What would fundamental changes in the federal tax code mean for state and local governments? Would it limit their ability to raise or borrow money? Would it make their revenue systems more or less progressive or even work more smoothly?
Last Friday, I participated in a joint Tax Policy Center and UCLA Law School conference sponsored by the MacArthur Foundation on what federal reform would mean to governments beyond the Beltway. And the short answer is: A lot.
Some change might be good, while other reforms might be quite disruptive. The bottom line seems to be that Congress could go a long way towards fixing the federal system without destroying state revenue codes—but only if reform is done carefully.
Take, for example, the federal deduction for state and local taxes, which reduces federal revenues by more than $70 billion annually. Policymakers have been talking about repealing it at least since the Reagan Administration.
Since most low- and moderate-income taxpayers don’t itemize, the deduction does them no good at all. Even many middle- and upper-middle class households who do itemize lose the benefit of the deduction if they fall into the dreaded Alternative Minimum Tax.
Still, the system encourages states to rely on deductible levies such as income and sales taxes. The good news is that state income taxes can be progressive (though many are not). The bad news is income and sales tax revenues are sensitive to changes in the economy and their decline is one reason states are in deep fiscal trouble today.
What would happen if Congress got rid of the deduction? To start, while upper-income households would owe more, it wouldn’t matter to the 70 percent of households that don’t benefit now. According to UCLA law vice-dean Kirk Stark and my TPC colleague Kim Rueben, while taxpayers in all states benefit from the deduction, the effects of repeal would be concentrated in a few, high-income, high tax states such as New York and California. Other alternatives, such as turning the deduction into a credit, could benefit lower-income households by reducing their federal tax.
Another item on many tax reform lists is the mortgage interest deduction. Completely eliminating the deduction would drive down home values, at least in the short-run, and hammer state and local property tax revenues. But more modest reforms, such as turning the deduction into a credit, would have relatively modest effects on state and local revenues overall, according to Andrew Hanson of Georgia State University and David Albouy of the University of Michigan.
What about a very broad federal reform, such as creating a national consumption tax? That could turn state tax systems upside down, but the two structures may still be able to live well together. Canada has a national Value-Added Tax, while its provinces operate their own sales levies or piggyback off of the federal tax.
Could the U.S. pull this off? Michael Smart of the University of Toronto felt such a transformation is doable, though not easy. But Stanford University’s Charles McClure, a veteran of Washington’s tax reform battles, was far less confident.
Canada, Charlie noted, was a “best case.” The Canadians replaced a bad tax with a good one and did not have to worry about raising new revenues, yet political opposition to reform was still strong. By contrast, it would be much tougher in the U.S., which suffers from a more toxic political environment, probably would be adding a consumption tax to an income tax, and would likely have to use reform to raise revenue.
While there was lots of healthy debate in LA last week, the participants did agree on one thing: When Congress does get around to federal tax reform, it better not forget what these changes will mean to the states.
On Tuesday, I testified before the Senate Finance Committee at a hearing titled “Extenders and Tax Reform: Seeking Long-Term Solutions.” I was already depressed about the state of our tax system before I started preparing. As I drafted my testimony, I became distraught.
Our tax system is a mess and unless we send a clear signal to Congress to do something about it, it’s just going to get messier and messier. As Bruce Bartlett writes in his book, The Benefit and The Burden, the tax system is like a garden. It gets overgrown and chaotic unless you regularly clean it. Well, we’ve got an eyesore now and need to bring in a bulldozer.
Here’s what leaves me distraught.
Sixty temporary tax provisions expired at the end of 2011. Congress enacted each with an expiration date and has subsequently extended almost every one. Most of these “temporary” provisions—nicknamed “extenders”—have been repeatedly extended.
Congress created the vast majority of extenders to provide special treatment for a particular activity or investment. They vary widely from special depreciation rules for NASCAR race tracks to subsidies for commuting. Unlike other tax provisions that provide targeted tax benefits, however, extenders have a limited shelf life. Much like the dairy section of the grocery store, our tax code is now littered with expiration dates.
For many taxpayers whom these extenders affect, the recurring ritual of enduring a tax code death watch only to be saved by last minute clemency — or, in cases like this year, resurrection — creates tremendous volatility and uncertainty. It creates a perception that our tax code is unfair and reinforces the view that the current legislative process is dysfunctional and our elected representatives are unwilling or unable to choose among competing priorities.
