There are two main reasons to levy a tax. The first is to try and reduce the occurrence of an activity or a type of behavior. Excise taxes on cigarettes are an example. The second reason for a tax is to raise money to fund spending priorities at levels that markets would not provide.

In the early 1930s, the market had spoken in terms of retirement income. More than half of the elderly persons in the nation lived in poverty in the aftermath of the Great Depression. Likewise, in the 1960s the market had spoken in terms of health insurance for elderly persons, as around half of them were uninsured.

The creation of Social Security and Medicare were explicit statements that what the market was providing for Seniors in the way of retirement, and health care was socially unacceptable. So, taxes were levied and these programs were designed to provide retirement income and health insurance for older persons. And in doing so, income was redistributed. That is what government spending does; it redistributes income. People who would have lived below the poverty line did not, and a great deal of health care was financed for the elderly that they otherwise would not have received. Lifespan has increased and disability from many conditions has declined.

In the case of Social Security, payroll taxes are the means of financing the program (6.20% of payroll paid by employer and employee from the first dollar up to $106,800 in wages, currently). Medicare is financed by payroll taxes (Part A, hospital insurance is financed by 1.45% of wages paid by employer and employee, applied to all wages) while income taxes and individually paid premiums fund the Part B doctors insurance portion of the program.

Other federal spending is financed primarily by income taxes, both individual and corporate.

Mix of Federal Taxes Over Time

The mixture of taxes employed by the federal government to raise revenue has changed substantially over the last 75 years. The amount of federal tax revenue collected by excise taxes and corporate income taxes has declined, while revenue from personal income and payroll taxes has risen.

In 1935, when Social Security was passed into law, excise taxes on items as diverse as steel, tobacco, and alcohol accounted for four in ten dollars collected by the federal government; in 2010 they accounted for just two in 100 dollars of federal tax revenue. Income tax receipts represented 15% of total federal tax dollars in 1935, but from 1945 until current day have accounted for between 40 and 50% of all federal tax receipts, and remain the largest source of revenue for the federal government today. Payroll taxes for Social Security and Medicare have risen from 1% of total receipts immediately after the passage of Social Security in 1935, to 40% of federal receipts in 2010, 46 years after the passage of Medicare. The share of federal tax revenue collected by corporate income taxes has plummeted from 35% in 1945 to 7.2% in 2010, and has not been above 10% of total federal tax receipts for the past 30 decades.

Key Goals of Tax Code

If we are going to ever have a balanced budget at any level of spending that is remotely realistic, then tax receipts will have to rise over current levels. I have set 21% of GDP as the amount of federal tax revenue at which to seek a long-range balanced budget. All taxes change people’s behavior in some way, so getting the optimal tax rate for economic growth while raising the revenue necessary to pay for the agreed upon level of spending is not simple.

Reform of the tax code means determining the best mix of taxes to raise the revenue needed to fund the spending we say we want. Personal income and payroll taxes account for around eight in ten dollars collected annually by the federal government, and I approach tax reform assuming this will remain the case. The following four principles guide my thinking on tax reform. First, the tax code must collect enough money to pay for the spending we want in the long run. Second, the tax code must be viewed as fair and legitimate by most people. Third, it should be straightforward and understandable so that the incentives inherent in whatever tax code is adopted are clear. Fourth, it should incentivize economic growth in our economy, and the creation of jobs.

The hardest of these four is actually the first: committing to have a tax code that raises enough money to cover the spending we say we want. This is a choice. If you want more spending, it will take more taxes. If you want lower taxes, we will have to cut spending. Most people essentially want low taxes and high spending, but that is how we have managed to have a long-term fiscal imbalance that must be addressed.

We have to develop a tax system that is viewed as fair, and that people can understand. During a recent conference I attended, a presenter said the following: “half of all Americans don’t pay taxes.” He meant that half of all Americans don’t pay federal income taxes, which is true, and is a testament to the fact that personal income tax rates have fallen drastically in the past 30 years, and are among the lowest in the world. But, that is not what he said.

