Loopholes for wealthy weaken fairness of income tax system

Published in The News Tribune, February 1, 2012

It shouldn’t be surprising that Mitt Romney pays only 15 percent of his income in federal incomes taxes.  After all, he benefits from the fact that his income comes mostly in the form of capital gains – income from selling assets that have increased in value.  Capital gains are taxed at a top rate of 15 percent, which compares with a top rate of 35 percent on wage income.

This provision in the income tax code explains why Mitt Romney, Warren Buffett and most other super-rich Americans, pay less as a share of their income than do many working Americans. Combining income taxes and payroll taxes, the super-rich pay about the same rate as do 40 percent of all Americans.

Buffett has famously argued that it’s not fair he pays so little in taxes — less than his secretary.  President Obama agrees; he even selected Buffett’s secretary to sit with Michelle Obama at his State of the Union address.  Romney hasn’t weighed in, although his silence suggests he’s not one to complain.  Who is right?

Let’s first consider why it is we should tax income.  Income has two features that make it a great candidate for taxation.  For one, there’s plenty of it.  This makes it much easier (tax rates can be lower) to raise a given amount of revenue.  Second, you can tax it according to people’s ability to pay.

In theory, then, income taxes accomplish what very few taxes can:  low tax rates raise a lot of money, and the tax burden corresponds with individuals’ ability to shoulder it.

In practice, though, income tax laws reflect the influence of decades of political movements that have successfully introduced one or another loophole into tax law.  Such loopholes (euphemistically called “tax preferences”) have significantly undermined the effectiveness of income tax policy.

Low taxes on capital gains is one example.  At 15 percent, the capital gains tax rate is at its lowest level since 1933.  Newt Gingrich now promises us he’ll eliminate the tax altogether.

Is this fair?  Common sense in on Buffett’s side:  Something’s amiss when those most able to pay relatively little in taxes.

Those who advocate for low or even zero taxes on capital gains don’t base their support on fairness, though (although I suspect many believe it is).  Rather they argue that a lower tax rate encourages the sort of investments that drive economic growth and job creation.

Yet this belief is based on faith more than evidence.  A 2010 report by the non-partisan Congressional Research Service concluded that there’s likely no relationship between capital gains rates and economic growth.  On the other hand, a December CRS report found that the rapid growth in capital gains income over the last decade coupled with its lower tax rate, explains much of our country’s growing income inequality.

Singling out the low tax rate on capital gains is admittedly a little unfair.  It is, after all, but one example of countless ways the tax code lets people unfairly escape paying taxes.  People can use deferrals to delay paying taxes; be compensated in ways that are not taxed; spend money in ways that reduce their taxes; and so on.

In fact there are so many giveaways that the reasons for taxing income – to raise money with low tax rates, and do so fairly –have been seriously weakened.  If it weren’t for all these giveaways, we could nearly cut the rate in half at which we tax ourselves, and still raise about the same amount of revenue.

But it’s unlikely we’ll reform our tax system to reclaim the features it would ideally have.  While Republicans support far-reaching reforms, their proposals reduce taxes on the wealthy at the expense of others.  For all its faults, current income tax policy does a better job than do alternatives of targeting those most able to pay.

The political value of tax giveaways also means that politicians will continue to prioritize them.  In his State of the Union address, President Obama predictably named eight new ones he’d like.

At least in the short term, politics promises to make existing shortcomings in our income tax system worse rather than better.

But nice try Warren.