the Freedom Savings Credit. The Freedom Credit would also extend the Saver’s Credit to joint filers earning up to $85,000, make it refundable, and eliminate the “cliffs” in the existing credit so that a much larger share of tax filers would be able to receive the maximum amount of savings. Most importantly, the newly refundable credit would be automatically deposited into the tax filer’s retirement account—effectively turning the credit into a matching fund. This credit would build opportunity for sizable retirement savings; matching the savings of an individual putting aside $13 per week, over 30 years the portfolio could grow to as much as $150,000 based on a target-date investment strategy. The annual cost to the government of the Freedom Savings Credit is approximately $3 billion.

The New America Foundation has taken a somewhat more ambitious approach. Its Financial Security Credit proposal would provide a dollar-for-dollar government match on savings up to $500 for low- and moderate-income tax filers. Most notably, the match would be available to savings vehicles other than retirement accounts. The match would include tax-advantaged education savings accounts such as Section 529 higher-education plans and Coverdell accounts, as well as U.S. savings bonds and certificates of deposit, or CDs. Savers would also be able to open an account directly on the tax form if they do not already have one.

Under the Financial Security Credit proposal, the match would be available to tax filers earning up to 120 percent of the earned income tax credit’s eligibility level—for example, approximately $44,000 in 2012 for a single parent with one child, or $56,000 for a married couple with two children. By rewarding a wide range of savings behaviors, the proposal would facilitate savings for different life goals at an estimated cost to the government of $4 billion per year.

Members of Congress have been receptive to the idea of Saver’s Credit reform. In 2008 Sen. Robert Menendez (D-NJ) introduced the Saver’s Bonus Act (S. 3372), which largely follows the Financial Security Credit proposal. And in 2012 Rep. Richard Neal (D-MA) proposed a version of the Freedom Savings Credit, entitled the Savings for American Families’ Future Act (H.R. 6472). Unfortunately, neither of these bills made it out of committee.

All of these proposals have a modest cost in the overall government framework of more than $140 billion in annual tax expenditures for retirement savings. They address the existing Saver’s Credit’s limitations and build on research that shows how to generate new savings—not just transitions from one type of account to another.

Recommendations

Pilot programs by local governments and tax preparers have made it easier for some working families to save at tax time through matching incentives and behavioral nudges. The Internal Revenue Service has also played an important role by enabling automatic refund splitting and greatly reducing the presence of costly refund-anticipation loans. But making tax-time savings work effectively for more low- and moderate-income families will require additional action by Congress and the executive branch.

1. As part of tax reform, Congress should convert the Saver’s Credit into a refundable credit that is deposited directly to the tax filer’s account

As a refundable credit, the Saver’s Credit would reach low-income workers who would otherwise be unable to claim the credit because they may not have a tax liability. And depositing the credit into the tax filer’s account reduces the possibility of leakage and effectively matches the tax filer’s savings. This not only encourages working families to save—whether at tax time or throughout the year—but it also allows savings contributions to increase more quickly.

A proposal to make the Saver’s Credit refundable was included in President Obama’s fiscal year 2011 budget. The president’s budget proposal also recommended extending the credit to joint tax filers who earn up to $85,000 per year and eliminating cliffs in the credit as it currently stands so that more tax filers would be able to receive the maximum match. These changes would cost the government approximately $3 billion per year out of the more than $140 billion in tax expenditures for retirement—a modest investment.

Policymakers should also consider what types of accounts should be eligible for the Saver’s Credit. Some have proposed expanding eligibility for the credit to include not only retirement accounts but also education savings in Section 529 higher-education plans, Coverdell accounts, savings bonds and CDs. They argue that retirement is not an attractive savings goal for low-income families and that savings for other life goals may be more appealing. But regardless of whether a converted Saver’s Credit can be used only for retirement accounts or for broader savings opportunities, reforming the credit will make savings more attractive to millions of low- and moderate-income families.

2. Consumers should have access to a savings vehicle at tax time even if they do not already have a savings account

Consumers expecting a tax refund should have the ability to automatically save a portion of their refund before they have an opportunity to spend it. Tax filers who already have checking and savings accounts can automatically split their refunds. And some tax preparers, such as Volunteer Income Tax Assistance sites, may have banks or credit unions on hand to open new savings accounts for filers who may not have them. But not all tax filers currently have the ability to open an account.

The Internal Revenue Service has enabled tax filers to purchase U.S. savings bonds at tax time, and it should continue to do so. Savings bonds are attractive to consumers who may not have or want other savings vehicles. But other types of accounts should be made available to consumers at tax time as well. One possible approach, as advocated by the New America Foundation as part of their Financial Security Credit proposal, would be for the Treasury Department to allow banks to competitively bid for the opportunity to offer savings accounts for tax refunds. All savings and investment vehicles that may receive federal tax refunds must be safe and affordable for consumers.

3. Congress should support free and low-cost tax preparation services, such as Volunteer Income Tax Assistance sites

The president’s budget for fiscal year 2013 recommended appropriating $12 million to matching grants for these nonprofit tax preparation sites, which prepare millions of tax returns for filers with an average adjusted gross income of $21,000. Given that low-income tax filers may lose several hundred dollars of their refunds to tax-preparation fees, these volunteer-staffed sites help consumers keep their maximum refund—dollars that can then be either saved or spent.

Other opportunities can also reduce the costs of tax preparation. An improved online free-file program could also help broaden outreach to working families. As demonstrated by the Refund2Savings pilot, this may present a low-cost savings opportunity. Paid preparers, too, may wish to seek out lower-cost opportunities. All tax preparers have an important role to play in building financial stability at tax time, but a balance must be struck between reasonable tax-preparation costs and fees and practices that ultimately erode the value of the tax refund.

4. The IRS and the Consumer Financial Protection Bureau should continue to monitor tax-refund financial products such as refund-anticipation checks and prepaid cards

While high-cost refund-anticipation loans have largely disappeared from the landscape as a result of IRS actions and the activity of banking regulators, refund-anticipation checks remain a very expensive way to receive a refund. Moreover, prepaid cards that receive government payments must already meet many stringent requirements, but some cards may still have high fees depending on how the card is used. Again, dollars that are not directed toward fees can be better spent on necessities or saved for a rainy day.

5. Federal and state lawmakers should ensure that asset limits in state programs do not threaten small amounts of savings

In some states, holding as little as $1,000 in savings can disqualify someone from receiving public benefits. While this may seem like an attempt to steer benefits toward the truly needy, it also discourages those receiving public assistance from attempting to save and move out of poverty. State human-services agencies must remain aware of the power of asset limits to discourage savings. Even after policies change, perceptions may remain, as public assistance recipients continue to believe that their benefits are threatened if they attempt to save money.

Conclusion

Tax time presents an opportunity for low- and moderate-income families to put a portion of their tax refunds toward emergencies and save it for future goals. While the current Saver’s Credit seeks to reward savings, its limitations mean that many of the families intended to benefit from the credit ultimately do not. But innovations by the Internal Revenue Service, like Form 8888, have made it easier for families to save, and cracking down on refund-anticipation loans has helped millions of families keep more of their tax refunds.

When Congress considers tax reform, it should look to facilitate tax expenditures that can ultimately change behavior, such as matched savings for working families. Stronger supports for tax-time savings can make American households more financially capable to deal with emergencies and plan for the future.

Joe Valenti is the Director of Asset Building at the Center for American Progress.

Just by eliminating a loophole that gives special treatment to corporate jets, for example—at a cost to taxpayers of $3.2 billion over 10 years—Congress could avert cuts that would cost thousands of jobs, hurt millions of disadvantaged students, and force hundreds of thousands of vulnerable families to lose critical nutrition and housing supports this year. Here’s the math:

Congress has some key choices to make in the coming weeks. If they don’t close the loophole for corporate jets:

• 600,000 women and children will lose the critical nutrition assistance they need
• 125,000 families will lose their permanent housing
• More than 100,000 formerly homeless people, including veterans, will be at risk to go back on the streets
• Students with disabilities will lose critical instruction and support from more than 7,400 teachers and staff
• 1 million disadvantaged students will lose critical education funding and 10,500 teachers and staff will be at risk for losing their jobs
• 70,000 poor children will lose their Head Start and Early Head Start slots as the jobs of 14,000 teachers and other staff are put at risk

The choice should be easy.

Melissa Boteach is Director of the Poverty and Prosperity Program at the Center for American Progress.

SOURCE: AP/Mark Lennihan

Donald Trump poses with his daughter Ivanka at the opening of the Trump SoHo New York in 2010. With the passage of the American Taxpayer Relief Act, the estate tax is permanently diminished.

The New Year’s Day agreement on tax rates, the American Taxpayer Relief Act, resulted in a modest amount of new revenue, coming mostly from an increase in taxes on the highest tax bracket—couples making more than $450,000 annually and singles making more than $400,000. But this revenue will not be nearly enough to achieve significant deficit reduction in a balanced way. More revenue is needed, and to raise it, Congress will have to confront the countless special tax breaks and loopholes in the tax code. This is true of the individual and corporate income tax, and it’s also true of the estate tax.

The estate tax—a tax on large amounts of wealth passed on to heirs—is permanently diminished in the wake of the new tax deal. The top estate-tax rate, though higher than it was last year, is still historically low. The deal also permanently extended a very large exemption that limits the tax to a tiny percentage of estates. But while making these parameters permanent, the law did not address the myriad estate-tax avoidance strategies employed by the richest Americans. It is therefore incumbent on Congress to put estate-tax loopholes on the table in future budget and tax reform negotiations. This column briefly explains the changes the estate tax has gone through over the years, and a number of ways to limit estate-tax avoidance.

The estate tax

For nearly a century the United States has imposed a tax on large estates to raise revenue and “preserve a measurable equality of opportunity,” according to one of its original proponents, former President Theodore Roosevelt. The estate tax is the most progressive part of our tax system because it is a tax on large transfers of wealth.

The estate tax has always been a small but consistent source of federal revenues, averaging about 1.5 percent of federal revenues between 1950 and 2000. But the Bush-era tax cuts enacted in 2001 dramatically reduced the estate tax to the point where it was entirely eliminated in 2010 before being brought back in greatly reduced form for 2011 and 2012 as part of the law that extended the Bush tax cuts.

The American Taxpayer Relief Act enacted earlier this month raised some revenue from changes to the estate tax compared to the tax’s 2011 and 2012 parameters—but not much. In his 2013 budget proposal, President Barack Obama proposed to tax estates valued at more than $3.5 million ($7 million for couples) up to 45 percent—which would have resulted in about $120 billion in new revenue over the next 10 years. Instead, the final deal set the exemption level at $5.25 million for 2013 ($10.5 million for couples), rising with inflation in future years, and set the top rate at 40 percent, which raises only $19 billion in new revenue over 10 years. (Compared to the pre-Bush estate tax that would have gone into effect had Congress done nothing, the deal lowers revenues by $369 billion over 10 years.)

As a result of these enacted policies, the estate tax applies to vanishingly few estates:

• The Tax Policy Center estimates that only 3,800 estates in the entire country—which is a miniscule 0.14 percent, or 1 in every 700 people who die—will pay any estate tax in 2013.

• While the top estate-tax rate is now 40 percent, the average taxable estate, because of the exemption and other special rules, will actually pay only 17 percent of the value of the estate. Even the richest estates—those worth more than $20 million—will only pay 19 percent on average, according to the Tax Policy Center estimates.
• While the estate tax has been frequently portrayed as a threat to small businesses and family farms, it is now clear that the estate tax is virtually irrelevant to small businesses and farms. The Tax Policy Center estimates show that only 20 estates in the entire country valued at less than $5 million, for which the bulk of the estate is comprised of a farm or a business, will owe any estate tax in 2013—and that tiny group will owe less than 5 percent on average. In fact, of the millions of farms and businesses in the country, only 120 large farm and business estates will owe any estate tax in 2013—and they will pay an average of less than 16 percent.

Given that the American Taxpayer Relief Act raised so little revenue from estate tax rates, it makes sense to now examine the estate tax base. In a recent op-ed, Harvard economist and CAP Distinguished Senior Fellow Lawrence Summers noted that the estate tax raises very little revenue compared to the vast wealth that is transferred to heirs every year:

A simple calculation shows that our estate tax system is broken. Assets that are passed to relatives or other personal relations are often badly misvalued relative to what they cost on an open market. The total wealth of American households is estimated at more than $60 trillion. It is heavily concentrated in very few hands. A conservative estimate given the lifespans of Americans would be that 2 percent ($1.2 trillion) is passed down each year, mostly from the very rich. Yet estate and gift taxes raise less than $12 billion, or just 1 percent of this figure each year.

The estate tax raises surprisingly little revenue in large part because of the various strategies that very wealthy families use to reduce the value of their estates for tax purposes. Some of these strategies are legitimate and clearly intended by Congress—such as the estate tax permitting a deduction for bequests to charity. But others push the bounds of the estate-tax rules.

The Obama administration has proposed several ways to reduce estate-tax avoidance that were estimated by the Treasury Department to raise a combined $24 billion over the next 10 years. (This estimate preceded the recent estate-tax changes.) These changes would not only raise revenue, but also would make our tax code more equitable. They are examined below.

Reform valuation discounts

Valuation discounts can be used to artificially reduce the value of one’s assets for estate- and gift-tax purposes. To give a quick example: Instead of bestowing one’s assets on heirs directly, a wealthy person can place his assets in a “Family Limited Partnership,” and then bequest units of the partnership to each of the heirs, with certain restrictions placed on the heirs’ ability to cash out or sell their respective interests. These restrictions allow the various interests to be valued separately, at less than the combined value of the Family Limited Partnership as a whole—the rationale being that no third party would pay full value for a partnership interest knowing about the restrictions. These kinds of discounts make some sense in other settings—for example, partnerships between unrelated people dealing at arm’s length with each other—but in a family setting, where the restrictions are set up for the very purpose of enabling the discounts, the logic is not as evident.

The Obama administration’s proposals would limit the use of valuation discounts involving family-controlled entities such as Family Limited Partnerships. Restrictions that lapse or can be removed by a family member would be ignored for purposes of valuing the assets transferred to heirs.

Impose consistent valuation rules for income-tax and estate-tax purposes

One’s “gross estate,” for estate-tax purposes, is based on the fair-market value of the person’s assets upon death. That same “fair-market value” standard determines the tax basis of the person inheriting the assets, which ultimately determines how much tax they’ll pay when they sell those assets. In general, putting a lower fair-market value on assets reduces the estate’s estate-tax bill, while putting a higher fair-market value on the same assets will reduce the heir’s future tax bills. Yet somehow, under existing law, estates can give one value and heirs can assume another value. The Obama administration would require that these two values match, with a reporting requirement on the estate that would allow the Internal Revenue Service to ensure that they do.

Reform Grantor Retained Annuity Trusts to limit estate-tax end-runs

Grantor Retained Annuity Trusts, or GRATs, are one of the exotic estate planning structures that allow wealthy people to transfer much of their assets to heirs tax-free. It’s especially beneficial for assets that are expected to increase in value. Case in point: A wealthy parent can establish a trust for the benefit of her children (a separate legal entity) and put her assets into it. The transfer is a gift, which can trigger a gift tax, but the gift tax applies to the value the parent puts on the assets now, not on what the value will be when she dies after it has appreciated in value.* (And with a Grantor Retained Annuity Trust, the gift-tax liability is reduced by the value of an annuity that the trust pays back to the parent.) If the assets appreciate in value while held by the trust, the appreciation escapes estate and gift taxes.

The Obama administration proposes to discourage the most aggressive uses of Grantor Retained Annuity Trusts by requiring a 10-year minimum term (ensuring some downside risk in the strategy because if the donor dies during the trust’s term, the strategy fails) and by requiring that the annuity not entirely zero out the gift tax.

Conclusion

These reforms are estimated to raise significant revenue, demonstrating why Congress can and should include revenues in any future budget deals. And these are hardly the only estate-tax avoidance strategies that deserve further scrutiny. Before Congress sacrifices needed public investments or puts programs that serve middle-class families at risk in the name of deficit reduction, it should ensure that the estate tax is actually paid by the few wealthy estates still subject to it.

Seth Hanlon is Director of Fiscal Reform and Sarah Ayres is a Research Associate at the Center for American Progress.

SOURCE: AP/Susan Walsh

A special rule in the tax code lets certain derivatives traders pay a “blended” rate on their income. Investors must generally hold onto assets for one year in order to enjoy low-rate, capital gains treatment, but traders who buy and sell derivatives are eligible for the blended rate even if they buy and sell instantly. Sen. Carl Levin (D-MI), above, introduced legislation in the last Congress to close this loophole.

Endnotes and citations are available in the PDF version of this issue brief.

As Washington heads into the next round of budget negotiations, congressional Republicans are again asserting that every dollar of future deficit reduction must come from cutting government programs and services, not from additional revenue. Congress has already cut spending substantially, however: Three-quarters of the $2.4 trillion in deficit reduction that had been enacted since 2011 has been in the form of spending cuts, and only one-quarter has come from increasing revenue. While Congress raised the top marginal tax rate in the recent legislative deal to avoid the fiscal cliff, it has not even begun to tackle the vast array of tax breaks that disproportionately benefit upper-income Americans, nor has it addressed the many loopholes enjoyed by large corporations. These special tax breaks must be on the table going forward if Congress is committed to a balanced approach to solving our fiscal challenges.

