Levin Speech on Tax Reform
“Eyes Wide Open: The Implications and Opportunities of the Current Tax Reform Debate”
The Honorable Sander Levin
Ranking Member, Committee on Ways & Means
At the Center for American Progress
June 3, 2011
(Remarks as Prepared)
Over the last months, there has been a great deal of discussion about the need for tax reform – a discussion that I welcome. Twenty-five years ago, I was not yet on the Ways & Means Committee, but I took a keen interest in the work that went into the Tax Reform Act of 1986. In 1985, the Ways & Means Committee held 30 days of full committee hearings on tax reform, followed by 26 days of mark-up. Members debated every aspect of the tax code, often provision by provision.
Today there is again a real need for reform. As we continue this discussion, tax reform is too important to be discussed only in glittering generalities. That has been too true to date, obscuring realities and unduly raising expectations.
It is irresponsible to throw out goals, numeric or otherwise, without any indication of how to achieve them, as done in the Republicans’ budget. We must be serious about tax reform, and we have to be serious about its implications. We need to be specific about what we hope to accomplish, and specific about how those goals relate to our present code.
My goal today is, in part, to dig beneath the glittering surface and bring to light some realities that should assist us in accomplishing real tax reform.
Clearly there is a need to address redundancies and reduce complexity. For individuals, the tax code can be a daunting system that is difficult to understand and comply with. This complexity and redundancy, even among some important provisions that have helped support and build the middle class, undermines the effectiveness of policy. Our tax system helps families afford college through the American Opportunity Credit, the Hope Credit, the Lifetime Learning Credit, a deduction for tuition, a deduction for student loan interest, Coverdell education savings accounts and 529 plans. Similarly, we encourage home ownership through the mortgage interest deduction, the exclusion of gain recognized on the sale or exchange of a primary residence, the deductibility of state and local property taxes and the deductibility of mortgage insurance premiums; in the recent past, we offered a temporary homebuyer credit. For retirement savings there is an alphabet soup of plans and incentives including 401(k)s, 403(b)s, IRAs, Roth IRAs, SEP IRAs and Keogh plans. In each area, provisions that serve a common goal have different rules, definitions and phase-outs that a taxpayer has to try to make sense of.
In addition to complexity, the Alternative Minimum Tax increases the tax liability of four million taxpayers every year, and causes millions more to compute their tax twice to determine if they are affected. As disruptive as this is, it would be even more so but for the annual “patch” enacted by Congress to prevent as many as 20 million taxpayers from paying the AMT.
For corporations, we have created enormous uncertainty by enacting too many provisions on a temporary basis, such as the R&D credit. This uncertainty undermines the efficacy of these provisions, since taxpayers cannot use them if they cannot plan for them. Simplification of our corporate income tax would free up resources now devoted to compliance for more productive purposes.
Even as the current discussion has been stuck in generalities, it has also gotten ahead of itself in that there are no principles guiding reform. In the 1986 Act, reform proceeded from three principles: Fairness, Efficiency and Simplicity. I propose that we build on that with three additional principles to guide today’s tax reform efforts: tax reform should protect working families; it should encourage economic growth and job creation in the United States; and it should be fiscally responsible.
The approach advocated by House Republicans has been to simply announce that tax reform should achieve a top rate of 25% for both individuals and corporations, with no discussion whatsoever of what we would need to change and give up to achieve those rates. This is the equivalent of putting a blindfold on, spinning around three times, and picking a number. It’s time to take the blindfold off. It’s time to understand clearly what that would mean for working families.
Working families should be a focus of tax reform, not an afterthought. Since the last major tax reform in 1986, the pretax income of the vast majority of Americans has been stagnant, while the highest earners have seen dramatic gains. In 2008, the average income for the bottom 90% of earners was essentially the same in real terms as it was in 1986. But the top 1% saw a gain of 50% to $1.1 million. The top one-tenth of one percent saw a gain of 61% to $5.6 million.
Some on the other side like to complain about the share of taxes paid by upper-income households. Their share of taxes has risen, but so has their income. The share of pre-tax income going to the top 10% rose from 41% in 1986 to 48% in 2008, and the share going to the top 1% rose from 16% to 21%. The tax system does not do much to reduce this disparity. In 2007, the top 1% of households had 19% of national income before taxes, and 17% after taxes. The bottom 20% on the other hand had 4% of national income before taxes and 5% after taxes.
It is also not fair to say that “half of all Americans do not pay tax,” as some do. All working Americans pay payroll taxes, which make up 40% of federal revenues. All income quintiles have a positive average tax rate when all federal taxes are included.
In 1986, there was bipartisan agreement that reform should be distributionally neutral, that it should not shift the tax burden from one group of taxpayers to another. Given the wage stagnation that most Americans have experienced over the last 25 years, and the sharp increase in income inequality, we should make clear that we are not going to unfairly increase the tax burden of working families. Tax reform must not make our tax system less progressive.
The discussion so far has been dominated by those calling for a sweeping cut to the top tax rates and paying for them through the elimination of tax credits and deductions – the largest of which benefit America’s middle class. Some of the more concrete proposals, such as one of the options put forth by the bipartisan fiscal commission, have called for the elimination of virtually all of these provisions in order to pay for lower rates.
