TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform should simplify the tax code. Instead, Congress is debating new ways to raise revenue that would make the tax code more complex and more difficult to administer. The new proposals—imposing an alternative minimum tax on corporate book incomeBook income is the amount of income corporations publicly report on their financial statements to shareholders. This measure is useful for assessing the financial health of a business but often does not reflect economic reality and can result in a firm appearing profitable while paying little or no income tax. , applying an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. on stock buybacks, levying a surcharge on higher earners, and, at one point this week, a tax on unrealized capital gains for billionaires—are unreliable and highly complex ways to raise revenue.
Instead of leaning on complicated ways to raise revenue, lawmakers should prioritize broadening the tax base and eliminate tax expenditures unrelated to cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. , international taxes, and deferral. Revenue increases can be structured to improve the tax code by making it simpler and more neutral across industries and households.
Alternative minimum tax on corporate book income
One proposal announced this week is a book minimum tax that would require companies making at least $1 billion in profit in a year to pay at least 15 percent of their accounting profits in taxes. According to the legislative description released by Senator Elizabeth Warren (D-MA), the tax could apply to roughly 200 companies. The proposal is the latest of several taxes related to book income, such as the book minimum tax proposed by President Biden earlier this year, as well as the surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on book profits Sen. Warren included in her presidential campaign platform.
There are two main ways to calculate corporate profits, typically defined as revenues minus costs. The first is using financial accounting rules, designed to match deductions for costs to the revenues the expenses will generate—producing book income. The second is using the tax laws enacted by Congress, designed to raise revenue for government activities and encourage or penalize certain behaviors—producing taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . The two approaches result in different measures of corporate profits, and in some years leads to certain firms paying no taxes, even if they had book profits.
Two major types of policies can create differences between book and taxable income. The first type is structural, such as faster deductions for physical capital investments that more accurately measure a firm’s profits on a cash flow basis. Another common example is deductions for past losses to ensure firms are taxed on profitability over time and not penalized for losses that don’t align with calendar years.
The second type of policy that creates book tax differences are tax subsidies, or deductions and credits that Congress has enacted to encourage or discourage certain behavior. Those include policies like the Research & Development (R&D) tax credit, the Low-Income Housing Tax Credit (LIHTC), various credits for renewable energy, and other tax breaks.
Unfortunately, the book minimum tax would limit the use of full and immediate deductions for the cost of investment, while explicitly protecting the tax subsidy provisions. The plan would preserve the use of many types of credits within the book minimum tax but disallow accelerated deductions for physical investment. There are several ways to reduce favoritism in the tax code, but the book minimum tax would broadly disadvantage investment while keeping targeted subsidies in place—meaning some companies with large financial profits would still not end up paying taxes.
Excise tax on stock buybacks
Another proposal being considered would impose a 1 or 2 percent excise tax on the value of stock that firms repurchase on net from shareholders, providing some exceptions for stock contributed into retirement accounts and stock-based compensation.
While it is meant to encourage firms to invest the cash being used to buy back stock, the tax would not create additional investment opportunities for firms. Investments are pursued based on their expected after-tax returns, not by the amount of extra cash that firms have.
When firms have excess cash, they can either return it to shareholders or hold onto it. Returning cash can provide shareholders with liquidity to invest in alternative, more productive investments. Taxing stock buybacks would not encourage investment or raise wages, and would instead be a distraction from better ways to reduce the cost of making new investments, such as permitting firms to receive a full and immediate deduction for those expenses.
An excise tax on stock buybacks may also impact a firm’s decision to issue dividends, which are an alternative way for firms to send cash to shareholders. It may also reduce the frequency and magnitude of stock buybacks, reducing the amount of revenue collected. Stock buybacks can vary over time, making the excise tax an unreliable revenue source for financing social spending.
Mark-to-market taxation of billionaires
Under current law, the increase in the value of an asset, such as a stock or a private business, is not taxed as the value increases; instead, it is taxed when an investor sells it for a profit and realizes a gain. The proposal for a “Billionaires Income Tax” (which has now fallen out of the debate) would change that system for taxpayers with at least $1 billion in assets or who report $100 million in adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” (AGI) for three consecutive years, such that unrealized gains, or “paper gains,” would be subject to capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. via a mark-to-market system of valuation.
These taxpayers would face a one-time transition tax on existing unrealized gains payable over five years, which would be a significant revenue raiser. Mark-to-market going forward, however, would be a less stable revenue raiser because capital gains are a highly volatile source of income, rising and falling with the health of the economy and other factors.