This issue brief identifies about $1 trillion in potential savings over 10 years that can be gained from reducing or reforming tax breaks for high-income individuals and corporations. That amount would be more than enough to replace the so-called sequester, the sudden and indiscriminate cuts to government programs that are now scheduled to take effect starting in March.

These common-sense reductions in tax breaks are far preferable to many of the alternatives: allowing the sequester to kick in; enacting deeper cuts to discretionary spending programs, which have already been cut to the bone; or reducing Social Security, Medicare, or Medicaid benefits.

This $1 trillion by no means comes from an exhaustive list. If Congress is committed to a balanced approach to solving our fiscal challenges and is serious about tax reform, there are even greater potential savings. But the $1 trillion in additional revenue is a reasonable step to take. And although it seems unlikely, if Congress were to achieve the next $1 trillion in deficit reduction solely on the revenue side, the ratio of spending cuts to revenue increases in the major budget deals over the past two years would be about 1-to-1.

In many ways, the distinction between spending cuts and revenue increases is an artificial one. Many tax breaks are simply government-spending programs delivered through the tax code. As economists have emphasized—and as many leading Republicans have acknowledged—the result is the same whether the government spends a dollar directly or delivers a dollar in tax breaks aimed at certain recipients or activities. Yet tax breaks—also known as “tax expenditures”—receive far less scrutiny than direct government spending and, as a result, are often inefficient, outdated, or in need of reform. With this in mind, it makes little sense to leave revenue off the table in the ongoing budget negotiations.

Below, we consider tax code spending that benefits high-income and wealthy individuals, followed by tax code spending that benefits corporations and other businesses.

Note: We have provided links to the sources of the revenue estimates, most of which are from official sources. We note, however, that the estimates were done before the recent tax agreement and could therefore change based on the new tax rates and other factors.

Tax breaks for high-income and wealthy individuals

The American Taxpayer Relief Act—the deal passed to avoid the fiscal cliff—allowed ordinary income tax rates to rise to their 1990s levels for families earning more than $450,000 and singles earning more than $400,000 while restoring certain phase-out provisions and modestly increasing tax rates on capital gains and dividends. The top tax rates on ordinary income and capital gains are now about where they were in the 1990s—though still low by historical standards. (see Figure 1) While the tax increases did pass, they are modest: The richest 1 percent of Americans will see their overall tax rates rise by 3 percent in 2013 as a result of the legislation. That is significantly less than the 5.3 percent increase that would have occurred under President Barack Obama’s full revenue proposals and the potential 7.2 percent increase had Congress done nothing and let all tax cuts expire.

To put that 3 percent increase in perspective, keep in mind that between 1979 and 2007, the inflation-adjusted after-tax incomes of the richest 1 percent of Americans rose by more than 300 percent—compounding annually in real terms at an average rate of more than 5 percent per year. Given historic income growth, the wealthiest 1 percent will likely make up for the tax increase in real terms in a short period of time.

The bottom line is that the wealthiest Americans can contribute substantially more to deficit reduction. At this point, the best way to raise the needed revenue is by reducing the hidden spending delivered by tax breaks and tax loopholes. Here are some ways we can do that, as well as how much taking each action could save.

Limit the extra benefit that top-bracket taxpayers receive from tax breaks: $520 billion

Most tax benefits and incentives come in the form of deductions or exclusions. Both are provisions that reduce one’s taxable income and include many of the most important—and most costly—tax breaks, such as those for mortgage interest, charitable giving, employer-provided health insurance, and retirement savings. One of the unfortunate and largely unintended effects of structuring tax benefits as deductions or exclusions is that they tend to provide much bigger tax benefits to those in the highest tax brackets.

For a wealthy taxpayer in the highest tax bracket—now 39.6 percent—a $10,000 itemized deduction, such as one for mortgage interest, results in $3,960 in tax savings. For a taxpayer in the 15 percent bracket, however, that same deduction is worth only $1,500.

This “upside-down” effect is not only unfair, but it’s also inefficient from a budgetary point of view: It gives the largest tax break to the people who are least likely to need it and also least likely to respond to the incentive. High-income people, for example, are already likely to be homeowners, and they would therefore likely use disposable income to save for retirement even without a tax incentive. We would not tolerate it if a federal spending program distributed benefits in such an inefficient way—and we should be equally cost conscious with programs and subsidies that operate through the tax code.

The president has proposed addressing this inefficient “upside-down” effect by limiting tax breaks for the highest-income Americans: People whose high incomes place them in the top tax brackets would be able to claim the same value from deductions that a middle-class taxpayer in the 28 percent bracket gets, but not more. This proposal would make tax breaks fairer and more efficient while raising substantial revenue. In 2012 it was estimated that such a proposal would raise $520 billion over 10 years. (The American Taxpayer Relief Act would reduce this estimate somewhat over the same 10-year budget window. Also, if policymakers create a separate higher limit for charitable deductions—an idea reportedly under discussion in the fiscal cliff talks—the revenue estimate would be further reduced.)

For those concerned about the effect of such a policy on incentives for homeownership, retirement savings, or other areas, it should be noted that the 28 percent incentive under the president’s proposal is greater than that of recent House Republican budgets, which cap tax rates at 25 percent, effectively limiting the value of deductions to 25 percent. Twenty-eight percent is also the level that was put in place by the legendary 1986 tax reform, which set the top marginal rate at 28 percent. The incentives retained under the president’s proposal are also much stronger and more sensible than the ones retained under proposals to impose a dollar cap on deductions, an idea floated by presidential candidate and former Massachusetts Gov. Mitt Romney (R) and some congressional Republicans.

Of the proposals under consideration, the president’s proposal is simply the most progressive and most efficient way to achieve savings from major tax expenditures while also addressing tax code unfairness. The Center for American Progress and others have advocated a more fundamental reform: turning deductions into credits that provide the same benefit for all taxpayers. The president’s proposal does not go that far, but it is still a major step toward a more rational tax code.

Close loopholes in the estate and gift tax: $24 billion

The recent tax deal was a boon for heirs of multimillion-dollar estates. Though the highest estate tax rate will rise from 35 percent to 40 percent, the American Taxpayer Relief Act permanently locked in the very high estate and gift tax exemptions approved by Congress two years ago, with those exemption levels rising with inflation in the future. For 2013 the exemption will be $5.25 million per person. That means that the heirs to a couple’s estate can inherit $10.5 million of wealth tax free, even without any creative estate planning.

Given the costly extension of estate tax cuts and the fact that the estate tax is now limited to the largest 0.14 percent of estates, it is now even more important that Congress address loopholes in the estate tax that enable the tax-free transfer of even greater sums to heirs.

In a recent op-ed, Harvard economist and CAP Distinguished Senior Fellow Lawrence H. Summers did some simple math to put our “broken” estate tax system in perspective:

Assets that are passed to relatives or other personal relations are often badly misvalued relative to what they cost on an open market. The total wealth of American households is estimated at more than $60 trillion. It is heavily concentrated in very few hands. A conservative estimate given the lifespans of Americans would be that 2 percent ($1.2 trillion) is passed down each year, mostly from the very rich. Yet estate and gift taxes raise less than $12 billion, or just 1 percent of this figure each year.

Estate tax planning strategies come in many different forms. President Obama’s budget identifies several reforms to prevent people from undervaluing assets or setting up certain trusts to pass assets to heirs free of tax. The Treasury Department estimated in 2012 that these reforms would raise $24 billion over 10 years, an amount that probably just scratches the surface when it comes to estate tax loopholes.

Close the “carried interest” loophole for hedge fund and private equity managers: $21 billion

Remember Gov. Romney? He may have left the political scene since the November elections, but he continues to benefit from the so-called carried interest loophole to the tune of millions of dollars. This loophole permits the managers of investment funds such as hedge funds and private equity funds to treat the bulk of their compensation—called the “carry”—as capital gain rather than as ordinary income. The carried interest loophole is unfair because for individuals at almost every other job, income from one’s efforts is generally taxed at ordinary income rates. In other words, people with regular jobs don’t have the opportunity to turn their income into lighter-taxed capital gains. The loophole represents an inefficient and wasteful subsidy for the professions that benefit from it.

The new tax bill let capital gains rates rise, but highly compensated fund managers can still save more than 15 percent in taxes by exploiting the carried interest loophole. In 2011 the Congressional Budget Office estimated that closing the loophole—requiring fund managers to pay ordinary tax rates on their entire compensation—would raise $21 billion over 10 years.

Eliminate the John Edwards-Newt Gingrich “S Corporation” loophole: $11 billion

Certain highly paid professionals sometimes take advantage of a tax loophole made infamous by former Speaker of the House Newt Gingrich (R-GA) and former Sen. John Edwards (D-NC). These professionals—lawyers, accountants, doctors, consultants, and entertainment professionals—form “S corporations,” whose profits are not subject to Medicare taxes and who characterize much of their income as profits of the business instead of salaries. Regular wage-earners can’t do this, and neither can the owners of other kinds of small businesses. Government watchdogs have flagged the S corporation loophole as an area of rampant abuse. Legislation introduced in the House and Senate in recent years would shut down this loophole, requiring these well-heeled professionals to pay their fair share into Medicare, which would raise $11 billion over 10 years.

Deny mortgage deduction for vacation homes and yachts: $10 billion

The mortgage interest deduction is intended to promote homeownership, but the tax code allows people to claim it not only on one property but two. Moreover, under current Internal Revenue Service rules, a second home doesn’t have to be a house—it can be a large boat, too. Under the rules, boats can qualify as second homes eligible for the tax break only as long as they contain sleeping spaces, bathrooms (heads), and kitchens (galleys). In other words, only large boats qualify.

This is a perfect illustration of how a tax break intended to help middle-class people afford homes winds up subsidizing lavish lifestyles and costing more than it should. It makes little sense to maintain tax breaks on vacation properties or yachts while regular homeowners who can’t afford such luxuries can claim only a deduction on one home and renters receive no deduction at all, especially at a time when budget constraints have put federal housing programs at risk. We estimate that limiting the mortgage interest deduction to primary residences would raise at least $10 billion over 10 years.

Close tax loophole for derivatives traders: $3 billion

Warren Buffett calls this one of the “extraordinary tax breaks” for the “mega-rich”: Due to a special rule in the tax code, certain derivatives traders pay a “blended” rate on their income—60 percent at favorable long-term capital gains rates and 40 percent at ordinary income rates.

Although investors must generally hold onto assets for one year in order to enjoy low-rate capital gain treatment, traders who buy and sell derivatives are eligible for the blended rate even if they buy and sell instantly. The loophole was carved out a generation ago to protect investors in commodities futures whose purpose was to protect long-term profits, not engage in short-term speculation. But financial markets have changed, and as Buffett explains, a trader can “own stock index futures for 10 minutes” and get the favorable tax treatment “as if they’d been long-term investors.”

Sen. Carl Levin (D-MI) introduced legislation in the last Congress to close this loophole. The Obama administration estimates that doing so would raise nearly $3 billion over 10 years.

Corporate and business tax breaks

The $2.4 trillion of deficit reduction since 2011 has left corporate taxes untouched even though the corporate tax has been a declining revenue source and special subsidies for businesses abound in the tax code. In fact, the American Taxpayer Relief Act included a two-year extension of more than 30 separate corporate and business tax breaks at a cost of $46 billion. It’s time to include corporate tax breaks as part of a plan for deficit reduction.

Close international tax loopholes and incentives to move jobs overseas: at least $168 billion

The biggest corporate tax loopholes are found in the tax rules for multinational corporations operating overseas. The U.S. tax code subsidizes offshore investment in myriad ways, stemming from the ability of U.S. multinationals to defer taxes on their foreign income. As a new Congressional Budget Office report explains:

The current tax system provides incentives for U.S. firms to locate their production facilities in countries with low taxes as a way to reduce their tax liability at home. Those responses to the tax system reduce economic efficiency because the firms are not allocating resources to their most productive use…The current system also creates incentives to shift reported income to low-tax countries without changing actual investment decisions. Such profit shifting erodes the corporate tax base and leads to wasted resources for tax planning.

President Obama’s proposals to close international tax loopholes would raise a combined $168 billion while helping to level the playing field for investment in the United States. These proposals include:

• Preventing corporations from taking immediate deductions for interest expense related to tax-deferred foreign income
• Determining foreign tax credits on a pooling basis to limit “cross-crediting”
• Cracking down on tax-avoidance schemes involving the transfer of intangible property to offshore locations
• Limiting the ability of certain corporations (“dual capacity taxpayers”) such as oil and mining companies to claim foreign tax credits for “disguised royalties” and other nonincome tax items

Eliminate write-offs for corporate meals and entertainment: up to $140 billion

Eating and entertainment are personal expenses. If an individual takes his family out to dinner, he cannot deduct the cost of that meal from his taxable income. If, however, that same individual takes someone out to lunch and claims it is for a business purpose, then IRS rules allow him to deduct half of the cost of the meal. This special exception acts as an unnecessary subsidy for many people who can benefit from expense accounts and their guests while potentially skewing business decision making in inefficient ways. Allowing deductions for business meals and entertainment also results in an unknown quantity of abuse and fraud, with personal expenses classified as “business” expenses and the IRS ill-equipped to police the legitimacy of the deductions.

Entirely eliminating meal and entertainment deductions would raise $14 billion per year, while reducing the deduction to 25 percent would raise $7 billion per year, according to estimates from the Committee for a Responsible Federal Budget.

End special tax breaks for inventory: $67 billion

The tax code allows companies to choose the most favorable method of valuing their inventory and cost of goods sold, and many taxpayers choose the “Last In, First Out,” or LIFO, method, which can provide a substantial tax-deferral benefit. LIFO, however, has been described as an inefficient and unnecessary subsidy for certain businesses.  Furthermore, International Financial Reporting Standards do not allow the use of the LIFO method, meaning that its use poses an obstacle to conformity with these standards. Phasing out LIFO over a transition period, as well as a similarly flawed accounting method known as “Lower of Cost or Market,” would raise $67 billion over 10 years.

End special fossil-fuel tax breaks: $25 billion

The oil and gas industry is one of the most profitable industries on earth. The top five multinational oil and gas companies have reported nearly $1 trillion in profits this decade, and yet the oil and gas industry continues to collect billions in tax subsidies. Two of the major subsidies—expensing of intangible drilling costs and “percentage depletion”—were enacted in 1916 and 1926, respectively. Today the oil and gas industry is a mature, extremely profitable industry enjoying windfalls from oil prices approaching $100 per barrel. The industry simply does not need billions in special tax breaks as an incentive to do what it already does. Moreover, in 2009 the G-20 nations agreed to phase out inefficient and wasteful fossil-fuel subsidies.

Eliminating the following fossil-fuel industry tax breaks would save nearly $25 billion over 10 years:

• Expensing of intangible drilling costs
• Percentage depletion for oil and gas wells
• Two-year geological and geophysical amortization period for independent producers
• Deduction for tertiary injectants
• Exemption to passive loss limitation for working interest in oil and natural gas properties
• Expensing, percentage depletion, and capital gains tax breaks for coal

Eliminate corporate jet loophole: $3 billion

The tax code includes innumerable subsidies that distort the choices made by businesses. One loophole that has drawn intense scrutiny is the tax treatment of corporate jets. Companies can write off the costs of corporate jet purchases over five years, even though passenger jets must be depreciated over seven years and the planes actually last for decades. Closing the corporate jet loophole—that is, simply applying the rule for commercial jets to corporate jets—would raise $3.2 billion over 10 years.

Eliminate special write-offs for horse breeders (the Bluegrass Boondoggle): $126 million

A special tax break slipped into the 2008 farm bill allows horse breeders to write off their investments—the horses—over three years. A report conducted by the Treasury Department determined that racehorses actually have a much longer useful life. A faster, three-year depreciation schedule represents an unwarranted subsidy for the breeders and costs a reported $126 million over 10 years.

Conclusion

All told, this hidden spending through the tax code adds up to roughly $1 trillion in potential budget savings—about enough to turn off the sequester while nearly stabilizing the nation’s debt over the next 10 years. And these are nowhere near the full list of areas for potential savings—including loopholes for cruise ship operators, loopholes that allow companies to defer capital gains taxes using “like kind exchanges,” an enormous tax break called “stepped up basis” that is the major reason why about half of all capital gains avoid tax permanently, and many, many more.

We can also recoup billions in lost revenue simply by enforcing the law better and cracking down on tax cheats. The IRS estimates that in 2006, despite enforcement efforts, the United States lost nearly $400 billion in revenue from unpaid and unreported taxes—a number that probably underestimates the revenue loss from offshore activity. Our $1 trillion in revenue includes the $10 billion that the Joint Tax Committee estimates can be raised from several proposals by President Obama to reduce the tax gap. But that is just the tip of the iceberg.

It is likely that the next round of deficit reduction will include a mix of spending cuts and revenues. But even if the entire next round comes from revenues—in other words, if Congress replaces the sequester with roughly $1 trillion in new revenue from reducing tax breaks—the overall ratio of deficit reduction since 2011 would only then approach 1-to-1 between program cuts and revenue.

That is what a truly balanced approach to deficit reduction looks like.

