How do politicians enact a substantial middle class benefit like health care reform when many in that middle class are happy with their health insurance? They rely on a bad economy that raises doubts about the security of their health insurance. They rely on the generosity of the American people who do not want to see their fellow Americans without any health insurance. They rely on the understanding by all that health care costs must be contained. These reasons should be enough, but the clincher for politicians is to convince the middle class that they will be getting something for nothing ― ergo a millionaire surtax paid by less than 1% of taxpayers.
Small Business. However, like the proverbial “free lunch,” the high income tax surtax is not free to the middle class. Its cost will fall principally on those small family businesses that create 80% of our jobs, and the middle class already suffers from a desperate shortage of jobs. Politicians can be sure that the middle class will notice a jobless recovery, assuming recovery can even begin. Almost all small businesses have "pass-through treatment" where the owners include the business income in their federal income tax returns and then pay tax on it, whether they receive cash or not. Thus, family and other small businesses pay tax not at corporate rates, but at individual rates. Small business owners, therefore, have to pay the surtax or any tax increase in marginal rates on their business income whether they spend the money or reinvest it in their businesses, leaving the owners with less capital to expand or hire. On the other hand, big international corporations would pay nothing more in tax, leaving small business at a competitive disadvantage and unable to raise prices to offset the increased tax.
An American Solution to Pay for Health Care. Thankfully Americans are not whiners who expect something for nothing as the politicians apparently believe. Americans understand that health care reform is insurance against job loss or a family medical disaster. Americans are willing to share the cost of providing insurance to the uninsured. Americans are smarter than the politicians and understand that universal health care requires a universal sharing of the cost. Health care reform can be paid for by a universal tax reflecting American values without burdening anyone unfairly.
The American model for successful financing of universal social benefits is a broad based tax tied to those benefits. Broad sharing of the costs and the benefits of Medicare and social security has protected these programs from partisan attack. Had they instead been structured as welfare programs where those receiving the benefits differ from those paying for those benefits, the programs would never have survived. Moreover, a universal tax to pay for universal health care reform can create and preserve jobs, make income taxes fairer and more efficient, offer a model for future tax reform and, unlike Medicare and social security, hold politicians accountable for truly reforming health care. Congress should reform the existing Medicare tax into a Universal Health Care (“UHC”) tax.
Medicare Tax. Under our current system, social security and Medicare taxes are imposed only on earned income and on top of the federal income tax. Investors with unearned income such as interest, dividends and capital gains, therefore, pay no Medicare tax. Because social security benefits are tied to lifetime earnings, linking social security taxes to earned income makes sense. However, Medicare benefits bear no relationship to earned income and, thus, should be imposed on both earned and unearned passive income. The Medicare tax rate currently is 2.9% with employers splitting the cost with employees and the self-employed and small businesses paying both halves on their business income.
Business Taxes. Small business income is taxed like salaried and other productive earned income, meaning small business owners must also pay the Medicare tax (and social security tax) on their business income in addition to paying the tax as employers and employees. All public and international corporations pay the corporate income tax and, therefore, do not pay the Medicare or social security taxes on their business income, nor do their owners pay Medicare or social security taxes on the dividends they receive. Because the owners of public corporations pay taxes at a 15% rate on dividends on income already subject to corporate tax at a 35% rate, some argue that corporate business income is subject to "double-taxation." However, those who see unfair double taxation simply misunderstand the real purpose of the corporate tax: equalizing the treatment of small businesses and big businesses by imposing the same tax rate on business income. Without a corporate income tax, big businesses would enjoy an unfair advantage over small businesses. Because the individual income tax is based on ability to pay, dividends are taxed as are other forms of cash income. The current 15% income tax on dividends and capital gains and the zero tax on exempt interest belie that fairness as taxpayers with productive earned income pay tax at a rate two and a half times the rate investors with passive unearned income.
