Fairer, simpler, and more pro-growth does not mean fair, simple, and pro-growth
I took my great-nephews to the fair in Page County, Virginia Fair last month. The carnie games reminded me of D.C. “Step right up! Win a prize!” Of course, even the 7 year-old knew the odds of winning were low, and the prize likely would disappoint.
We’ve heard a lot of “Step right up for tax reform! Win a fairer, simpler, and more pro-growth tax code!” But like the carny games, winning is not so easy. But right now, let’s focus on the big prize – a “fairer, simpler, more pro-growth” tax code.
In 37 years of tax policy work, I have never heard an elected official or other policymaker say: “Let’s see if we can make the tax code a less fair, more complex, and anti-growth.” The system we have today reflects attempts by successive Congresses to balance fairness, simplicity and economic concerns. Voters would do well to ask what definitions candidates have in mind when they use these words and how they would compromise when all three goals cannot be achieved.
With no issue is the fair/simple/pro-growth tension more apparent than on the tax treatment of long-term capital gains.
Is it possible to have a fair tax on capital gains? If fair means fair in the eyes of most people – then the answer has to be “No.” The contrast between current law with the Bush tax cuts in effect, and what is scheduled to happen next year demonstrates this. For 2012, the top tax rate on long-term capital gain is 15 percent. Next year, 2013, it is scheduled to increase to 20 percent, and a new 3.8 percent Hospital Insurance tax added in healthcare reform, will apply. In effect, the top rate is scheduled to be 23.8 percent. These different approaches are in the law because at different times different majorities in Congress thought they were fair.
If there is little or no prospect of finding a fair treatment for capital gains, is there at least a tax treatment that would be both simple and pro-growth? I doubt it. Let’s look at three different approaches.
Taxing capital gains just like all other income would be very simple. There would be no lines to draw between types of income, fewer special forms to fill out, and fewer tax distortions in making investment choices.
A less simple approach would be to go in the opposite direction and not tax investment income at all. This sound simple, but an army of tax lawyers and accounts would quickly turn their skills to the question of how non-investment income could be turned into investment income. A competing army at the IRS and Treasury would set out to write regulations to thwart such planning.
The most complex approach would be to continue the current system which taxes different kinds of investment income at different rates. This differentiated tax treatment is more complicated because taxpayers most segregate and document various forms of income and apply special rules. The rules produce even more complexity when taxpayers begin to structure transactions to produce capital gains or qualified dividends rather than other income.
On the question of a pro-growth approach to capital gains, the consensus view in Washington is that some form of preferential treatment is needed. Favorable treatment of capital gains is seen as encouraging capital investment and, therefore, economic growth. How big a preference is desirable is hotly debated.
The bottom line trade-off seems to between two broad options:
- No tax on capital gains, but complexity and uncertainty – A system that exempted investment income, including capital gains, would have a surface simplicity but invite complexity and “creative” planning in its implementation. Additionally, I bet the resultant shift in tax burden to lower and middle income taxpayers and the radical departure from traditional income tax notions would score as very unfair in the minds of enough citizens to keep the debate over fairness going strong.
- A simple, full tax on capital gains, but less incentive for growth – In the Tax Reform Act of 1986, Congress taxed capital gains at the same rate as ordinary income. If overall rates are not low enough, this policy would be seen by many as anti-growth. But, top marginal tax rates that are low enough to be indisputably pro-growth are rates some will see as unfair to the middle class.
In other words, the taxation of capital gains cannot be fair, simple and pro-growth. We cannot have a system that a large majority would score as fair. We can have simple or we can have pro-growth. Or, we can have a second best on both fronts. All this suggests that we will keep a version of the current system. We will keep the complexity. We will keep some incentives for growth.
And, we will keep the current arguments about fairness.
For most other tax issues, the trade-offs may be less obvious, but they are no easier. The tax code can, and should be, improved. Pretending that it can simultaneously be fair, simple and pro-prowth does not advance the cause. Compromise will be necessary. Any tax code will be complex, unfair in the view of some and a burden on economic activity. The challenge will be whether the political system can produce a better, but not perfect, outcome that deserve the proud a title of “Tax Reform” more than the small stuffed animal won at the county fair deserves the title of “Big Prize.”