Seth Hanlon is the Director of Fiscal Reform at the Center for American Progress.

SOURCE: AP/ Harry Hamburg

Although House Speaker John Boehner (R-OH), right, and Senate Minority Leader Mitch McConnell (R-KY) oppose raising it, the carried interest loophole is just one of many ways the U.S. tax code offers preferential treatment to some of the wealthiest Americans.

In recent days Senate Minority Leader Mitch McConnell (R-KY) and House Speaker John Boehner (R-OH) have both suggested that they might be willing to allow some tax cuts for high-income individuals to expire. But Sen. McConnell—and evidently Rep. Boehner, as well—are reportedly still insisting that the Bush tax cuts on investment income be extended.

The Republican leaders’ willingness to discuss top tax rates is a welcome step forward. But until policymakers address the gap between tax rates on ordinary income (income from wages, salaries, and so on) and the tax rates on investment income (capital gains and dividends), they will not have fully addressed the fundamental unfairness in the tax code.

No tax policy better illustrates this unfairness than the tax treatment of “carried interest”—a loophole that some of the wealthiest people in the country use to take advantage of the special low tax rates on capital gains. Closing the carried interest loophole should be a part of any significant deficit-reduction or tax-reform effort.

In anticipation of this next front in the fiscal policy fight, here’s a quick primer on the carried interest loophole.

What is the carried interest loophole?

The carried interest loophole allows people who manage investment funds—such as private equity funds and hedge funds—to convert their income into lower-taxed capital gains.

Here’s how it works: The partners in businesses that manage pools of money on behalf of investors are paid in two ways. One part of their income is a “management fee” for managing the investments. This fee is generally taxed as ordinary income, according to progressive tax rates that currently top out at 35 percent.[1] The other part of the fund managers’ income is their cut of the fund’s profits. The fund managers treat their part of the fund’s earnings as a capital gain, subject only to a top rate of 15 percent.

Investment managers, who include some of the world’s richest people, typically take a management fee equal to just 2 percent of the assets they manage—plus a 20 percent cut of their investors’ profits. In doing so, they are able to shield the bulk of their income from ordinary tax rates.

Why is the carried interest loophole unfair?

Our tax code treats labor income and investment income differently. If you are paid for performing a service (such as managing a company), your compensation is subject to ordinary income tax rates. If you make an investment (such as buying the stock of a company), any profits you earn when selling that stock are subject to the lower capital gains tax rates. The differential treatment of labor and investment income is problematic in and of itself, but the carried interest loophole is particularly unfair because it treats fund managers’ compensation as if it were investment income, when it is actually derived from the labor and skill involved in managing other people’s investments.

The main justification given for the low rates on capital gains is that it is needed to incentivize investors to put their capital at risk. But fund managers’ so-called carried interests do not represent a return on capital. The capital is put up by the investors, who are simply compensating the managers for their services by sharing a percentage of the profits. The fund managers do incur some level of risk and uncertainty by agreeing to be compensated in this manner, but that is no different from other compensation arrangements—such as sales commissions, tips, or performance bonuses—that are not fixed in advance and entail differing degrees of risk. All of those forms of compensation income are taxed as ordinary income.

What should Congress do?

Congress should close the carried interest loophole by taxing all fund manager compensation—including incentive compensation—as ordinary income. Eliminating this loophole would raise $21 billion in revenue over 10 years, according to the Congressional Budget Office.

The carried interest loophole is just one of many ways the U.S. tax code offers preferential treatment to some of the wealthiest Americans. Our recently released tax reform and deficit-reduction plan addresses this and other loopholes while raising revenue, simplifying the tax system, and making it more progressive.

Seth Hanlon is Director of Fiscal Reform and Gadi Dechter is Managing Director of Economic Policy at the Center for American Progress.

[1] Some fund managers, however, have entered into agreements to “waive” the management fee in exchange for an additional carried interest, thus converting ordinary income from the management fee into lower-taxed capital gains. Such fee conversions are legally dubious. See Nicholas Confessore, Julie Creswell, and David Kocieniewski, “Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms,” The New York Times, September 1, 2012, available at http://www.nytimes.com/2012/09/02/business/inquiry-on-tax-strategy-adds-to-scrutiny-of-finance-firms.html?pagewanted=all&_r=0.

SOURCE: AP/Pablo Martinez Monsivais

The U.S. Capitol Building is seen in Washington.

Download this synopsis (pdf)

Read the full plan: Reforming Our Tax System, Reducing Our Deficit by Roger Altman, William Daley, John Podesta, Robert Rubin, Leslie Samuels, Lawrence Summers, Neera Tanden, Antonio Weiss, with Michael Ettlinger, Seth Hanlon, and Michael Linden

Earlier this year, with the fiscal showdown on the horizon, the Center for American Progress convened a group of leading economic experts—including former White House chiefs of staff, former U.S. Treasury Department secretaries, and former directors of the National Economic Council—to develop a plan that would address some of the most serious flaws in the federal tax code and achieve meaningful deficit reduction.

The plan addresses some of the most serious flaws in the federal tax code while raising additional revenue to be used for deficit reduction, and at the same time offering changes to government spending. Chief among our tax system’s problems is the fundamental failure to raise revenues adequate to fund the necessary operations, services, public investments, and protections of government. In addition to this most basic of shortcomings, the current tax code is also weighed down with far too many special provisions, loopholes, targeted tax subsidies, and sheltering opportunities. These aspects serve to not only complicate the code and the process of tax filing, but some of them introduce economic distortions and undermine the confidence of the American public that their tax system is treating everyone fairly.

Amending our tax system to raise more revenue progressively, simply, and efficiently, coupled with targeted spending reductions, are the keys to addressing our long-term fiscal challenges. These are challenges we must address or face a future in which critical public investments such as education and infrastructure will go underfunded; key national priorities such as strengthening the middle class, reducing poverty, and building a world-class infrastructure will remain unaddressed; income inequality will continue to rise; and confidence in America’s ability to govern its fiscal affairs will continue to fall. The report being released today outlines a plan that reduces the federal budget deficit by $4.1 trillion over the next 10 years while offering measures to boost the economy in the short run as we recover from the recession.

Our plan accomplishes its deficit reduction primarily through a wide-ranging reform of the personal income tax system that raises adequate revenues progressively while making the tax system more efficient, simple, fair, and comprehensible. The key features of our plan are:

• A top marginal rate for the personal income tax of 39.6 percent as it was under President Bill Clinton
• Converting tax deductions that tend to favor those in top tax brackets into uniform credits that bestow equal benefits on taxpayers in all brackets
• A top marginal rate of 28 percent on capital gains as it was under President Ronald Reagan and throughout much of the 1990s
• Closing tax loopholes
• Simplifying tax filing

In addition our plan includes targeted spending cuts, most significantly $385 billion in federal health care savings.

The Center for American Progress plan will set the federal budget on a sustainable course, beginning with a comprehensive reform of the tax code. First and foremost, this plan will raise approximately $1.8 trillion more than we would under current tax policies. By the end of the decade, our tax system would match the revenue proposed by the bipartisan chairs of the president’s 2010 fiscal commission, Alan Simpson and Erskine Bowles. Furthermore, our reforms ensure that the additional revenue is raised in a progressive way. The vast majority of the new revenue will come from households making more than $500,000 a year, and households earning less than $100,000 a year will, on average, pay a little less.

Second, our tax plan will simplify the filing process and streamline the code so that everyone can trust that each taxpayer is being treated fairly. Our plan would tax different sources of income much more equally than the current code does. It would remove the alternative minimum tax, repeal other provisions that add complexity, reduce the number of people who have to itemize, and eliminate unjustified tax loopholes. It would also turn certain deductions that currently favor those in higher tax brackets into credits that will bestow equal benefits. A large “standard credit” protects middle-income filers and relieves even more taxpayers of the need to itemize expenses than under the current tax code.

Our plan restores the top rate to the same rate that existed during the 1990s’ economic expansion: 39.6 percent for those in the top bracket (people earning more than $400,000). Most taxpayers would be in the 15 percent tax bracket under our plan. The plan also treats investment income and wage income more equally. It restores the capital gains rate to 28 percent—where it was after President Reagan signed the 1986 tax reform act and where it was for most of the 1990s. And it treats dividends as ordinary income—as they were for decades until 2003. The vast preponderance of the economic evidence shows that tax rates at these levels are no obstacle to economic growth. In fact, the cuts in top tax rates has only led to deficits and increased after-tax inequality.

This tax reform, combined with reasonable spending reforms, will place our federal budget onto far stronger foundations. We identify hundreds of billions of dollars in new spending savings that come on top of the $1.5 trillion in spending cuts already enacted into law. These include nearly $385 billion in mostly Medicare savings, $100 billion in further defense savings, and $100 billion from other programs. And by putting these measures into place, which will reduce budget deficits over the next decade, we make room for critical investments in job creation today.

All together, our combined plan will reduce the projected federal budget deficits by approximately $4.1 trillion over 10 years. Enactment of our plan would reduce the publicly held debt from currently projected levels of near 90 percent in 2022, to below 72 percent and falling.

Our proposed tax reform at a glance

Personal exemptions, standard deduction, itemized deductions: Replaced with a “standard credit” ($5,000 for couples and $2,500 for singles) and 18 percent “itemized credits,” except charitable contributions would generally receive an itemized credit of up to 28 percent. Taxpayers would have the choice of claiming the standard credit or itemized credits. The impact of the effective reduction of the mortgage interest tax preference for those in higher tax brackets is phased in over time.

Dependent exemption: Replaced with an expanded child tax credit of $1,600. Child credit is refundable under today’s rules and the phaseout point is lifted to $200,000. A $600 nonrefundable credit is available for nonchild dependents.

Capital gains and dividends: Tax capital gains at a maximum 28 percent rate (including the Medicare tax that goes into effect in 2013) and dividends as ordinary income.

Health care exclusion: The value of the exclusion is limited for those with earnings in excess of $250,000 per year to 28 percent.

Marginal tax rates: (see Table 3 below)

Earned income tax credit: Recent EITC enhancements are permanently extended.

Personal exemption phaseout, or “PEP,” and itemized deduction limitation, or “Pease”: Eliminated.

Alternative minimum tax: Eliminated.

Estate tax: Exemption of $2 million per individual—$4 million per couple and 48 percent top rate—indexed for inflation. Close loopholes in the estate and gift tax as proposed by President Obama.

Other elements:

• 50-cent increase in cigarette tax
• Tax on alcoholic beverages at a uniform $16 per proof gallon
• Regulating and imposing small fees on Internet gambling
• Permanent extension of the research and experimentation, or R&E, tax credit and clean energy incentives
• Corporate tax reform that increases corporate tax revenues by 4 percent and results in a lower statuatory rate
• $12 billion in savings from reforms to tax-preferred retirement and savings plans.
• Elimination of “carried interest” loophole and “S corporation” Medicare tax loophole

Note: Numbers and amounts are for the 2017 tax year. All parameters would be indexed for inflation according to the chained consumer price index. 

Download this synopsis (pdf)

Read the full plan:

• Reforming Our Tax System, Reducing Our Deficit by Roger Altman, William Daley, John Podesta, Robert Rubin, Leslie Samuels, Lawrence Summers, Neera Tanden, Antonio Weiss, with Michael Ettlinger, Seth Hanlon, and Michael Linden

SOURCE: AP/J. Scott Applewhite

In order to secure our fiscal future and achieve meaningful deficit reduction over the next 10 years, we need a plan that combines progressive, revenue-enhancing tax reform with pragmatic spending cuts that do not undermine the middle class, the poor, or seniors.

See also: A Synopsis of CAP’s Comprehensive Tax Reform and Deficit Reduction Plan

Endnotes and citations are available in the PDF version of this report.

There are very few things everyone in Washington can agree on these days. But the one notion that will get heads nodding across the political spectrum is that today’s fiscal policies simply are not sustainable. If we keep doing what we’ve been doing, not only will the federal budget stay permanently deep in the red but critical public investments such as education and infrastructure will continue to go underfunded. Key national priorities such as strengthening the middle class, reducing poverty, and building a world-class infrastructure will remain unaddressed. Income inequality will continue to rise, confidence in America’s ability to govern its fiscal affairs will continue to fall, and sooner or later we will find ourselves struggling through another economic crisis. Clearly, these are all outcomes that we must avoid. That is why nearly everyone—left, right, and center—agrees that changes in fiscal policy will be necessary.

The nonpartisan Congressional Budget Office estimates that if we do not change course, annual federal budget deficits will never drop below $800 billion. Tax revenues will cover only 80 percent of federal spending, which means we will have to borrow 20 cents for every dollar we spend. As a result, publicly held debt, measured as a share of our national economy, will rise from about 73 percent today to nearly 90 percent by the end of the decade, according to current projections.

That is a budget trajectory fraught with serious risk. No one knows with precision when our debt levels will become so burdensome that they trigger severe economic consequences. But there are few who would disagree that such a level does exist, and that we would do well to avoid finding out exactly what that level is. For that reason, budget experts and economists from all perspectives agree with the goal of preventing such a treacherous rise in the debt-to-GDP ratio.

To do so does not require radically decreasing our deficits immediately as we continue to recover from the Great Recession of 2007–2009. Instead our goal should be to reduce our deficit to stabilize the debt-to-GDP ratio at a responsible level in the medium term. We can achieve this by lowering our annual budget deficits to a level where any new debt incurred in a given year is smaller than overall economic growth that year. Under normal economic conditions, this means deficits of approximately 3 percent of GDP or lower. Though still lower deficits are desirable when the economy is at full employment and operating at potential GDP, getting deficits under 3 percent of GDP would address the most pressing concern in the medium term and put the budget on a sound footing.

Accomplishing that critical goal is going to be difficult. Deficit reduction is always hard—after all, it means cutting back on public services and programs that are important to the nation, and it means raising taxes.

This report offers a plan to achieve meaningful deficit reduction over the next 10 years that rests on two pillars:

• Progressive, revenue-enhancing, efficient, simplifying, and pragmatic tax reform
• Pragmatic spending cuts that do not undermine the middle class, the poor, or seniors

First, we should recognize our revenue problem. Repeated tax cuts played an outsized role in creating the budget deficits of the last decade and they have hurt our country. As Oliver Wendell Holmes said, “Taxes are what we pay for civilized society.” They pay for the foundational public investments that are critical to a modern prosperous society, such as infrastructure, education, and basic scientific research. They pay for services that only the government can effectively perform, such as national defense and ensuring clean food, safe consumer products, and clean water. Taxes make it possible for us to meet our societal obligation to care for our veterans, our aged, and our impoverished. And taxation allows us to overcome national challenges and achieve extraordinary feats. Apollo 11, the Hoover Dam, and the Internet were all financed with tax revenues.

Current federal revenue levels are at their lowest levels since the 1950s. And the assumption that all of the tax cuts scheduled to expire at the end of this year will continue is the single-largest reason why budget experts expect federal deficits to remain far too high over the next 10 years. Clearly we have a big revenue problem.

When thinking about where the revenue we need should come from, the starting point should be that our tax system must be progressive. From Adam Smith down to today, it has been a long-recognized principle that those with higher incomes should pay a higher share of their income in taxes because they have the ability to pay and have benefited the most.

After all, no one disagrees that, to take a hypothetical example, a 10 percent tax on a family making $50,000 has a far greater impact on the life of that family than a 10 percent tax on a family making $5 million. And those at the top of the income ladder benefit significantly from our civil society, public investments, the protections taxes pay for, and all our nation provides. It’s only fair that the better off be asked to pay a larger share of the bill.

And, in fact, our tax system is progressive. But over the last several decades, the trend has been to ask less and less of those at the top. The very highest-income households have enjoyed substantial tax cuts, even as their incomes have risen: From 1979 to 2007, for example, the pretax incomes of the top 1 percent more than tripled, while their tax rates declined by about one-fifth. And while, on average, higher-income Americans do pay higher federal tax rates than middle-income Americans, there are too many high-income households for whom that general rule does not apply.

Finally, it is important to remember that the federal income tax is only one piece of a larger national tax system. Most of the other pieces—excise taxes, payroll taxes, state and local taxes—ask much less of high-income households than they do of low- and moderate-income households. Taken together, our national tax system is already less progressive than it might appear, which is one reason why it’s so important for the federal income tax to be substantially progressive.

In addition to concerning ourselves with progressivity as we address the need to raise more revenue, we should also address the fact that the current tax code is too complex. It contains too many narrowly targeted special interest breaks. In some cases these special preferences create economic inefficiencies that can no longer be justified. They also erode Americans’ faith that the tax code is treating everyone fairly.

Our tax reform plan addresses these failings. First and foremost, it would redesign the income tax code so that it will generate adequate levels of revenue to meet our crucial fiscal goals. Over the next 10 years, our tax reform would put us on a stronger fiscal footing by raising $1.8 trillion and, by the end of the decade, matching the overall levels of revenue proposed by fiscal commission co-chairs Alan Simpson and Erskine Bowles as part of their bipartisan deficit reduction plan. Though these proposed revenue levels will likely be insufficient for the country’s long-term needs, they are enough to do the job in the medium term. And given their bipartisan pedigree, they provide a realistic target.

Our tax plan would raise this revenue in a progressive way, asking those in the top income brackets to pay more. On average, households making less than $100,000 would pay a little less than they do now, those making between $100,000 and $250,000 would see only tiny increases, and the tax hikes up to $500,000 would be small.