Small Businesses Are Already Tax-Disadvantaged. The top individual income tax rate is 35% so small business owners start by paying the same rate on their business income as their big publicly-traded competitors. However, small businesses then have to pay the 2.9% Medicare tax on their business income (plus a 12.4% social security tax on the first $106,000 of earned income). (Some small businesses legally arrange their operations to avoid paying these taxes. The UHC tax will also put all small businesses on an equal footing.) Moreover, in 2011 that rate on small business income increases to 39.6% while the rate on corporate income remains 35%. Small businesses then will pay tax at a rate more than 20% higher than their corporate competitors. The low rates paid by investors on dividends and capital gains further disadvantage small business owners. Because buyers of public corporation pay taxes at a low 15% rate on dividends and capital gains, the corporations can price their capital much lower than owners of a small business who have to pay the current 37.9%. A 5% surtax would mean an additional 2% increase in rates. Small businesses typically finance growth and reinvestment from business income. Ironically family business owners pay more tax on income from reinvesting in their own businesses than from passively investing in their competitors’ big businesses – more than two and a half times.
Paying for Health Care Reform Fairly. A surtax on individual income taxes will fall on small business owners not their public company competitors, thereby making the tax system less fair and depressing the economy further. Universal health care can be financed, while making the income tax system fairer to family businesses. Congress should redirect the existing Medicare tax to fund all health care and impose it on passive unearned income as well as productive earned income. Because the goal is universal medical insurance, the Universal Health Care tax should be imposed as broadly as possible and, thus, at the lowest possible rate. Not only on passive income such as interest, dividends, gains, royalties and rents, but also on tax exempt interest and corporate income. States and municipalities will benefit greatly from health care reform and should shoulder a bit of the burden indirectly by slightly higher interest rates on their borrowing. Imposing the UHC tax on corporate income will reduce both the burden on all taxpayers and the tax advantages they enjoy over small businesses. Charities already pay regular income tax on their unrelated business income; Congress should consider charging the UHC tax against their unrelated business income and their passive investment income.
Model for Tax Reform. In addition to establishing the principles that the tax system should be fairer to small businesses and that taxes should be broad-based, the UHC tax could be a model for other improvements. First, the existing Medicare tax is paid through withholding on earned income; withholding reduces tax avoidance and is an efficient means of collecting the tax at a low flat rate. The UHC tax should be paid primarily through withholding on unearned income. Second, the Medicare tax is paid independent of the income tax; thus, even those workers who do not pay income tax share in the cost of Medicare. The UHC tax also should be structured more as a premium than an income tax, preserving the concept of health care as an insurance benefit, rather than a welfare program. The UHC tax ensures that the costs of, and the benefits from, universal health insurance are shared broadly. Finally, the Medicare tax fund will be replaced with the Health Reform fund and all of the UHC taxes would go to that fund. Unlike the Medicare tax, however, the UHC tax rate would adjust annually to a rate necessary to fund Medicare, Medicaid and any other universal health care benefits for that year. Resetting the rate annually ensures that politicians would be accountable to taxpayers for their stewardship of health care reform unlike social security and Medicare where the politicians are often unable to ensure the financial viability of these programs.
Accountability. Including a public option in health care reform should be less objectionable if taxpayers are able to judge its cost by the UHC tax rate they pay. Because the UHC tax rate will be set annually, it will provide a brake to increasing health care costs, thereby reducing the future costs of health care. Just as deductibles limit individual from choosing unnecessary health care, an automatically increasing UHC tax rate will limit politicians from providing unaffordable government health care benefits. The discipline provided by an automatic UHC tax should attract wavering Republicans to health care reform. Moreover, taxpayers will know exactly what they pay for the health benefits they receive. If enough taxpayers feel the two are unbalanced, they will insist on changes. The UHC tax will be dedicated to health care benefits, not lost in the maw of the federal budget.