The discussion of tax credits and deductions needs to recognize that the vast majority of these provisions – by value – benefit individuals, not businesses. According to the Joint Committee on Taxation, 92% of these provisions by value benefited individuals in 2007. Of those, 74% of the value falls into four categories: Capital Gains and Dividends, Health, Retirement Savings, and Owner-Occupied Housing.
Ultimately, these are provisions that Congress would need to curtail in order to reduce the top individual rate to 25%. One of the illustrative tax reform plans in the Bowles-Simpson report achieved a 24% individual rate (and raised some revenue for deficit reduction) by eliminating every so-called tax expenditure other than the Earned Income Tax Credit and the Child Tax Credit. Let me say that again: by eliminating every individual tax benefit other than the EITC and the Child Credit. That means no mortgage interest deduction, no charitable deduction, no health insurance exclusion, no state and local income tax deduction, no exclusion for pensions, no IRAs and 401(k)s and no exclusion for military and veterans benefits. If no money had been set aside for deficit reduction, it might have been possible to retain one or two of the major provisions while still lowering the rate, but certainly not more than one or two. Thus, even under the most optimistic assessment, a 25% top rate would require the elimination of nearly all of the major tax benefits for individuals in the code.
So to reduce the top marginal rate for the wealthiest people in this country to 25%, Republicans would need to eliminate many provisions that benefit – and indeed helped build – the middle class of this country. There is a growing assumption that tax benefits, and itemized deductions in particular, primarily benefit the wealthy and that their elimination, in conjunction with lower rates, would benefit the middle class. I don’t believe this – my experience and, more importantly, the data support the reality that many of these provisions have helped support and build the middle class.
In my district outside Detroit, and all over this country, middle-class families bought their own homes, often for the first time, in part because of the mortgage interest deduction. They had employer pensions and employer-provided health care, again often for the first time, in part because of tax preferences. They sent their children to college, again a first for many of these families, in part because of tax preferences for education.
The Joint Committee on Taxation reports on the distribution of many of these provisions as part of its annual tax expenditure pamphlet, and we have asked them to analyze more of them. It is often assumed, and unchallenged, that these provisions primarily benefit upper-income households. The results are somewhat surprising.
In this chart, you can see that the exclusion for employer-provided health care and the deduction for self-employed health benefit, for instance, benefits over 58 million households making less than $100,000, representing 46% of the total benefit of the provision. If you go up to $200,000, you are looking at nearly 77 million households, and almost 82% of the benefit. The health care exclusion is a broadly utilized benefit for the middle class. But the chart doesn’t tell the whole story. The elimination of the exclusion for employer-provided health care would disproportionately burden those in occupations that have high health care costs – police and firefighters, miners, and factory workers – not lawyers and lobbyists.
Similarly, this chart shows that 70% of the benefit of the mortgage interest deduction goes to 31 million households making less than $200,000. And interestingly, less than 5% of the benefit of the deduction is associated with second homes. But it is unlikely that the burden of repeal would fall on the wealthiest taxpayers. The wealthiest homeowners could sell assets that are currently generating taxable income and pay down their mortgages. As a result, their tax bills would not go up. Middle-class homeowners, whose wealth is mostly tied up in their homes, would not have the same ability to shift assets in their portfolios and would bear the cost of repeal. Moreover, we must be very careful with respect to any action that could further reduce home values in the United States.
The benefit of the charitable deduction and the deduction for state and local income taxes are somewhat more concentrated in the upper-income ranges, but in both cases nearly half of the benefit is still going to more than 20 million households making less than $200,000.
But again, the charts do not tell the whole story. In the case of the deduction for State and local taxes, the deduction is primarily a matter of fairness: it prevents double taxation of income. If a repeal of the deduction led State and local governments to reduce taxes and cut services, those cuts are likely to be in services that support working families. In the case of the charitable deduction, one has to keep in mind that the recipients of the contributions include universities, hospitals, churches and soup kitchens that provide critical services to working families.
The EITC and Child Credit are targeted at low-income families, and between them they lift seven million working families out of poverty each year. Likewise, the education credits are targeted, so essentially all of the benefit goes to families making less than $200,000. Tax reform that builds the middle class must retain these benefits.
One notable exception to this pattern is the preferential rate for capital gains and dividends. The 15% maximum capital gains rate is estimated to cost $55.9 billion this year on a static basis. As you can see, the Joint Committee estimates that 71% of that benefit will go to 138,000 households making more than $1 million per year. About 12% goes to households making less than $200,000. Dividends are slightly less skewed toward the wealthiest taxpayers, but still 41% of the benefit of the 15% dividend rate goes to those making over $1 million. These preferential rates make it possible for the richest 400 Americans, whose average income in 2007 was $345 million, to pay tax at an average effective rate less than 17 percent – a rate lower than that paid by many middle-class families.