Our reform would also simplify the filing process and streamline the code so that everyone could trust that each taxpayer is being treated fairly. It does this by turning certain deductions that currently favor those in the highest tax brackets into credits that will bestow equal benefits. Our plan would tax different sources of income much more equally than the current code does. It would remove the alternative minimum tax, repeal other provisions that add complexity, eliminate unjustified tax loopholes, and reduce the number of taxpayers who would have to itemize.

Of course deficit reduction will not be limited to tax reform. Spending reform will also be necessary. It is important to note that the federal government has already cut spending substantially. In the last two years, President Barack Obama has signed into law $1.5 trillion in spending cuts over the next decade. We propose hundreds of billions of dollars in additional spending savings that can be achieved without reducing retirement or health benefits, without shredding the social safety net, and without further disinvesting in America’s future.

The result is a comprehensive deficit reduction plan that will substantially reduce our future deficits, set the budget on a sound course for the coming decade, and bring our debt-to-GDP ratio below 72 percent by 2022.

See also:

• A Synopsis of CAP’s Comprehensive Tax Reform and Deficit Reduction Plan

SOURCE: AP/Erich Schlegel

Sgt. Howard Acoff hugs his family as U.S. Army 1st Cavalry 3rd Brigade soldiers return home from deployment in Iraq at Fort Hood, Texas, Saturday, December 24, 2011.

The House of Representatives today is scheduled to vote on a House Republican proposal (H.R. 8) that purportedly extends all tax cuts but actually raises taxes on about 25 million families by reducing certain tax credits. The 25 million families include middle-class families and students who currently benefit from a tax credit for college expenses. Others are parents raising children on modest incomes who are helped by the child tax credit and earned income tax credit. Some, as illustrated below, are members of the U.S. military and their families.

The competing Democratic proposal, which has already passed the Senate (S. 3412 / H.R. 15), extends all income tax cuts for the 98 percent of families with incomes under $250,000 ($200,000 for singles), including these tax credits in their current forms.

Below are three illustrative examples of military families whose tax bill would rise next year under H.R. 8, the House Republican tax bill.

A corporal (E4) in the Marines with four years of service, who is married and has two children would see a tax increase of $448 under H.R. 8

In 2009, President Barack Obama signed into law improvements to the earned income tax credit—an important tax credit that boosts the earnings of low- and moderate-income workers. In 2009, 211,000 military families benefitted from the earned income tax credit.[1] One of the 2009 improvements reduced the tax credit’s so-called marriage penalty (phasing out the credit at higher income levels for families that file joint tax returns). H.R. 8 would let that provision expire, increasing the marriage penalty and thus reducing the EITC for married couples in the phaseout range.

With military basic pay of $27,660[2] (and assuming no other household income), this Marine Corporal’s family is affected by the worsened marriage penalty under H.R. 8. As a result, the family’s tax credit would be reduced by $448 under H.R. 8 compared to the current tax rules, the Senate-passed bill, and the House Democratic alternative. Here are the details:

Marine corporal (E4), four years’ service, married with two children

• Military basic pay: $27,660
• Earned income tax credit under current tax policy and Democratic plan: $4,326
• Earned income tax credit under H.R. 8: $3,878

Tax increase under H.R. 8: $448

A military police staff sergeant (E5) in the Air Force with eight years’ service, with a spouse and three young children at home, would see a tax increase of $1,118 under H.R. 8

Another provision enacted in 2009 boosted the value of the earned income tax credit for families with three or more children, reflecting the fact that these families have a higher cost of living. H.R. 8 would let this provision expire, so that families with three or more children get the same-sized tax credit as families with two children.

With basic pay of $34,723, this staff sergeant’s family would be affected by both the earned income tax credit’s worsened marriage penalty under H.R. 8 and the reduced credit for families with three or more children. In total, the family’s earned income tax credit would be reduced by $1,118 under H.R. 8. Under the Senate-passed bill and the House Democratic alternative, it would not be cut. Here are the details:

Air Force staff sergeant (E5), eight years’ service, married with three children

• Basic pay: $34,723
• Earned income tax credit under current tax policy and Democratic plan: $3,508
• Earned income tax credit under H.R. 8: $2,390

Tax increase under H.R. 8: $1,118

A private in the U.S. Army (E1) in his first year of service, who is married with an infant child, would see a $273 tax increase under the Republican plan

The child tax credit generally provides a $1,000 credit per child. But the credit is only partially “refundable” for families who do not have federal income tax liability in a given year. H.R. 8 would reduce the ability of some low-income families to claim the credit. That is because the credit’s refundability is based on the level of a family’s earnings above a certain threshold—and H.R. 8 would raise that threshold.

With basic pay of an estimated $18,196 in 2013, the Army private’s family’s income is too low to owe federal income tax because of the standard deduction and personal exemptions. Under H.R. 8, the family would only be able to claim a partial child tax credit, limited to $727. In contrast, under the Senate-passed bill and the House Democratic alternative, the family could claim the full $1,000 credit for its child. Here are the details:

U.S. Army private (E1), first year of service, married with one child

• Basic pay: $18,196
• Child tax credit under current tax policy and Democratic plan: $1,000
• Child tax credit under H.R. 8: $727

Tax increase: $273

These are just three typical military families who face a tax increase from H.R. 8’s failure to extend important tax benefits for working families. Many families with similar incomes, military and nonmilitary, would face similar tax increases because of H.R. 8’s failure to extend the child tax credit and earned income tax credit improvements. H.R. 8 also fails to extend the American opportunity tax credit for families and students paying for college.

In all, the House Republican plan raises taxes on about 25 million families, including 18 million families with children (constituting 37 percent of all families with children).[3] By contrast, all 98 percent of families with incomes under $250,000 ($200,000 for singles) would see no tax increase under the Democratic bill, and the 2 percent of Americans with higher incomes will keep tax cuts on their income up to those amounts.

Seth Hanlon is Director of Fiscal Reform at the Center for American Progress.

See also:

• Standing in the Way of Middle-Class Tax Cuts, by Seth Hanlon and Sarah Ayres

Endnotes

[1]. Internal Revenue Service data provided for the 11th Quadrennial Review of Military Compensation (2009 tax year).

[2]. The income figures are from “2012 Monthly Basic Pay Tables,” available at http://militarypay.defense.gov/PAY/BASIC/docs/Active%20Duty%20Tables/2012%20Basic%20Pay%20Table%20-%20Active%20uncapped.pdf. A 1.7 percent military pay increase is assumed for 2013. Other forms of pay and benefits (allowances, combat pay, retirement) that are not included in taxable income are not reflected in the calculations. All tax calculations use estimates of 2013 tax parameters for the earned income tax credit and the child tax credit.

[3]. See National Economic Council, “The President’s Proposal to Extend the Middle Class Tax Cuts” (2012), available at http://www.whitehouse.gov/sites/default/files/uploads/middleclassreport_7_24_2012.pdf. This report cites Department of Treasury data; Tax Policy Center, “table T12-0165.” This table analyzes the Senate Republican tax bill, S. 3413, which is the same in relevant part.

SOURCE: AP/J. Scott Applewhite

House Speaker John Boehner (R-OH) stands next to a portrait of former President George W. Bush as he waits to speak with reporters on Capitol Hill in Washington, Tuesday, July 24, 2012, following a House GOP caucus meeting.

The House of Representatives has the opportunity this week to extend tax cuts for all Americans and dramatically reduce the uncertainty surrounding the so-called “fiscal cliff” at the end of the year. If the House approves legislation the Senate passed last week, President Barack Obama stands ready to sign it into law immediately. The only thing stopping that from happening is the House Republicans’ insistence on maintaining additional tax cuts for high-income households.

Under the Senate-passed bill, 98 percent of Americans would keep all of the income tax cuts they enjoy now and pay no more in taxes next year. The richest 2 percent of Americans would continue to benefit from the “Bush” tax cuts on their first $250,000 of yearly income ($200,000 for couples), but would pay higher rates on income exceeding those levels. In all, wealthy Americans would pay more than they do now, but less than they would if Congress did nothing. (The Senate bill is S. 3412. An identical version was introduced by House Democrats as H.R. 15.)

The House Republican leadership bill (H.R. 8) purports to extend all tax cuts, including those for the rich, but in fact it would raise taxes on about 25 million working Americans. That is because it lets enhancements to three tax credits benefitting middle- and low-income families expire. H.R. 8 has no chance of reaching the president’s desk—the Senate rejected a substantially identical version—and he would not sign it anyway.

The House should drop its insistence on continued tax cuts for high incomes and join the Senate in preventing a tax increase on 98 percent of Americans next year. Figure 1 shows the surprising breadth of agreement in Congress on the need to extend tax cuts into 2013—except for House Republicans’ continued refusal to extend middle-class tax cuts without also extending the additional high-end tax cuts. (see Figure 1)

Comparing the House and Senate approaches on tax cuts

Because the Senate bill extends tax cuts on all income under $250,000 ($200,000 for singles), it means that 114 million families, or 98 percent of taxpayers, will not face any tax increase next year. That includes 97 percent of small businesses. Extending tax cuts for 98 percent of Americans would prevent an average middle-class tax increase of $1,600, or about $2,200 for a typical family of four.

The 2 percent of Americans with the highest incomes would still enjoy the current lower rates on all of their income up to the income thresholds, but would pay the higher rates that existed during the Clinton presidency on income exceeding those levels. And families just above the $250,000 threshold (up to $300,000) would keep 98 percent of their tax cuts, resulting in a minuscule tax increase.

By contrast, the House bill, which purportedly extends all tax cuts, would actually raise taxes on about 25 million families by rolling back enhancements to tax credits enacted under President Obama in 2009. Specifically:

• 11 million families paying for college would lose American Opportunity Tax Credits worth an average of $1,100. This tax credit defrays a larger portion of tuition costs than previously existing credits, is available to third- and fourth-year college students, and is partially refundable (up to $1,000 can be claimed by students or families even if they do not owe federal income tax in a given year).
• 12 million families raising children would lose some or all of their Child Tax Credits, costing them an average of $800. The Child Tax Credit provides a $1,000 per-child credit to reflect the costs of raising children. An improvement enacted in 2009 enhanced many low-income families’ eligibility for the tax credit by allowing them to count more of their earnings toward the credit’s refundable portion.
• 6 million working families would lose some or all of their Earned Income Tax Credits, costing them an average of $500. In 2009 the Earned Income Tax Credit was also expanded to provide an additional benefit for families with three or more children.  In addition, the tax credit’s “marriage penalty” was reduced, meaning that couples who get married and combine their earnings do not lose as much of the credit as they did before. The House Republican bill’s failure to extend this provision is notable given the party’s expressions of concern for reducing marriage penalties in the tax code. 

Though the high-income tax cuts receive much more attention, the looming expiration of these tax credit provisions would affect far more people. In fact, by failing to extend them, the House Republican bill raises taxes on more than 10 times as many people as the Democratic plan. (see Figures 2 and 3)

Indeed, fully 37 percent of families with children would face a tax increase next year under the Republican plan. The GOP tax plan would raise taxes on 18.6 million families with children, including 9.2 million single parents. (see Figure 4)

In sum, the Senate bill is not just the only legislation with a realistic chance of reaching the president’s desk. That bill ensures that many more families’ taxes do not go up at the end of the year. The only thing standing in the way of continuing tax relief for 98 percent of Americans and dramatically easing the “fiscal cliff” is the House Republicans’ insistence on continuing the wasteful high-end tax cuts. The House should not miss this opportunity to ensure tax cuts for 98 percent of American households.

Seth Hanlon is Director of Fiscal Reform and Sarah Ayres is a Research Associate at American Progress.

SOURCE: AP/J. Scott Applewhite

Senate Minority Leader Mitch McConnell (R-KY) gestures during a news conference on Capitol Hill in Washington.

In defending tax breaks for the highest-income earners, Senate Republican Leader Mitch McConnell (R-KY) has argued, “We ought not raise anybody’s taxes at the end of the year.”

Strange, then, that the tax plan Sen. McConnell has put forward with other Senate Republicans would raise taxes on millions of families at the end of this year. In fact, based on our analysis, the Senate Republicans’ plan would likely raise taxes on more than 20 million families—about 10 times as many people who would see higher taxes next year under the Senate Democrats’ plan offered by Majority Leader Harry Reid (D-NV). Under Sen. Reid’s bill, the only people who would lose tax cuts are the roughly 2.1 million households, or less than 2 percent, with incomes of more than $250,000. The Senate is expected to vote on both tax plans next week.

How is the Senate Republicans’ plan a tax hike on some 20 million families? While it extends all of the tax cuts first enacted under President George W. Bush, it lets several important tax cuts enacted under President Barack Obama expire at the end of the year. Apparently Sen. McConnell thinks tax cuts signed into law by President Obama don’t count as tax cuts.

The Senate Democrats’ tax plan would extend these Obama tax cuts, which include:

• Tax credits for college tuition: Enacted in 2009, the American Opportunity Tax Credit provides a tax credit of up to $2,500 for families paying for college. 9.1 million families claimed it in 2011. If the credit is allowed to expire, families paying for college will only be able to claim the smaller credit that existed before. Some students will not be eligible for any college tuition credit, including third- and fourth-year college students.

• Tax credits for working families: In 2009 the Earned Income Tax Credit for low-income working families was expanded to reduce the credit’s “marriage penalty” (the potential loss of the credit’s benefits when couples get married and combine their earnings) and provide an additional benefit for families with three or more children (reflecting their higher cost of living). More low-income families also were made eligible for the Child Tax Credit through a rule allowing them to count more of their earnings toward the credit’s “refundable” portion. These improvements would expire at the end of the year, affecting 13 million working families with 26 million children.

In all, it is likely than more than 20 million families would lose tax credits under Sen. McConnell’s plan, compared to the 2.1 million high-income households that would lose some of their George W. Bush-era tax cuts under the Senate Democratic plan.

Seth Hanlon is Director of Fiscal Reform at American Progress.

Notes and sources

According to Citizens for Tax Justice, 8.9 million families benefit from the Child Tax Credit improvement while 6.5 million benefit from the Earned Income Tax Credit improvements. But some families benefit from both. In total, 13.1 million families are affected if the enhancements to both credits expire.

9.1 million households claimed the American Opportunity Tax Credit in 2009, a figure that would likely be higher for 2013 if the credit is extended. The American Opportunity Tax Credit probably also overlaps somewhat with the other two provisions.

See: Government Accountability Office, “Higher Education: Improved Tax Information Could Help Families Pay for College,” GAO-12-560, Report to the Committee on Finance, U.S. Senate, May 2012, available at http://www.gao.gov/assets/600/590970.pdf; Citizens for Tax Justice, “The Debate Over Tax Cuts: It’s Not Just About the Rich” (2012), available at http://www.ctj.org/pdf/refundablecredits2012.pdf; Tax Policy Center, “Extend 2001-10 Tax Cuts Except for Certain High-Income Provisions Individual Income and Estate Tax Provisions Baseline: Current Policy Distribution of Federal Tax Change by Income Percentile, 2013,” July 11, 2012, available at http://www.taxpolicycenter.org/numbers/displayatab.cfm?Docid=3445&DocTypeID=2.

SOURCE: AP/Evan Vucci

Callista Gingrich looks on as Newt Gingrich speaks at an event in Virginia earlier this year. Newt Gingrich has previously used the so-called Gingrich-Edwards loophole, which allows certain well-heeled professionals to avoid paying Medicare taxes on income.

Interest rates on newly issued subsidized Stafford loans are set to double on July 1 if Congress does not act. In general the leaders of both the House and Senate say that they want to block this rate increase for at least one more year, but they have put forward differing proposals on how to offset its budget cost.

The House bill (H.R. 4628) would cut a fund for public and preventive health care. The Senate bill (S. 2343) takes a far better approach: closing a tax loophole used by certain well-off professionals to avoid Medicare taxes—most famously used by former Sen. John Edwards (D-NC) and former House Speaker Newt Gingrich during their private-sector careers. The U.S. Treasury’s inspector general for tax enforcement has called the loophole a “multibillion dollar employment tax shelter.”

This column is intended to explain the so-called Gingrich-Edwards loophole and why closing it is a commonsense way to pay for the student loan fix.

The problem: The Gingrich-Edwards loophole

Imagine if avoiding payroll taxes were this simple—step 1: Form your own corporation called Your Name, Inc.; step 2: Tell your employer to stop sending you a paycheck and start sending a check to Your Name, Inc., for the gross amount of your salary before taxes; step 3: Pay yourself a “dividend” from Your Name, Inc., every other Friday.

Obviously, it’s not that simple. For regular workers this kind of scheme wouldn’t work. Employers withhold Medicare taxes directly from paychecks and also pay their share of Medicare taxes directly to the government. The Medicare tax is 1.45 percent on both employee and employer, and it applies to all wages. Most self-employed people who operate their own businesses generally are required to pay self-employment taxes (at the combined rate of 2.9 percent) on all of the income from their businesses. The upshot is that nearly all people who work for a living are required to pay Medicare taxes on all of their earnings. It’s not optional.

That’s not the case, however, for some well-compensated professionals, including many lawyers, doctors, consultants, and entertainers. They sometimes use a scheme that is similar to the one described above, though a little more complicated, to avoid paying their fair share of Medicare taxes.

