Tax Reform and the Twenty-Eight Percent

Apostolos Pittas contributed to this post.

Republican Senator Pat Toomey of Pennsylvania put forth a proposal to the super committee that would raise about $300 billion in new tax revenues while simultaneously lowering the top marginal individual income tax rate to 28 percent.

Democrats roundly criticized his plan, claiming that it would be a distributional nightmare, cutting taxes for the richest Americans while raising them for everyone else.

Contrary to common wisdom, however, slashing the top marginal income tax rate to 28 percent and producing a more progressive tax system can go hand-in-hand. But, in order to achieve both of these goals, capital gains and dividends must be taxed as ordinary income.

Eliminating the differential between the top tax rate on capital gains and dividends (currently at 15 percent) and that on ordinary income will establish equal treatment among taxpayers with different sources of income, and destroy the benefits of tax shelters that convert ordinary income into capital gains. These distortions breed unfairness in the system. Under current law, for example, partners in private equity firms receive a substantial share of their compensation as tax-favored capital gains, while others with variable earnings, such as salesmen on commission or executives receiving performance-based bonuses, must pay ordinary income tax rates on their compensation.

Equalizing the two top rates also will reduce the compliance and administrative costs associated with sophisticated tax-planning strategies.

The proposal put forth by the Bipartisan Policy Center’s (BPC) Debt Reduction Task Force follows this path, calling for comprehensive, pro-growth tax reform. Under BPC’s proposal, there would be two rates for individuals – 15 and 28 percent – and a top rate of 28 percent for corporate taxes. Moreover, capital gains would be taxed as ordinary income, solving the aforementioned problems. To further reduce the deficit and simplify the code, BPC’s proposal also eliminates most tax expenditures and streamlines the deductions left in place. The plan would introduce a 15 percent flat refundable credit for charitable contributions and for up to $25,000 of mortgage interest on a primary residence.

Should the super committee eliminate differential treatment of capital gains/dividends and ordinary income, they would be acting in line with President Reagan’s vision of tax reform – specifically, with his Tax Reform Act of 1986. This Act similarly taxed capital gains and dividends as ordinary income, subject to a top-bracket rate of 28 percent.

BPC’s plan achieves a massive simplification of the tax code by aligning the top individual, corporate, capital gains and dividend tax rates. As an added bonus, most individuals will no longer have to file an annual tax return beyond an initial declaration of status because the most commonly taken deductions either have been transformed into refundable credits or can only be deducted above a substantial floor. Despite a low top rate of 28 percent, the new tax system also would be more progressive than the one in place today.

We need a Grand Bargain – one that addresses rising health care costs, particularly in the Medicare program, and also raises the requisite revenue to achieve a reasonable debt-reduction goal. BPC’s plan accomplishes this, primarily through a practical and efficient defined support system for Medicare and an attractive overhaul of our arcane tax code. Domenici and Rivlin put it best in yesterday’s Hill op-ed, “any plan without those two essential components should go back to the drawing board.”

Related Posts

• The Case for Eliminating the Preferential Treatment of Capital Gains, November 16, 2011
• Entitlement and Tax Reform: The Two Must-Haves, November 7, 2011
• BPC’s Recommendations to the Super Committee
• It’s Time for a Holiday!, October 19, 2011
• How the Sequester Works if the Joint Select Committee Fails, August 5, 2011