FT-Opinion by Burton Malkiel “How the US should reform taxes”

Many proposals coming from both political parties make little sense and would upend the principles of a fair and efficient system

The article provides a critical analysis of various tax reform proposals being discussed amid the U.S. presidential election, as candidates address how to generate revenue to address the rising budget deficit. The focus is on evaluating the fairness, efficiency, and practicality of these tax ideas, particularly considering their potential economic impact. Below are more detailed insights into the major points raised:

1. 1. High Marginal Tax Rates:

      • Some proposals suggest substantially increasing the top marginal income tax rates. Proponents argue that the U.S. had marginal tax rates as high as 90% during the early 1950s, yet the economy continued to grow, albeit slowly.
      • However, the article argues that the historical context reveals a different reality. While nominal tax rates were high, few people actually paid those rates due to widespread tax avoidance, shelters, and income-shifting strategies.
      • Income Shifting and Loopholes: Wealthier individuals used strategies such as shifting income to lower-taxed entities like corporations or transferring income to family members in lower tax brackets. This reduced the effective tax rate for high earners.

   2. Proposals to Eliminate Taxes on Specific Income:

      • There are proposals to exempt certain types of income, such as tips or overtime pay, from taxation. While this might appear to benefit workers directly, it risks creating systemic issues.
      • Erosion of the Tax Base: Exempting tips from taxation could incentivize employers to restructure compensation packages to maximize untaxed income, such as converting wages into tips. This would erode the income tax base and result in lost revenue.
      • Similar risks apply to other types of income-specific tax exemptions, such as overtime pay, which could be exploited through income reclassification.

   3. Wealth Taxes:

      • The idea of imposing a wealth tax, particularly targeting ultra-high-net-worth individuals, has gained traction. Such taxes have a history in Europe but have been largely abandoned due to various challenges:
        • Administrative Difficulties: Accurately valuing assets, especially illiquid ones such as privately held businesses or artwork, poses a significant challenge.
        • Tax Avoidance Strategies: Wealthy individuals often employ sophisticated tax planning techniques to minimize exposure to wealth taxes.
        • Limited Revenue Generation: In practice, wealth taxes have not raised significant amounts of revenue in proportion to their intended targets, leading many European countries to drop these taxes.

   4. Alternative Approaches to Raising Revenue:

      • Closing Loopholes: The article suggests focusing on eliminating existing tax loopholes, such as the favorable tax treatment of “carried interest.” Private equity managers often receive a share of profits from investment deals taxed as capital gains (at a lower rate), rather than as ordinary income. Changing this could ensure fairer tax contributions from high-income earners.
      • Capital Gains Tax at Death: Currently, when an individual dies, the cost basis of their assets is “stepped up” to the market value at the time of death, which allows inheritors to avoid paying taxes on the capital gains accrued during the decedent’s lifetime. The proposal suggests taxing unrealized capital gains at death, which would close a significant loophole and prevent tax avoidance by simply holding onto appreciated assets indefinitely.
      • Federal Consumption Tax: Introducing a federal consumption tax could shift the tax burden from income to consumption. The article argues that this approach may be more efficient because it taxes individuals based on what they consume (take out of the economy) rather than what they contribute (earn through labor and investment).
        • Reducing Regressivity: Although consumption taxes are generally considered regressive (affecting lower-income households more), there are ways to design them to be less so, such as exempting basic necessities or providing rebates to low-income households.

   5. Challenges to Implementing Reforms:

      • The article notes that efforts to close loopholes and implement significant tax reform are complicated by the influence of lobbyists. Various interest groups may resist changes that affect their tax benefits, making it difficult to pass legislation that would effectively close loopholes or alter tax structures.
      • Political and Economic Trade-offs: Any tax policy changes must balance the need for increased revenue with the potential impact on economic incentives. High taxes on income, investments, or wealth can discourage economic activity, while poorly designed consumption taxes may disproportionately affect lower-income groups.

Conclusions and Recommendations:

The article concludes that while there is no perfect solution, the goal should be to create a tax system that raises revenue efficiently and equitably. Policymakers should avoid extreme proposals, such as very high marginal tax rates or complex wealth taxes, which may lead to unintended consequences like tax avoidance or economic distortion.

Instead, a more pragmatic approach involves:

• Closing existing loopholes to ensure the wealthy pay a fair share of taxes.
• Taxing unrealized capital gains at death to capture revenue from asset appreciation.
• Considering a federal consumption tax to diversify revenue sources and reduce reliance on income taxes.

Such reforms, while challenging, could make the U.S. tax system fairer and more sustainable in addressing the nation’s fiscal challenges.