The scheme exploits a loophole in the payroll tax rules that apply to so-called S-corporations. An S- corporation (named after subchapter S of the tax code) is one of several ways to organize a business. In general it’s a common and perfectly legitimate business form. But because of the loophole, some S-corporation owners have an opportunity to avoid payroll taxes—an option that other workers and other small business owners (such as sole proprietors or general partners in a partnership) do not have.

The key to the scheme is that while payroll taxes apply to virtually all income derived from working, they do not apply to profits from an S-corporation. So certain professionals such as lawyers and doctors can avoid payroll taxes by first organizing their business as an S-corporation and then characterizing their income as business profits rather than as wages or salaries.

Because these professionals both own and work for the business, they can decide how much to pay themselves in salary, which means they have an incentive to shortchange their own salaries so that the rest of the money their businesses take in after expenses is treated as profits—and therefore free of Medicare taxes. The same rules apply to the Social Security tax, but because that tax applies to a capped amount of wages or self-employment income, high-income professionals are probably more likely to use the loophole to reduce their Medicare taxes.

This scheme is supposed to be limited by an Internal Revenue Service rule requiring business owners to pay themselves “reasonable compensation” in the form of wages or salaries. If a business paying an unreasonably low salary to its owner is audited, the IRS can potentially recharacterize profits as wages and impose payroll taxes. But whether a salary paid to oneself is “reasonable” is a fuzzy standard, allowing for a great deal of leeway. A report by Congress’s investigative arm, the Government Accountability Office, found that, “The vagueness of federal tax law on determining adequate wage compensation shareholders mean that the facts and circumstances have to be analyzed in each case.” The “difficulty and subjectivity in determining what constitutes an adequate wage enables some S-corporations to pay inadequate wage compensation,” which results in more of the income treated as profits that are free from payroll taxes.

The Government Accountability Office also found extensive abuse of this loophole. From 2003 to 2004, 13 percent of S-corporations underpaid wages to owners, resulting in about $24 billion in underpaid wages. That translates into approximately $3 billion in lost federal revenue that had to be made up for by other taxpayers, according to a rough estimate by the Government Accountability Office. In one year, according to the Treasury Department’s tax inspector general, 36,000 single-shareholder S-corporations reported profits of $100,000 or more (totaling $13 billion)—without paying a penny in employment taxes.

The solution: Making people pay the taxes they owe

Senate bill S. 2343—Stop the Student Loan Interest Rate Hike Act of 2012—closes the Gingrich-Edwards loophole. It does so by requiring the owners of professional services businesses—those who themselves perform substantial services for the business such as a lawyer who owns her own firm—to pay employment taxes on any income from that business. The bill is crafted to root out common areas of abuse. It would require individuals with incomes of more than $250,000 ($200,000 for singles) to pay payroll taxes on all of the income they receive from an S-corporation or a limited partnership interest in a professional service business—those providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice, or management or brokerage services. The bill’s provisions apply to S-corporations deriving 75 percent of their income from the service or with three or fewer shareholders (or where the S-corporation itself is a partner in a professional service business). S-corporations with three or fewer shareholders account for “almost all” of the underpayment of wages by S-corporations, according to the Government Accountability Office.

In other words, the bill takes away the opportunity to recharacterize income from a professional service business to avoid payroll taxes. That solution puts such businesses on par with other kinds of small business owners, who are required to pay self-employment taxes on all of their business income.

Closing this tax loophole is a commonsense measure to make people pay what they should be paying already. But closing any tax loophole always provokes opposition. It’s worth addressing some of the claims of critics, and then examining further why we indeed need to shut down the Edwards-Gingrich loophole. 

Closing the loophole will help honest small businesses by requiring other businesses that shirk their responsibilities to pay what they owe.

Those opposed to closing the tax loophole say that doing so would impose a new tax on small businesses. In fact, closing the loophole would not impose a new tax. It would instead simply require businesses that have found aggressive ways to avoid the Medicare tax to pay what they legitimately owe. That would help the vast majority of small businesses that simply pay what they owe.

Congress needs to act because existing enforcement mechanisms have proven inadequate. 

Critics of the loophole-closing provision have claimed that the IRS already has the ability to pursue people who are not paying what they owe. The facts, however, show otherwise. In its 2009 report the Government Accountability Office found that IRS enforcement was thin despite the prevalence of abuse. The IRS examined the employment tax issue only “in the most egregious cases,” representing just a tiny fraction of S-corporation returns.

Similarly, the U.S. Treasury inspector general for Tax Enforcement found that IRS audits did not always examine the employment tax issue even in cases where little or no compensation was paid (and therefore little or no employment tax was paid). With a lack of enforcement, the inspector general found that, “there are evidently many owners of S-corporations who have determined the employment tax savings available from minimizing salaries is worth the risk of an IRS examination.”

The fundamental problem is the law, not the IRS. The determination of whether compensation that business owners pay themselves is “reasonable” inevitably depends on the specific circumstances of each individual case. As the inspector general emphasized, “The cost of the IRS resources needed to effectively combat such a large problem on a case-by-case basis would be prohibitive.”

The accusation that closing this loophole represents a raid on Medicare is illogical.

Some critics have made the provocative claim that closing the loophole and at the same time extending the current student loan rates would represent a “raid” on Medicare. This makes no sense. To state the obvious, Medicare taxes go into the Medicare trust fund only if people actually pay them. When business owners find ways to avoid paying their fair share of Medicare taxes, the taxes they owe are not going into the Medicare trust fund. If anyone is raiding the Medicare trust fund, it is the people who are exploiting the loophole.

The implication that S. 2343 would divert funds from the Medicare trust fund to other programs is also false on a mechanical level. The additional Medicare self-employment taxes collected because of S. 2343 would, in fact, go into Medicare’s trust fund, while the extended student loan subsidies would be paid for by the federal government’s general revenues.

But what’s most important is the bottom line: The bill would have a net-positive impact on the overall federal budget, according to Congressional Budget Office.

Conclusion

A basic question underlying the Gingrich-Edwards loophole issue is why any income should be exempt from Medicare tax. The answer is that there is no good reason. Income from work has long been subject to Medicare taxes—working people pay Medicare taxes on all of their wages, salaries, or self-employment income. In 2010 Congress removed the exemption from Medicare taxes for income from investments, including dividends, capital gains, interest, and the profits of “passive” investors in a business. (This applies to the high-income people who receive the bulk of such income and will be effective in 2013.) Yet there is a special category of income exempt from Medicare taxes: the business profits earned by some people “actively” engaged in a business. There is no logical or economic reason why this type of income should have a special Medicare tax exemption. After all, everyone benefits from Medicare no matter the source of their income. Exempting such income from Medicare taxes makes loopholes like the Gingrich-Edwards loophole possible.

The more fundamental issue is not what’s at stake with S. 2343. The bill simply zeroes in on a very specific loophole that allows certain people, whose income is clearly derived from their skill and labor, to avoid the taxes paid by all other working people. This loophole is without purpose, unfair, inefficient, and costly for other taxpayers. Closing it is simply common sense. Closing the loophole while also preventing a student loan rate increase is common sense times two.

Seth Hanlon is Director of Fiscal Reform at the Center for American Progress.

SOURCE: AP/ Pat Wallenbach

University of Southern Maine students march down Congress Street in Portland, Maine for an organized May Day rally. Robert J. Samuelson's recent suggestion in The Washington Post that federal policy isn’t heavily influenced by the rich and powerful rests on a shaky foundation of misleading numbers and notable omissions.

Does the existence of Social Security and Medicare prove that the rich and powerful don’t exercise an exaggerated influence on federal policymaking? If we spend more today than we did 50 years ago aiding impoverished families, does that mean the richest 1 percent are politically marginalized? That’s essentially the argument made by Robert J. Samuelson in the pages of The Washington Post earlier this week.

Samuelson sets up a straw man—the idea that the federal government spends little or no money on poor people or on the middle class—and effectively tears it down. In fact, says Samuelson, at least 60 percent of federal spending goes to help the poor and the middle class. And furthermore, the amount of money we spend on poor people has increased significantly since 1962. Samuelson suggests that these facts prove that federal policy isn’t in the pockets of the rich and powerful.

But Samuelson’s argument rests on a shaky foundation of misleading numbers, as well as a dedicated refusal to acknowledge an entire category of federal spending that mainly benefits the rich. And while it’s true that the federal government has, in the past, put policies in place that aid the poor and protect the middle class, it’s also true the impact of those policies has eroded over time. What’s more, those very same programs are now under attack from Samuelson’s political compatriots. Finally, and most egregiously, by focusing only on federal spending, Samuelson utterly misses the myriad of other ways the rich and powerful can and do make the federal government work for them.

Samuelson’s numbers don’t tell the whole story

Let’s start with Samuelson’s shaky numbers. He says that when you combine spending for the poor along with Medicare and Social Security, federal support for the middle class and the poor comes out to about 60 percent of all federal noninterest spending.

First of all, if only 60 percent of federal dollars are going to the bottom 99 percent of Americans (or bottom 90 percent or even 80 percent for that matter), it suggests precisely the opposite of what Samuelson says it does. Secondly, Samuelson deliberately chose to remove interest payments on the debt from his calculation. But according to the Department of the Treasury, a large portion of our current debt exists because of the Bush tax cuts, which primarily benefited the wealthy.

Samuelson also points to the fact that federal spending on poverty programs has increased from $516 per person in 1962 to $13,000 per person last year. That does sound like a big increase. But, in fact, nearly the entire increase is due to the introduction of Medicaid. There was no Medicaid in 1962, and by 2007—before the onset of the recession—it accounted for more than half of all federal spending on low-income Americans. And of course, the growth in Medicaid spending has been primarily driven by growth in health care costs overall, not generous increases in benefits.

Aside from Medicaid, federal spending on poverty programs grew from only 0.8 percent of gross domestic product in 1962 to just 1.2 percent of GDP by 2007, according to the Office of Management and Budget. That’s not exactly the massive increase suggested by Samuelson.

At this point it’s also important to note that at least one of Samuelson’s numbers is just flat out wrong. He says that the average food stamp benefit per person in 2010 was $287 each month. Wrong. That was the average benefit per household. In fact, the average benefit per person was less than $130 per month—just $4.30 a day.

But don’t let all these numbers obscure one very simple fact that Samuelson never bothers to mention. Even during the height of the Great Recession, even as federal antipoverty programs kept nearly 20 million people from falling below the poverty line, even then, total federal spending on the poor—including the federal share of Medicaid—amounted to less than 4 percent of our entire national income. To repeat: 4 percent.

Samuelson conveniently leaves out an entire category of federal spending that helps the wealthy

There’s also an entire category of federal spending—never mentioned by Samuelson—whose cost far exceeds 4 percent of gross domestic product. In 2011 there was more than $1 trillion in spending that operated through the federal income tax code. These so-called “tax expenditures” are economically equivalent to traditional spending. They create government obligations and public benefits just as real as those of the food stamp program. But because they are created by carving out loopholes in the tax code or by designating special categories of income that get a lower tax rate, Washington has chosen to think of them as “tax cuts,” rather than spending.

But spending is what they really are, and the well-to-do is whom they primarily benefit. Fully two-thirds of the benefits of these tax expenditures go to the richest 20 percent of Americans, according to the Tax Policy Center. In fact, the richest 1 percent get as much benefit from tax spending as the bottom 60 percent combined. In 2011 the average millionaire received nearly $450,000 a year in tax spending, which is the equivalent of about $1,225 a day (and certainly puts into perspective the average daily food stamp benefit of $4.30).

But of course, Samuelson doesn’t include tax expenditures in his account of federal spending. If he did, he’d have to acknowledge that the rich are, indeed, the beneficiaries of significant government largesse.

In fact, Samuelson hardly mentions the tax code at all. He does dredge up the specious claim about the “share of taxes paid” by the rich, but that particular talking point has been so repeatedly debunked that it hardly bears mention. Suffice it to say that the rich pay most of the taxes because they make most of the income.

Given the argument Samuelson tries to make, you can understand why he doesn’t dwell on the tax code. After all, taxes for the super rich have been cut dramatically and repeatedly over the past 30 years. According to the nonpartisan Congressional Budget Office, in 1979 the top income tax rate was 70 percent, and the richest 1 percent paid about 37 percent of their income in federal taxes. By 2007 that top rate had been cut in half, and the richest 1 percent paid less than 30 percent in federal taxes. These numbers don’t fit with Samuelson’s story of an overburdened and underrepresented wealthy class.

Federal programs for the 99 percent are less effective and under the knife

But it gets worse for Samuelson’s argument. Over that same period, the richest 1 percent of Americans enjoyed an enormous explosion in prosperity. Their average income more than tripled. Their share of total national income more than doubled. Their incomes grew more than 10 times faster than the incomes for households in the middle. As a result, American society is now more unequal than it has been at any point since before World War II.

And though Samuelson would have you believe otherwise, the federal government actually has done less and less to combat that rising inequality. In 1979 federal policies—including both transfer programs and the tax system—reduced income inequality by 23 percent, according to a recent report from the Congressional Budget Office. In 2007 that reduction was down to 17 percent.

And if conservatives in Congress have their way, they will gut the very programs that Samuelson points to as evidence of the political strength of poor and the middle class. The House Republican budget plan, authored by Rep. Paul Ryan (R-WI), cuts federal spending by more than $5 trillion over the next 10 years. Nearly two-thirds of those cuts come from low-income programs such as Medicaid and food stamps. The remaining third falls heavily on “non-defense discretionary” programs, a category of spending home to such middle-class investments as transportation funding, food and drug safety, and law enforcement.

Rep. Ryan’s budget cuts would come on top of the more than $1 trillion in reductions already enacted, a large portion of which also fall on nondefense discretionary. And as is well known, the House Republican budget also dramatically cuts Medicare starting 10 years from now.

Samuelson mentions precisely none of this. If it is true, as he argues, that the mere presence of programs for the middle class and the poor suggests that the rich aren’t gaming the system in their favor, then what must it mean when those same programs are at grave risk of being slashed to the bone?

The rich exercise plenty of influence over government

Putting aside all of these numbers, perhaps the most critical failing of Robert Samuelson’s bizarre claim that the rich and powerful aren’t actually all that powerful is that his method of accounting for their influence, looking only at federal spending, is woefully limited. There are myriad ways for big corporations, superwealthy individuals, and powerful interests to use the federal government for their benefit—many of which, perhaps even most, would never show up on a balance sheet. To cite just a few examples: government rules that preference existing companies over newcomers; deregulation that pads profits but exposes the public to greater risk; weakened labor laws that make it harder for workers to form unions; government contracts; and implicit government subsidies.

And even when the government does spend some money on something that ostensibly helps the middle class or the poor, very often a closer look reveals some powerful and wealthy interests as equal beneficiaries. Medicare Part D, which provides Medicare coverage for pharmaceuticals, is a perfect example. Yes, this program helps a lot of middle-income seniors, but its passage also expressly forbid Medicare from negotiating for lower prices, leading to a massive windfall for drug companies.

Just a straw man in the end

In the matter of Straw Man vs. Robert J. Samuelson, the victor is clearly Mr. Samuelson. That poor straw man never had a chance. But Samuelson does not fare nearly so well when pitted against reality. Of course the government spends a large portion of its budget on the poor and the middle class. They do make up the vast majority of the population, after all. But Samuelson ignores the tax code, both the spending embedded in it, and the fact that taxes for the rich have dropped precipitously at the same time that their incomes have skyrocketed.

He also fails to mention that the very programs to which he points as evidence of the political strength of the middle class are under serious assault. And he simply does not grapple at all with the nonspending ways in which the government can be and has been bent to the will of the rich and powerful.

It would be nice if Samuelson’s argument were true—if the influence of the vast middle class and the poor did indeed outstrip that of the rich—but, sadly, it’s not.

Michael Linden is the Director for Tax and Budget Policy at the Center for American Progress.

See also:

• The Federal Tax Code and Income Inequality by Michael Linden
• The Richest 1 Percent Get More, Pay Less by Michael Linden
• Rich Americans Are Not Overtaxed by Sarah Ayres and Michael Linden
• Why We Need a Buffett Rule by Seth Hanlon

SOURCE: AP/Steven Senne

Rep. Paul Ryan's (R-WI) tax proposal would do far less to reduce income inequality than the current tax system does.

Download this issue brief (pdf)

Read the brief in your web browser (Scribd)

Endnotes can be found in the PDF and Scribd versions.

Introduction

Over the past 30 years, our nation’s income has grown increasingly unequal. In 1979 the average income for a household in the richest 1 percent was about 10 times higher than the average income for a household in the middle 20 percent. By 2007 that ratio had almost tripled. The average household in the richest 1 percent was now earning nearly 30 times as much as those in the middle. Yet even as income inequality increased dramatically, the effect of the federal tax code on income distribution declined substantially.

Because, on average, richer households pay more of their income in federal taxes than do middle- and low-income households, the “after-tax” distribution of income is always somewhat more equitable than it was before federal taxes are taken into account. But the magnitude of this effect can vary quite a lot because policy changes make the tax code less or more progressive.

