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Richmans' Trade and Taxes Blog
What Income Tax Reforms Are Needed?
Raymond Richman, 8/8/2017
The principal cause of the anemic growth of the U.S. economy in recent decades was the chronic trade deficits with the rest of the world which have cost millions of U.S. manufacturing jobs and converted the U.S. the world’s leading creditor to the world’s leading debtor. Multi-country trade agreements encourage corporations to invest in countries with low corporate income tax rates and to export the goods they produce to the U.S. duty-free. The government’s first task is to bring our trade into better balance. Tax reform will not do it.
As the U.S. Gross Domestic Product statistics show, the US international trade deficits averaged about 3 percent per year in recent decades. If trade had been in balance, the growth of the GDP would have been nearly five percent on the average instead of one to two percent. What causes international trade deficits are the relative costs of producing goods and services in different countries, the foreign exchange rates, and the existence of barriers to trade imposed by our trading partners. Wilbur Ross, the Secretary of Commerce, in an opinion piece in the Wall Street Journal 8/1/2017 states that the U.S. imposes fewer barriers on imports than the European Union and China with which we have huge trade deficits. Other countries with which we are experiencing large chronic trade deficits are Japan, Korea, and Mexico. Together with China and the EU, these countries accounted for 88.9 percent of our trade deficit in 2016. Single-Country-Variable-Tariffs are all that we need to balance trade(See below}
Income taxes do not affect the costs of producing goods and do not affect the volume of exports and imports. Profits, the principal component of corporate income, is what is left after subtracting expenses from revenues. The corporate income tax is considered by many economists as an abomination. Low and middle income shareholders and their pension plans pay the same tax rate as billionaire shareholders. The corporate income tax induces all sorts of uneconomic business practices from debt-financing to buying back shares. Many economists believe that corporations with monopolistic power shift the burden of the corporate income tax to consumers and themselves bear little of the tax burden. Little shifting can occur in highly competitive industries like agriculture and retailing. The solution is to abandon the corporate income tax and tax corporate earnings as personal income, just as we do with partnership earnings.
It is alleged that the personal and corporate income taxes reduce the ability to save and lowers investment but the low current interest rates show that there is plenty of savings relative to the demand.
Clearly, the key to accelerated economic growth is balancing our foreign trade. The proposed cuts in the corporate and personal income tax rates and the proposed tax reforms will have hardly any effect on the US trade deficits. They would not affect relative costs of production between us and our trading partners, would not affect exchange rates, and would not erase the formal and informal barriers of trade imposed by our trading partners. The reforms call for eliminating the AMT (the alternative minimum tax), imposing a limit on charitable deductions, increasing deductions for dependents, and eliminating the Estate Tax.
The principal reform needed is to abolish the corporate income tax and tax the earnings of corporations as personal income as we currently treat partnership earnings. Such treatment would result in no revenue loss whereas the proposed cutting of personal and corporate income tax rates would cause a huge loss of revenue and increase the budget deficits.
Other personal income tax reform are desirable to eliminate inequities in the present system. The present rules for calculating personal deductions, other than standard deductions, do need revision to prevent abuse. Eliminating some tax expenditures, especially those which involve tax credits buried in the income tax code to conceal how much they cost the taxpayer, is probably the most needed tax reform. The proposed reforms overlook reforms that economists have long recommended, such as changes in the provisions for depreciation allowances and the tax treatment of capital gains.
Eliminating the estate tax is a non-reform since the estate tax is important in reducing the huge inequality of wealth over generations. It is one thing to reward the inventors of products and good ideas with huge wealth to which we have no objection. This is an important incentive to invent and innovate. It is quite another to perpetuate those difference in wealth beyond the life of the productive individuals who earned it. The estate tax falls only on estates totaling $5.45 million or more and the maximum rate is 40%. The very existence of the tax provides an incentive to the extremely wealthy to arrange for the continuation of their businesses and dispose of much of their wealth during their lives. Condemnation of the estate tax because it supposedly causes the break-up of family businesses turns out to be largely hokum and misplaced sentimentality.
Reasonably progressive income taxation and estate taxation are sound means of reducing income and wealth inequalities inherent in a market characterized by invention and innovation. For example, the four wealthiest Americans include the founders of Amazon, Microsoft, Apple, and Oracle. Economists provide an additional reason for progressive rates, namely that very high annual personal incomes are often the result of monopoly power, what economists call economic rents. Some Republicans believe that to be conservative means to oppose all forms of progressive taxation. They favor the flat tax and sales taxes like the value-added tax. That’s not conservatism but being a reactionary.
The internal revenue code encompassed about 500 pages in 1930 and now covers 2652 pages, not and the . Some estimate that the code and its regulations covers 74,000 pages! As the Tax Foundation points out,
Over the decades, lawmakers have increasingly asked the tax code to direct all manner of social and economic objectives, such as encouraging people to buy electric and hybrid vehicles, turn corn into gasoline, purchase health insurance, buy a home, replace that home's windows, adopt children, put them in daycare, purchase school supplies, go to college, invest in historic buildings, spend more on research, and the list goes on.
