Common Sense: Tax Reform for the Rich: Reduce the Rates but Lose the Breaks


When the Trump administration unveils new details of its tax plan, promised for next week, one group of taxpayers will be under the microscope: the rich.

That’s because they take advantage of so many tax breaks that few, if any, pay the top rate of 39.6 percent. Eliminating at least some of those breaks would make it possible to reduce tax rates for the highest earners (and everyone else) while raising the same or even more in total revenue.

Doing so would reduce rates while broadening the base, and simplify the tax code while making it fairer — goals that nearly all economists from across the political spectrum say they support.

The administration, too, seems to have embraced such an approach. “The rich will not be gaining at all,” President Trump said last week.

So who are the rich?

Based on comprehensive data now available from the Internal Revenue Service, it’s possible to pinpoint who pays what based on their percentile of adjusted gross income. The top 1 percent seems a fair representation of the rich. This group — about 1.4 million taxpayers — reported adjusted gross incomes of over $466,000 in 2014, the most recent year for which the data is available.

The top 1 percent paid a total of $542.6 billion in federal tax, or an astounding 39.5 percent of the total income tax. If you want to take a more expansive view of rich, the top 10 percent (who earn upward of $133,000) pay 71 percent of the total tax.

Do they pay the top rate? Not by a long shot. The average rate for the top 1 percent is 27 percent of their adjusted gross income. (It’s even lower — 24 percent — for the superrich in the 0.001 percent bracket.) The top 10 percent pay an average of 21 percent.

That’s why tax reform is all about them. They take most of the itemized deductions and have a disproportionate share of capital gains and dividends, which are taxed at a much lower rate than salaries and wages.

Reform means ending those tax breaks, a move that always draws protests and intense lobbying from those who have benefited from them.

Getting rid of them all would enable a huge reduction in overall rates and would have the advantage of penalizing just about everyone in the upper income brackets (not to mention radically simplifying the tax code). The nonpartisan Congressional Budget Office estimated that the 10 largest tax expenditures (its term for what most people consider tax breaks) would amount to $12 trillion, or 5.4 percent of gross domestic product, over the decade from 2014 to 2023.

While such breaks may yield benefits, the budget office warned that they also “may lead to an inefficient allocation of economic resources by encouraging more consumption of goods and services receiving preferential treatment” and “may subsidize activity that would have taken place without the tax incentives.”

The report specifically cited the home-mortgage deduction as encouraging taxpayers to “purchase more expensive homes, investing too much in housing and too little elsewhere relative to what they would do if all investments were treated equally.”

But it’s mostly hard-core libertarians and free market purists who want to get rid of all tax breaks for the rich. The political reality is that some of these “expenditures” are off the table. The charitable deduction has proved untouchable for decades. The top 1 percent gave $77 billion in 2014, 37 percent of total charitable contribution deductions. Perhaps it’s not so bad for the rich to pay a lower marginal rate, if it’s because they give away so much.

So what’s left?

LONG-TERM CAPITAL GAINS The biggest revenue target is the preferential rate for long-term capital gains, which raises a perennial question: Why should capital income be taxed at a much lower rate than ordinary income? Capital assets are owned overwhelmingly by the rich. The top 1 percent reported $561 billion in capital gains taxed at the preferential rate, or 68 percent of the total. As a simple matter of math, the rich will never pay anything close to the top statutory rate as long so much of their income is taxed at a much lower rate (currently 20 percent for the top bracket, not counting the Affordable Care Act surcharge of 3.8 percent).

The Congressional Budget Office estimates that the preferential capital-gains rate will cost the Treasury $1.34 trillion from 2014 to 2023.

“We’re taxing the rich much too lightly because we tax capital so much less than labor,” said Steven M. Rosenthal, a senior fellow at the Tax Policy Center.

Mr. Rosenthal favors taxing capital gains at the same rate as regular income — the approach adopted in the Tax Reform Act of 1986 during the Reagan administration and one supported by many economists. That would eliminate a host of tax shelters that capitalize on the differential, including special treatment for carried interest, a form of income for many wealthy hedge fund and private equity managers.

This path would require Republicans to set aside a long-held belief that lower capital-gains rates promote more economic growth and investment. But that doesn’t mean capital-gains rates have to be lower than rates for ordinary income. “There’s no support for the idea that not taxing capital unleashes economic growth,” Mr. Rosenthal said. He noted that after the 1986 tax reforms, “the economy did great.”

If Republicans are correct that lower rates spur economic growth, then lower rates on all income — made possible in part by raising capital-gains rates — should bolster economic growth across the economy.

CAPITAL GAINS AT DEATH Another big break for the rich is that capital gains go untaxed at death. Why should that be the case? Republicans could probably exempt family farms and family-owned businesses from the estate tax — or even eliminate it — if the government simply taxed other capital gains (like appreciated stock) transferred at death. The Congressional Budget Office estimates that the exclusion will cost the Treasury $644 billion from 2014 to 2023.

That would also address the probability that raising rates on long-term capital gains would encourage investors to defer selling assets, thus postponing or escaping the tax. While higher capital-gains rates might encourage holding assets longer (which some economists consider a good thing), eliminating the special treatment at the investor’s death would ensure that the gains were eventually taxed.

And given that the Trump administration’s proposed 15 percent corporate tax rate is in many ways a windfall to shareholders, it seems only fair to tax their capital gains at higher rates.

“You can’t really broaden the base without addressing capital gains,” said Frank Clemente, executive director of the liberal-leaning Americans for Tax Fairness He, too, favors taxing capital gains at death.

STATE AND LOCAL TAXES Next largest of the major tax breaks is the deduction for state and local taxes, which the Congressional Budget Office estimates will cost the government nearly $1.1 trillion over 10 years. The deduction is on the chopping block under virtually all Republican proposals. It obviously hits high-tax states the hardest, which tend to be Democratic strongholds like New York and California.

Many economists agree, including N. Gregory Mankiw of Harvard, who told me this week that he favored eliminating the deduction.

That deduction, too, overwhelmingly benefits the rich. Most middle-class and low-income taxpayers don’t itemize deductions, even in high-tax states, so they get no benefit. The top 1 percent accounts for 27 percent of the total taxes-paid deduction.

Democrats, many representing high-tax states, have said eliminating the deduction is out of the question in any tax negotiations. One compromise that might attract at least some Democratic support would be to retain the deduction, but only for taxpayers with incomes below a certain level.

MORTGAGE INTEREST Like the charitable deduction, the mortgage-interest deduction has long survived reform attempts. But unlike breaks that encourage giving, it’s hard to defend tax incentives that enable the rich to buy ever-more-expensive houses and apartments (with sale prices now pushing above $100 million in a few markets) when middle- and lower-income taxpayers are being priced out of many cities.

As with state and local taxes, most middle- and lower-income taxpayers don’t itemize, so they don’t benefit from the mortgage deduction. The Congressional Budget Office estimates that the mortgage deduction will cost the Treasury about $1 trillion, slightly less than the state and local tax deduction, over a decade. But it’s not as skewed as heavily toward the top 1 percent — they account for under 10 percent of the total interest-paid deduction. That may be because many of the rich don’t need to borrow to buy a house (or houses).

As with state and local taxes, one approach would be to eliminate the deduction only for high-income taxpayers. The Tax Foundation has offered a proposal to lower the cap on mortgage deductions to $500,000 from $1 million, which it says would raise about $300 billion over the next decade, primarily from high-income taxpayers.

A study by the foundation also found that the mortgage deduction had disproportionately favored taxpayers in states with high real-estate costs, which also tend to be blue states like New York and California.

“The mortgage deduction is supposed to make homes more affordable, but do people with mortgages over $500,000 really need that?” asked Kyle Pomerleau, director of federal projects at the Tax Foundation and the author of the study.

There are plenty of egregious smaller loopholes that should be eliminated, like the provision that lets real-estate developers (but not the rest of us) deduct passive losses against ordinary income. But these are the big four, based on Congressional Budget Office estimates. In total, they will cost the government $4.1 trillion over 10 years.

(This doesn’t guarantee that the government would actually raise that much if the tax breaks were eliminated, because the estimates don’t account for the way taxpayers would change their behavior, such as by deferring capital gains.)

Conversely, if proposed reforms don’t address the biggest tax breaks, there will be little room to reduce rates over all — which is the carrot to make reform more palatable. “If all you do is eliminate the state and local tax deduction, there’s not much room to maneuver,” Mr. Pomerleau said.



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