It’s time to take a stand on extenders and on tax reform. I recommended at the hearing that the extenders be considered within the context of fundamental tax reform.
We seem to have forgotten that the fundamental purpose of our tax system is to raise revenue to fund government. The current system is riddled with tax provisions that favor one activity over another or provide targeted tax benefits to a limited number of taxpayers. Whether permanent or temporary, these provisions create complexity, impose enormous compliance costs, breed perceptions of unfairness, create opportunities to manipulate rules to avoid tax, and lead to an inefficient use of our economic resources. The tax code has become less stable, increasingly unpredictable, and more and more difficult for taxpayers to understand.
A reform that broadens the base would not only raise revenue but would also simplify the system, increase transparency, make it less distortive by reducing tax-induced biases towards certain activity, and improve the fairness of the system. Broadening the base requires deciding which special tax provisions to keep in the code and how best to design them.
Our current fiscal situation demands that we refrain from our habit of kicking the can down the road on tax reform and face the challenges ahead. It’s time to bring in that bulldozer.
On Tuesday, the Senate Finance Committee held a hearing on “Extenders and Tax Reform: Seeking Long-Term Solutions.” It’s about time! The charade of annual or biennial debate about perpetually “expiring” tax provisions is terrible tax policy and a symbol of our failure to come to terms with budget reality.
If you need help sleeping, download the Joint Committee on Taxation’s (JCT’s) annual list of expiring tax provisions—tax laws that have built in sunset dates. The latest list is here. More than 70 provisions expired in 2011. Based on past experience, almost all will be extended after some debate about how or whether to pay for their budgetary cost. They include very popular provisions like the research and experimentation (R&E) tax credit and the so-called “patch” that prevents tens of millions of middle-class taxpayers from falling prey to the AMT. There is a host of tax credits for energy efficiency and alternative fuels. There’s the tax deduction for state and local sales taxes. And the list includes the ethanol tax credit that provides a windfall to Midwestern farmers while contributing to higher food prices here and starvation in the rest of the world.
Given that the merits of some of these provisions are debatable (to put it nicely), subjecting them to periodic review would seem to be the epitome of frugal budgeteering. But pretending that the provisions will only be in place for a year or two makes them appear to be much more affordable than they will turn out to be. The AMT patch and the Bush tax cuts have been extended without offsetting tax increases or spending cuts, in part justified by the relatively modest budgetary cost of a short-term extension.
University of Virginia law professor (and former JCT director) George Yin has argued that all tax breaks should be subject to annual review, as discretionary programs are, so that Congress will have to take an up or down vote on the provisions to continue them. George argues that temporary provisions are the only tax laws where the costs are fully accounted for because permanent tax cuts can cost much more outside the budget window than in the five- or ten-year period considered when the legislation is debated. Temporary measures, in contrast, typically incur all of their cost within a few years.
Even if you buy George’s analysis of the budgetary effects (Howard Gleckman does not), there are other issues. One is that the provisions are continually extended and become a vehicle for more dumb tax laws. When I worked at the Treasury Department, we deliberately aligned temporary measures so that they would come up for renewal at the same time as the R&E credit, because we knew there would be a vote on extending that popular measure. The AMT patch has become another must-pass extender. It seems likely that the less popular measures would have a hard time surviving if they had to be voted on separately. And without the vehicle for mischief, some dubious new measures might never become law.
Furthermore, Congress’s chronic procrastination means that many temporary provisions are not extended until after they have expired. Astute calendar watchers will no doubt have noticed that 2011 came and went while the 70+ expiring provisions waited in vain for action. There will be an extenders bill this year, but the uncertainty means that taxpayers might rationally discount the actual tax breaks and that raises the odds that they will simply provide windfalls rather than affecting behavior. Research expenditures, for example, have a very long lead time. Investors might guess that the R&E credit will be in place when the research occurs, but they can’t be sure that the provision will not change. There’s some evidence that research is relatively unresponsive to the credit, and its ephemeral nature might be part of the explanation. Similarly, taxpayers don’t know for certain whether they can take tax credits against the AMT. (The provision allowing the use of personal credits is up for renewal.) And, of course, all of those green tax incentives are doubly uncertain—they may or may not be extended and if they are, their value will depend on the size of the AMT patch (since business credits are not allowed against the AMT).
If Congress is going to spend the money to provide incentives, it shouldn’t undermine them by making them uncertain.