From 1979 to 2007 there were a number of major tax changes, but the cumulative effect was to render the federal tax code less progressive and therefore less able to dampen income inequality. By one measure of inequality, the federal tax code in 2007 was about one-third less effective at reducing income inequality than it had been in 1979.

This issue brief will examine the consequences of these changes to the federal tax code on the income distribution. It will begin with a review of several measures of income inequality. The second section will briefly explain why federal taxation has the effect of reducing income inequality. Next up is a close look at how changes in the tax code since 1979 have affected its impact on the after-tax income distribution. The final section will compare how some proposed changes to today’s tax code would affect income inequality in the future.

Measuring income inequality

In order to measure the impact of the tax code on income inequality, it is important to understand how income inequality itself is measured. There are a variety of different ways to measure income inequality, each with its own strengths and weaknesses. Each metric, however, tells essentially the same story about income equality in the United States: We have relatively high levels of income inequality, income inequality has gotten worse over time, and the federal tax code can make a significant difference in income inequality. So let’s look briefly at three different metrics for measuring income inequality.

The Gini index

The most comprehensive and widely used measure of income inequality is the Gini index. This index (also known as the Gini coefficient, Gini ratio, or Gini score) essentially measures the difference between actual income distribution and a perfectly equitable distribution in which everyone makes the same amount. A perfectly equitable distribution of income scores a 0 on the Gini index, whereas the most unequal distribution, in which a single person makes all the income, scores a 1.

According to the U.S. Census Bureau, the Gini index for the United States in 2010 was 0.469—a score that high indicates we have a far more unequal society than most other advanced, developed countries. The Scandinavian countries are the most equal with Gini scores of around 0.25. But even compared to countries that are far more similar to us than Sweden or Norway, the United States is still an outlier. Canada, for example, has a Gini index of 0.321, and the United Kingdom’s Gini index is 0.34. In fact, our Gini index is much closer to countries like Malaysia (0.462) and Uganda (0.443). (see Chart 1)

Ratio of average incomes

Though the Gini index is the broadest and most widely used measure of income inequality, it does have the disadvantage of being rather technical. Saying that a country’s Gini index is 0.469 does not have an intuitive meaning for most people. Saying that the average household among the richest 1 percent of households takes home nearly 30 times as much as the average household among the middle 20 percent, however, may be a clearer way of expressing the same thought.

In 1979 the average income for a household in the richest 1 percent of households was $550,000 (in 2007 dollars) before federal taxes, according to the nonpartisan Congressional Budget Office. That same year, the average household in the middle 20 percent of all households made $54,100. So three decades ago the average household in the top 1 percent made more than 10 times as much as the average household in the middle. In 2007 that ratio was all the way up to almost 30. The average household in the top 1 percent made almost $1.9 million in 2007, compared to the $64,000 made by the average household in the middle 20 percent. (see Chart 2)

Share of income going to the richest 1 percent

Fundamentally, income inequality is all about the relative concentration of income. If a rich few claim more and more of the total income then the distribution of income is necessarily very unequal. Indeed, the Gini index is calculated by looking at income concentration across the entire income spectrum. In a very equal society, the richest 1 percent of households would make close to 1 percent of the income, as would the poorest 1 percent of households, as would any other percentile. The Gini score is essentially a combination of all the differences all along the income scale between an income distribution that has no disproportionate concentration and reality.

But we can take a shortcut by looking just at the top 1 percent. Synonymous with rising inequality is a growing concentration of income at the top. Therefore, we could also measure inequality by simply looking at the share of total income flowing to the top 1 percent. This is obviously a cruder measurement than the Gini index since the distribution of income among the bottom 99 percent doesn’t factor in at all. But it turns out that looking just at the share of income flowing to the richest 1 percent will tell the same basic story as looking at the Gini index. In 1979 the top 1 percent claimed 9.3 percent of all the income. In 2007 they enjoyed 19.4 percent. (see Chart 3)

How the federal tax system reduces income inequality

If every household in the United States paid exactly the same share of their income in federal taxes—if everyone’s effective tax rate was the same—then the distribution of income after federal taxes would be precisely identical to the distribution of income before taxes. The tax code only makes a difference to income inequality if households at different points on the income spectrum pay different effective tax rates. If the tax code asks higher-income households to pay, on average, higher taxes than middle- and low-income households then the post-tax incomes of rich households will be reduced by a greater amount than the post-tax incomes of those in the middle and at the bottom. This would result in an after-tax distribution of income that is more evenly spread than the pre-tax distribution.

This means that the more progressive the tax code is, the more it will reduce inequality. The converse is also true. The closer the federal tax code comes to a pure “flat tax” with everyone paying the same effective rates, the less it will do to reduce income inequality. And of course it is also possible that the tax code could turn regressive, with higher-income households paying average effective tax rates below those of middle-and low-income households. In that case, the federal tax code would actually exacerbate income inequality. It is worth mentioning that this is precisely the effect of state and local taxes, which, as a whole, are regressive.

Since at least 1979 the federal tax system has been progressive, with overall effective tax rates generally going up with household income. Some parts of the tax code are more progressive than others. The federal individual and corporate income taxes are progressive, whereas payroll taxes and excise taxes are not. But with all the pieces together, the federal system is progressive.

In 2007, the most recent year for which we have historically comparable data, the richest 1 percent of households paid 29.5 percent of their income in federal taxes. The middle 20 percent of income earners paid 14.3 percent, and the poorest 20 percent paid 4 percent. As a result of this progressive structure, the after-tax income distribution was substantially more equal than the pre-tax distribution. Before federal taxes our Gini index for 2007 was 0.524. After taxes it was 0.489, a 7.2 percent reduction. The tax code has reduced income inequality, to varying degrees, every year since at least 1979.

Before turning to how changes in tax policy over the past 30 years altered the magnitude of the code’s impact on inequality, it should be noted that taxation is not the only way the federal government directly effects income inequality. Benefits such as Social Security or unemployment insurance help reduce income inequality. So too do programs that supply “in-kind” substitutes for income such as supplemental nutrition assistance or rental housing assistance to those in the middle and the bottom of the income spectrum. Together, these programs are known as “transfers.” In fact, the entire suite of federal programs that “transfer” income does significantly more to reduce income inequality than the tax code does. In 2007 the Gini index for U.S. household income distribution before this assistance was 0.59. Government assistance reduced it to 0.524, an 11.2 percent reduction.

Though it is outside the scope of this analysis to discuss these government transfers in detail, suffice it to say that their impact on income inequality has declined over time.

Major tax policy changes since 1979 and their impact on inequality

Since the late 1970s there have been many changes to the federal tax code. Some of those changes have been progressive, asking those at the top of the income pyramid to pay more or those in the middle and bottom to pay less. And some have been regressive changes, mostly in the form of large tax cuts that disproportionately benefit the rich. Not surprisingly, fluctuations in the effect of the federal tax system on income inequality track very closely to major policy changes in the federal tax code.

1979 to 1986

In 1979 the Gini index for before-tax income inequality was 0.407. Before federal taxes the richest 1 percent claimed 9.3 percent of all pre-tax income. That year federal taxation reduced the Gini index by 11 percent to 0.367 and reduced the share of income flowing to the richest percentile by nearly a quarter to 7.5 percent. 1979 is both the first year of reliable data and the high-water mark for income-inequality reduction through the federal tax code.

In the early 1980s President Ronald Reagan spearheaded major tax cuts that primarily benefited those with higher incomes. The total federal effective tax rate for a household in the richest 1 percent declined from 37 percent in 1979 to less than 26 percent by 1986. Tax rates for everyone else barely moved at all. For those in the middle 20 percent of income, the effective federal tax rate in 1979 was 18.6 percent. Seven years later it was 18 percent. And taxes actually went up for households in the bottom 40 percent of income earners. The result was a tax code that asked far less from the rich—even as it asked the same or more from everyone else.

Consequently, the effect of the federal tax system on income inequality dropped sharply. Whereas in 1979 the after-tax income distribution was 11 percent more equitable than the pre-tax income distribution, in 1986 after-tax income was just 5 percent more equitable than pre-tax income. And whereas in 1979 the after-tax share of income claimed by the richest percentile was 24 percent below its pre-tax share, in 1986 the richest percentile’s share of post-tax income was just 6 percent lower than its share of pre-tax income. If 1979 was the high-water mark for the tax code’s effect on income inequality, 1986 was the low point. (see Chart 4)

1986 Tax Reform

In 1986 Congress passed and President Reagan signed a comprehensive tax reform package that temporarily boosted the power of the federal tax system to reduce income inequality. The 1986 reforms lowered the top marginal tax rate but also removed or reformed a host of provisions that allowed rich households to reduce their tax bills, and raised the tax rate on investment income. The combined effect was an increase in the effective tax rate for the richest 1 percent from 25.5 percent in 1986 to 31.2 percent in 1987, and small tax cuts for the bottom 60 percent of households.

With the rich paying more and the middle and poor paying less, the after-tax distribution of income was substantially more equitable than it had been before the tax reform. In 1986, before the reform was implemented, federal taxes reduced the Gini index by 5 percent. In 1987, after reform, federal taxes reduced the Gini score by 7 percent. The following years saw a slow erosion of the tax code’s impact on inequality and by 1990 the tax code was bringing down the Gini index by about 6 percent—lower than the 7 percent reduction in 1987 but still higher than the 5 percent reduction in 1986.

Tax hikes of the early 1990s

In the first years of the 1990s, President George H.W. Bush and then President Bill Clinton signed major federal deficit-reduction packages into law. Both packages included tax increases, and one important component of each was an increase in the top marginal income tax rate. The Clinton tax increase also included additional Medicare taxes for higher-income individuals. Both packages served to boost the impact of the tax code on inequality. From 1990 to 1995 the reduction in inequality, as measured by the Gini index, grew from 6 percent to 8.5 percent.

The other measures of income inequality actually show an even more marked change, especially after the 1993 tax increases. In 1992 the average before-tax income for someone in the top 1 percent was nearly 15.5 times greater than the average before-tax income for someone in the middle 20 percent, but was 13 times greater after federal taxation. In other words, using this measure, the 1992 tax code reduced inequality relative to the pre-tax distribution by about 19 percent. Two years later the tax code reduced inequality, using the same measure, by almost 29 percent. In fact if we measure inequality based on average income of the top 1 percent versus the middle, then federal taxes in 1995 and 1996 actually reduced income inequality just as much as the taxes of 1979. (see Chart 5)

Tax cuts return

In 1997 President Clinton signed another budget package, but this one included a tax cut, not a tax hike. The major component of this tax cut was a reduction in rates for capital gains, or the income earned from investments as opposed to salaries. Though it also included some tax cuts for people in the middle and at the bottom of the income spectrum, the overall tax cut was regressive, meaning richer households benefited more than those poorer than them. Four years later, President George W. Bush enacted a much larger package of regressive tax cuts, and then did so again in 2003.

The combined effect of all these tax cuts was a steady reduction in taxes paid by the richest households. In 1996 the richest 1 percent of households paid an average effective federal tax rate of 36 percent. By 2001 that rate was down to 32.8 percent, and by 2007 it was down to 29.5 percent.

Predictably, as the tax rate for the rich dwindled, so too did the impact of the federal tax system on after-tax income inequality. Whereas in 1996, federal taxes reduced the Gini index by 9 percent, by 2007 that reduction was down to just more than 7 percent. The other measures of income inequality show a similar decline in effectiveness.

The critical importance of the effective tax rate for rich households

Examining three decades’ worth of tax law changes and the attendant consequences for the tax system’s relationship to income inequality reveals something striking: The one thing that matters most in determining how effective the tax code will be at reducing income inequality is the effective tax rate for the richest 1 percent of households.

Chart 6 compares the effective tax rate for the richest 1 percent of households since 1979 and the tax system’s impact on inequality, as measured by the reduction in Gini scores, over the same time period. Mathematically, the two lines have a 92 percent correlation. In other words, when the effective tax rate for the rich goes up, so does the impact the tax code has on inequality, and vice versa. Looking at Chart 6, this relationship is immediately obvious.

By contrast, another supposed metric of “progressivity,” the share of taxes paid by the rich, has no relationship whatsoever to the tax code’s impact on income inequality. Over the past three decades, the share of federal taxes paid by the richest 1 percent has consistently risen, while the impact of the federal tax code on inequality has fluctuated up and down. Some have suggested that this rise in the share of taxes paid by the rich proves the tax code has become more progressive. But of course the rise in share of taxes paid by the rich precisely mirrors the rise share of income going to the rich. Far from being a measure of progressivity, the share of taxes paid by the rich is actually an indirect measure of income inequality.

Looking ahead

On January 1, 2013, the Bush tax cuts are scheduled to expire. So too are a smaller package of tax cuts passed originally as part of the American Recovery and Reinvestment Act in 2009. If all of these tax cuts are allowed to expire as scheduled, the entire tax code would all but reset to its state before President Bush took office. Given the impending “reset,” Congress will certainly be forced to, at the very least, consider making some changes to the tax code. And though the menu of possible changes is infinite, there are two basic options for Congress to consider:

• Allow the tax cuts to expire, and therefore return to the tax code as it was at the end of President Clinton’s term.

Or:

• Permanently extend all of the expiring tax cuts, thereby maintaining the tax code in its current form (with the exception of the payroll tax cut).

Using distributional estimates from the Tax Policy Center, we can calculate what each of these options would do to post-tax income inequality. Based on the Tax Policy Center’s projections, the pre-tax income distribution in 2013 will have a Gini index of 0.494 (note that this Gini score is not comparable to the historical Gini scores because the Congressional Budget Office, which produced the historical data, uses a different definition of income than the Tax Policy Center does, and the Tax Policy Center data are categorized by tax unit rather than by household). The average income for the richest 1 percent will be nearly 35 times greater than the average income for someone in the middle 20 percent, and the richest 1 percent will claim 17.8 percent of all income.

Based solely on the single criterion of reduction in after-tax income inequality, returning to the “Clinton tax code” is clearly the superior of the two basic options. The Clinton tax code would reduce the Gini index by 9.4 percent, compared to an 8.6 percent reduction under the current tax code. The Clinton tax code would reduce the ratio of average incomes by 19.4 percent, compared to a 17 percent reduction under the current code. And the Clinton code would reduce the share of total income flowing to the richest 1 percent by about 13.5 percent, compared to an 11.8 percent reduction under current tax policies.

In addition to these two basic options, there have been several proposals recently that would more dramatically alter the tax code. These include:

• President Barack Obama’s proposal to allow the expiration of the Bush tax cuts for those making more than $250,000, limit the value of certain tax benefits for high-income households, and eliminate a variety of tax subsidies and loopholes
• House Budget Committee Chairman Paul Ryan’s (R-WI) proposal to reduce the top income tax rate to 25 percent, eliminate the alternative minimum tax, and reduce the corporate income tax rate to 25 percent
• The illustrative tax reform plan offered by the chairman of the president’s fiscal commission chaired by Erskine Bowles and Alan Simpson
• A tax reform plan put forth by the Bipartisan Policy Center as part of their recommendations to last fall’s congressional “super committee”

The Center for American Progress also released a tax reform proposal as part of our comprehensive plan to balance the budget. And although we commissioned an outside consultant to conduct distributional analyses of our income tax reform, the Tax Policy Center did not evaluate our plan. Therefore, its impact on income inequality cannot be included in this analysis.

Figure 7 shows the reduction in the after-tax Gini index achieved by each of the above tax proposals, along with the reduction achieved by the current tax code. Note that the Tax Policy Center’s distributional analyses, on which these calculations are based, were conducted for different years depending on the plan. President Obama’s proposals were evaluated for 2013. The proposals from Rep. Ryan and Bowles-Simpson were evaluated for 2015. The Bipartisan Policy Center’s plan was evaluated for 2021. These differing years of evaluation make direct comparisons slightly more problematic. But because the key metric is percent reduction in income inequality from the pre-tax distribution of income—and not the relative levels of post-tax inequality under each tax plan—we can still draw conclusions about the relative magnitude of each plan’s effect on inequality.

With that minor caveat in mind, it is nevertheless clear that the proposals from President Obama, Bowles-Simpson, and the Bipartisan Policy Center would improve the tax code’s impact on income inequality compared to the current system, while the other two would dramatically reduce it. (see Chart 7)

Given the historical relationship between the average effective tax rate for the richest 1 percent and the tax code’s impact on income inequality, these results should not be too surprising. The three plans that result in a more equitable distribution of post-tax income also share the characteristic of raising the effective rate for the richest 1 percent. The Bipartisan Policy Center’s plan, President Obama’s proposal, and Bowles-Simpson’s illustrative plan all increase the effective tax rate for the top percentile by between 4.9 and 5.5 percentage points compared to today’s tax policies (we estimated that the Center for American Progress plan, by comparison, would raise the effective rate for the top 1 percent by 6.4 percentage points).

President Obama accomplishes this increase by allowing the top tax rate to return to 39.6 percent, what it was under President Clinton, by limiting the value of tax benefits for high-income households, and by returning the capital gains rate to 20 percent, also where it was at the end of President Clinton’s term. The Bipartisan Policy Center and the Bowles-Simpson plans do not raise the ordinary income tax rate. In fact they both lower it. But they compensate by limiting the value of tax benefits even more than President Obama’s proposal, by taxing capital gains as ordinary income, which effectively increases the capital gains rate to 28 percent.