An important reform that we recommend is to eliminate most of the enumerated tax expenditures provisions from the Internal Revenue Code. Congress would then be forced to include such tax expenditures in the federal budget where their cost would be transparent. Subsidies do not belong in the tax code but in the budget where taxpayers can see how much the subsidies are costing and who receives them. Aside from entitlements in the nature of welfare, the principal beneficiaries are millionaires and at least one, Elon Lusk, a South African-born Canadian, became a billionaire as a result of U.S. subsidies buried in the tax code.
Among the proposed reforms is imposition of a ceiling on total personal deductions, other than deductions for dependents. The purpose of such a provision is to deny the very wealthy the ability to avoid personal income tax liability by excessive deductions made from their accumulated wealth and to disincentive establishing private charities which pay salaries to relatives and cronies, like the Clinton charitable foundation.
Another proposed reform is to allow the deduction of health insurance premiums for persons not included in an employer-paid health insurance program. The expenditures currently are deducted as a business expense by the employer but are not counted as employees’ income. It is the largest tax expenditure amounting to about $235 billion. So those who are self-employed or whose employers do not provide free health insurance are severely disadvantaged. Employees could be required to include the value of their employer-financed health insurance in their personal income subject to tax but Congress is unlikely to eliminate an entitlement received by millions of voters. Alternatively, those paying for their own health insurance should receive the same entitlement.
Reform proposals include a reduction of the number of tax brackets from seven currently to three. This does not simplify the calculation of the tax at all. Regardless of the number of brackets, once taxable income is calculated the calculation of the tax liability is simple involving at the most calculation of the sum of two numbers and addition of one. Reducing the number of brackets interferes with the progressivity of the tax. Over wide ranges of income the tax rate becomes constant with those at lower levels of the income brackets paying the same rate as those at the highest level of the range.
When depreciable property is sold, the buyer should take the seller’s basis for depreciation. Hotels, office buildings, and other commercial real estate are depreciated over and over again because the purchase price becomes the basis for a new depreciation schedule. Accelerated depreciation is allowed to stimulate investment but it is often abused by the seller who has an incentive under current law to sell the depreciable property as soon as he has taken most of his depreciation allowance. Percentage depletion allowances should be eliminated or restricted to the actual cost of newly built physical assets. Under percentage depletion, taxpayers deduct a percentage of gross income from mineral production and the deduction bears no relation to actual out-of-pocket cost.
Capital gains on the sale of homes and securities should receive no special treatment. They should not be taxed at all if the proceeds are reinvested in similar properties. The reason for taxing capital gains is that they equal the capitalized value of the stream of increased income that occurred after the asset was purchased, which is the definition of the capital gain. When you sell the asset you are realizing the expected future income stream. If you reinvest the proceeds, you will pay income tax on the future earnings of the investment. So the taxpayer would be put in the same position before he sold or exchanged the asset.
Economists fail to make a distinction between tax expenditures intended to conceal government subsidies and so-called tax expenditures that are due to the fact that we are a federal system. They have come to consider that State income taxes paid should not be allowed as a deduction and neither should home real estate taxes and interest paid on home mortgages. But the federal government is a creature of the States with limited powers under the Constitution. Amendments to the federal Constitution and judicial decisions have made the federal government the more powerful level of government. To argue that it is a tax expenditure to allow the deduction of taxes paid State governments and the deduction of mortgage interest and real estate taxes on homes is to ignore states’ rights. Local governments, the creature of the States, tax the value of real estate, a tax which we believe is the best tax local governments can levy. Including mortgage interest and local taxes on homes would seriously reduce the value of homes and affect the tax base of state and local governments. Remember Chief Justice’s Marshall’s dictum in McCulloch vs. Maryland, “The power to tax involves the power to destroy.”
It is an argument that could be used against the AMT. The AMT makes it more costly for the States to borrow money because AMT nullifies that State’s issuance of tax-free bonds. When the AMT was imposed in 1969, it was expected to affect fewer than 200 or so taxpayers who were avoiding federal income tax by investing in tax-free state and municipal bonds. In 2015 it applied to several million taxpayers. .” It is an argument that could be used against the AMT. The AMT makes it more costly for the States to borrow money. Americans deserve a single income tax applicable to all taxpayers.
The administration and the Congress ought to be as concerned with the federal budget deficit as they are with tax reform. As the attempted repeal of Obamacare shows, entitlements once given are hard to eliminate. We see this also in the fiasco of government providing low-rent housing (the most expensive housing constructed). Not only is the original cost high but so is maintenance and its short life. In Pittsburgh, two high-rise buildings and a garden apartment complex were recently demolished. Under private ownership they would have increased in value! We need government expenditure reform as much or more than tax reform. Whole departments and hundreds of agencies have dismal records of accomplishment and fail to meet the test that benefits should exceed costs.