The phrase half of all Americans don’t pay taxes is of course false: payroll taxes for Social Security and Medicare are applied to the first dollar of wages, and anyone who buys something pays a sales tax. However, the sentiment behind the statement and the nods of people in the audience signaled their gut that they are paying the way for others in a manner that is unfair.

This was a group of relatively high income professionals. After my presentation, several approached me to say their tax burden was unfair and we needed to reduce spending and cut taxes. I asked if they wanted to end tax code provisions like the tax deductibility of mortgage interest and receiving tax free income via employer paid insurance, tax expenditures that disproportionately help upper income citizens like themselves. Several told me that I was making this up—government spending only helps poor people! Others said that aspects of the tax code that benefit some taxpayers but not others weren’t spending programs, or didn’t provide them with a subsidy. Others acknowledged the existence of these large tax expenditures but said that they deserved them because they worked hard.

An important part of developing a fair tax system is for everyone to understand it, particularly, how tax expenditures work and serve to increase the budget deficit in the same manner that explicit government spending does. The simpler the tax code the better so far as the clarity of incentives concerned.

Finally, a robust and growing economy is key if we are going to have a balanced budget, so any changes in the current tax code need to incentivize economic growth and job creation. This is especially important given the current weak state of our economy.

Fiscal Commission Tax Reform

The Fiscal Commission provides a detailed plan for comprehensive tax reform and is a general approach that I support. Their goal is to develop a tax code that could generate 21% of GDP, the point at which balance is to be achieved by 2035 when spending should decline to that level. Because there has already been some political buy-in by members of both parties voting for the Fiscal Commission proposals, this makes their recommendations a good place to start. I will focus my comments on income taxes, both personal and corporate since I have addressed payroll taxes in the health care and Social Security chapters (7 and 8), and I propose no changes other than those already noted.

Income Tax Rates

The current federal income tax has six rate bands:

  • 10%

  • 15%

  • 25%

  • 28%

  • 33%

  • 35%

Our tax code is progressive, which simply means that higher marginal tax rates apply to income above certain threshold amounts. Someone with an income of $50,000 would pay more on his or her last $5,000 of income than they would for his or her first $5,000. For example, the first $8,500 of income for all taxpayers is subjected to a tax rate of 10%. Bill Gates pays 10% of his first $8,500 of taxable income just like a person with an income of $50,000 would pay 10% of his or her first $8,500 in income (note that aspects of the tax code such as the Earned Income Tax Credit mean that approximately half of all households owe no income tax). Income between $8,500 and $34,500 is subjected to a tax rate of 15% and so on. The top marginal tax bracket of 35% is applied to all income above $379,150.

The Fiscal Commission proposed replacing these six marginal tax brackets with just three brackets; the rates in the three brackets would depend upon other decisions that must be made about tax expenditures, or policies that provide subsidy to certain situations or types of activity, like the Earned Income Tax Credit, or the home mortgage deduction. The Commission proposal very usefully demonstrates the relationship between the number of tax brackets, the marginal tax rate in each bracket, and the number of tax expenditures maintained in the tax code. For example, if all tax expenditures were ended, then the three tax rates proposed by the Commission are:

  • 8%

  • 14%

  • 23%

If only two tax expenditures that are designed to aid lower income persons and families were maintained (earned income tax credit and child tax credit), then the three rates would be:

  • 9%

  • 15%

  • 24%

As you add tax expenditures, the tax rate must go up just as it would have to if you add direct spending, if your goal is to generate the same amount of revenue and maintain progress toward increasing tax receipts and achieving a balanced budget by 2035.

The Fiscal Commission put forth a list of tax expenditures that might be retained such as the tax deductibility of mortgage interest on a first home, the Earned Income Tax Credit, Child tax credit, deductions for charitable giving. If this were the policy, then the three marginal income tax rates would be:

  • 12%

  • 22%

  • 28%

These are the three suggested rates under the assumption that while most tax expenditures could be expected to be ended or reduced, we would be unlikely to end all such provisions of the tax code.

Another key aspect of the Fiscal Commission report recommendation is to treat dividends and capital gains as normal income and do away with a separate rates and rules for such income received from business investments or the sale of stock. The recommendations of the Fiscal Commission are premised on the idea of lowering the marginal tax rate and broadening the base of income that is taxable by limiting deductions, credits and exclusions. They note a possible modification of this proposal, which would be to exempt the first 20% of capital gains or dividends in an effort to encourage business investment. If this policy were chosen, then they proposed offsetting the lost revenue by raising the top (28% above) marginal tax rate.

The recommendation of making capital gains and dividends taxable as normal income is a good one, in conjunction with a broadening of the tax base, simplifying the tax code and dropping the marginal tax rates.

End the Corporate Income Tax

The Fiscal Commission suggests lowering the corporate tax rate to 28% from 35% in conjunction with reduction of loopholes, deductions, and exemptions to provide incentive for business to invest in the United States and create jobs. However, I believe that Progressives should propose ending the corporate income tax in order to provide the maximum possible long-run incentive for companies to create jobs in the United States and to do business here. In conjunction with ending the corporate income tax, the following modifications would be needed:

  • Capital gains and dividends should be taxable as normal income

  • Increase the top marginal tax rate above the 28% noted above

  • Enact a federal estate tax of 45% on amounts above $3.5 million

While US personal income tax rates are quite low by international standards (only Japan and Ireland have lower personal income tax rates), the stated corporate tax rate is quite high by comparison. There is a worry that this provides a disincentive to doing business in the United States and causes large corporations to move business to other nations. However, the effective tax rate paid by corporations differs wildly and very few pay anywhere near the stated rate of 35% of income due to exemptions, deductions, loopholes, and exceptions granted to particular ­businesses or industries. Public utilities are the only group of corporations that consistently pay anywhere near 35% of their income.

At the other end of the spectrum, General Electric infamously paid no corporate income tax in 2010 even though it earned $14.2 billion in profits. Some say that this was due to income being reported in overseas holding companies, while General Electric says that it was due to losses in the financial sector; so the facts leading to their paying of no corporate taxes are in dispute, and my brief research into the matter doesn’t make clear what interpretation is correct. That is actually the most important thing to know about General Electric’s (lack of) tax liability—it is confusing, hard to understand, but obviously legal given how high profile their lack of paying corporate income tax has been.

Ending the corporate income tax is obviously not a typical Progressive policy suggestion, and many Progressives will likely be thinking the opposite is true: we must figure out a way to extract more tax revenue from corporations. There are several reasons why I believe that it is a good idea to move in the opposite direction.

First, there is no greater Progressive priority than encouraging job creation and growth. What our country most needs now are good jobs, and ending the corporate income tax should directly stimulate job creation by making available more funds for businesses to use for investments, and provide long-range certainty about the fact that the United States is a good place to do business. While the rhetoric around job creation typically centers on small businesses, large corporations are the source of most jobs. In theory, the end of the corporate income tax should spur a great deal of investment and job creation. If it did, that would be great news for the country and the general fiscal situation (increased income taxes, increased payroll taxes, less unemployment benefits, reduction in Medicaid eligibility). A hiring and job creation boom would be the most important Progressive policy outcome that could come to pass.

Second, corporate income taxes are a relatively small portion of the total federal tax revenue collected, just 7.2% of total federal receipts in 2010, and from 10 to 13% of total receipts over the past 15 years. The revenue would have to be replaced by other sources and I suggest a higher personal income tax rate in the top bracket, perhaps from 28 to 30%, with the full value of dividends and capital gains being taxable as normal income as noted.

Third, part of the reason that the proportion of federal receipts that flow from corporate taxes is so low is that most corporations pay an effective tax rate that is much lower than the stated marginal rate of 35%. The only corporations who seem to pay anything near the full rate are public utilities. Other industries such as those in high tech industries pay very little in corporate income taxes, and there was the General Electric case already noted. There is a sense in which corporations cannot effectively be taxed due to their ability to lobby, and to move income and business around the globe. Lobbying for changes (deductions, exemptions, credits) in the corporate tax code may have a spillover effect in making the personal income tax code less efficient. It is simpler and more realistic to simply end the corporate income tax than it is to fight this battle, especially given the potential for this change to incentivize job creation.