It might, however, make sense to make new provisions temporary. Congress might even go a step further and mandate data collection so that Treasury or other agencies could study their effectiveness. But temporary provisions should not be extended endlessly.
I propose a “three strikes and you’re out” rule. After a provision has been extended three times, it should either be made permanent (and its cost fully offset) or it should be erased from the books.
A better solution still would be fundamental reform, which is at least hinted at by the hearing title and Chairman Baucus’s statement at the hearing. Many of the expiring provisions would not survive a rational reworking the tax code. RIP.
A well-designed Value-Added Tax could simplify the tax code for most households and finance significant reductions in corporate and individual income tax rates without adding to the budget deficit. And it could be a key piece of a revenue system that is both progressive and less intrusive in economic decisions than today’s law.
The VAT, a national consumption levy that would tax household purchases of all goods and services, is hardly perfect—no tax is. But properly structured, it could be a vast improvement over what we have.
In a project funded by the Pew Charitable Trusts, TPC modeled a sweeping reform of the federal tax system that includes a VAT. The plan was authored by Columbia Law School professor Michael Graetz . While there are many forms of consumption taxes (Herman Cain’s 9-9-9 tax included several), Graetz’s is similar in structure to the one used by most other countries. In effect, every business pays tax on its sales and gets a credit for any tax that is included in the price of what it buys from other firms.
Graetz does not eliminate the existing income or payroll tax. This no doubt disappoints some reformers, but helps fix a problem that is common to many consumption taxes—they hit poor people (who spend nearly all of their income) more than rich people (who don’t).
Mike’s solution is two-fold: First, he creates a family allowance of $100,000 ($50,000 for single filers), which wipes out all income tax liability for 8 out of 10 households. To ease the burden of the VAT on low-income families, he also creates a rebate tied to wage and self-employment income. But he does not exempt items such as food or housing from the tax.
Graetz sets two income tax rates–16 percent and 25.5 percent—that apply to all income, including capital gains and dividends. He’d repeal the Alternative Minimum Tax. He’d also eliminate the standard deduction and all family-based provisions, such as personal exemptions and the child credit and earned income credit, which he’d replace with the rebates.
He’d allow deductions for charitable gifts and mortgage interest only if they exceed 2 percent of adjusted gross income. Of course, these wouldn’t matter for those making $100,000 or less, since they’d owe no income tax anyway.
Finally, Graetz would cut the corporate rate to 15 percent, eliminate all business credits except the foreign tax credit, and end many deductions and exemptions.
Eric, Jim, and Joe figure Graetz could do all this with a relatively low VAT rate of 12.3 percent. That would raise the same amount of money as the 2011 tax law and be just about as progressive. People in various income groups might pay a bit more or less on average than they do today, but the changes would be surprisingly small.
Besides fairness, economists always look at how much any tax law distorts economic decisions. The current code is a swamp of subsidies aimed at encouraging or discouraging specific economic behavior. By contrast, a well-designed VAT mostly keeps government out of these decisions. It would reduce effective marginal taxes on labor, thus encouraging people to work. And it would reduce overall effective tax rates on capital.
The VAT does have issues. While it would reduce compliance costs for individuals, it would also create new administrative burdens for businesses that have to collect it.
But the biggest question is whether Congress would ever pass such a levy in anything like its ideal form. Any consumption tax must have a very broad base to succeed and this one does. It would apply to new home construction, health and education spending, and purchases and payrolls of non-profits and state and local governments. If Congress buckles under the inevitable pressure to exempt some or all of this consumption from tax, it would have to raise the rate.
Still, at a time when the campaign trail is awash in tax “reform” plans that are more surreal than serious, it’s nice to see a proposal that has the potential to vastly improve the revenue code without adding trillions to the deficit or providing a windfall to those who need it least.
Despite evidence to the contrary, there is a lingering view that Mitt Romney’s tax plan would primarily help middle-income households and not favor the rich. Yet TPC’s analysis of the plan clearly showed that high-income households would win big and others would do less well. Poor families would actually lose, relative to the taxes they’re paying this year. What’s really going on?
Romney’s plan has five main components. In order of size, they are:
1. Permanently extend the Bush-era tax cuts. Romney would make the 2001-03 tax cuts and the AMT “patch” permanent for everyone, thus precluding the very large tax increases that would otherwise come at the end of this year. Most households would benefit but the largest tax savings would go to those with the highest incomes.
