How to fix costly and unjust US tax system

December 17th, 2012

Too many provisions favour a very small minority of fortunate taxpayers

December 17, 2012

Sooner or later the American tax code will be reformed. Probably sooner. Raising revenue will be the main motivation, but at a time of sharply increasing economic polarisation issues of fairness will be prominent too. There are also legitimate concerns about the complexity of current tax rules and their adverse effects on the economy.

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So far, the debate has focused on scaling back provisions of the tax code that have favoured activities traditionally deemed to be valuable. For example, there is talk of reducing reliefs for charitable contributions, taxes paid to state and local governments, home mortgages, employer-provided health insurance and many less important provisions.

There are reasonable arguments to be made in each case. But taking only the “limit tax incentives” approach to tax reform has several major defects.

First, if reform is designed to avoid perverse outcomes, such as the crushing of charitable contributions or more pressure on state budgets, then it will raise limited amounts of revenue.

 Second, this approach will address very little of the complexity in the code and is not likely to do much for recovery, since it will do little to increase demand.

Third, it will do little to address concerns about fairness: the richest taxpayers actually make relatively little use of deductions and credits.

What is needed is an additional element, one that has largely been absent to date: the numerous exclusions from the definition of adjusted gross income that enable the accumulation of great wealth with the payment of little or no taxes. The issue of the special capital gains treatment of carried interest – performance fee income for investment managers – is only the tip of a very large iceberg. There are far too many provisions that favour a small minority of very fortunate taxpayers. Because these provisions effectively permit the accumulation of wealth to go substantially underreported on income and estate tax returns, they force the federal government to consider excessive increases in tax rates if it is to reach any given revenue target.

All parties – whether their primary concern is preserving incentives for small businesses, closing prospective budget deficits or protecting the social safety net – should be able to come together around the idea that it should not be possible to accumulate and transfer large fortunes while avoiding taxation almost entirely. Yet this is all too possible today.

Here are some issues the Obama administration and Democrats and Republicans in the US Congress should consider given the magnitude of prospective deficits and the extraordinary good fortune of those at the top of the income distribution.

Why do current valuation practices built into the tax code make it possible for investment partners to end up with $50m or more in entirely tax-free individual retirement accounts when the vast majority of Americans are constrained by a $5,000 annual contribution limit?

A simple calculation shows that the US estate tax system is broken. Assets that are passed to relatives or other personal relations are often badly misvalued relative to what they cost on an open market. The total wealth of American households is estimated at more than $60tn. It is heavily concentrated in very few hands.

A conservative estimate given the lifespans of Americans would be that 2 per cent ($1.2tn) is passed down each year, mostly from the very rich. Yet estate and gift taxes raise less than $12bn, or 1 per cent, of this figure each year.

If a family’s home rises in value by more than a $500,000 exclusion over the course of its dwelling, then it pays capital gains tax on the difference between the value now and the value at purchase. But real estate investment operators, who sell properties whose value is measured in the hundreds of millions if not the billions of dollars, are able to take tax deductions for “depreciation” on their properties. And they are then able sell these properties at an appreciated price while avoiding capital gains tax through what is known as a “like kind exchange” – but is in fact a sale.

Why should international companies be able to locate the lion’s share of their foreign income in small, low-tax jurisdictions such as Bermuda, the Netherlands and Ireland, and avoid paying taxes?

There are sound arguments for a preferential rate on capital gains. But is there any real justification for allowing those who do not need to sell their assets to finance retirement to avoid capital gains taxes entirely by including them in their estates?

These tax rules, which permit the taxes of the most fortunate Americans to be far less than commensurate with their good fortune, have the virtue of being relatively comprehensible. There are many others, involving issues such as derivative accounting, pooled interests and leveraged leases, that are neither easily explainable nor easily justified.

The failure to tax capital gains at the point of death costs the federal government about $50bn a year. Since its removal would both raise money in the future, and induce earlier and greater realisations of capital gains in the short term, its removal would likely add well over $500bn during a 10-year period. I believe it is plausible to raise $1tn over the next 10 years by going after provisions that cause what adds to wealth and spending not to be regarded as income.

It has been observed that the greatest scandals are not the illegal things that people do but the things that are fully legal. This is surely true with respect to a tax code in urgent need of reform.

The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary