Paul L. Caron

Monday, November 26, 2012

Tax Reform: What Would Reagan Do?

New York Times:  Tax Reform Might Start With a Look Back to ’86, by Floyd Norris:

As Washington grapples with the budget, it might be worth asking a simple question: What would Ronald Reagan do?

He was the last president to preside over a significant tax reform, one that did exactly what both candidates in this year’s presidential election said they want to do: lower tax rates and close loopholes.

And a critical part of that reform was to end the historical system of taxing capital gains at lower rates than ordinary income.In the name of fairness, the Tax Reform Act of 1986 raised the maximum tax rate on long-term capital gains to 28% from 20% at the same time it reduced the maximum rate on ordinary income to 28% from 50%.

Doing that again in a tax reform act of 2013 would do more than raise revenue and increase fairness. It would bring an abrupt end to the “carried interest” tax dodge, in which managers in the private equity business are able to define their compensation as capital gains and thus pay far lower income tax rates than do ordinary people with far less income.

Ideally, there will be two tax reform efforts in the next 18 months.

The first, going on now, is a simple patch-up, aimed at dealing with the pending increases in taxes brought on largely by the expiration of the Bush “temporary” tax cuts. If the lame duck Congress and President Obama can avert disaster, raising some revenue while not devastating the economy, they will have succeeded.

But the next move should be aimed at comprehensive tax reform. The Obama administration should look to President Reagan’s second term for inspiration. The Reagan method included a comprehensive, well-thought-out proposal that dealt with the myriad details that can rise up to frustrate any efforts at change, put together painstakingly by the Treasury Department.

(Hat Tip: Mike Talbert.)

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Why are so many of these writers economically illiterate? Most of total dollar volume of capital gains is reported by high-wealth taxpayers. Most of these taxpayers have the financial flexibility to decide whether to sell appreciated assets or just hold onto them, as Warren Buffett and Bill Gates do. Refraining from selling appreciated assets is the ultimate tax shelter.

This flexibility means that wealthy taxpayers' reported capital gains are highly responsive to tax rates. When taxes are "on sale" at 15%, these taxpayers sell assets freely. As taxes approach 50%, these taxpayers will resist mightily what they see as unreasonably high tax rates. When much of the gain is due to decades of inflation, a 50% tax rate is literally confiscatory.

California now imposes a 13.3% tax on large (more than $1M) capital gains. ObamaCare adds a 3.8% tax. If the federal income tax rate rises to 35% and state income tax deductions are denied, the total rate will be 52.1%. I'm certain that such a rate will lose revenue by persuading wealthy taxpayers to hold rather than sell. Perversely, only taxpayers who are in financial difficulty will pay this tax.

A tax system designed for raising revenue, as opposed to one intended to make a political statement, requires a lower rate for capital gains and other highly elastic income. That's an economic fact which politicians ignore at their peril and ours.

Posted by: AMTbuff | Nov 26, 2012 12:18:40 PM

Or you just tax unrealized gains.

Posted by: the real anon | Nov 26, 2012 3:51:24 PM

If Ronald Reagan were to revisit us, he would laugh heartily at the N. Y. Times asking, "What would Reagan do?" Was that ever their touchstone when he was President? The N.Y. Times is only willing to recognize the wisdom of someone like Reagan after he has either (i) "grown" away from it or, (ii) as in Reagan's case, died such that he is no longer in a position to answer the Times.

Posted by: Joseph W. Mooney | Nov 27, 2012 3:20:35 AM