Both the Bipartisan Policy Center and the Bowles-Simpson plans also increase the effective tax rate for rich people by preventing huge amounts of money from transferring to heirs and heiresses completely untaxed. Bowles-Simpson accomplishes this by taxing unrealized capital gains at death, while the Bipartisan Policy Center’s plan eliminates the so-called “stepped-up” basis for capital gains.

In contrast to the two bipartisan plans and to the president’s plan, the Ryan tax proposal would substantially cut the effective rate for the richest 1 percent. It does so by cutting the top income tax rate, without identifying any reforms that would offset the resulting massive tax cut for the rich. The predictable consequence is that the Ryan tax code would do far less to reduce income inequality than the current tax system does.

In short, post-tax income inequality would worsen under this proposal.

Conclusion

The primary role of the federal tax code is to raise sufficient revenue to pay for government services, benefits, programs, and investments. But so long as the overall federal system is progressive, it also serves to dampen income inequality. Over the past three decades, income inequality has been rising rapidly, and by some measures is now at heights last seen before the Great Depression. University of California economist Emmanuel Saez recently marveled that “The United States is getting accustomed to a completely crazy level of inequality.”

But even as inequality has risen, the federal system has become less progressive and therefore less able to reduce that inequality. In 1979 the richest 1 percent of Americans paid 37 percent of their income in federal taxes. Nearly 30 years and numerous tax cuts later, the effective tax rate for the richest 1 percent of American households was down under 30 percent. As the amount of taxes paid by the super-rich fell and then temporarily rose, and then fell again, so too did the overall impact of the tax code on the post-tax distribution of income. By 2007 the federal tax system’s impact on income inequality was at a 15-year low.

There are big decisions regarding federal taxation looming on the horizon. The Bush tax cuts are set to expire at the end of 2012 along with the payroll tax holiday and several other tax cuts passed under President Obama. Even beyond the basic question of what to do with all those expiring provisions, the air in the nation’s capital is thick with talk of broader tax reform. And though those decisions should be primarily driven by the need for additional revenue to reduce the federal budget deficit, policymakers must take into account the important role that the federal tax code plays in reducing income inequality.

Michael Linden is Director of Tax and Budget Policy at the Center for American Progress.

Download this issue brief (pdf)

Read the brief in your web browser (Scribd)

Endnotes can be found in the PDF and Scribd versions.

SOURCE: AP/Paul Sancya

A mansion is shown in Detroit. The effective federal tax rate of the richest 1 percent of Americans has plummeted even while their incomes have skyrocketed.

The effective federal tax rate of the richest 1 percent of Americans has plummeted even while their incomes have skyrocketed, as the chart below shows. Households in the top 1 percent more than doubled their incomes from an average of more than $800,000 in 1993 to nearly $1.9 million in 2007. During that same period, their effective federal tax rate dropped from 35 percent to 30 percent.

That’s good for the wealthy but bad for a country facing long-term deficits. Any serious effort to balance the federal budget must start by asking the country’s most privileged people to pay their fair share. The alternative is to raise taxes on the middle class and abandon the least fortunate—while the rich get richer, and the country sinks ever deeper into debt.

Michael Linden is Director for Tax and Budget Policy at the Center for American Progress.

See also:

• Rich Americans Are Not Overtaxed by Sarah Ayres and Michael Linden

SOURCE: AP/ Nati Harnik

The Buffett Rule vote, which will take place early next week, provides an opportunity to make a modest, but important, improvement to the tax code, both in terms of fairness and in terms of raising sufficient revenue.

As Americans complete their tax returns U.S. Senators are preparing to cast an important vote on tax fairness. Early next week the Paying a Fair Share Act of 2012 (S. 2230) will be put to a vote.  The bill, sponsored by Sen. Sheldon Whitehouse (D-RI), codifies the “Buffett Rule,” the principle that no millionaire should pay a smaller percentage of income in taxes than middle-class families.

Though the Fair Share Act aims to implement a principle of tax fairness that should be uncontroversial, it has become a lightning rod for criticism, much of it misplaced. So it’s worth focusing on what the Fair Share Act will and won’t do.

What the Buffett Rule will do

Under the Fair Share Act, taxpayers with adjusted gross incomes of more than $1 million who pay less than 30 percent in federal income and payroll taxes under the existing tax code would be subject to an additional “Fair Share” tax to make up the difference. (Between $1 million and $2 million, taxpayers would pay an increasing portion of the difference because of the bill’s phase-in.) Taxpayers would be allowed to deduct charitable contributions before figuring whether their effective tax rate is lower than 30 percent.

The Buffett Rule would address a number of critical issues:

1. The Buffett Rule will restore a sense of fairness by ensuring that no millionaire is paying a lower tax rate than middle-class families  

Some conservatives have claimed that the Buffett rule is “trying to solve a problem that doesn’t exist” and that there isn’t a problem with millionaires paying a lower tax rate than average American families. But let’s consider the facts.

• According to an analysis by the nonpartisan Congressional Research Service, 25 percent of millionaires pay a lower effective tax rate than 10 million Americans who earn less than $100,000. This includes 4,000 “ultramillionaires” (those making more than $5 million a year) who pay a lower tax rate than average Americans.
• The top 400 richest Americans – a group whose incomes averaged $270 million –  paid an average rate of only 18 percent in 2008, according to data from the Internal Revenue Service. The vast majority (85 percent) paid a rate of less than 30 percent.
• According to the IRS, there were 1,470 households with more than $1 million in “adjusted gross income” who managed to pay no federal income taxes at all in 2009.

Conservatives are certainly entitled to believe that this isn’t a problem, but it is true that a great many millionaires pay a lower tax rate than average Americans. When a millionaire pays a lower tax rate than an average American family, it is not an anomaly. This is a commonplace occurrence every Tax Day. The Buffett rule offers a fix for unfairness in the tax system that is both real and pervasive.

Further, there is no evidence that the rich are currently overtaxed. In fact, the share of taxes paid by the rich is about proportional to their share of income, when all taxes, including federal payroll taxes and state and local taxes are included. The richest 1 percent of taxpayers take home 20.3 percent of the nation’s income and pay 21.5 percent of the taxes, according to an analysis by the Institute on Taxation and Economic Policy. In other words, the overall tax system is only slightly progressive.  And in many specific instances, it is upside-down, with millionaires contributing less than those below them on the income scale.

2. The Buffett Rule will require those who have captured an outsized share of the gains to finally contribute to deficit reduction

Over the past three decades the top 1 percent has captured more of the nation’s riches, yet the burden of deficit reduction has so far fallen squarely on the middle class. Since 1980 the incomes of the top 1 percent have nearly quadrupled in real terms, while the share of income going to the richest 1 percent of Americans has more than doubled. And the wealthiest 1 percent now owns more than 40 percent of all the wealth in America. Inequality has reached levels not seen since the 1920s. Given the disproportionate share of the nation’s prosperity that has gone to the rich, it makes sense that we should ask them to contribute to reducing the deficit.

But we haven’t. Instead, measures adopted over the past year aimed at reducing the deficit have consisted entirely of spending cuts that mostly harm the middle class. The Budget Control Act, which was enacted into law with bipartisan support last summer, achieves deficit reduction through discretionary spending cuts. And House Republicans would take these spending cuts even further, while also offering tax cuts for the richest 1 percent. Slashing investments in education, infrastructure, research, and safety net programs—the key drivers of economic growth and mobility—puts the burden of deficit reduction on the middle class and cripples future economic growth. The Buffett Rule would help distribute the burden of deficit reduction to include those who can most afford it.

3. The Buffett Rule will make a sizeable contribution to reducing deficits

Among the many arguments lobbed against the Buffett Rule is that it would only raise a “meager” amount of revenue. In fact, the Buffett Rule would significantly contribute to meeting our fiscal challenges. 

The congressional Joint Committee on Taxation estimated the Buffett Rule to raise $47 billion in additional revenue over 10 years. But that estimate was against a “current law” baseline that assumes that the Bush tax cuts expire—a scenario that would result in hundreds of billions in additional revenue from high-income taxpayers. In other words, the $47 billion would be on top of the revenue from ending the high-end Bush tax cuts. An estimate from the Institute on Taxation and Economic Policy using the same baseline but different assumptions about behavioral responses estimates Sen. Whitehouse’s bill would raise $171 billion in revenue over 10 years.

Against a “current policy” baseline, the Buffett Rule legislation would raise more than three times as much, or $160 billion over 10 years, hardly a meager amount. That amount exceeds the budget savings that the House Republican budget gets from cutting federal nutrition assistance.  Even the lower $47 billion amount is about enough to prevent interest rates on new student loans from doubling, as is scheduled to happen on July 1, and to make the lower rates permanent.[1]

In addition, Sen. Whitehouse’s bill is only a first step toward a fairer and more adequate tax code—essentially a failsafe mechanism to ensure basic fairness. It carefully shields everyone making less than a million, even those making $999,999, from any tax increase. To do so, it is necessary to phase in the “Fair Share” tax between $1 million and $2 million of income, which results in less revenue.

In addition, the Joint Committee made fairly clear that it assumed millionaires would seek to avoid the Fair Share tax through tax planning, such as delaying asset sales from one year to the next. If the Buffett Rule were implemented as part of broader tax reform that reduced the disparities in the treatment of wage and investment income, such strategies would be less prevalent. That would result in both a fairer tax code and significantly more revenue.

Buffett Rule critics often compare the budget savings from the Fair Share Act to the size of future deficits. That’s a false comparison because no single policy can come close to closing deficits on its own. But the Buffett Rule is a step in the right direction, and an essential part of any balanced approach.

What the Buffett Rule won’t do

A number of claims have been lobbed against the Buffett Rule, none of them compelling. It’s worth setting the record straight about what the Buffett Rule won’t do.

1. The Buffett Rule won’t harm small businesses or job growth 

A frequently used claim is that since millionaires are small-business owners, we cannot raise taxes on millionaires without harming small businesses. For example, Rep. Paul Ryan (R-WI) has said, “When we think of millionaires in the tax code, we often think of Aaron Rogers or Prince Fielder or a movie star… It’s mostly small businesses.” He’s flat-out wrong.

Small business owners are not millionaires. A report by the Office of Tax Analysis at the U.S. Treasury found that millionaires only own 3.3 percent of small businesses. In reality, the vast majority of small businesses are owned by taxpayers who make under $200,000 a year. Furthermore, the report found that only 2.5 percent of millionaires’ income comes from small businesses. There simply isn’t much overlap between millionaires and small-business owners. For this reason, the Buffett Rule would have no effect on the vast majority of small businesses.

Nor will raising taxes on millionaires hurt overall economic growth. Despite the conservative dogma that we need to cut taxes on “job creators” in order to facilitate growth, most economists and small-business owners agree that lack of consumer demand is hampering growth—not high taxes. The National Federation of Independent Businesses, a small-business organization, reported again this month that sales are still the most important concern for their members, as has been the case since July 2008.

Indeed, economists ranging from Federal Reserve Chairman Ben Bernanke to those surveyed by the Wall Street Journal have all cited a dearth of demand as the biggest factor holding back job creation. Millionaire entrepreneur and venture capitalist Nick Hanauer puts it this way: “An ordinary middle-class consumer is far more of a job creator than I ever have been or ever will be.”

Requiring the ultra-wealthy to pay at least 30 percent is not a heavy burden. Millionaires were paying an average effective federal income tax rate higher than 30 percent as recently as the 1990s, a time of strong economic growth and small-business job creation.

2. The Buffett Rule won’t affect the middle-class … not even close

Some Buffett Rule critics have advanced the creative argument that the Buffett Rule could eventually become a tax on the middle-class. Republican economist Douglas Holtz-Eakin writes that the Buffett Rule could mean “another alternative minimum tax,” which, he says “stands as a perennial threat to the middle class because it was never indexed to inflation.” 

But the Fair Share Act expressly indexes the $1 million threshold to inflation. In any event, at the rate that median household income has grown in recent decades, it would take nearly a half-century before a family earning $200,000 would hit $1 million in annual income. (In nominal terms, median household income as measured by the U.S. Census Bureau has grown by 3.6 percent since 1980.)  There is no chance, therefore, that the Fair Share tax would apply to the middle class, now or ever.

3. The Buffett Rule won’t preclude tax reform, and in fact is a step toward tax reform 

Other Buffett Rule critics argue that more fundamental tax reform is preferable to the Buffett Rule. But it is not an either-or proposition. Nothing about the Buffett Rule would make future, more comprehensive tax reform less likely.

The refrain “what we really need is fundamental tax reform” has ironically become the most common defense of the status quo. The prospect of some future, idealized tax reform is used as an excuse for officeholders not to exercise any leadership on taxes in the present. But tax reform is extremely difficult. It hasn’t happened in more than 25 years—and there are large disagreements on the fundamental question of whether revenues should even be a part of any long-term deficit solution.

There is simply no need to wait until all aspects of the tax code are overhauled before addressing one glaring area of unfairness. That’s like refusing to fix a leaky faucet because you are planning to remodel the kitchen some day. The Buffett Rule vote provides an opportunity to make a modest, but important, improvement to the tax code, both in terms of fairness and in terms of raising sufficient revenue.

A vote for the Buffett Rule is a vote to move forward in addressing national challenges with balance and fairness.

Seth Hanlon is Director of Fiscal Reform and Sarah Ayres is a Research Associate at the Center for American Progress.

Endnotes

[1]. Estimate by the Senate Budget Committee.

SOURCE: AP/Paul Sakuma

A man picks up a federal tax form at a post office in Palo Alto, California, Wednesday, April 15, 2009.

The latest House Republican budget plan asks low-income and middle-class Americans to shoulder the entire burden of deficit reduction while simultaneously delivering massive tax breaks to the richest 1 percent and preserving huge giveaways to Big Oil. It’s a recipe for repeating the mistakes of the Bush administration, during which middle-class incomes stagnated and only the privileged few enjoyed enormous gains.

Each component of the new House Republican budget threatens the middle class while doing nothing to add jobs or grow our economy. It ends the guarantee of decent insurance for senior citizens, breaking Medicare’s bedrock promise. It slashes investments in education, infrastructure, and basic research, all of which are key drivers of economic growth and mobility. And it cuts taxes for those at the top, asking the middle class to pick up the tab. It’s a budget designed to benefit the top 1 percent at everyone else’s expense.

Regressive policies that would shift the tax burden from the rich to those below them on the income scale are of course very unpopular. And so they are often presented as something they are not: measures to simplify tax filing.

The budget outline released Tuesday by House Budget Committee Chairman Paul Ryan (R-WI) is a case in point. The House budget bemoans the complexity of the tax code at length. But the actual policies have nothing to do with making the tax code simpler and everything to do with making it less fair. The talk of simplicity is a distraction from the budget’s real goal of shifting the tax burden from the rich to the middle class. In fact, this approach would keep or expand features of the tax code that add complexity and encourage gaming the system.

Below we examine the two ways it makes the tax code more regressive: by eliminating tax brackets, which will cut taxes on the rich, and by continuing to treat different kinds of income unequally.

Eliminating tax brackets is phony simplification: It will cut taxes on the rich but won’t simplify tax filing

One way you can tell that Rep. Ryan is more interested in making the tax system less progressive than making it simpler is that the one specific tax policy change offered in his budget is to eliminate top tax brackets. Eliminating those brackets means a less progressive tax code, not a simpler one.

The number of tax brackets has absolutely nothing to do with how complicated tax filing is. Once you’ve figured your taxable income, applying the tax brackets to figure your taxes owed hardly takes any time—and that doesn’t depend at all on whether there are three, six, seven, or 100 tax brackets. It’s automatic for those who use tax software or preparers. And for those who do their own taxes, the Form 1040 instructions come with tax tables where you can simply look up what you owe before credits.

Figuring one’s taxable income is the onerous part, but that largely results from the number of special exclusions and deductions Congress has created. Rep. Ryan’s budget talks in general terms about eliminating deductions and preferences but fails to identify any specific provisions that he’d eliminate.

While the number of brackets is irrelevant to the complexity of tax filing, it is highly relevant to how progressive the tax system is. An income tax with only one bracket would be unavoidably regressive, with rich and poor paying the same percentage of their incomes. That’s why so-called “flat tax” proposals, which are often sold as simplification measures, are terribly regressive.

Unfortunately the House budget would take a large step toward this kind of regressive system. It collapses the top three brackets (now 35 percent, 33 percent, and 28 percent) into the 25 percent bracket, which now applies to taxable income for couples between $70,700 and $142,700. In other words, the same marginal rate would apply to millionaires and middle-class households. The House budget also apparently combines the 15 percent and 10 percent brackets into a single 10 percent bracket, though it’s unclear what income levels that bracket would apply to.

With no brackets above 25 percent, it is all but impossible not to shift the tax burden onto the middle class. People whose high incomes currently place them in higher tax brackets would receive by far the largest benefits from consolidating the tax brackets in this way. A couple with $1,000,000 in taxable income, for example, would receive a tax cut about 125 times as big as a middle-class couple with $30,000 in taxable income (nearly four times bigger as a percentage of taxable income).*

If the unspecified “base broadeners” in Rep. Ryan’s budget are factored in, the middle-class couple could easily see a sizeable tax increase. He refuses to specify how he would broaden the tax base. But combine the drop in top rates with the fact that he rules out eliminating tax breaks for investment income and it becomes clear that his budget entails a major tax shift from the rich to the middle class.

