Representative Chris Van Hollen (D-MD) has proposed a series of taxes, credits, and subsidies to redistribute the 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. burden and income from the top one percent of income earners to middle-income workers, two-earner households, and savers. The plan would raise tax rates on capital formation, and would lower taxes on wages (although not generally at the margin). The net economic effects would be negative for the GDP, and could reduce pre-tax wages and job opportunities, offsetting some of the gains to workers from the tax subsidies.
Middle Income Tax Breaks
A New Payroll Credit
The congressman proposes a payroll credit, in addition to the current earned income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , of $1,000 for a single worker and $2,000 for a married couple. It would phase out at incomes of $100,000 (single) and $200,000 (joint filers).
The credit, being flat rate amounts, would not add to the reward for working longer hours; however, it might induce some people not in the work force to participate. The phase-out would raise the tax penalty for earning additional income near the cut-off points, and discourage some work and saving by affected taxpayers. When modeling the EITC, we find that its phase-out creates a tax penalty on incremental income that discourages more labor input than the credit induces. We do not have sufficient information about what the phase-out of the congressman’s new credit would look like to determine if it would create the same adverse net effect on work effort.
The congressman’s rationale for the credit is that after-tax wages in the middle and lower middle income ranges have not grown as much as in the top one percent of the income distribution in recent decades. In part, this is due to a shift in the mix of employment away from high-wage manufacturing jobs into lower-paying jobs in some areas of the service sector. The wage growth in a given occupation has been more in line with productivity. Nonetheless, lower skilled workers have faced some additional competition from foreign labor.
There are other reasons for the slow growth of after tax wages. Higher payroll taxes taking effect in 1988-1990 hit lower income workers harder than top earners. But the chief reason for the recent slow gains in after-tax wages has been slower growth of pre-tax wages, and the chief culprit for that slowdown has been inadequate investment in plant and equipment per working age American. The growth in the stock of capital per person has taken a terrific nose-dive since the start of the great recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. , and will not recover under current policies. The congressman’s proposed tax increases, described below, would further depress the already-inadequate pace of investment and would make that problem worse.
A Federal Saving Match for Credit Recipients
Taxpayers who save a portion of the new payroll credit or the EITC in a tax-favored retirement plan would receive a federal “saving bonus” of $250 for the first $500 of saving.
Much of the money would go to people already saving at least that much. It would do little to raise the national saving rate or boost investment. It would serve to introduce some non-savers to the advantages of retirement savings accounts.
An Expanded Dependent Care Credit
The congressman’s plan would increase the current Dependent Care Tax Credit, now limited to a partial offset of the first $3,000 in outlays for one eligible child or elderly dependent and $8,000 for two or more dependents. The limits on these eligible outlays would jump to $6,000 and $16,000, respectively. He would make the expanded credit refundable. The credit would be a flat rate of 20 percent to 25 percent of expenses up to these limits, provided total income was less than $200,000.
The credit encourages work for those able to take it, but the phase-out would make it a disincentive to add to income in the phase-out range (above $200,000). (See here for our study of the regular child credit.)
A Second Earner Deduction
The proposal includes a second worker tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. for married couples, equal to 20 percent of the first $60,000 of the lower earning spouse’s income. When a second earner in a family begins to work, his or her income is stacked atop the primary worker’s income, and faces the couple’s top tax rate from the first dollar earned. A similar deduction (of 10 percent on up to $3,000 of earnings) was enacted as part of President Reagan’s 1981 tax cut, effective from mid-1982 through 1986. It was eliminated by the Tax Reform Act of 1986, effective in 1987.
The second-earner deduction was more urgent in 1981, because there was a significant marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. in place. In those days, the tax bracketsA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. for married couples were less than twice as wide as for single filers, and the second worker’s earnings would push the couple up into higher tax rates sooner than for two single workers.
Today, after the Bush tax cuts eliminated the marriage penalty for couples in the bottom three tax brackets, the provision is somewhat less urgent. However, it would reduce the 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 the earnings of second workers with less than $60,000 in wages, and have some modest positive effect on the labor supply and GDP. This assumes that the deduction is not phased out if family income exceeds some threshold.
Tax Subsidies for Training and Apprenticeship Programs
The Van Hollen proposal includes some type of federal support for training and apprenticeship programs. If these programs are to be new government-run or government-contracted ventures detached from actual businesses, one must question their efficacy. The old Jobs Corps program failed to impart the skills that businesses actually needed and were a boondoggle.
Private employers normally provide on-the-job training for new workers, and the costs are deductible expenses, usually taking the form of the wages paid to the workers instructing the new hires. Providing a new tax subsidy for what companies already do would be wasteful.
Federal support for job training would not be needed, except for other errors in federal policy, such as high payroll taxes, a rigid minimum wage, and excessive taxation of investment that builds industries requiring additional workers. Normally, a firm will pay for training that is specific to the job at hand, and does not result in a portable skill that workers can take to other jobs. However, in the case of skills that are more general in nature which the worker can take with him to other jobs, the usual arrangement is an apprenticeship or training period in which the worker receives a lower wage than is paid to the experienced workers already on the job. In effect, the worker is buying his training with a wage reduction. This arrangement can be short-circuited by the minimum wage, because the wage cannot be reduced by the cost of the training below the statutory floor.