2. Cut the corporate tax rate from 35 percent to 25 percent. Using its assumption that owners of capital bear the full burden of the corporate tax, TPC found that more than half of the tax savings—roughly $100 billion in 2015 alone—would go to the 1 percent of households with the highest incomes. The assumption is controversial among economists, but even if workers or consumers bear part of the tax burden, high-income households would still enjoy a disproportionate share of the benefit of the lower tax rate.
3. Eliminate income tax on long-term capital gains and qualified dividends for households with income under $200,000. Nearly 80 percent of households already pay no tax on gains and dividends—either because they have no investment income or because they’re in the 15-percent tax bracket or below. This cut—about $40 billion in 2015—can only help the remaining 20 percent. Not surprisingly, the bulk of benefits go to high-income households. And, because the threshold would apply only to non-gains and non-dividend income, households in the top 1 percent would get nearly a tenth of the tax savings.
4. Repeal taxes imposed by the health reform legislation. The healthcare legislation raised the Medicare payroll tax by 0.9 percentage points for couples with income over $250,000 ($200,000 for single filers) and imposed a 3.8 percent tax on investment income for the same taxpayers. Repealing those taxes—worth nearly $40 billion in 2015—would help only the high-income households that would otherwise pay the tax. Not surprisingly, about 80 percent of the benefit would go to the top 1 percent.
5. Repeal the estate tax. Only the wealthiest households pay the estate tax so only they would benefit from repealing it—to the tune of roughly $15 billion in 2015.
One omission from Romney’s plan would raise taxes compared with what people pay this year: not extending the remaining tax cuts created by the 2009 stimulus bill and scheduled to expire at the end of 2012. Because those cuts were initially intended to be temporary, the Romney campaign argues that not extending them wouldn’t be a tax increase. The same logic could apply to the 2001-2003 tax cuts but I don’t hear anyone claiming that letting them lapse wouldn’t count as boosting taxes. In any case, not extending the 2009 tax cuts still in effect in 2012 means that Romney’s plan would, on average, raise taxes for households in the bottom two quintiles, relative to what they’re paying this year.
Mitt Romney’s tax plan would cut taxes, by about $180 billion in 2015 alone, relative to current tax policy. And, despite all arguments to the contrary, a disproportionate share of the savings would go to households with the highest incomes.
Earnest Hemingway: I am getting to know the rich.
Mary Colum: I think you’ll find the only difference between the rich and other people is that the rich have more money.
It turns out that when it comes to taxes, at least, Ms. Colum, was mostly—but not entirely–right. To see why, let’s take a quick trip through the tax returns of Newt Gingrich, Mitt Romney and their spouses.
Admit it: Peeking at a celebrity’s tax return is more than a little voyeuristic. But get beyond the sheer prurience of the exercise and the Romney and Gingrich returns tell us a lot about the way those with incomes of $1 million or more are taxed, and how they structure their lives to minimize taxes. But mostly, they tell us that all those who make $1 million-a-year are not alike. And most of them are surprisingly like the rest of us, only more so.
Gingrich is typical. He made more than $3 million in 2010—mostly through distributions from an S Corporation. This allowed him to avoid double-taxation (since the S Corp is a pass-through entity that pays no tax). He also used this device to reduce his Medicare payroll tax.
But of his $3.1 million in income, only about $35,000 came from investments, and the rest was taxed at ordinary income rates—much of it at the top rate of 35 percent. It is no wonder that he paid close to $1 million in income taxes–an effective rate of about 32 percent.
Despite the rhetoric coming from President Obama and the claims of Buffett and others, that is not at all unusual. Of the slightly more than 400,000 households making $1 million-plus, the vast majority make most of their income from wages or distributions from pass-throughs, and not from investments. Think entrepreneurs, doctors, lawyers, movie stars, and professional athletes.
As my Tax Policy Center colleague Bob Williams has noted in TaxVox, even among those in the more rarified top 0.1 percent of the earnings distribution (households making at least $2.5 million) fewer than 15 percent make more than two-thirds of their money from investments. Perhaps surprisingly, more than half make less than 10 percent.
In 2011, those making $1 million or more paid an average effective income tax rate of about 19 percent of total cash income. If you want to compare the tax they pay to their adjusted gross income (the smaller amount that appears on a tax return), it would be closer to 24 percent.
