Four Big Ideas for Tax Reform

The coming debate over tax reform will likely be a wasted opportunity to fix the tax code for the good of the economy and working-class Americans.

After the spectacular crash-and-burn that was the GOP’s prolonged effort this year to repeal the Affordable Care Act, Republican leaders in Congress are desperate to chalk up at least one legislative victory before the quickly-approaching 2018 midterms.

Tax reform is now the life raft for these ambitions, and House Ways and Means Chairman Rep. Kevin Brady (R-Tex.) recently promised that Congress is “on track” to deliver “transformational, bold tax reform” before the end of the year to boost the economy.

Unfortunately, what the GOP is really after is an easy political win, which means that anything Congress delivers—if it delivers at all—will fall far short of Brady’s optimistic goal.

Tax reform is really, really tough. The last major overhaul—in 1986—took years of bipartisan negotiation over multiple sessions of Congress. This Republican Congress, however is giving itself three months (if it tries to adhere to Brady’s deadline) to reform a system that touches the economic fortunes of every American household and business, and that could set the course of the American economy for decades. That’s less than half the time the GOP gave itself to draft (the failed) legislation intended to reorder U.S. health care system, which comprises one-sixth of the economy.

Republicans moreover have shunned the input of Democrats, while the White House has been no help. Aside from hectoring Congress for results, Trump’s White House has provided little direction, releasing a one-page “framework” in April and promising a 3-to-5 page document in September.

Given all this, it’s highly doubtful that anything the GOP Congress puts forward this fall will truly count as “reform.” Rather, the likeliest scenario is a modest—or not so modest—set of corporate tax cuts aimed at placating the president and his base and, of course, squeezing vulnerable swing-state Democrats into making difficult pre-election choices. As Trump adviser Kellyanne Conway signaled as early as January, Trump would be just as happy with tax “relief” as he would be with “reform.”

A tax cut package disguised as reform could do serious damage—such as by blowing a mile-high hole in the federal deficit while aggravating the blatant inequities of the current system. More significantly, it would be an enormous missed opportunity for genuine discussion about the kinds of reforms that could grow the economy and make it fairer for working-class Americans.

If Congress were to be serious about tax reform, it should pursue two major goals:

First, it should remove the burdens and complexity that have accreted since 1986, and fix the many distortions that have crept in. The current system, for example, fails to raise enough money to fund the nation’s priorities, while being absurdly generous to wealthy Americans the least in need of help. And it encourages bad behavior by U.S. companies—such as corporate “inversions” to overseas locales—while encouraging firms to stockpile billions of dollars overseas instead of investing it at home.

Second, Congress should reimagine the tax code—which has never been just about raising revenue—to promote the social, economic and environmental goals we want to achieve, such as reducing the carbon emissions that drive climate change.

Both objectives would be doable if real reform were on the table, and there is no shortage of good ideas to improve the U.S. tax system. For example, here are just a few of the goals Congress could achieve with real tax reform—but in the name of political expediency likely won’t.

1. Combat climate change with a price on carbon.

Consensus has been building for years around the virtues of a carbon tax as an efficient, market-driven way to reduce carbon emissions while raising revenues and spurring clean energy innovation. A carbon tax, the logic goes, would motivate both companies and consumers to look for lower-priced, lower-carbon alternatives while penalizing polluters.

In British Columbia, for example, which launched a carbon tax in 2008, per capita emissions dropped by 12.9 percent from 2008 to 2013—more than triple the rate of decline in the rest of Canada, according to a study by the Carbon Tax Center. As one result of this success, Canada is set to adopt a national carbon tax in 2018 that follows the British Columbia model.

Contrary to what some might expect, businesses—including the world’s largest oil companies—support a carbon tax. As early as 2009, former ExxonMobil CEO Rex Tillerson, now secretary of state, praised a carbon tax as “the most efficient means of reflecting the cost of carbon in all economic decisions” and as a “more direct…a more transparent…and a more effective” approach than top-down regulatory regimes such as “cap-and-trade” or outright regulatory limits on carbon emissions.

In June, the company made headlines when it endorsed a bipartisan carbon tax proposal offered by the Climate Leadership Council, a newly-launched effort involving a diverse set of luminaries from former New York Mayor Michael Bloomberg to famed physicist Stephen Hawking to Laurene Powell Jobs, a businesswoman, philanthropist and the widow of Apple founder Steve Jobs. Democrats, such as by Rep. John Delaney (D-Md.), have proposed similar bills that have also enjoyed broad support.

Given the level of interest and the urgency of global and national concerns around climate change, consideration of a carbon tax should be part of the congressional debate on tax reform. Instead, Congress will likely forfeit its chance to pass a bipartisan reform that could save the planet, promote clean energy and raise money to boot.

2. Encourage companies to invest at home by fixing how we tax foreign profits.

In 2015, according to the economic research firm Capital Economics, U.S. companies were hoarding as much as $2.5 trillion in cash overseas—a figure equal to two-thirds of the federal budget that year. The U.S. firms with the biggest cash stashes, according to CNBC, were Microsoft and General Electric, each of which held more than $100 billion overseas, Apple ($91 billion) and Pfizer ($80 billion). This is money that could be invested in new research, new facilities or even higher pay for workers, considering that real wages for the average American haven’t budged in decades.