Instead of lowering the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. , or lowering the minimum wage, Van Hollen would pay out a tax subsidy for training expenses, and raise taxes to cover the costs. The taxes would boost the cost of capital while lowering the cost of new hires. But if the taxes discourage capital formation, what tools will the new workers have to work with? Will there be desirable jobs for them to take?
Paying for the Expanded Middle Income Tax Breaks with New Taxes and Unspecified Caps on Tax Deductions
Financial Transactions Tax
The congressman would pay for most of his tax subsidies by imposing a low rate tax on the trading of financial instruments, presumably stocks and bonds. It would fall on the total value of the assets being traded, not just on the gains from the trade. It would fall on trades with capital losses as well as trades with capital gains. He contends that the bulk of the levy would be collected from large volume traders whose trading, he claims, provides no economic value.
He cites similar taxes either adopted or being proposed in the European Union (ranging from 0.1 percent to 0.5 percent) as being harmless, and asserts without evidence that the foreign taxes would prevent U.S. trading from fleeing to Europe if similar taxes were adopted here.
In fact, these European tax proposals have not yet been implemented in the major nations, and are causing some considerable discord in Europe. A similar tax attempted in Sweden between 1984 and 1991 failed to generate the expected revenue, reduced trading, lowered stock prices, and diminished 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. revenue. If enacted, a European financial transaction tax may give new life to listings and trading on U.S. exchanges, a competitive advantage we would lose by mirroring the foreign levies. U.S. accounting and reporting rules make it harder for foreign shares to be listed here than elsewhere in the world. European taxes could rectify the imbalance. Mimicking the foreign taxes would drive listings and trades away from the U.S.
The proposed European financial transactions tax (FTT) would be imposed on stock, bond, and derivatives transactions between financial institutions. Language in the congressman’s initial descriptive material suggests he would apply the tax to ordinary stock and bond trades of individuals as well. We await clarification and legislative language to understand the proposal more clearly.
These tax rates are not small compared to the size of the gains and losses on the transactions. They may be a small percentage of the price of the bond, stock, or currency trade, but it is the gain or loss on the trade that bears the tax.
Suppose an exchange specialist in a stock, who makes the market in that security, offers a bid-ask spread of a few cents, or even fractions of a cent in the case of bonds trades (which dwarf stock trading in volume). Suppose an active high volume trading program normally trades a $100 stock if the price rises (on a long position) or falls (on a short sale) by $0.20. A transactions tax of 0.2 percent, or $0.20 on a $100 stock, would be a 100% tax on the gain. And the transaction tax would apply to trades involving losses as well as gains.
Clearly, such small margin trades would be impossible. The manger would have to wait for price moves twice as large before acting. In recent years, spreads between bid and asked prices have narrowed as trading fees have fallen, benefitting all investors. This tax would undo a portion of those improvements.
The congressman contends that individual investors would not notice a half percent tax because in many cases they are already paying brokerage fees that are on the order of two or three percent. (Although for accounts with fixed annual management fees, there is no charge per trade.)
The effect of a tax or fee is tied to its impact on the after-tax yield on the activity, not to the size of some other levy. In fact, adding a tax to an existing tax or fee may be more damaging than if it stood alone. One could just as easily argue that workers would not mind a 4 percentage point jump in the payroll tax because they are already paying a 15.3 percent payroll tax. This is clearly wrong.
In any event, Representative Van Hollen hopes to raise $800 billion over ten years from the financial transactions levy, while discouraging “unnecessary” trading. But one cannot have it both ways. The assumed revenue can only be raised if the trading continues. To the extent that the tax depresses the volume of trading, that portion of the anticipated revenue will disappear. We have seen this effect from the capital gains tax; increases in that tax have discouraged trading and generated a lock-in effect that reduced revenues when the rate was increased.
If the high volume trading has only very thin economic value and hence very thin profit margins, it will prove highly “elastic” and collapse under the weight of the tax. If instead the trading is doing important work to reduce price spreads, it will be passed on to ordinary shareholders, owners of mutual funds, and pensioners. Insofar as they demand a higher pre-tax return on their investments to cover the tax, it will raise the cost of capital much as would be the case from an increase in the corporate tax rate.
The numbers cited by the congressman would be equivalent to a 6.2 percentage point increase in the corporate tax rate, from 35 percent to 42.6 percent (based on CBO projections of corporate tax revenue over the budget window). The Tax Foundation Taxes and Growth model predicts that such a tax hike would depress GDP by 1.4 percent. It would lower the stock of business equipment, factories, other buildings and structures, and inventories by 3.9 percent. The wage rate would be 1.2 percent lower, and hours worked 0.25 percent lower, than before the tax. This is equivalent to the loss of about 25,000 full time jobs.
Instead of raising about $80 billion a year on average over the decade, as the static estimate assumes, it would reduce total federal revenue from all sources by about $17 billion a year, as a result of the lower level of economic activity. That assumes that trading continues apace. If people avoid the tax by reducing trading, there would be less economic damage, but also less initial estimated revenue.