Fourth, the huge differential in effective corporate tax rates makes any sort of tax reform very difficult because many industries have a great deal to lose, and they presumably have gotten their current very low effective tax rate due to their political clout. If there is a reduction in loopholes and deductions for corporations and a lowering of the rate to 28% from 35% as the Fiscal Commission proposes, this will likely represent an effective corporate tax increase for some (many?) industries. They can be expected to fight this vigorously. So, the only type of corporate tax reform that may be politically plausible is the ending of the tax altogether.

Finally, from a political standpoint, ending the corporate income tax would remove a powerful rhetorical device from Conservatives about the role of the tax code and job creation. A common narrative for Conservatives is that the reason the economy is not producing jobs is that taxes on businesses are too high. If the corporate income tax is put to zero, then it can hardly be claimed to be too high. I believe that there is likely to be both a real as well as a qualitative effect to eliminating the corporate income tax. Politically, this will rid Conservatives of an incessant arguing point that taxes are too high and that Progressives do not support business. If corporate tax rates are simply lowered, even to 1%, then Conservatives and the corporations themselves will still say they are still too high.

It is true that many corporations have a great deal of cash on hand currently, and that has not led to massive job creation, but instead a tepid job growth even as corporations have made a great deal of money. This is worrying, but ending the corporate income tax and increasing the highest rate of the personal income tax seem to be both a more predictable source of raising federal revenue as well as providing the maximum long-range incentive for corporations to do business in our nation and produce jobs.

Another key point is that a reduction of the corporate income tax rate to 0% would have to be done in concert with a comprehensive reform of the personal income tax code to be a viable option. Particularly important would be clarification of what constitutes a corporation? The logic of ending the corporate income tax only makes sense if dividends and capital gains are taxed as normal income, and further that loopholes do not allow individuals to become corporations and somehow access money in a way other than a salary, capital gain, or dividend. There are numerous details that would have to be gotten straight to make this a viable policy.

I am unsure of what the top marginal income tax rate would need to be in order to offset the ending of the corporate income tax and reinstating a federal inheritance tax as noted. The setting of this rate would require forecasting beyond my capabilities, but given that the corporate income tax has produced no more than 10% of federal revenue for the past 30 years, the top marginal rate should still be lower than it is currently (35%).

Inheritance Tax

Some reasonable inheritance tax should also be reinstated. The Fiscal Commission suggested using the 2009 federal inheritance tax structure that exempted the first $3.5 million in assets from the tax, with amounts above this having a tax of 45% applied to amounts above this, with a common sense updating for inflation. This seems a reasonable way forward.

Other Tax Changes I Have Proposed

As noted in Chap. 8, I favor lifting the wage cap to which the OASDI payroll tax applies, and recalibrating it to the 90th percentile. I think that the pace at which the Fiscal Commission calls for the phase in of this increase (fully linked to the 90th percentile by 2050) is too slow. I would favor moving more quickly to increase this payroll tax and essentially reestablishing the 1983 political deal for Social Security that has simply eroded due to the fact that wages in the top 10% of earners have risen much faster than have average wages.

I suggest the creation of a health care cost inflation payroll tax that would be triggered if long-term federal health care growth rates are not held to GDP growth plus 1 percentage point, and efforts by Congress to slow them do not work, or are not tried. This tax would be paid by employees only who were in the top half of the wage earners; I suggest 0.5% of payroll from the median wage on up, paid by workers only. I believe such a tax is needed because of the evidence that Americans have a far more difficult time making tradeoffs in the realm of health care as compared to other spheres. As noted in the previous chapter, study participants who were provided with accurate budget information did a fairly good job reducing the deficit that results from the discretionary portion of the budget as well as with Social Security. When it came to health care, however, they had a far more difficult time with Medicare. Further, the gestalt of the health care chapters (3–7) shows that there seems to be a persistent cultural inability to deal with limits in medicine and to practically address health care cost inflation and adopt methods to address the same.

This tax acknowledges that on the road to a sustainable health care system, we may decide that we really don’t want to cut health care spending as much as we claim to want in the abstract. If so, the tax also provides us with a straightforward manner of paying for this decision.