The reason so much money is sitting overseas is that the United States taxes U.S. companies under what’s known as a “worldwide” system of taxation. This means that Uncle Sam taxes a company’s revenues everywhere in the world where it’s earned, rather than just income earned in the United States. A U.S. company’s French subsidiary, for example, would owe taxes to the French government as well as to the United States (though the amount owed to the United States would be offset by the amount paid to France).

The catch in the current system is that U.S. companies don’t have to pay these taxes on their foreign earnings until they “repatriate” them—that is, until they bring that money home. This ability to put off paying taxes—called “deferral”—encourages companies to stockpile money overseas tax-free until they can find the right opportunity to repatriate those funds—such as if Congress passes a giant tax break. In 2004, Congress passed a repatriation “tax holiday” in an effort to bring back U.S. money and stimulate domestic investment. What happened instead is that companies mostly used this windfall to buy back stock or issue dividends—at a cost of billions in foregone tax dollars.

One option for ending this madness—supported by both President Trump and Senator Bernie Sanders—is simply to end deferral on foreign profits while retaining the worldwide system of taxation. U.S. companies would then immediately owe U.S. taxes on any income earned abroad. Under current corporate tax rates, however, the amount of taxes owed could be punitively high, thereby encouraging U.S. companies to shift their headquarters overseas to other countries that would tax them less.

A second—and better—option is to switch the United States to a “territorial” system of taxation, which is used by most European countries. Under this system, U.S. companies would only pay taxes on income earned in the United States while foreign profits would be exempt, which was the approach preferred by the Obama administration. The result would be the freer flow of profits back home.

Given the desire for a corporate tax cut and the vast amounts of money parked overseas, the Republican Congress will be tempted to pursue the sugar high of another repatriation tax holiday without also enacting broader reform – the policy equivalent of eating five slabs of cheesecake for your dinner. While the revenues raised by such a move could help pay for touted priorities such as an infrastructure bill, the biggest beneficiaries of a repatriation tax windfall would be stockholders and CEOs, not U.S. workers.

3. Benefit the middle class by distributing tax benefits more fairly.

According to the nonprofit Prosperity Now, the federal government spends $500 billion a year on tax breaks to help Americans build wealth. But nearly 80 percent of that amount—or $319 billion in 2013—goes to benefit the top fifth of U.S. households.

Higher-income households disproportionately benefit from federal tax breaks in two ways. First, many tax breaks—such as the home mortgage interest deduction—are only available to taxpayers who itemize. Because wealthy taxpayers are much more likely to itemize, they are much more likely to benefit from these tax breaks. An analysis by the Tax Foundation, for example, found that households earning $30,000 or less claimed just 9 percent of home mortgage interest deductions, while the vast majority of benefits went to households earning $75,000 or more. Among households earning $200,000, the average deduction was a handsome $14,374 in 2003, compared to just $910 for someone earning under $30,000.

A second way that wealthy taxpayers disproportionately benefit is through the myriad of tax breaks rewarding savings. 401(k)s, IRAs, 529s for college savings, and other tax-preferred savings vehicles all accrue much more to the benefit of rich people—in large part because middle income and lower-income households simply can’t afford to save. According to the Federal Reserve’s 2013 Survey of Consumer Finances, families in the bottom half by income held an average of $39,100 in IRAs or defined contribution retirement plans—such as 401(k)s—while families in the top 10 percent held an average of $446,000.

Redirecting even a small proportion of the tax benefits that flow to the wealthiest households—such as by limiting the home mortgage interest deduction and using the proceeds to “match” retirement savings by lower- and middle-income households—would go a long way toward making the tax code fairer while improving the financial security of millions of American family.

4. Save taxpayers money and hassle with return-free filing.

According to the 2016 Taxpayer Advocate Service’s Report to Congress, individuals and businesses spent 6 billion hours a year filing tax forms. Moreover, more than half of Americans end up paying for professional tax preparation—including through buying software such as TurboTax—because of the complexity of the code. These tax preparation fees also tend to fall heavily on lower-income households, who often pay hundreds of dollars for tax preparation services to companies such as Jackson-Hewitt and H&R Block in order to get help claiming benefits such as the notoriously complex Earned Income Tax Credit (EITC).

One step Congress could take to ease these burdens is to simplify the tax code, such as by consolidating the now 15 different tax breaks for retirement savings.

A more radical step would be to explore the idea of “return-free” filing—i.e., eliminating the need for at least some taxpayers to file an income tax return at all. Countries such as the United Kingdom, Russia, Germany and Japan already use variants of this system, under which the government calculates and tries to withhold exactly the amount of taxes due based on what it knows about a taxpayer’s paychecks and income. The Tax Policy Center analysis argues that such a system could also work in the United States if the U.S. tax system were simplified to make those calculations possible (and taxpayers trusted the IRS to do a good job, which is a separate issue). Realistically, such a system would likely work best for taxpayers with the simplest returns—i.e., lower-income filers who don’t itemize their deductions, have a single source of income, and likely don’t owe federal taxes anyway.

Return-free filing would not only save these taxpayers time, but potentially enormous sums of money, particularly if they can ill-afford the expense of paying for professional tax preparation services.

These ideas are just a smattering of the potential ideas Congress could take up if it were serious about tax reform—experts have had 30 years since the last effort to devise new ways to make the tax code more efficient and more fair.

Alas, the GOP’s pending effort on tax “reform” will likely not be so much about helping the U.S. economy or American taxpayers as it will be about boosting Republicans’ ailing political fortunes. But whether it will achieve even that is far from clear.

Anne Kim

Anne Kim is senior writer at the Washington Monthly.