Tax Justice. Citizens for Tax Justice ("CTJ") recommend an expansion of the 1.45% Medicare tax to unearned income. However, CTJ does not extend it to corporate income thereby missing the opportunity to reduce the unfair advantage that big businesses enjoy over small businesses. Indeed, CTJ proposes to increase the unfairness by raising the tax from 1.45% to 2.5% on higher productive incomes. It is simply impractical to have a multi-tiered tax rate on a withholding tax. Moreover, CTJ wants to limit the Medicare tax paid by seniors who make less than $50,000. They fail to explain how giving seniors who benefit substantially from government health care a complete pass on helping to pay for that care is "tax justice." The proposed UHC tax would be applied to pensions, IRA distributions and other deferred compensation as the Medicare tax would have been avoided at the time the benefits were funded. Also by broadening the tax base to include unearned income, the aging of the population and the shrinkage of workers to beneficiaries will have less adverse impact on funding.
Lowering the Medicare Tax Rate. Based on the computations of CTJ and other sources, it appears that a broad based UHC tax could be set at a rate lower than the current 2.9%. Lowering the payroll taxes has been discussed as one of the most effective means of providing a second stimulus. Because those earning less than $250,000 have such a high portion of their income from salary and earned income, rather than unearned income, lowering the Medicare tax rate could offset the cost of paying the UHC tax on unearned income for these taxpayers, keeping President Obama’s promise. Unlike the proposed surtax, by lowering tax rates on earned income the UHC tax could increase jobs and strengthen the economy.
The McCain/Bush Tax Cuts have failed to produce any substantial economic growth the last eight years despite unprecendent federal spending and borrowing because those cuts are directed to investors, rather than entrepreneurs and family business owners and their employees. Investors with unearned income do not hire a single employee, produce a single product or provide a single service; it is the entrepreneurs, employees, managers and family owners whose productive earned income is taxed at the highest income tax rates. The following chart illustrates this observation:
Pre-Bush Bush/McCain Tax Cut
Labor 39.6% 35.0% 11.6%
Business 39.6% 35.0% 11.6%
Interest 39.6% 35.0% 11.6%
Dividends 39.6% 15.0% 62.1%
Cap Gains 20.0% 15.0% 25.0%
As we discssed before, capital gain and dividend tax rate cuts do little to benefit family business owners and entrepreneurs who pay taxes at individual rates. In fact the harm is not limited to the higher tax rates family business owners have to pay to offset the tax breaks for investors. Lowering tax rates on dividends and capital gains lowers the capital costs for their largest public corporation competitors. This leads to the tragedy that a family business owners who reinvest int their businesses would pay a tax a tax about two and a quarter times higher on increased business income than if they invested in their public corporation competitors.
Moreover, the tax rate on interst income has not been cut. Not only is this unfair to our senior citizens who might invest more conservatively, it has the effect of directing savings away from the local banks that might fund family businesses and entrepreneurs, raising their capital costs while lowering the capital costs to their big competitors.
Clearly em;oyees, employers, business owners and entrepreneurs have an interest in ending this unfair tilt of the income tax system to Wall Street at the expense of Main Street.
The federal inocme tax is intrusive and complex. This intrusiveness and complexity can be justified only if the tax is fairer than other types of taxes. Yet the income tax is replete where similarly situated taxpayers pay radically different amounts of tax based on their types of income, although such income all spends the same.
I believe that the right and left can be united in reforming the income tax if the result is a fairer tax with a lower tax rate. We have already seen this happen in 1986 when Reagan and a Chicago Democrat, Dan Rostenkowski, developed a similar compromise.
The problem with the 1986 compromise is that it did not go far enough: in broadening the tax base or lowering the tax rate. One start would be to tax interest on municipal bonds purchased after the law is changed. Announcing the pending change would also cause a rush into municipal bonds to get in under the deadline, which then could be used to fund an unprecedented national capital improvement program.