Then there is that small subset of those whose principal occupation is investing. That’s Buffett. And that was Romney, at least before he took up presidential politics.
Of the $21,646,507 Romney reported on his 1040, $20,792,324 was investment income. And most was taxed at the 15 percent rate reserved for most dividends and long-term capital gains. Romney also gave away almost $3 million in charitable gifts (big contributions such as this are common—through hardly universal– among those making that kind of money). As a result, his effective income tax rate was a Buffett-like 13.8 percent.
Romney’s returns paint a picture of a man who was enormously successful in his business career (good for him) and who has, with the help of lawyers and accountants, carefully structured his income in a way that minimizes his tax liability. The result: a 203-page return and a very low effective tax rate.
If that offends you, don’t blame Romney. Blame the politicians who created this mess of a tax code. And remember that despite what Buffett and Obama say– and you might think–many high-income people do pay a bigger share of their income in taxes than their secretaries.
For a while there, I thought President Obama was going to embrace tax reform in his State of the Union address. Instead, following the lead of his predecessors, he offered a laundry list of new tax subsidies, bragged about some old ones, and said almost nothing about a top-to-bottom rewrite of the Tax Code.
Here’s just a partial list of the targeted tax breaks Obama promoted: Tax credits for clean energy and college tuition, as well as tax cuts for small business that create jobs, domestic manufacturers, high-tech manufacturers, and companies that close overseas plants and move production back to the U.S.
At the same time, he’d require individuals making more than $1 million to pay an effective income tax rate of at least 30 percent, in part by eliminating their ability to take many deductions. And, he’d use the tax code to punish companies that do business overseas, creating a new minimum levy that is supposed to assure that all multinationals pay some U.S. tax.
Obama’s embrace of the tax code as a vehicle to pick winners and losers sounded more than a little discordant in a speech whose theme was “everyone gets a fair shot and plays by the same set of rules.” Not so much in a tax code where you get special rules for the government’s favored activities.
As Obama was tossing out his tax baubles, I kept wondering about those firms that somehow didn’t get on his gift list. I can just imagine lobbyists’ cell phones abuzz from furious clients wondering why they weren’t getting a tax break of their very own.
For instance, think about a start-up software company that has to compete with an established firm. Because new businesses rarely make money in their first years, extra tax deductions do them no good. By contrast, a more established competitor, especially if it can qualify for Obama’s high-tech tax break, would benefit—perhaps substantially.
The multinationals’ minimum tax would be entirely unworkable. Even if Congress passed the levy, which it won’t, those firms will find ways around it. Minimum taxes are Band-Aides for a flawed tax system. The solution is not to create a new penalty for firms that learn to manipulate the law, it is to fix the basic law in the first place.
If Obama wants to prevent companies from gaming the system, he could lower the corporate rate and eliminate tax preferences. He raised this in last year’s state of the union address but did nothing about it. That’s too bad. With a low enough domestic tax rate, companies would have less incentive to shuffle income overseas.
Or he could go in the opposite direction and eliminate deferral, the practice that allows multinationals to avoid U.S. tax until they bring earnings back to the U.S. But this minimum tax seems to be a half-measure that may play to his populist base but will achieve little.
I suppose it is inevitable that a president beginning his fourth year in office and facing a deeply divided Congress would go small-bore. After all, there will be no fundamental tax reform in the current environment and even proposing such a step would only open him to criticism from the usual suspects in housing, non-profits, finance and other industries that are very happy with the system as it is.
Still, it is a shame that, instead, Obama would make things worse.
If we are going to reduce the medium- and long-deficit, new tax revenues must be part of the solution. And those taxes must be progressive and as conducive to economic growth as possible.
Historical revenue levels will not be sufficient to fund the federal government in the future. We will need to control the ballooning costs of Medicare, Medicaid, and Social Security. However, because their enrollment will be growing with the aging population, additional revenue still will be needed.
Past major budget agreements included both revenue increases and spending cuts because using both sides of the budget provides a sense of fairness and shared sacrifice. Americans prefer a balanced approach to spending cuts alone
Interestingly, raising taxes has proved more effective at restraining spending than allowing the government to finance its outlays with deficits. Under presidents Reagan and George W. Bush, taxes fell but spending rose. Spending fell only in the 1990s, when President Clinton and Congress raised taxes. This makes sense, since raising taxes to pay for current spending makes it clear to taxpayers that there is a cost to current spending, whereas the cost of deficit financing, while real enough, are obscured by the fact that it is does not create current tax liabilities.