For example, if a billionaire had started a business 20 years ago that grew in value to $3 billion today, they would owe a one-time transition tax on that increase in value. (The proposal would allow $1 billion of stock in a single corporation to be treated as non-tradable in an attempt to provide protections for business founders.) At the current top capital gains tax rate of 23.8 percent, the tax bill on a $3 billion gain would be $714 million, spread over five years. Or, if the billionaire used the option of treating $1 billion of stock as non-tradable, $2 billion of the gain would face an immediate tax of $476 million spread over five years.
Going forward, publicly-traded assets would be taxed each year on their increase in value and non-traded assets would face a nearly equivalent recapture charge when they are transferred, sold, or when the taxpayer dies. Taxpayers with losses would be able to carry them back for three years to offset previous unrealized gains or carry them forward to offset future unrealized gains. In years in which stock prices decline, that could mean the government cuts refund checks to billionaires as their assets fall in value and they offset past mark-to-market taxes, making for an unreliable tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .
To prevent avoidance, lawmakers have designed several enforcement rules such as lower tax thresholds for trusts and limits on the use of opportunity zones established in 2017. It will be administratively costly to anticipate and prevent taxpayer avoidance while measuring the change in asset values annually.
Taxing gains as they accrue may also result in situations where taxpayers do not have the cash or liquidity to pay their tax bill in a given year. That is particularly concerning in the case of business founders who may have to sell stock, and potentially lose control of their business, in order to pay the tax bill. This could also create market instability for owners of U.S. equities.
More broadly, the proposal would raise the tax burden on U.S. saving. As domestic savers reduced their saving, it would be made up for, in part, by foreign savers. American incomes could drop as the returns to that saving would flow to foreigners instead.
Surtax on High Income Individuals
The White House and House Rules Committee proposed a new 5 percent surtax on modified adjusted gross income (MAGI) above $10 million, and an 8 percent surtax on MAGI over $25 million. It is similar to the surtax proposal in the original Build Back Better Act but kicks in at a higher income threshold and applies higher rates.
While the ordinary income tax system applies the tax rate schedule to taxable income, the surtax applies to MAGI, which is calculated before taking itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. s. That means surtax liability cannot be reduced by taking larger itemized deductions such as for charitable contributions and state and local taxes paid, or by the Section 199A pass-through deduction.
The surtax would bring the top ordinary income tax rate up to 48.8 percent between 2022 and 2025 when including the 3.8 percent net investment income tax (NIIT), and to 51.4 percent after 2025 when the top ordinary rate rises from 37 percent to 39.6 percent. It would also raise the top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. on long-term capital gains and qualified dividends to 31.8 percent.
Despite the claims that tax rates on ordinary and qualified income are not being increased in the package, the surtax would result in a large increase in top marginal tax rates for high-earning households. In combination with the proposed change to apply the 3.8 percent NIIT to active business income, this proposal would result in much higher top rates on noncorporate business income (which is reported and taxed on individual tax returns) compared to the top rates on corporate income—a differential which may distort whether certain firms decide to become C corporations or pass-through entities. Using MAGI for the surtax base also introduces more complexity into the tax code, as taxpayers must calculate their tax liability using taxable income and AGI.
Looking at IRS data, we found that about 13,000 taxpayers would face a tax increase due to the surcharge. They differ from other taxpayers in that they are more likely to earn their income through investments rather than through wages and salaries. This group derives nearly half of its income from capital gains alone, not including other kinds of investment income such as interest. For comparison, for taxpayers earning under $100,000, less than 1 percent of their income is derived from capital gains. As a result, the surcharge would hit 29 percent of all capital gains income reported to the IRS.
Unlike income earned through wages and salaries, taxes on capital gains are easier to avoid. As capital gains are only taxed when they are “realized,” when the assets are sold, taxpayers can avoid the tax by not realizing those gains while the surcharge is in effect. Alternatively, they can realize their gains just before the surcharge is imposed to pay taxes under the lower marginal rate (i.e., before the new year). In fact, when we modeled a hypothetical 70 percent marginal tax rate on incomes above $10 million, we found that it would raise very little revenue due to these behavioral effects.
Top taxpayers are also responsible for a disproportionate share of pass-through business income reported to the IRS. As the surcharge also applies to this income, this will lower the after-tax return on an entrepreneur’s investment and will reduce their incentive to invest in their business. This reduction in investment would have negative impacts on economic growth. However, taxpayers earning more than $10 million report a smaller share of all pass-through income to the IRS (6 percent) compared to taxpayers earning between $1 million and $10 million (25 percent).
At first glance, the surtax might appear to target a broad class of income, because it applies to income before the taxpayers itemize any deductions. But considering that the tax targets a small group of taxpayers, who generate a large share of their income through capital gains and other kinds of investment income, the tax base is narrower and more volatile than it appears. Policymakers should consider more broad-based taxes such as consumption taxes if they are looking to raise revenue from high-income taxpayers and minimize economic damage.
Launch Resource Center: President Biden’s Tax Proposals
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