Although at one time, the nontaxation of municipal bond interest was thought to be constitutionally required, it is not so viewed any longer. Municipalities and states would have to pay higher interest rates, this increase should be offset by several factors. The states should be able to tax interest on US Treasury debt, which will make their taxes fairer. Tax reform should also preserve the tax deduction for state income tax payments, if taxpayers itemize. Even if the federal income tax rate is reduced to 25%, it is still high enough to require a state income tax deduction to eliminate unfair double taxation.
One must understand what has been going on in our politics the last eight years and its effect on eroding a principled, policy driven tax, rather than one dictated by politics (the Democrats are not innocent in this regard). However, I want to spotlight now how the Republicans have made changes in the income tax to punish taxpayers in high income tax states, mostly blue ones, while providing additional tax benefits to those taxpayers living in no or low income tax states, mostly red ones. This is "reverse Robin Hood" at its worst.
To pay for the cuts in income tax rates, Republicans decided to soak taxpayers in blue states by allowing the Alternative Minimum Tax (AMT) to soar. The principal reason for the AMT applying to more taxpayers is that it eliminates the state income tax deduction, thereby punishing taxpayers in states with high income taxes. If the base is broadened as proposed here, the AMT is unnecessary anyway. (Just as eliminating the lower tax rate for capital gains, eliminates the need to rewrite a century of partnership tax laws to catch "profits interests" to fund the AMT change as the House has done. Under the House bill, even a parent-child farm partnership could be caught as could many other partnerships involving the equivalent of "sweat equity.")
The law was also changed to give a sales tax deduction for those taxpayers in states without an income tax. No federal sales tax so no double tax here; a give away to taxpayers in the red states. (Although the lack of a federal property tax would justify the repeal of the deduction for state property taxes, deductibility should be continued for a taxpayer's prinicpal residence. I would not broaden the tax base by eliminating existing tax breaks for ownership of the principal residence, especially now.)
The hoariest of tax chestnuts is that capital gains need to be taxed at a lower rate than labor to encourage capital formation and grow the economy. Because US economic growth depends on the growth of family businesses and entrepreneurs, rather than international corporations whose stock is publicly-traded, lowering capital gains threatens economic growth not enhances it. Low capital gains rates lower the cost of capital for international corporations by raising the price of publicly-traded stocks. Family business owners and entrepreneurs rely on bank financing to start and usually finance growth from their earnings. Under current law, however, grocery store owners, for example, would pay a 35% income tax on any profits from reinvesting in their own businesses, but only a 15% tax if they invested in one of their large public company competitors like Walmart or Target. This shows the failure of the current tax system.
As we discussed before, most family businesses and entrepreneurs pay taxes at individual income tax rates. The Bush cut in the dividend tax rate by more than 60% to 15% provides almost no tax benefit to family business owners; those subject to the corporate tax would prefer elimination of the restrictions and taxes on conversion to a "pass-through" entity. The one benefit to famly businesses of a low capital gains rate is the ability to sell the business at a reduced cost. Once sold to a public company local jobs are often shipped overseas. (Small businesses such as farms that have been unable to fund tax-free retirement benefits might need a capital gains exclusion if the business is sold to allow transfer to a retirement fund.)
In 1986 the Republicans and Democrats united to apply a top rate of 28% to both ordinary income and capital gains. However, they failed to take out the distinctions between the two types of income and it soon returned. Whenever income is taxed in two different ways or at different rates, an entire industry develops to change income from one type to the other. The only way to prevent this manipulation is to eliminate these differences that tax lawyers like myself tend to legally exploit.
Congress often uses the tax system to promote a favored policy -- solar power, hybrid cars, farming, home ownership, education, business investment -- the tax break for capital gains and dividends only favors investment in public companies rather than family companies. It does nothing to ensure investment in productive or American businesses. The reason for the lack of economic growth during the Bush years despite unprecedented tax cuts and government spending is that most of those cuts went to investors who do not create jobs, grow businesses or invest in communities. The key to revamping the tax system and producing economic growth is to lower the tax rate on PRODUCTIVE, EARNED income and raise the tax rate of UNEARNED income such as capital gains. The result will be a lower tax rate for individuals, on labor, entrepreneurship and more investment in family businesses.
