Tuesday, November 15, 2005

Tax Reform: Simplicity and the Tax Base

by Tom Bozzo

It's a little funny that of the tax reform panel's recommended alternatives, the "Simplified Income Tax" and the "Growth and Investment Tax Plan," the Simplified Income Tax is the less simple option. While its name may look less progressive than "Simplified Income Tax," if Republican guerrillas broke into the house and forced me at gunpoint to choose one of the panel's tax plans (*), I would in fact probably choose the Growth and Investment Tax.

The nice thing about the Growth and Investment Tax Plan is that it treats all investment income equally, subjecting it all to a 15% tax. The "Simplified" Income Tax, in contrast, taxes (qualified) dividends not at all, capital gains at a top rate of 8.25%, and taxable interest at the same rates as wage income. Really, the only thing better would be something like the Center for American Progress tax plan, which would subject all individual income to a common set of rates. The CAP plan would also do useful things like address the regressive burden of payroll taxes that were beyond the Bush tax panel's remit.

It should be noted that the broader the income base, the lower the rates can be, which makes economists happy by reducing tax distortions of economic decisions. (The current fashion is to care about capital market distortions a lot more than labor market distortions.) And the panel's analysis showed that income tax rates could be markedly lower if the array of tax preferenced items in the current system were eliminated. They came up with this set of rates:
Picture 4
One can imagine it being popular to pull down the rates applicable to the lower, middle and upper-middle classes a bit further while subjecting the rich to a top rate in the ballpark of today's upper-middle earners. The panel had made something of a fetish of preserving the present system's division of responsibility for paying taxes, though.

As it happens, the Simplified Income Tax's low rates for capital gains happen to be particularly favorable to the very wealthy. Based on 2003 tax data (Excel spreadsheet), the 0.4% of returns showing adjusted gross income in excess of $1 million represented 13% of income, 29% of taxable interest, and 33% of qualified dividends, but 61% of net capital gains. Indeed, the capital gains reported by the top 0.4% was just a few billion dollars shy of the total taxable interest and ordinary dividends received by everyone.

The case for preferential capital gains rates is dodgy in some other respects, too. While I wouldn't lose sleep over it in any event, the double taxation argument against taxing dividends as individual income doesn't really apply to capital gains, as the assets' basis is excluded and capital gains enjoy tax deferral until they're realized. High rates may cause a compliance issue by providing an incentive to play games with accounting for the basis, though contemporary U.S. tax rates wouldn't seem to make risking a date with the feds very appealing — at least in a world where returns showing large capital gains had a perceptible probability of audit.


(*) This sort of scenario, with "Communists" replacing "Republicans" and "renounce the faith" replacing "choose one of the tax plans," was a staple of McCarthy-era Catholic catechisms.
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