Done right, higher taxes will not destroy the economy. In 1993, top income tax rates rose to 39.6 percent, and the economy flourished for the rest of the decade. Even the massive tax increases during and after World War II-amounting to a permanent rise of ten to fifteen percent of GDP-did not hamper U.S. economic growth.
The best way to raises taxes is to broaden the tax base by reducing the number of specialized credits, deductions, and loopholes. For example, limiting the tax benefit of itemized deductions to 15 percent would affect mostly high-income households and raise more than $1 trillion over the next decade without raising marginal tax rates.
New revenues should come from a progressive tax, which means the tax burden on high-income, high-wealth households needs to rise. Last year’s debt deal contained only spending cuts that place almost the entire burden of closing the fiscal gap on low- and middle-income households but have little or no impact on high-income households.
Over the past 30 years, the share of total household income for the top one percent of the income distribution more than doubled. Yet, those high-income households have seen their average tax burden fall, not rise, during that period.
The claim that these tax increases will harm small business is often overstated. Most income for high-income households is not business income. Yet, a recent Treasury report shows that just 1 percent of small business owners would be affected by a “millionaire’s surtax.” And even those firms face effective tax rates likely to be zero or negative since they can immediately and fully deduct the cost of new investment, even as they finance it WITH tax-deductible debt.
In addition to income tax reform, our leaders should move the United States toward a system that taxes consumption (using a value-added tax for example) and nonrenewable and polluting energy use (by increasing gasoline taxes or implementing a carbon tax).
The VAT exists in about 150 countries worldwide. It can raise substantial revenue, is easily administrable, and is minimally harmful to economic growth. In addition, a pre-announced, phased-in VAT could accelerate economic recovery. Concerns about regressivity and transparency can be addressed, and concerns that it would fuel an increase in government spending are overstated.
Long-term challenges related to energy production and consumption and long-term fiscal challenges can be addressed together. A far-reaching, upstream carbon tax can reduce the deficit and our dependence on foreign oil, protect the environment, lower the costs of healthcare, and encourage the development of clean, sustainable energy sources without the need for costly, inefficient energy subsidies. In the absence of a full-blown carbon tax, raising the gas tax offers many of the same advantages.
None of this means the United States needs to move to European levels of taxation. But between the very low tax revenues we raise now-the lowest share of the economy in six decades-and the high levels of taxation in other developed countries, there is room to raise revenue in a way that achieves serious medium- and long-term deficit reduction and supports a reasonable level of government.
Mitt Romney’s holdings in the Cayman Islands have generated lots of interest in investment funds that are managed from the U.S. but incorporated in foreign jurisdictions. But taxable U.S. investors like Romney don’t get much benefit from such funds. The real winners are U.S. tax-exempt entities, such as charities, pension funds, university endowments, and IRAs, as well as foreign investors. And investment fund managers can benefit too.
Here’s why: When tax-exempt investors make money that is separate from their tax-exempt purpose, they are subject to a special tax, known as the “UBIT” or the unrelated business income tax. A special rule also deems all debt-financed income to be unrelated business income. Because deals put together by private equity firms are often heavily leveraged (as are investments by hedge funds), debt-financed income often is generated.
If a tax-exempt entity were a partner in one of these deals, it would be taxed as if it earned the income that was earned by the partnership and, thus, be subject to the UBIT.
But tax-exempts (including individuals who invest through their IRAs) can avoid this tax by investing in a corporation which, in turn, invests in the partnership (or invests directly in the deal). The tax-exempt’s income from its investment then comes either as dividends or capital gains, neither of which is subject to the UBIT. But there is a problem: If the corporation were based in the U.S., it would have to pay corporate-level tax on the earnings from the partnership, thus lowering returns to the tax-exempt. But, if the corporation located in a tax haven, it would owe no tax (U.S. or foreign) on the earnings.
Similarly, foreign investors could use a corporation to block tainted income from a partnership. Normally, foreign investors would be subject to tax on U.S. income that is effectively connected to a U.S. trade or business. But a foreign investor who received distributions from another foreign corporation or realized gains from the sale of its stock could avoid any direct U.S. tax and would not have to file any U.S. returns.
