What if we told you there’s a way to make the U.S. tax system fairer, get corporations out of politics, improve the country’s global competitiveness, bring home more than $1 trillion in offshore earnings, increase wages, end the double taxation of company profits, and improve returns for many shareholders?
You’d say we were dreaming. But all this could be achieved if Congress would agree to a simple deal: Lower marginal rates, tax long-term capital gains and dividends at the same rate as regular income, and eliminate the corporate income tax.
Under current U.S. law, long-term capital gains and dividends are taxed at a preferential top rate of 15 percent, as opposed to the top rate on labor income of 35 percent. This is quite favorable to the wealthy, who earn more of their income from investment. It leads to such famous distortions as Warren Buffett having a lower tax rate than his secretary.
It also leads to herculean tax-avoidance efforts, as the rich hire armies of accountants to manipulate their incomes to get the preferential rate. And then there’s the matter of inheritance: When the wealthy die, any gain in their investments passes untaxed to their heirs.
The current system also often amounts to double taxation, since income earned by a business is subjected to the 35 percent corporate rate, then taxed again when it’s paid out as a dividend.
Although taxing capital has long been anathema to many economists—on the theory that it discourages investment and thus economic growth—recent studies are casting doubt on those assumptions. The Congressional Research Service found in 2010 that reductions in the capital-gains tax are “unlikely to have much effect” on long-term growth and “would mostly benefit very high-income taxpayers.” Leonard Burman, a public administration professor at Syracuse University, has found that capital-gains rates “display no contemporaneous correlation with real [gross domestic product] growth during the last 50 years.”
In a recent working paper published by the National Bureau of Economic Research, economists Thomas Piketty and Emmanuel Saez argue that the old consensus that taxing capital is always and everywhere a bad thing fails to fully account for the effects of inheritance and tax avoidance. In the real world, with inequality widening, they suspect the optimal tax on capital isn’t necessarily zero: It could even be higher than the optimal tax on labor.
On the other side of the bargain, the corporate income tax has been subjected to so many distortions that it’s no longer effective. As a share of GDP, the amount it brings in has been declining since the 1950s. This is partly because loopholes and preferences keep proliferating, which means most companies now pay a much lower effective rate.
The tax prompts executives to take outsize pay, because their salaries are a deductible expense. It reduces wages, meaning that its burdens fall heavily on labor. It makes attracting investment in a world of mobile capital more difficult. And, as mentioned above, the corporate income tax invites the double-taxation problem, which encourages companies to pass along their tax expense to consumers and employees and discourages dividend payments.
Eliminating the corporate income tax in exchange for a higher capital-gains rate would make the tax system fairer, simpler, and more rational. It would eliminate inducements to tax avoidance and yield further benefits for investors such as pension funds and 401(K) accounts that already pay no capital-gains taxes and would see better dividends.
Ending the tax breaks for specific industries would also help get the government out of the dreaded practice of picking winners and losers and providing corporate welfare. Much of the vast corporate lobbying apparatus that pervades Washington would be neutralized, and companies could finally repatriate the more than $1 trillion in overseas earnings they’re holding to avoid taxation.
Economists are starting to get on board with variations of this idea. Luigi Zingales of the University of Chicago recently argued for reducing the corporate rate to 15 percent and increasing the capital-gains rate to 35 percent. A study by Rosanne Altshuler, Benjamin Harris, and Eric Toder of the Tax Policy Center argued for a capital-gains rate of 28 percent and a corporate rate of about 26 percent.
In the interest of compromise, we’d endorse such variations on our proposed deal. But it’s important to remember that none of these reforms would result in a fiscal utopia, and there would surely be complications.
Most crucial, there’s a revenue mismatch: Total savings to taxpayers from paying a lower rate on capital gains and dividends than they do on income was about $158 billion in 2011, according to the Joint Committee on Taxation. How much of that would go to the Treasury under our proposed reform would depend on investor behavior, but it probably wouldn’t make up for what the corporate income tax brings in.
That’s why this deal must be a first step toward a more aggressive overhaul. As we’ve argued before, tax reform should simplify the code, lower marginal rates, and prudently phase out all or most tax expenditures.
Taxes on capital should be treated as a unified system—rates should be low and simple and fair in the way they are applied to similar kinds of economic activity. President Ronald Reagan had it roughly right, in other words, when he agreed in 1986 to tax capital gains at the same rate as labor in exchange for reduced marginal rates. Perhaps that’s a lesson we need to relearn every 25 years or so.