Ryan’s budget rejects real simplification: Treating different kinds of income equally

If Rep. Ryan were truly concerned about tax complexity, his budget would confront what may be the biggest source of the problem: the unequal treatment of different kinds of income. Instead, his budget keeps or expands those differentials.

For individuals he would retain the special preferences for investment income such as capital gains and “qualified dividends,” which are taxed at much lower rates than wages and salaries. These preferential rates add enormous complexity because they require taxpayers to distinguish between different forms of income.

Worse, the special rates on dividends and capital gains create opportunities for tax shelters. As a result, big portions of the Internal Revenue Code are dedicated to policing the boundaries between ordinary income and capital gain.

As elaborate as these rules are, though, they include major loopholes. One of those loopholes is the tax treatment of “carried interest”—the profits that hedge fund and private equity managers receive as part of their compensation for managing funds. Due to the carried interest loophole, these financial professionals can characterize much of their income as capital gain, cutting their tax rates.

The tax preference for capital gains has been a source of great complexity for decades, though it was briefly eliminated following the last major tax reform in 1986. The dividend preference is more recent. It was added in 2003, making the tax system ever more complicated. The creation of a special category of low-rate dividends necessitated the addition of a complicated definition of “qualified dividend” in section 1(h)(11) of the tax code, IRS administrative guidance, a new box on the Form 1040 (which now must separate ordinary and qualified dividends), and corresponding additions to the IRS instructions. The discrepancy in rates between tax-preferred dividends and other income has led to controversies and litigation between the IRS and taxpayers over what counts as a “qualified dividend.”

Preferential tax rates also distort real-world activity. Tax professor Jim Maule sums it up:

Taxpayers generally, and their advisors, not only try to find ways to bring income within the special low rates but also to structure their business activities in ways that they otherwise would avoid, simply to take advantage of special low rates. Repeal of these rates would not only allow removal of at least one-third of the Internal Revenue Code and a similar substantial part of the regulations, it would free taxpayers, the IRS, and the courts from a huge chunk of planning and litigation that consume far more of the economy than the special low rates contribute to it.

On the corporate side, Rep. Ryan also exacerbates one of the most severe causes of friction and complexity in the tax system: the differential treatment of foreign and domestic profits. Because foreign profits are treated more favorably, global corporations devote large amounts of resources to paying lawyers, accountants, and economists to develop complex strategies to ensure that as much of their global profits are reported overseas as possible. (A recent CAP report outlines these strategies here, and you can read more about their mind-boggling complexity here, here, here, and here.)

These corporate resources would be better spent developing better products or services for customers. At the same time, the IRS is forced to devote more of its resources to monitoring these strategies and enforcing the law when necessary.

Chairman Ryan’s proposal would make the problem worse. His plan adopts a “territorial” tax system where foreign profits are not only tax deferred but fully tax exempt. That enhances the rewards for artificially gaming the system to shift profits to foreign countries. By increasing the tax bias in favor of earning profits overseas, it could also have harmful incentives for U.S. job creation though the sizeable industry built around complex ploys to minimize corporate taxes would surely get a boost.

A better way

In sum, Ryan’s proposals would not simplify the tax code, nor are they intended to do so. If anything, they would take a complicated system and make it more complicated while also making an unfair system less fair.

Policymakers interested in simplicity and fairness should consider eliminating the preference for investments. That was a key component of the Tax Reform Act of 1986, signed by President Ronald Reagan, and also of the recommendations of the Fiscal Commission co-chairs (“Bowles-Simpson”) and the Bipartisan Policy Center (“Rivlin-Domenici”).

They should also consider the tax code’s favored treatment of corporate profits reported offshore. That favored treatment can be eliminated, as Sens. Ron Wyden (D-OR) and Dan Coats (R-IN) have proposed, or at least reduced in ways that President Obama and others have proposed.

Seth Hanlon is Director of Fiscal Reform at the Center for American Progress.

*This assumes that the current 10 percent and 15 percent brackets are combined and the 25 percent and higher brackets are combined.

See also:

• The 6 Key Failures of the House Republican Budget Plan by Michael Linden
• New Ryan Plan Is Austerity on Steroids by Heather Boushey
• Latest House Republican Budget Threatens Medicare and Shreds the Safety Net by Topher Spiro
• New Ryan Plan Would Harm Our Most Vulnerable Citizens by Melissa Boteach and Katie Wright (CAPAF)
• New Ryan Budget Disinvests in America by Adam Hersh and Sarah Ayres
• Shortsighted Education Cuts in New Ryan Budget a Giant Step Backward by Diana Epstein
• Ryan’s Secret Plan to Shift the Tax Burden Onto the Middle Class by Seth Hanlon
• If Ryan Gets His Way on Poverty by Joy Moses

SOURCE: AP/Haraz N. Ghanbari

President Barack Obama signs the payroll tax cut extension, Friday, Dec. 23, 2011. A small provision of the bill encourages states to adopt so-called “work-sharing” programs as part of their unemployment insurance systems.  

A little-noticed provision of the payroll tax cut extension signed into law by President Barack Obama in February encourages states to adopt so-called “work-sharing” programs as part of their unemployment insurance systems. Work sharing—or short-time compensation, as it is referred to in the bill—is a policy that provides an alternative to businesses facing the unwelcome prospect of having to lay off workers. Instead of laying off a single worker, a business instituting work sharing could, for example, reduce the hours of five employees by 20 percent while partially supplementing the workers’ lost wages with unemployment insurance money. The idea is to help businesses avoid layoffs during down times by giving them the option to spread the cut in hours among a larger group of employees.

The work-sharing policy included in the payroll tax cut extension bill echoes a proposal put forth by the Center for American Progress in 2009. In that report CAP proposed several steps that Congress should take to promote work sharing. We encouraged Congress to provide incentives for nationwide implementation of state programs and to instruct the U.S. Department of Labor to provide clearer regulations to states stipulating how those programs should be run. Both of these provisions were included in the new law, and prior iterations of this policy were also featured in President Obama’s American Jobs Act and championed in stand-alone bills by Sen. Jack Reed (D-RI) and Rep. Rosa DeLauro (D-CT).

As CAP’s proposal for work sharing points out, the program can provide tremendous economic benefits during a recession, as evidenced in other countries. Germany’s work-sharing program, for instance—known as Kurzarbeit—helped to keep total employment in Germany stable during the Great Recession, while employment in the United States during that same period dropped by almost 6 percent. Work sharing also makes sense from an investment perspective. Moody’s Analytics Chief Economist Mark Zandi estimates that a work-sharing program such as the one recently signed into law would generate an enormous return on investment—$1.69 for each dollar spent on benefits under the program. This is even higher than the multiplier Zandi estimates for unemployment insurance—$1.60 for each dollar spent. Additionally, work sharing has a number of benefits that make it easier for workers, families, and businesses to weather tough economic times.

Work sharing 101

Faced with less demand for their products during a recession, businesses oftentimes try to reduce costs by laying off workers. The result of this type of cost-cutting approach is to increase unemployment and further weaken the economy. Work sharing is a policy designed to combat that trend by allowing businesses to retain employees while still reducing costs. The way it works is simple: Instead of laying off a few workers, a company would reduce the hours of a larger number of employees. These employees would then be compensated partially for their lost income through unemployment insurance, while retaining the majority of their workload. Although the reimbursement to workers is generally not enough to completely make up for their lost pay, it usually provides about 50 percent of the pay they would receive for the hours cut. Under such a scenario, a worker who had his or her hours reduced by 20 percent would receive unemployment insurance equal to about 10 percent of his or her total wages, meaning the employee would earn about 90 percent of his or her normal pay while working about 80 percent of his or her normal hours.

Although some states had adopted work sharing prior to Congress passing the bill a few weeks ago, it was a fairly obscure program with only spotty implementation. As of 2011 only 20 states had modified their unemployment insurance programs to include work sharing as an option for employers. There were two primary obstacles that prevented more states from implementing the program. First, many states could not afford to pay for work sharing, as most states retained embarrassingly low unemployment insurance trust fund levels even prior to the recession. Second, confusion over work-sharing guidelines from the U.S. Department of Labor made many states wary of stepping into an administrative muddle. (see text box) The payroll tax cut bill, however, solves both of these problems by providing for federal financing of state work-sharing programs for up to three years and clarifying the state requirements under the program.

Work sharing supports workers, businesses, and the economy

If adopted by all of the states, work sharing will be highly beneficial for workers, employers, and the larger economy. For workers, the program will allow them to retain their jobs, avoiding the economic insecurity and social stigma that accompany unemployment. Affected workers will also retain access to their full medical and retirement benefits under the new provision, providing added security for them and their families. Furthermore, workers in short-time compensation arrangements will have the opportunity to maintain their work knowledge and skills, preventing a diminishing of skills that can result from lengthy unemployment and that may hamper future career prospects.

Employers likewise will see benefits from work sharing. First, employers will still be able to reduce costs when faced with decreased demand for their products and services through short-time compensation. Because workers will remain on the job and thus maintain their knowledge and skills, employers will also see dramatically reduced turnover and retraining costs compared to those of layoffs since they will not have to replace workers down the line. As the economy continues to improve, businesses will also be able to ramp up production much faster with workers who are already on payroll, eliminating or greatly lessening the need to hire new workers. Further, companies may also realize the benefit of work sharing in indirect ways such as increased employee loyalty.

But perhaps the greatest benefit of work sharing will occur in the larger economy. As the experience in Germany shows, work sharing can keep unemployment low even during a recession. Research shows that work sharing also boosts economic output by more than 1.5 times what it costs to operate such programs, leading to more economic growth and a faster recovery. Because of this, economists across the political spectrum—from Jared Bernstein, a former Obama administration adviser, to Kevin A. Hassett of the conservative-leaning American Enterprise Institute—all support work sharing.

Although it’s an ostensibly small policy change, this program has tremendous potential to further our economic recovery and mitigate the effects of future recessions. It is heartening to see that Congress and the president have embraced a commonsense, bipartisan reform that will help keep workers in their jobs, provide more security for middle-class families, and allow employers to respond more quickly to economic changes all at the same time.

Matt Separa is a Research Assistant with the Economic Policy team at the Center for American Progress.

SOURCE: AP/Jacquelyn Martin

House Budget Committee Chairman Rep. Paul Ryan (R-WI) holds up a copy of his budget plan, entitled "The Path to Prosperity," on March 20, 2012, during a news conference on Capitol Hill/

Download this column (pdf)

Read the column in your web browser (Scribd)

The latest House Republican budget plan asks low-income and middle-class Americans to shoulder the entire burden of deficit reduction while simultaneously delivering massive tax breaks to the richest 1 percent and preserving huge giveaways to Big Oil. It’s a recipe for repeating the mistakes of the Bush administration, during which middle-class incomes stagnated and only the privileged few enjoyed enormous gains.

Each component of the new House Republican budget threatens the middle class while doing nothing to add jobs or grow our economy. It ends the guarantee of decent insurance for senior citizens, breaking Medicare’s bedrock promise. It slashes investments in education, infrastructure, and basic research, all of which are key drivers of economic growth and mobility. And it cuts taxes for those at the top, asking the middle class to pick up the tab. It’s a budget designed to benefit the top 1 percent at everyone else’s expense.

The Republican leadership in the House of Representatives today unveiled their latest budget proposal. Though there are many questions yet to be answered, one thing is clear—they have learned nothing from the damaging budget battles of last year. This latest budget blueprint not only mirrors last year’s disastrous effort but also manages to reject what little bipartisan budget agreement was forged in 2011.

This year’s proposed House budget for fiscal year 2013 starting in October would once again end the Medicare guarantee, once again slash investments crucial to the middle class and to future economic growth, and once again cut taxes for the rich and protect taxpayer subsidies for oil companies. It once again ignores current economic challenges by offering no credible job-creation measures, and it once more places virtually the entire burden of debt reduction onto the shoulders of those least able to bear it.

On top of all that, the new plan, designed by House Budget Committee Chairman Paul Ryan (R-WI), proposes spending levels that are well below those that were agreed to by both Republicans and Democrats just eight months ago. And so once again this appears to be a budget specifically designed to cater to the richest 1 percent while poking everyone else—including the middle class and anyone who wants to see bipartisan agreement on the federal budget—right in the eye.

Here are the six most important failures of the new House budget plan. It would:

• Undermine the middle class
• Rig the system even more heavily in favor of the richest 1 percent
• End the Medicare guarantee and raise health care costs for seniors
• Undercut the economic recovery
• Deviate dramatically from a balanced approach to deficit reduction
• Renege on last year’s bipartisan budget agreement

Let’s look at each in turn.

Undermining the middle class

Nearly every important element of the new budget proposal from the Republican leadership in the House would weaken the middle class in America. First and foremost, the plan ends the Medicare guarantee of decent health insurance in retirement. It also slashes critical middle-class investments, such as education and infrastructure by 45 percent and 24 percent, respectively. It includes not a single new measure to help the nearly 13 million unemployed get back into a decent job. And on top of all that, the middle class would end up paying higher taxes as well.

Rigging the system even more heavily in favor of the richest 1 percent

But this budget plan isn’t content just to take from the poor and middle class—it also gives generously to the rich. It protects existing tax breaks for those at the top of the income spectrum, and then goes the next step and offers them huge new tax cuts. Rep. Ryan and his colleagues insist that the more than $3 trillion in tax cuts for the rich won’t result in lower revenue, but are deliberately vague about how the numbers could possibly add up. The reality is that the only way to pay for such huge tax cuts for the 1 percent is to make the 99 percent pick up the tab.

Ending the Medicare guarantee and raising health care costs for seniors

Their plan for Medicare is similar to their proposal from last year to end the program as we know it. This year’s plan, just like last year’s, calls for replacing the system we currently have with a capped voucher that seniors would use to purchase health care coverage on the private market. Unlike last year, however, the new plan claims to maintain traditional Medicare as an option that seniors could choose to purchase. This sounds a little better, but in reality their latest health care scheme for senior citizens would inevitably result in a “death spiral” for Medicare that means higher costs for seniors.

Undercutting the economic recovery

Though we’ve recently enjoyed several months of solid job growth, our current economic recovery is by no means assured, and we still have a long way to go to get back to full economic health. Not only does the House Republican budget plan fail to propose even a single new idea for spurring job creation, it would also force an immediate swerve into severe austerity. It’s an economic prescription that, as Europe is finding out, will make matters much worse.

Deviating dramatically from a balanced approach to deficit reduction

Rep. Ryan is fond of starring in videos in which he gravely lectures on the need to address our long-term fiscal challenges. He’s not wrong about that. We do need to address those challenges. And over the past 18 months, many a detailed plan have been put forth to do just that. Several of those plans have even garnered bipartisan support. What they have in common is a commitment to balanced deficit reduction—which includes both spending cuts and revenue increases—and realistic proposals with numbers that add up.

Rep. Ryan’s new plan doesn’t come close to fitting that bill. It’s definitely not balanced. Not only would he place the entire burden of deficit reduction on the middle class and the poor but also would actually give the rich additional tax breaks at the same time. And the numbers don’t even add up to real deficit reduction. The tax proposals alone would break the bank, and the spending cuts are unrealistic in the extreme. It’s no wonder that Rep. Ryan didn’t allow the Congressional Budget Office to evaluate the budget’s actual policy proposals.

Reneging on last year’s bipartisan budget agreement

The debt-limit debacle of last summer did have one positive outcome—after narrowly avoiding a government shutdown several different times in 2011 it cleared the way for a smooth budget process this year. The debt-limit deal, known as the Budget Control Act, included an agreement on overall “discretionary” spending levels—the money that Congress appropriates each year—for the coming fiscal year. The Budget Control Act passed both houses of Congress with wide bipartisan majorities and was signed into law by President Obama in August last year.

For his part, President Obama adhered to the enacted law when he presented his proposed budget for FY 2013 earlier this year. The new House Republican plan, however, completely reneges on it. It’s tough to see how a bipartisan deficit reduction agreement can ever be reached when even previously agreed-to bipartisan deals fall through.

Conclusion

There is no question that the United States today faces enormous economic challenges. We lost over 8 million jobs during the Great Recession, the middle class just suffered through a decade of stagnant or even declining incomes while those fortunate enough to be in richest 1 percent are collecting an increasingly large share of the national income. And of course, the federal budget is in need of a serious recalibration to put it on a more sustainable path.

For most of these problems, the House Republican budget offers no solutions at all. It has nothing to offer the middle class aside from more struggles and fewer protections. It completely ignores widening income inequality except to exacerbate it by delivering the rich more tax cuts. It wouldn’t even balance the budget for decades, and in the meantime, by brushing off a previously agreed-upon budget law, it signals an utter rejection of the very concept of compromise.

In short, today was not a good day for American economic progress.

Michael Linden is Director of Tax and Budget Policy at the Center for American Progress.

Download this column (pdf)

Read the column in your web browser (Scribd)

See also:

• New Ryan Plan Is Austerity on Steroids by Heather Boushey
• Latest House Republican Budget Threatens Medicare and Shreds the Safety Net by Topher Spiro
• New Ryan Plan Would Harm Our Most Vulnerable Citizens by Melissa Boteach (CAP Action)