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How Lawmakers Should Think About Tax Reform

Tax reform should make the tax code fairer and simpler for the middle class and raise revenue for investments in future economic growth.

Senate Finance Committee Chairman Sen. Max Baucus (D-MT), left, and Ranking Member Sen. Orrin Hatch (R-UT), right, open a hearing on Capitol Hill in Washington, May 12, 2011. Congress has an opportunity to strengthen the middle class and encourage economic growth through tax reform. (AP/J. Scott Applewhite)
Senate Finance Committee Chairman Sen. Max Baucus (D-MT), left, and Ranking Member Sen. Orrin Hatch (R-UT), right, open a hearing on Capitol Hill in Washington, May 12, 2011. Congress has an opportunity to strengthen the middle class and encourage economic growth through tax reform. (AP/J. Scott Applewhite)

How can tax policy strengthen the middle class?

This is the key question that policymakers should be asking themselves as they think about tax reform. Middle-class families are struggling as their incomes stagnate or fall and the costs of housing, education, and health care rise. A weak middle class holds back economic growth and undermines our democracy.

Tax policy can and should play a critical role in rebuilding the middle class.

Unfortunately, for most of the past three decades, Congress has designed tax policy to benefit the top 1 percent of Americans under the “trickle-down” theory—that these so-called job creators will expand the economy for everyone. In fact, these supply-side tax policies have been clear failures; the economy works best when it grows from the middle out.

Today, if Congress wants to improve the tax code, it should follow these three simple, middle-class-focused principles:

  • Make the code fairer for the middle class. Real, comprehensive tax reform should redress ballooning inequality, reform or eliminate tax expenditures that mostly benefit the wealthy, convert “upside-down” tax breaks to uniform credits with the same value to all taxpayers, and increase revenues from the corporate tax.
  • Make the code simpler for the middle class. Real, comprehensive tax reform should make the code simpler for the middle class and make tax-credit compliance easier for working families. A regressive flattening of the rate structure is not simplification; the real drivers of complexity are preferential rates and exotic loopholes.
  • Ensure that the code generates enough revenue to protect and invest in the middle class. Any tax bill should raise at least as much revenue as the Senate Budget Resolution requires as a prerequisite to tax reform. But real, comprehensive tax reform should raise substantially more.

Tax reform should make the code fairer for the middle class

Tax reform should make the code more progressive, not be distributionally neutral. Over the past 30 years, as income growth for the middle class has stagnated and the very richest Americans have seen their share of national income grow at a tremendous rate, the tax code has actually become less progressive, doing less to redress inequality than it did a generation ago. Between the early 1990s and the financial collapse in 2007, households in the top 1 percent more than doubled their incomes while their effective federal tax rate actually dropped by one-seventh.

Senate Finance Committee Chairman Max Baucus (D-MT) and Ranking Member Orrin Hatch (R-UT), among others, have argued that any tax reform should be distributionally neutral. What they mean, broadly, is that tax reform will not change how progressive the tax code is: The reformed tax code will do no more and no less to ameliorate income inequality than it does now. This is much better than proposals such as Rep. Paul Ryan’s (R-WI) budget, which would make the code much less progressive by slashing middle-class tax breaks to pay for lower rates that primarily benefit the wealthy, and Sens. Baucus and Hatch’s plan makes clear that they intend to protect low-income and middle-class families. But tax reform is a perfect opportunity to make the code more progressive.

Even more egregiously, as of last year, one in four households making more than $1 million per year paid a lower federal tax rate than middle-class families. In 2011 an estimated 7,000 millionaires paid nothing at all in federal income taxes.

The American Taxpayer Relief Act of 2012, or the so-called fiscal cliff deal, allowed a portion of the Bush-era tax cuts to expire for the very wealthiest Americans—those making more than $400,000 per year. But with top incomes continuing to grow at a tremendous rate, it is unlikely these modest changes will do much to significantly alter the underlying trends.

Given that the top marginal income tax rate is 39.6 percent—still substantially lower than the top rate in the United States in the early 1980s or in other rich countries now—how is it that so many wealthy people avoid paying their fair share?

First, the individual income tax code is riddled with exemptions, deductions, special preferences, and loopholes that disproportionately or even exclusively benefit high-income taxpayers. The most expensive of these high-income tax breaks is the preferential treatment of income from investments. Under the current code, long-term capital gains and qualified dividends are taxed at a maximum rate of 23.8 percent, well below the top statutory rate of 39.6 percent on labor income. Ninety-six percent of the benefit from these special low rates on capital gains and dividends goes to households in the top 20 percent of income earners, with nearly three-quarters going to the top 1 percent.

Second, even supposedly middle-class tax breaks, such as the home mortgage interest deduction or tax-preferred retirement savings, are actually skewed to the wealthy by their structure: Exemptions and deductions are worth more to taxpayers who are in higher tax brackets. A wealthy taxpayer in the highest tax bracket—39.6 percent—with a $10,000 itemized deduction, such as one for mortgage interest, for example, receives $3,960 in tax savings from the deduction. For a taxpayer in the 15 percent bracket, however, that same deduction is worth only $1,500 in tax savings.

This so-called upside-down effect is not only unfair but it is 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 least likely to need an incentive. Any comprehensive tax reform should fix this problem. The best approach is to convert deductions and exemptions into uniform credits with the same value to all taxpayers, as the Center for American Progress has proposed. The president’s proposal to limit deductions and exemptions for high-income taxpayers to the value that a middle-class taxpayer in the 28 percent bracket receives would partially address the upside-down effect and raise substantial revenue.

