Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate December 17th.
It was quite a surprise, three years ago, when Donald Trump won a majority in the US Electoral College, thus becoming the 45th president. In the search for explanations, one immediately dominated: Democrats had not been sufficiently aware of the problem of income inequality or had neglected to propose good solutions to it.
This is presumably the logic behind radical proposals coming from some of the leading contenders for the Democratic nomination in the 2020 presidential election. Senator Elizabeth Warren, for example, has proposed an annual tax on the wealth of the wealthiest Americans (originally to be 2 % per year, but now up to 6 %).
The problem with the wealth tax is not so much that it is radical. I, like many economists, would for example support a high carbon tax. That is radical, but it is the most economically efficient way to respond to the problem of global climate change. The wealth tax is not the most efficient way to respond to the problem of inequality. It is not even one of the six most practical ways of responding.
There are at least six practical policy changes that could increase the progressivity of the US tax system. They have all been proposed in the past by mainstream Democrats such as President Barack Obama, along with the Affordable Care Act and other ways of addressing inequality. In most cases they have been blocked by Republicans.
They are practical in two senses. If a presidential candidate were eventually to succeed in getting them adopted, they are more enforceable than a wealth tax and more likely to avoid costly unintended side effects. Moreover, proposing moderate policies is more likely to get a political candidate elected than proposing radical policies. Political scientists studying recent congressional elections have found that the old median voter approach still holds. Radical-left economic proposals do gain new voters on the left, but it turns out that they lose substantially more voters on the right.
Here is my list of six:
- Reinforce the estate tax. The US might begin by restoring the estate tax on all estates above, say, $5 million. More importantly, however, eliminate the “step-up” of the valuation of the assets in the estate, which currently allows generations to pass on capital gains without ever paying tax on them. It would be far easier for the Internal Revenue Service to place a dollar value on assets on a once-a-lifetime basis (that is, on the estate, before it passes to the heirs) than to try to do so every year. And it would ultimately accomplish the same objective as the wealth tax: putting some friction into the inter-generational accumulation of dynastic wealth, which currently never gets taxed.
In a promising (and rare) bi-partisan move this month, Senators Michael Bennet (D-CO) and Mitt Romney (R-UT) proposed curtailing the step-up of basis and using the revenue to fund an expansion of the child tax credit. Kudos to them.
- Give the Internal Revenue Service the resources it needs to collect taxes. Natasha Sarin and Larry Summers have recently pointed out that the IRS currently fails to collect nearly 15 percent of total tax liabilities, a gap that primarily benefits those with high incomes. Although it is impossible to close the gap, giving the IRS more resources would have a high “benefit/cost “ ratio and bring estimated net revenue benefits of more than a trillion dollars over the next decade. (This is money that could be spent on lots of good causes, such as helping to put Social Security and Medicare on a sound financial footing.)
- Expand the Earned Income Tax Credit, to help “make work pay.” Incentives do matter. But those trying to lift themselves out of poverty, up into the middle class, often face the steepest effective marginal tax rate (counting lost benefits), not the rich. Bringing the benefits of the EITC to more households is one of those ideas that would expand the size of the economic pie while also sharing it more equally: enhancing both efficiency and
- Make the payroll tax more progressive. The social security system is not as progressive as many think. Even workers who don’t earn enough to pay the income tax, pay a payroll tax (both directly and indirectly: employers nominally pay half of the total, but tend to pass it through to workers as lower wages). Raise the threshold at which workers start forking over. How to make up the lost revenue? (After all, the social security and Medicare systems are facing huge future deficits.) One way is to bump up the upper threshold, the level at which Americans no longer incur additional payroll taxes, from its current level of $118,500 in wages.
- Make the income tax more progressive. Cut the gap between the tax rates on investment income versus earned income. (Why should Warren Buffet pay a lower tax rate than his secretary?) Also, clearly, abolish the carried interest loophole.
- Revisit the 2017 corporate tax cut to make it revenue neutral. There did exist good arguments for cutting the corporate tax rate, to bring it more in line with other countries. But all Republican Senators voted for the December 2017 reduction in the corporate tax rate in the declared belief that it would boost income growth so much as to be revenue-neutral. This has not happened, of course. Firms turned their windfalls over to shareholders in the form of dividends and share buy-backs, rather than investing in capital as intended. Revenue fell. Now US firms pay virtually the lowest level of tax revenue of major advanced countries (followed only by Ireland, according to the OECD (that is 24.3 per cent of national income in 2018, down from 26.8 per cent the year before).
The solution is not to limit firms from buying back their shares, as Senators Bernie Sanders and Chuck Schumer have proposed. The solution is, rather, to close loopholes so as to put overall corporate tax revenue back at its pre-reform level, as intended. The biggest potential revenue-saver is to curtail the tax-deductibility of interest payments. This is another one of those proposals that could be good for GDP at the same time it is good for income distribution. If there is a successor to the 2007-09 financial crisis, it is now less likely to come from an excess of housing debt, and more likely to come from an excess of corporate debt — especially so-called “covenant-light” debt. Curtailing the interest rate deduction could motivate firms to strengthen their financing structure.
Fortunately, few of the Democratic candidates have committed irrevocably to extreme policies. To draw an analogy, Senator Warren has moderated her position on health insurance. She now sensibly says her administration might start with offering a public option to those without health insurance (“Medicare for those who want it,” as Mayor Peter Buttigieg says), rather than jumping directly to the more radical plan that Bernie Sanders insists on: “Medicare for all, even those who prefer their current private health plan.” It is not too late for her or other candidates to adopt further proposals to address inequality that are more practical than the wealth tax and would naturally come before it.
This post written by Jeffrey Frankel.