When you put all of this together, it is hard to see how the tax reform outline in the Republican budget would benefit working families. While a top rate of 25% may sound tantalizing to some, to raise the revenue necessary to keep the reform revenue neutral, you would have to eliminate virtually every tax incentive for middle-income and poor families. Even if proponents of such a rate eliminate the capital gains and dividend preferences, a rate that low still likely means a tax cut for many of those at the top, and a tax increase for broad portions of the middle class.
We should simplify the code to reduce overlap and unnecessary complexity. We should make sure that tax incentives are working as intended. But we should not blindly cut back the policies that helped to build a strong middle class in order to remake the rate structure in a way that benefits those at the top.
The need for tax reform also comes at a time when we need to find common ground on a balanced framework for immediate and long-term deficit reduction that allows for investments in economic growth. We are still emerging from the worst recession since the Great Depression, and targeted government investments in infrastructure, research and education will continue to be a key to getting Americans back to work.
The second key principle of tax reform is that it should encourage economic growth and domestic job creation. I think we should lower our corporate tax rate in a manner that does not lose revenue, but the trade-offs involved in getting there matter.
In the corporate tax system, three of the largest tax expenditures are the Section 199 domestic manufacturing deduction, accelerated depreciation, and the R&D credit. Each of these provisions provides a direct incentive to invest and create jobs here in the United States. We need to really understand the effect of these provisions, what we would be getting if we eliminate them, and the implications of a reformed system for domestic job creation. At the same time, we should examine whether each of these provisions is providing as strong an incentive for investment and job creation as it could be.
Over the last 14 months, the economy has created more than two million private sector jobs and economic recovery is slowly taking hold. But we still have a long way to go before we make up the nearly nine million jobs destroyed by the financial crisis and recession; so we must be extremely sensitive to the effect tax reform has on jobs.
Much of the discussion on corporate tax reform so far has centered on our international tax system. These issues are inherently complicated. Some years ago, my colleague Amo Houghton and I sat down with the staff of the Joint Committee on Taxation and essentially had a seminar on international corporate taxation for several days. We introduced a bill with a number of provisions designed to better reflect the realities of international competition, and a number of them became law. It was clear that some of the larger issues like deferral and worldwide versus territorial systems required further consideration and work, because there was no consensus about the effect of potential changes.
We need to move beyond the current easy rhetoric about a move to a territorial system because it does have the potential to encourage American corporations to shift more of their income, and possibly jobs, overseas. If we are going to consider a territorial system, we will need to strengthen our transfer pricing rules, address the allocation of expenses, and consider provisions to deal with tax havens. Similarly, we will need to carefully weigh the burdens that might be imposed on American workers by the elimination of provisions in the present worldwide system such as the export sales-source rule and rules that allow tax on foreign-source royalties to be minimized. These rules support U.S. exporters and U.S. R&D, respectively. Would a territorial system offer the same benefits to the providers of good jobs?
Furthermore, it was striking in a recent hearing in the Ways & Means Committee about other countries’ tax systems that all of the countries that were looked at had taken measures to protect their corporate tax bases, limit income shifting, and limit abuse. These provisions have the effect of turning these systems into hybrids – no one has a pure territorial system. But these provisions, which will not be universally popular with multinationals and their lobbyists, would be a critical part of any reform.
We should also be very wary of proposals to repeal provisions that encourage domestic investment in order to pay for a move to a territorial system. Depending on the design of such a system, it could lose tens – if not hundreds – of billions of dollars over ten years. It is far from clear whether or how Republicans could offset those losses while lowering the corporate rate to 25% and raising the same level of revenue as the present system.
We need to carefully examine all of these issues so that we can reform our corporate tax code in a way that encourages economic growth, investment, and job creation.
Finally, we have to recognize that this entire debate is taking place in the context of our need to implement a framework for immediate and long-term deficit reduction. Whether as part of tax reform or separately, revenues need to be part of the solution. In 2010, federal revenues as a percentage of GDP were 14.9%, near historic lows. This is due in no small part to the recession, but the Bush tax cuts played a large role as well.
Today, Republicans are not only refusing to even discuss revenues as part of deficit reduction goals, they are trying to rig tax reform. The Republican proposal would “stabilize revenues at 18 to 19 percent of GDP,” which implies making the Bush tax cuts permanent, even for the highest earners. During the only five years we have had balanced budgets since World War II, revenues averaged 20% of GDP. So even as an aging population places increased pressure on our healthcare and retirement systems, and even as we have incurred higher national security costs since 9/11, the Republicans want to shrink revenues. This reflects a prevailing Republican ideology of shrinking government down to a size where, as Grover Norquist puts it, they can “drown it in the bathtub.” Or, as a Republican witness at a recent hearing in the Ways & Means Committee put it, government is a “disease.”
Overall then, we should be working to reform our tax code. But we need to go into this effort with our eyes wide open, not blindfolded. We need to be clear and specific about what we hope to accomplish. We need tax reform that protects working families, encourages economic growth and domestic job creation, and is fiscally responsible. Unfortunately, the goals laid out by the Republican majority, while vague, have clear implications that should make us very skeptical of whether their reform plans could achieve any of those goals. It’s time to take off the blindfold and get down to work.