Setting up as a foreign corporation may also benefit the investment fund managers by allowing them to defer compensation. By now, most readers of Tax Vox know that these managers often are paid for their services with profits of a partnership (“carried interest”). But they can also be compensated with a contractual right to payment from a foreign corporation which, like carried interest, can be based on an investment fund’s performance.
Income from a carried interest often is taxed as capital gains rather than as ordinary income, and thus enjoys a lower rate (15 percent v. 35 percent). But the tax is owed right away. The contractual right is taxed as ordinary income, but generally is deferred until the manager is actually paid. If the investments are throwing off long-term capital gains, the manager may prefer to be paid through carried interest. But if the fund is turning over frequently and thus generating lots of short-term gains (which are taxed at ordinary rates anyway), the manager may prefer a contract payment that is deferred—and taxed later.
These arrangements don’t entirely wipe out every investor’s tax liability. U.S. taxpayers, such as Romney, pay tax on their income regardless of where they earn it, so they can’t avoid U.S. tax by investing in Cayman entities. In addition, although U.S. taxpayers generally are not taxed on income derived through a foreign corporation until the income is distributed as a dividend, U.S. investors often must accrue income currently if the foreign corporation primarily has passive income or assets or U.S. owners.
Of course, investment funds may want to incorporate abroad for non-tax reasons, such as fewer regulations and less disclosures. But tax advantages are a major factor. Despite the headlines, tax-exempt investors, and fund managers, and not U.S. taxable investors often benefit most from these arrangements.
Rick Santorum, who may have won the Iowa caucuses after all, favors a huge broad-based tax cut that would massively increase the budget deficit. According to new estimates by my colleagues at the Tax Policy Center, the former Pennsylvania senator would cut taxes for nearly all households making $40,000 or more. But the impact on the deficit would be enormous: He’d cut taxes by roughly $1 trillion in 2015 alone.
Unlike Mitt Romney, who would slash taxes for those with high-incomes while raising taxes for many low- and moderate-income households, Santorum would boost after-tax incomes for the vast majority of Americans. Only a handful would pay more than they do today.
For individuals, Santorum would start by extending the 2001-2010 tax cuts that are due to expire at the end of this year. But he’d go far beyond that. He’d collapse today’s six tax brackets to just two—10 percent and 28 percent. He’d triple the personal exemption for children, cut taxes on dividends and capital gains from 15 percent to 12 percent, and repeal the Alternative Minimum Tax, the estate tax, and the tax increases in the 2010 health reform law.
For companies, he’s cut the corporate tax rate in half, to 17.5 percent, and allow full first-year expensing of capital equipment. Domestic manufacturing companies would owe no taxes at all. Multinationals could bring profits back to the U.S. at a 5.25 percent tax rate. They’d owe no taxes at all on repatriated earnings they invest in plant and equipment.
As always, measuring the effect of the Santorum tax plan depends on whether or not you assume the 2001-2010 tax cuts are extended. But either way, both the tax cuts for high-income households and the increase in the deficit would be enormous.
Even if you assume the 2011 law is made permanent, the top 0.1 percent (who make more than $2.9 million and average $8.4 million) would get an average tax cut of more than $1.3 million in 2015. By contrast, a typical household making less than $20,000 would get a tax cut of $39. Middle-income households making between about $50,000 and $75,000 would get a tax cut of about $2,000. This largess would add about $900 billion to the deficit in 2015.
If you prefer to compare the Santorum plan to a world where the 2001-2010 tax cuts have expired, they look even more generous. The top 0.1 percent would get an average tax cut of $1.7 million. Those making less than $20,000 would see their taxes cut by $265, and those in the middle would get a tax cut of $3,500. Santorum would increase the deficit by $1.3 trillion in 2015 compared to a budget without the Bush/Obama tax cuts.
The TPC analysis of Santorum’s tax plan comes with the usual caveats. It is static, and thus does not include new revenues generated by economic growth. Much of the benefit to high-income households would come from Santorum’s deep cuts in corporate taxes since TPC assumes those taxes ultimately are paid by owners of capital.
One final caveat: Santorum’s plan includes few details. For instance, while he proposes two individual tax rates, he does not say what the brackets are. Normally, TPC works with the campaigns to clarify these specifics, but the Santorum campaign did not respond to TPC’s requests for information. Thus, the estimates include some heroic assumptions.
Still, like his opponents in the race for the GOP’s presidential nomination, Santorum is proposing extremely generous tax cuts at the price of big increases in the budget deficit.