Obama’s tax proposals would make the tax code more complicated, less fair

Chris Edwards Director of Tax Policy Studies, Cato Institute
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President Obama has a new budget and a new Treasury study that promise “tax reform.” He says that he wants to abolish “dozens of tax loopholes,” but he also proposes a boatload of new special-interest tax breaks. The president says that he wants everyone to “play by the same rules.” His tax plan does the opposite.

Serious economists know that tax reform means lower marginal tax rates, simplification and a neutral tax base that doesn’t distort investment. Those were the goals of the bipartisan Tax Reform Act of 1986 and of many reform proposals since. However, that basic understanding of tax reform has eluded the Obama administration.

The administration is calling for “corporate tax reform that will close loopholes,” but it is also proposing new tax breaks (“loopholes”) for green buildings, green manufacturing and green car production. And it is proposing tax breaks for “manufacturing communities,” “advanced manufacturing,” “growth zones,” businesses that insource production and businesses that increase their wages. The administration also wants to expand the low-income housing tax credit, which is a giveaway to real estate developers.

The president’s budget states correctly that tax reform should “simplify the tax code and lower tax rates.” But the raft of special breaks would make the code more complex, and the budget includes higher rates on individuals, not lower ones. The president’s health care law increased tax rates on investment income and other items, and his budget would raise tax rates on wages, small business earnings, capital gains, dividends and estates.

Higher tax rates on dividends would exacerbate a well-known distortion in the tax code: the double taxation of corporate equity. The new Treasury study discusses this problem, but the president’s own plan would make it worse by raising the dividend tax rate from 15 percent to more than 40 percent.

The administration also proposes to raise the overall personal income tax rate to more than 40 percent, which is far removed from the 28 percent rate achieved under the 1986 tax reform. That hike would reduce productive activities such as working and investing. Yet listening to the president’s rhetoric, he seems to think that tax-rate increases do no harm because people with high incomes are just a bunch of Wall Street speculators with ill-gotten gains.

The reality is that America’s top earners are highly productive people who are crucial to the economy. Aside from small business owners and investors, there are a huge number of doctors and surgeons in the top income tax brackets. There are 700,000 doctors and surgeons in the nation, and a recent survey found that median salaries in various medical specialties ranged from $209,000 to $502,000. That means that Obama is painting a big bulls-eye on doctors’ white coats with his income tax hikes.

Economic research shows that high earners are far more responsive to tax rate changes than are people with lower incomes. With higher tax rates, for example, some share of doctors would work fewer hours and retire earlier. That withdrawal of labor supply would exacerbate already expected doctor shortages in coming years.

To further penalize high earners, Obama’s budget talks about a “Buffett rule,” under which no household at the top should “pay a smaller share of its income in taxes than middle-class families pay.” But IRS data show that high earners already pay an effective income tax rate of about 25 percent on average, which is far more than the average rate on middle-class families of less than 10 percent.

So I’ve got a better idea for a Buffett rule — no one should pay a larger share of their income in taxes than Warren Buffett does. In a recent interview, Buffett said that he paid 17 percent. That rate would be a good target for tax reform since it’s the same rate as the flat tax proposed by former House Majority Leader Dick Armey.

Perhaps you are thinking that while Obama adds special breaks to the tax code and hikes individual tax rates, he at least gets rid of loopholes that cause corporations to “ship jobs overseas.” Actually, the 11 provisions in Obama’s budget that penalize corporate foreign income would hurt the U.S. economy, not help it. That’s because the foreign operations of U.S. companies mainly complement their domestic operations, not undermine them. Many of Obama’s foreign income provisions would make the tax code more complex, and they move in the opposite direction of the efficient territorial systems that most of our trading partners have.

Besides, it is America’s uniquely high 40 percent corporate tax rate that encourages businesses to invest abroad. To the president’s credit, he has proposed a 7-point reduction in the corporate tax rate. But even with a federal-state corporate tax rate of 33 percent, we would still be far above the 25 percent average rate of nations in the Organization for Economic Cooperation and Development.

In sum, the president’s rhetoric about tax reform is at odds with the reality of his own proposals. While Obama’s proposals would trim the corporate rate, they would also give us more loopholes, more complexity and higher individual rates. The budget says that the “tax code has become increasingly complicated and unfair.” That’s right, and President Obama’s proposals would make it worse.

Chris Edwards of director of tax policy studies at the Cato Institute and editor of www.DownsizingGovernment.org.