The problem is that too many Democrats see the top individual income tax rate as an indication of whether the wealthy are paying their fair share of taxes. This is frankly a mirage; the wealthy can just convert their investment income to capital gains, real estate income sheltered by depreciation and interest or tax exempt municipal bonds. Eliminating tax loopholes and preferencew (which the 1986 tax changes failed to do enough of) while lowering the top rate will make it more likely that the top rate will actually reflect the rate the wealthy are paying. Barack could use these types of tax changes to show that he is a different kind of politician interested in merging Republican and Democratic ideas. More importantly, this type of change links the interests of labor and family businesses on Main Street as compared to corporate interests on Wall Street. This type of tax reform would allow the corporate tax to go to 25% as John McCain has proposed without producing a huge tax revenue loss. Lowering the corporate tax also would mitigate the stock market decline from raising the capital gains tax.
Finally, raising the capital gains tax historically has produced a significant revenue bump if sufficient time is given to sell assets at the lower rate. That revenue increase will help fund a middle income tax cut. Next time we will discuss changes to the FICA and Medicare tax to further correct the unfair taxation of productive, earned income and eliminate the current tilt toward lower taxes for unearned income.
McCain has announced his support for cutting the corporate income tax from 35% to 25%. Rumors abound that Barack also will propose a corporate income tax cut. The corporate income tax rate should not be cut without careful consideration of the pain a cut would cause family businesses and entrepreneurs. Although McCain hopes that a corporate rate cut may bring jobs to America, the only sure way of increasing American jobs and benefitting American communities is to avoid unfairly relieving taxes on international corporations while increasing taxes on American family businesses and entrepreneurs.
Few economists have any real understanding of the tax system. Most family businesses and entrepreneurs pay taxes at individual income tax rates, that now go up to 35%. The only family businesses and entrepreneurs paying corporate income tax rates are those where tax code complexity or costs prevent a family business from converting to a "pass-through" entity where the owners, rather than the business, pay the income tax. Thus, the corporate income tax rate must remain tied to the top individual income tax rate. If that rate goes to 39.6% when the Bush tax cuts expire, the corporate rate should also be increased.
Unless the corporate and individual tax rates remain the same, an international public corporation will have much more after-tax income to reinvest and expand than its family business counterpart. Yet family businesses and entrrepreneurs are much more likely to invest in America. Just as investing in American infrastructure creates jobs in this country so will investing in American family businesses create job and growth in this country and in local communities.
Nor is it workable to drop the tax rate on business income to 25% while leaving a higher rate on other types of income. Characterization of income is subject to easy manipulation. Thus all types of income should be taxed alike. The only justification for a tax so intrusive and complex as the income tax is fairness. Yet taxing different types of income or not taxing income at all undermines that fairness.
The corporate income tax rate is too high, but it cannot be lowered without also lowering the top individual rate. By eliminating loopholes and expanding the tax base, it should be possible to get the top tax rate down to 25% for everyone. After all Democrats and Republicans united in 1986 to the the top rate down to 28% without making many hard choices.
In a future post, I will discuss the negative effect the capital gains tax has on family businesses and entrepreneurs.
Richard Lee
This blog is dedicated to developing ideas in tax policy, particularly those that can attract support from both the left and right. In the area of tax policy, Barack's team has developed ideas that fail to match his rhetoric. For example, eliminating federal income tax for seniors who earn under $50,000 is pure pandering of a type Barack rejected with respect to the gas tax. One group Barack needs to reach out to is family business owners. Historically that group has supported Democrats as well as Repubicans. Republican success has atrracted them in rescent years, but Republican tax policies actually favor Wall Street Business over Main Street Business. Yet Barack is passing up an opportunity to attract family businesses to his campaign by advocating lifing the income limit on the self-employment tax. This change would add 12.5% tax to every dollar of earned income for family business owners.
Richard