Tighter Limits on Deducting Compensation for Highly-Paid Employees
Mr. Van Hollen proposes to tighten the current million dollar cap on business deductions for the cost of salaries for top management. He would extend the limit to cover bonuses and performance incentives currently exempt from the cap, unless businesses raised wages by at least 4 percent a year (regardless of the rate of inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. or the change in productivity).
Denying a deduction for business costs is bad policy. Failing to match pay to performance creates a disincentive to produce, misallocates the resource, and injures all those who would otherwise get to work with the affected individuals. Raising wages at a fixed nominal rate regardless of price changes and productivity changes is never right. The real wage would fall if prices are rising faster. Or, as in some industries in the 1970s, wages would be driven up faster than prices and productivity, raising labor costs and forcing companies to curtail output and employment or go broke.
The congressman’s contention that items on the tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit (EITC), child tax credit (CTC), deduction for employer health-care contributions, and tax-advantaged savings plans. list can be capped or curtailed with no economic loss is probably an error. Many of the items on the list are offsets to double or triple taxation of saving and investment inherent in the current tax code. These include all pension and tax preferred saving arrangements, lower tax rates on capital gains and dividends, and all forms of so-called accelerated depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. . Making them unavailable to a segment of the population that does a large share of the saving and investing is certain to reduce capital formation and wages.
Deductions for State and Local Taxes
Congressman Van Hollen asserts that curbing 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. could raise revenue without raising marginal tax rates. That is not always true. For example, limiting the deduction for state and local income taxes would raise effective marginal tax rates, because the state taxes are also proportional to income. The congressman is right that the statutory marginal federal tax rates would not go up, but the income subject to them would. A 35 percent statutory federal tax rate applied to a new 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. that is 105 percent of the old one becomes a 36.75 percent effective marginal rate on the old income.
Curtailing the Mortgage Interest DeductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. Further
Current law disallows the mortgage interest deduction on principle amounts in excess of $1 million. Tighter limits on the deduction, or its elimination, would reduce housing construction, affecting workers in that industry, and would result in a smaller stock of housing (both in number and size per unit!). It would reduce the tax tilt in favor of housing, but would do so by raising the cost of financing housing, rather than lowering the cost of obtaining plant and equipment or other types of buildings. The net effect would be a smaller stock of capital and a lower GDP.
Eliminating the deduction for interest while continuing to tax the recipient of the interest creates double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . The interest between borrower and lender is not additional income or output for the economy, just a financing arrangement to facilitate the purchase or building of something that does constitute additional GDP. For example, producing and selling a car is added GDP. Whether I pay for my new car with my money or money that I have borrowed does not change the number of cars produced. The financing is not net added output or income to the economy.
Either interest should be deductible by the borrower and taxable to the lender, or it should not be tax deductible by the lender and the lender should not have to pay tax on it. Both parties must be treated alike. The current tax treatment of mortgage interest is already being curtailed in an inappropriate manner. Do not make it worse.
Raising Taxes on Capital Gains
Eliminating or reducing the capital gains and qualified dividend differential would raise the cost of creating and using capital assets, reduce productivity, and reduce jobs and wages. It would not raise the expected revenue, in part because of the reduction in GDP and labor income. In addition, it would reduce the rate at which people trade assets. This lock-in effect, by itself, has been shown to eliminate gains from raising the rate.
Coupled with the increase in the cost of capital due to the rate hike, it is clear that such a tax change would depress federal revenues, as well as hurt the economy and the work force.
The current reduced tax rate on capital gains and qualifying dividends is no “loophole.” It is branded a “tax expenditure” only because that list is keyed off of the arbitrary definition of “income” attached to the “income tax.” That definition includes income from capital multiple times in the tax base with the intent of redistributing wealth. It is not an economically optimal definition of the tax base.
Under a cash flow tax, which does not discriminate between consumption and saving, a rate differential capital gains would not be a “tax expenditure.” Gains and dividends would not be taxed if the saver had already been taxed on the initial savings (as in a Roth IRA). Alternatively, the saving would be tax deferred, and the savings, including gains and dividends, would only be taxed when withdrawn for consumption (as with a pension or regular IRA).
The current rate differential offers partial relief from the multiple taxation of capital income inherent in the income tax. It offsets some of the double taxation of corporate income, which is hit at both the business level and the shareholder level. It also protects non-corporate capital gains, which also involve double taxation, because the value of a business or other asset equals the present value of its future after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. . If the future income goes up, and that additional income is to be taxed when it is earned, then taxing the current gain in asset value is to tax the future earnings twice.
Conclusion
Congressman Van Hollan’s tax and income redistribution proposals would not address the causes of the sluggish growth of income in the middle and lower-middle quintiles of the population. His proposed tax on financial transactions would make financial trades more expensive, make markets more volatile, and depress capital formation, which would further impede productivity and wage gains where they are most needed. His view of tax expenditures is based on the concept of an “ideal” income tax, which is inherently tilted against saving and investment, favors consumption, and is not economically efficient or optimal if one’s goal is to increase incomes and employment.
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