Third, while the corporate income tax is extremely progressive, it has fallen as a share of federal revenues. Corporate profits are at a 60-year high but corporate taxes are at a 60-year low. While the statutory corporate tax rate is 35 percent, the average rate that large profitable corporations actually pay is only 12.6 percent. The corporate income tax is in need of reform, and this reform should raise substantial revenue—not reward companies for hiding money in foreign subsidiaries or permanently exempt corporations from contributing to our national needs.

Tax reform should make the code simpler for the middle class

A core goal of comprehensive tax reform is to make the tax code simpler. The proliferation of special deductions, exclusions, and tax breaks for particular activities makes tax time difficult, adding extra calculations and burdensome documentation requirements. But even more than that, it encourages individuals and businesses to spend time and resources playing complicated games to gain tax advantages.

This enormous complexity typically benefits high-income individuals who have the most to gain from these efforts and can afford to hire lawyers and accountants to craft their tax-avoidance strategies. It also engenders a deep mistrust of the tax system. Middle-class families rightfully worry that hidden tax breaks to which they do not have access are allowing others to get away with not paying their fair share.

Fairness and simplicity should go hand in hand. Some of the tax expenditures that most radically increase the need for regulation, tax planning, and litigation are the very same tax breaks that allow the wealthy to pay extremely low rates. One tax expert, for example, has estimated that fully one-third of the Internal Revenue Code and the accompanying regulations would be unnecessary if income from labor and capital were taxed at the same rate, as they were after the 1986 tax reform. Furthermore, some of the provisions in the current code that create additional complexity—such as the Alternative Minimum Tax—would be unnecessary if the underlying tax code were redesigned to be both simpler and more fair.

This does not mean that every tax expenditure is inherently too complicated or unfair and should be abolished. There are some provisions, such as the Earned Income Tax Credit and the Child Tax Credit, that make up for their added complexity by being well targeted at the middle class and low-income households. And there are others that serve reasonable policy goals such as encouraging saving for retirement and making higher education more affordable.

But even the tax programs that are beneficial and fair could still be simplified to make filing easier and less complicated. The Child Tax Credit, Earned Income Tax Credit, and the Head of Household filing status, for example, currently have different definitions for a child, with different requirements for both qualified ages and levels of support. Creating a uniform definition would make tax filing much simpler for many low- and middle-income families. And there is no reason why Congress cannot consolidate the myriad tax breaks that incentivize saving.

Simplification is not achieved, however, by reducing the number of tax brackets, as some lawmakers have incorrectly suggested. The number of tax rates has nothing to do with the complexity of the tax code. Whether we have 1 rate or 1,000 rates, calculating your tax liability from your taxable income is still only one simple step—and this holds true whether you are calculating by hand or letting software calculate it for you. In addition, reducing the number of tax rates makes it harder to maintain progressivity. Congress should be very wary of regressive tax policies masquerading as simplification.

Tax reform should raise sufficient revenue to protect and invest in the middle class

Why has the richest country in the world spent the past three years cutting essential services to the bone? Because we have been trying to match our spending to levels of revenue that are completely inadequate in a 21st century industrialized economy.

The federal government has many important roles to play in protecting and investing in the middle class, from ensuring that middle-class families can have a dignified retirement to supporting a world-class public education system to building and maintaining the basic infrastructure networks on which every American relies. If the federal government does not have sufficient revenue to pay for these investments and protections, the middle class ends up paying the price.

Unfortunately, the lack of sufficient revenue is already leading to cutbacks in foundational middle-class investments. After a decade of unaffordable tax cuts, we are now being told that we do not have enough money to pay for the very programs our country needs to grow and thrive. We do not have the money because of low taxes, not because we cannot afford these investments.

Over the past three years, lawmakers have enacted cut after cut to crucial middle-class programs. First, lawmakers drove planned spending on domestic investments to historic lows through the discretionary spending caps in the 2011 Budget Control Act, or BCA. Then they allowed the misguided, damaging across-the-board cuts known as sequestration to take effect.

Between the BCA and sequestration, not only are we slashing investments in future growth, but we are also holding back the recovery and causing human suffering—turning domestic violence victims away from shelters, cutting Meals on Wheels services for the elderly, reducing access to cancer treatments, increasing homelessness, causing furloughs and layoffs across the country, and even reducing our ability to predict and respond to future natural disasters.

The Senate has already agreed to a budget resolution that calls for a revenue level that makes room for full repeal of sequestration and $100 billion in immediate job creation. Revenues at least as high as the Senate Budget Resolution levels should be adopted as a prerequisite to any tax reform deal. But policymakers should push for more.

The first job of any tax code is to raise the revenue necessary to fund needed public services, investments, and protections. Instead, we have spent years cutting taxes for the rich and waiting for prosperity to trickle down. Now that the economy is in crisis, we are being told that there is not enough revenue to go around. If we do not fix this fundamental problem, Social Security, Medicare, and Medicaid will be next on the chopping block.

Real tax reform must address our nation’s pressing revenue needs and growing inequality and reduce opportunities for wealthy individuals and corporations to avoid paying their fair share. We must not ignore the fundamental problems with the current tax code. Our lawmakers have an opportunity to boost growth and strengthen the middle class through real, comprehensive tax reform. They should not waste it.

Kitty Richards is the Associate Director of Tax Policy at the Center for American Progress. Michael Linden is the Managing Director for Economic Policy at the Center.

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Kitty Richards

Associate Director, Tax Policy

Michael Linden

Managing Director, Economic Policy