The 70% marginal tax rate is only the beginning of a fair system

Alexandria Ocasio-Cortez has begun a better tax debate, but we still need to close loopholes, not just raise rates.

There’s a wonderful clarity to New York Rep. Alexandria Ocasio-Cortez’s call for a 70 percent marginal tax rate on incomes over $10 million. Compare it to past Democratic or progressive efforts to nudge up taxes on the superwealthy, which inevitably became mired in complexity as they struggled to avoid violating an inexplicable promise never to raise taxes on any households with incomes below $250,000.

Recall, for example, the “Buffett Rule” that President Obama and Sen. Sheldon Whitehouse (D-RI) designed in 2012, in response to Warren Buffett’s point that he paid taxes at an overall rate lower than his secretary, simply because, like all investors, most of his income is in the form of capital gains and dividends. The obvious answer would have been to bring the tax rate on investment income in line with the ordinary rate on income from work, which is the rate his secretary pays. But fearful that might touch some of those struggling quarter-millionaires, Whitehouse and the administration cobbled together the Paying a Fair Share Act, which looked more like a second layer of the dauntingly complex alternative minimum tax.

Even Sen. Bernie Sanders (I-VT) joined in the promise to protect households under $250,000 — about the top 3 to 4 percent — from any tax increases, which made his 2016 campaign proposal to raise the cap on taxable wages for Social Security as convoluted as the Buffett Rule bill.

Ocasio-Cortez didn’t put forward a full tax proposal (there’s no reason she should), but her top-end number alone signaled a departure from the tiptoe caution of earlier Democrats. The focus on the top marginal rate also marks a break from a more traditional approach to tax policy, which aims to keep the tax base broad (as much income as possible should subject to tax, with few special breaks) and rates relatively low. This is the approach of tax reformers from the Kennedy administration through the tax reform of 1986. It’s what Republicans claimed they were aiming to achieve in 2017, although what they actually did was entirely different.

There’s both an economic and a political logic to the low rates/broad base model of traditional tax reform. The economic logic is that the tax system should be fairly neutral about economic activity; it shouldn’t favor one form of investment or income over another, because economic choices should be motivated by economic logic, not tax avoidance. The political rationale was that if rates were very high, politicians would be sympathetic to influential constituents who complained about the rates, and would push through special benefits for favored industries or firms.

That story rang true in the 1980s, when rates were nominally high but the tax code was larded with provisions that directly or indirectly benefited the politically influential oil and gas and real estate industries. (That’s why Donald Trump hated it: “Some very foolish people,” he told a congressional committee, “heard the word ‘tax shelter’ and thought it was a bad thing.”) Starting over with lower rates and as few exceptions as possible would mean that the wealthy would actually pay something close to the nominal rate, and the hope was that the system would be stable.

The tax reform of 1986, which embodied those ideas, doesn’t get much respect on the left today, in part because the lower top rates coincided with, and may have caused, the staggering increase in executive pay, a key driver of inequality. And the lower rates didn’t keep the wealthy special pleaders at bay for very long, so that today we have what might be the worst of all worlds — relatively low top marginal tax rates by historical standards (although at 37 percent, not as low as the 28 percent of the late 1980s), but also dozens of exceptions and special deals, some of which serve good purposes and some of which don’t. These “tax expenditures” totaled about $1.5 billion in 2017.

If the traditional tax reform model has failed, then just raising top rates makes a lot of sense. But it’s still important to clear away as many of the tax expenditures, old and new, as possible, particularly because the form they take will make them even more valuable to the very wealthy if the top marginal rate were to be set as high as 70 percent.

The first priority should still be to make sure as much income as possible is subject to the same rate, whatever it is. Members of the $10 million-plus club, like Buffett, get most of their income from investments, so it won’t do much just to raise the ordinary rate if the top tax rate on capital gains remains at the current level of just 20%. Many of the most notorious tax evasion schemes — the “carried interest” loophole, the “hedge fund” loophole — involve treating ordinary compensation as if it were capital gains. The main effect of raising the top rate on regular income to 70 percent would be to make those tricks, which are only available to the very wealthy, all the more valuable.

And then there’s a whole family of tax expenditures that have the effect of taking huge streams of income out of the tax system altogether. Take, for example, the increasingly popular Roth IRA, in which you pay taxes on the money when you contribute it, after which it grows tax-free and is tax-free on withdrawal — all that investment income is invisible to the tax system. Married taxpayers can contribute if they make less than about $200,000. So if you expect to be in the 70 percent bracket later in your career, you can (and should!) park all the money you can in a Roth IRA now, paying at your current lower tax rate, and that income will never see taxes again, at any rate. Other tax expenditures that take a similar form include 529 programs for college savings and health savings accounts.

The newest tax shelter, and a particular obsession of mine, is a program called “Opportunity Zones,” which allows investors with capital gains income to avoid tax altogether if they put their gains into a fund that, in turn, invests partly in “economically distressed” neighborhoods such as Brooklyn Heights. While taking very little risk in such gentrifying, or long-gentrified neighborhoods, the program will allow investors to take even more income out of the tax system.

The next generation of progressive tax policy won’t go back to the low rates/broad base model that long ago achieved a bipartisan consensus. But it’s not enough to just raise rates. Given a choice between a 70 percent top rate, with all the tricks and shelters that will allow the very wealthy to avoid it, and a 60 percent or even 45 percent marginal rate that the very wealthy actually pay, we should always prefer the second. But at least the debate has begun and we’re past the cautiousness of the Buffett Rule era.

Author: Mark Schmitt

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