UI Senior Fellow Eric J.Toder talks about tax reform priorities, how the tax system can help promote social and economic goals, and whether tax law can be “environmentally friendly.”
Dr. Toder supervises studies on retirement and tax issues inthe Urban Institute’s Income and Benefits Center and the Urban-BrookingsTax Policy Center. Before joining the Urban Institute, Dr. Toder held several policy advisory positions in the U.S. government and overseas, including Deputy Assistant Secretary for Tax Analysis at the U.S. Treasury Department and Director of the IRS Office of Research.
Five Questions Archives
August 8, 2007
1. What should today’s tax reform priorities be?
Before getting to the problems, I would say that our tax system has several positive features. It’s moderately progressive and a strong revenue raiser. Most revenue comes in through a self-assessment system—a good thing—and the top rate, now 35 percent, is lower than in many other countries and not at all excessive. On balance, the current system has served the country well since the modern income tax was instituted during World War ll.
Having said that, the current system needs to be reviewed and reformed because it has four big problems. First, it’s way too complicated, partly because Congress wants to give out tax benefits, but doesn’t want people to use too much of them so they have all kinds of complicated restrictions plus the alternative minimum tax, a whole separate system for people who use certain benefits too much. If nothing is done, 23 million taxpayers will pay the alternative minimum tax next year. Second, it’s unfair and hurts the economy by favoring some activities over others. This is true even for widely used and popular provisions. For example, the mortgage interest deduction is supposed to encourage home ownership, but what it ends up doing is encouraging people who already own a home to buy a bigger one. Instead, we could use the same money to have a refundable tax credit for first time homebuyers and lower tax rates for others. There are also many narrow tax breaks that favor special interests. An example that Congress is now examining is the taxation of wealthy people who run private equity firms. Many of them pay the capital gains tax rate of 15 percent on their earnings instead of the regular 35 percent rate. This is just one example.
Third, the rules for taxing investment income and international income are outmoded and ill-suited for our globalized economy. For example, our corporate tax rate is now higher than in most OECD [Organization for Economic Co-operation and Development] nations—causing investment and the tax base to shift out of the U.S., but U.S. investors get tax breaks on their dividends and capital gains no matter where their money is invested. With capital mobile across borders, we would be better off taxing Americans the same way no matter where or how they earn their money, than taxing income based on where investments are placed.
Finally, we don’t raise enough tax revenue given the demands baby boomers will place on the federal government as they move into retirement. Some people say we should solve the problem by spending less on Social Security and Medicare and we will have to do some of that, but these cuts will be painful, so we can’t solve this on the spending side alone. We need to call on the tax system to raise more revenue than in the past. I suggest that we do so through a Value Added Tax (VAT) that would supplement the income tax. Almost every other country has one, and it works without dampening saving or corporate investment. This would not fly today, but its need may become clearer in the future.
2. You have written about how the tax system not only raises revenue but also promotes social and economic goals. Is this legitimate? Should tax benefits that promote health insurance, home ownership, charitable giving, higher education spending, income support for low-income families, and other important social goals be eliminated? Should these programs be driven by government spending instead of tax breaks?
Tax law provisions that provide special benefits to selected activities or taxpayers to advance social and economic policy goals are often called tax expenditures. Much of our social safety net programs—for example, health insurance and pensions for workers, earnings subsidies for low-wage workers with children—are funded through the tax system instead of direct spending programs. If we wiped out those tax benefits we’d have a cleaner tax system, but would have to spend more because those benefits serve key societal goals.
A key issue is whether these types of programs belong in the tax system at all. Sometimes it’s legitimate to use the tax system and sometimes not. If a group or taxpayer is already dealing with the IRS and filling in one more line on a form yields a tax benefit, then it makes sense administratively to use the tax system this way. But for other programs, it tortures logic to embed them in the tax system.
But overall there is a bias to use the tax system too much. Politicians like this as a way of enacting new programs, while appearing to cut taxes instead of spending more. Tax expenditures get less scrutiny than spending and make it easier to start and continue programs that the government shouldn’t be doing.
3. Following up on this, how should tax incentives be used to promote such social safety net features as retirement savings and income security for low-income families?
As for retirement savings, we need to expand tax credits that help low-income families who would not otherwise save. The biggest beneficiaries under the current tax laws are high-income people who are saving anyway. Some retirement saving should be exempt from tax for all workers. But we have been expanding contribution levels for tax benefits way beyond what the average person is saving.
As for tax incentives that promote income security for low-income families, the EITC [Earned Income Tax Credit] is one of the most successful programs to encourage work and reduce poverty. Some people have suggested improved designs that combine the EITC with various child benefits into a simpler incentive structure. These should be considered, but overall EITC is one of our better programs.
4. Should tax enforcement be a high-profile issue for presidential candidates and other policymakers even though the IRS has had limited success in raising revenue through enforcement?
IRS recently estimated the tax gap to be $345 billion, or 16 percent of tax liability—for tax year 2001. This is the amount of tax that people owe, but do not report or pay on time. Improving compliance is an important good government issue that requires some new legislation and additional IRS spending, but tax enforcement shouldn’t be a burning political issue. People want political leaders to talk about bigger issues like health care, energy policy, and tax policy. Political parties should debate how big the tax burden should be and who the taxes should come from, but everyone should favor collecting what is owed.
Enforcement resources have not kept up over time with rising costs and an increased IRS workload and need to be increased gradually over time to boost tax compliance rates. We also need new ways to increase information reporting on some transactions such as stock sales and credit card payments to businesses. The President’s budget has some good proposals, but we shouldn’t expect any of this to raise a lot of money or close much of the tax gap soon.
5. You have recently written several papers on the relationship between tax policy and energy policy. Is the tax law becoming more environmentally-friendly as the realities of global warming become more apparent?
Unfortunately, I would have to say no—tax law is not yet more environmentally friendly. That’s largely because there’s a big disconnect between what economists on both the left and the right think should be done and what Congress is willing to do right now.
Carbon is currently under-priced because the price doesn’t account for the environmental damage that’s done when we burn it. We should have a tax on the carbon emissions that are causing global warming. This would encourage conservation and alternative fuels development and encourage entrepreneurs to come up with new technologies. But today it would raise prices of electricity, gasoline, and other consumer goods so politicians are loathe to do that. We could also increase the gasoline tax. Since the point is to change incentives instead of raise money, the tax revenue could be returned either as payouts to people or as cuts in other taxes. But even with that, it would be a hard sell.
A cap and trade system that limits carbon use, but allows users to buy and sell emission rights, is another way to do the same thing but, like a tax, it would also raise prices. Who wins and loses would depend on whether the emission rights are sold by the government or given away.
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