Considering all the talk in Washington about “tax reform,” you might think serious work is underway to adapt our century-old federal tax system to the 21st century digital economy.
The only matters under discussion are more tax favors that will shift even more of the burden off those with speed-dial access to lawmakers and White House staff and onto ordinary tax payers.
We have a tax code designed for the middle of last century, when we had a national economy with cash incomes that could be levied efficiently and hard assets, like factories, which could be taxed easily because they were immovable.
Today we live in a global economy with compensation schemes that are easy to hide for those at the top, while intangible sources of wealth, such as patents and other intellectual property, are sheltered from the Internal Revenue Service in tax havens.
The tax system has become so contorted that a single worker making the median wage of about $28,000 labors every Monday just to pay his federal taxes while Apple, GE and other multinationals use accounting alchemy to convert the leaden burden of taxes into golden profits.
But you never hear about that in political speeches and Sunday morning talk shows. After decades of repeated economic ideas that are out of context, disconnected or outright untrue, elites have left much of the American public ignorant about how the tax system actually works.
To reform means to make something better. Two recent examples illustrate that faux tax reform would make things worse.
Let’s start with President Barack Obama's flip-flop on tax-free investments to pay for college tuition. In his State of the Union address the president called for taxing gains from new 529 college tuition investment plans, named after a section of the tax code. Parents and others who set aside money in these plans pay no taxes on capital gains, dividends and interest provided the money pays for college tuition.
House Speaker John Boehner praised how 529 plans “help middle-class families save for college, but now the president wants to tax those plans. It’s another example of his outdated, top-down approach — when our focus ought to be on providing opportunity for all Americans.” Boehner said Obama should instead support expanding these plans to include purchasing computers with tax-free gains.
Minority Leader Nancy Pelosi and other top Democrats joined Boehner and within days the president abandoned his proposal.
Despite the grand rhetoric, the debate had almost nothing to do with middle-class families. In fact, 529 plans help those who need help the least, if at all, especially multimillionaires such as the president and first lady, who put $240,000 into 529 plans for their two daughters.
A 2009 Treasury Department study found that less than one percent of those in the bottom half of Americans had 529 plans. Up to the 75th rung on the income ladder, the average 529 plan balance was $8,000, indicating likely tax savings of a few hundreds of dollars, while those on the 95th rung and above averaged more than $100,000, indicating tax savings in the thousands of dollars.
After decades of bogus proposals, how will we know when Washington begins to talk real tax reform, rather than more tax favors for the wealthy and politically connected?
Economists call this an upside-down subsidy. Our tax code is full of such subsidies that favor those higher up the income ladder. The mortgage-interest deduction, for example, gives no benefit to more than half of homeowners while the lion’s share of tax savings going to the one in seven taxpayers making $100,000 or more.
A much more damaging example of faux tax reform came with President Obama’s proposed 2016 budget. The White House said it wants a 19-percent “mandatory tax on previously untaxed foreign earnings” whether kept abroad or brought home. That sounds like an incentive to bring home profits earned in foreign countries.
Again, not so.
Most of the estimated $2 trillion plus in such untaxed earnings consists of profits earned in the United States and then paid to their offshore subsidiaries for the rights to use intellectual property such as patents. Those profits are invested and grow untaxed so long as they are owned by offshore subsidiaries. Companies often invest this money in U.S. Treasury bonds, on which the government pays interest with your tax dollars. Yes, your timely tax payments pay for their deferred tax payments. How’s that for economic craziness?
What Obama’s plan would do, from a U.S. perspective, is give these companies a 16-percentage-point discount on the tax they would have paid but for Congress letting these profits become tax-deductible expenses paid to offshore subsidiaries. It is the equivalent of Congress giving you a tax deduction for each dollar in your left pocket that you move to your right pocket.
Obama’s plan would also only benefit multinational companies, advantaging them over purely domestic enterprises.
Profits earned from real economic activity overseas are subject to tax by the host country, but there is no double taxation, as politicians so often claim. That’s because Congress gives a dollar-for-dollar offset for taxes paid to foreign governments.
But there is another awful aspect to this huge tax giveaway to American multinational corporations, as pointed out by James S. Henry, former chief economist for the prestigious McKinsey consulting firm and a senior GE executive before he became a crusader for a better tax system. Namely, Obama’s plan would worsen inequality between rich nations such as America and developing countries such as Argentina, Indonesia and Mexico.
“Developing countries rely heavily on corporate income taxes and they would all get whacked by this,” Henry said, noting that the U.S. is by far the largest direct investor in the developing world.
Henry rightly says that it will either force these countries to cut their actual corporate tax rates, half of which are above 29 percent, or encourage even greater use of “tax haven tax games by any company doing business in the developing world.” Either way, the poor and middle class in the developing world would immediately lose while the rich would gain.
So after decades of bogus proposals, how will we know when Washington begins to talk real tax reform, rather than more tax favors for the wealthy and politically connected? When they propose to scrap the whole system and start from scratch.