America’s Distortionary Taxation A review of the optimal path to reform our tax policy

by / 0 Comments / 94 View / April 22, 2016

In the wake of the Panama Papers, the United States has an opportunity to act on the flaws of the current international system, which has precipitated a rampant rise in economic inequality, through the immoral tax avoidance tactics of the world’s wealthiest individuals. This inequality has been caused by globalization, which has empowered the most wealthy individuals and mobile enterprises and has morphed the system of international trade and domestic policy to benefit themselves at the expense of the poor and the middle class. Furthermore, if this distorted system of inequality becomes more endemic to the American system then it already is then as noble prize winning economist Robert Solow said, “we’re headed for oligarchy.” This decline in the economic parameters for success, which is associated with inequality, is not just confirmed by meta-studies, but is also shown by a meta-analysis from the Dana Farber Cancer Institute to have modest negative effects on health outcomes as well. To ignore this problem is to ignore the obligations of government under our social contract. This is why economic inequality in the United States must be remedied in the United States through regressive and progressive tax reforms in order to make the structural reforms necessary to create sustainable, instead of exclusive development.

Our reforms must include progressive and regressive policies because that is the only way that we can gain the necessary revenue to fund the reforms to our human and physical capital. On the progressive end of our taxation, according to a 2007 study by Emmanuel Saez of the University of California Berkeley, since 1995 the US tax code has gotten less progressive. This means that the extent of taxation on the rich has become evanescent, while taxation on the rest of Americans has not changed to a great degree. It is true that the rich pay the largest percentage of total federal taxes, which is according to an article by CNBC, but that argument is very misleading when you look at the percentage of the wealth that the rich took in. While the rich did take in 42% of the nations income, a study by the Institute for Policy Studies found that the richest 10% of American families own 75% of all the wealth created and 84.5% of all financial assets in the United States. Despite this, they only paid around 50% of all federal taxes and when you factor in state and local taxes the overall tax burden is barely progressive at best.

A question arises: how can there be such a large hole in the amount of taxes paid by the wealthy 10% if they own most of America’s wealth and at a time when, according to a separate article by the economist magazine, nominal wage stagnation is present throughout the poor and middle class of most advanced economies? Thomas Piketty answers this question through a literature review of micro level tax studies; and he explained that the answer lies in the fact that the behavioral elasticity for progressive taxation, in a poorly designed system, is very high, with the most common behavior being tax avoidance. The US tax system fits Piketty’s criterion of poor design, because according to the Huffington Post tax avoidance costs the US government 3 trillion dollars a year. The way that we came to have such a system was through a combination of errors in the progressive and populist movements in US history.

The plight of the American welfare state has its etiology rooted in the focus of these movements on revenue sources that are too vulnerable to special interests. Monica Prasad of Harvard University elaborated in her book “America the Land of Too Much”: “Progressive taxation seems to be a more politically vulnerable form of revenue generation and may also be less economically efficient, so American resistance to regressive taxation closed off the easy source of revenue that the European states had found.” She also went on to note that tax exemptions for fringe benefits, and the focus of unions on the development of a system of private welfare, created a destruction of the ability of the US to develop a public welfare state that could eliminate poverty, despite the support that such a welfare state receives today. The juxtaposition of Europe and the United States on regressive taxation is made clear by the Tax Foundation’s presentation of OECD data. According to the source, America’s reliance on consumption taxes was 17.9% in 2012, whereas the OECD average was 32.8%. These consumption taxes if introduced could bring in 50 billion dollars in revenue for every 1% increase of the value added tax.

With the clear contrast between the United States and the OECD average in revenue collection, the focus of the United States must be on reducing its dependence on taxes that are economically distortionary, like corporate taxes and capital gains taxes. Our corporate tax rates need to be reduced along with the closing of loopholes and deductions that enable companies to engage in accounting tricks, which limit our ability to collect revenue. In a briefing paper, the Congressional Research Service confirmed that in order to avoid corporate taxes companies will resort to income shifting to low tax locations, which the use of this technique exploded after the creation of check the box rules in 1997 that led to the creation of hybrid entities. They will also use tax transfer pricing that can shift income by raising prices on purchases while lowering them on transfers. Through debt and equity tricks companies can have low tax entities lend to high tax entities, while borrowing less in the high tax entity, which will lead to what is actually taxable income, will actually be classified as nontaxable debt. Even contract manufacturing can lead to low or no tax outcomes because a low tax foreign subsidiary can contract with another manufacturer from a high tax country, without having to pay the tax in the second and high tax jurisdiction, effectively outmaneuvering the tax code.

