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.