The solution to this predicament in our corporate tax system is to lower the rates below the OECD average, while putting stringent regulations on practices that corporations use to pay low taxes. According to Stephen Shay, of Harvard Law School, the US treasury has regulatory authority to curb the use of debt as un-taxable income by providing strict criteria to prevent it from being a feasible option. Other ways are further addressed in the CRS report, which includes the tightening of penalties for transfer pricing and eliminating check the box provisions that allow for hybrid entities and foreign subsidiaries to engage in contract manufacturing and conduct abusive earnings stripping practices. Some say that we should adopt a territorial tax system, however, a new economic analysis of four nations suggests that a territorial system is not a magic bullet solution that has been previously suggested. Plus the Shay evidence that I presented earlier suggested that a territorial system would exacerbate incentives to strip the tax base.

Simultaneous to this refutation of the idea of a territorial system, another concern was made by the Peterson Institute, which explained that the ending of deductions and the creation of these regulations would lead to economic volatilities resulting from a new higher tax rate on foreign income. This concern relies on the assumption that capital gains reform, of which I will touch on later, would not occur with the increase in taxable income from corporate reforms. It also fails to take into account that this kind of reform would come synchronous to a lowering of the rate of corporate taxation. For example, if we lowered the rate of corporate taxation to 20% or lower, this change in taxation would not be conducive to the evisceration of economic growth. Michelle Hanlon, of the University of Michigan, found that 22% of firms were already able to sustain a tax rate of 20% or less, with long run tax avoidance being directly tied to firm size and other characteristics of traditional tax avoiders. The impact of this finding is important for us to consider because the OECD average corporate rate was 24.1%.

This means that the firms that would feel a tax increase would be able to handle it because of their privileged position in the market. It also adduces that the firms that don’t practice tax avoidance would be able to receive a tax cut following rate changes, which would benefit the system as a whole. This systemic benefit would come from the ending of tax practices that enlarge a company’s balance sheet, which according to an analysis by Rossane Atshuler, of Rutgers University, leads to an increase in the cost of capital. Additionally, it would also positively change a company’s investment preference, inevitably leading to an increase in efficiency. Following this up with a lower rate, the OECD, Harvard University, and the University of Mannheim outlined that workers would see an increase in their wages, the country would see an increase in investment and entrepreneurship, an increase in productivity, and every one percent decrease in corporate tax rates would see a 3.7% increase in foreign direct investment.

With reform to corporate taxation, the US must reform capital gains taxation because the two taxes are intertwined in the tax system. According to an article by Harvard University, the basic problem is that the current capital gains system is producing a short-term business culture that treats a long-term investment the same as a short term one. Long-term investment strategies include “empowerment innovations”, which lead to the creation of entirely new products that produce explosive economic growth. The solution to this phenomenon, according to the Harvard article, is to create a capital gains tax that decreases in scale over the course of the medium term. This can prevent people from trapping capital that would never be taxed, while also encouraging people to use that capital to invest in innovation. Presidential candidate Hillary Clinton is the only candidate in the presidential field that has proposed a strategy like this one, which means that political leadership in the future could follow this kind of evidence based approach to economic restoration. However, that same reform can be followed up with treating dividends as corporate income, which would prevent double corporate taxation. Therefore, capital gains taxation must be include a strategy that will raise revenue through serving the function of increased innovation, which will turn into taxable income.

This reform to rate structures must come, at the same time, with the ending of step up in basis. The Center For American Progress said: “As an example, imagine that Jill purchases a share of stock in 1980 for $10. Jill still owns the stock when she dies in 2003, and the stock is now worth $50. Jill’s son Jack inherits the stock and sells it in 2007 for $55. Even though the stock has gained $45 from its initial cost of $10, Jack only has to pay capital gains taxes on the $5 gain that occurred after Jill passed away. The other $40 in capital gains is never subject to income taxes, since Jack benefited from a step-up in basis.” If step up in basis were to be removed, the same CFAP analysis suggests that 644 billion dollars would be gained over 10 years. Eliminating this provision from the tax code could be accompanied by eliminating the loophole for hedge funds, whose labor income is taxed at the capital gains rate, despite the fact that eliminating this provision and its increased taxation effect on labor income would not affect investment behavior, according to Bloomberg. With this being said, an overall decrease in the rate of capital gains taxation on future-term productive investments could spur investment. An update of an important study on venture capital suggests that cutting their rate of taxation is shown to increase entrepreneurial activity. It’s also shown to increase investment in risky innovation by a study by University of Miami, and to decrease stock volatility by another study from the University of Texas.

So, reform to these integral areas can vary, but any proposal that will increase the revenue coming from taxation is necessary in order to repair the lack of investment in education, infrastructure, scientific innovation, democratic transparency, and healthcare reform. The revenue coming from these tax reforms is prerequisite to commit to these structural reforms. But more importantly, the satisfying of this prerequisite is necessary to satisfy the social contract for our citizens. Not just a basic social contract, but a Berkian social contract between the generations of our people. The Just Savings Principle of John Rawls echoed this idea of mending economic inequalities between the wealthy and poor to benefit the overall societal welfare of our nation. If we ignore this philosophical wisdom, then we cannot have a basic moral paradigm to approach institutional reform. Only when our political leadership realizes this reality will they commit to the efficacious tax reforms that will fulfill the criterion set by liberal philosophers of our time.