Oct 2, 2021
AGOVERNMENTS SPEND more, it is increasingly important that they manage their taxes carefully. Large European welfare states like Sweden or Germany rely on growth-friendly value added taxes (VAT) to raise the huge amounts of money they spend. America gets away with a grossly inefficient and unnecessarily complex tax system only because its total revenues are relatively low.
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Small but growing. House Democrats are working on how to pay for President Joe Biden’s proposed Social Expenditure Bill that would see America take a step towards Europe with spending money on parents, childcare grants, green investments, and more money on health care. The bill is likely to be watered down in the Senate, but its current size is $ 3.5 trillion (1.2% of forecast GDP) over the next decade. To pay for that, lawmakers are proposing the largest tax hike since 1993.
The plan adds little to the efficient taxation that would be necessary if America ever had the European welfare state that many Democrats aspire to. This is because the proposals were made with the aim of raising taxes only for households with incomes greater than $ 400,000. The left thinks the rich are not paying their fair share. They want to raise the top federal income tax rate from 37% to 39.6% and introduce a new 3% tax on income over $ 5 million. They also want to raise the federal tax rate on corporate profits over $ 5 million from 21% to 26.5% (while overlooking the fact that doing so will at least reduce wages a little). The plan Increase the rate of capital gains tax and introduce various new taxes.
The federal government has some leeway to raise more money from high earners. But the notion that the main problem with the existing system is that tax rates are too flat is wrong. In 2018, the bottom fifth of the workforce paid no net federal taxes at all on average. According to the Congressional Budget Office, the top 1% paid a total rate (ie after all deductions) of 30%. Take state and local taxes into account, and high earners must pay a marginal tax rate – the rate important for work incentives – on every extra dollar they take home, which is mediocre for rich countries. Tax refunds for poor families are exceptionally generous. In 2019, a single parent of two children earning two thirds of the average wage had to pay a net wage tax of just 10%, according to an analysis by the OECD, a club of the most rich countries. In egalitarian Sweden, the rate was almost 33%.
Inefficiency is a bigger problem in America than interest rates failing to be sufficiently progressive. Countless deductions enable the very rich to disguise labor income as easily taxed capital income. And reluctance to collect a sales tax that is an excise tax means America relies on taxes that discourage labor and investment. America is one of only three rich countries that derives more than 70% of its tax revenue from labor and corporate profits. Sales taxes levied by states and municipalities are the only excise taxes of any interest.
The plan does far too little to improve efficiency. On the flip side, it would limit the carried interest loophole that allows investment managers to classify their fees as capital gains rather than income. It would reduce tax evasion through increased enforcement, such as auditing the tax returns of high earners, which more than pays off. And it would try to get more money from “pass-through” companies, shells that allow many professionals to treat their income as business profits, resulting in a lower tax rate.
But much is wrong with the Democrats’ plans. You seem to have passed up on closing one of the most expensive loopholes that depreciates capital gains when assets are inherited. The corporation tax increase would raise the total rate, including the average state and local taxes, to 31%, the third highest among rich countries. In the house, they seem disinterested in a CO2 tax to combat climate change. And while it’s not yet on schedule, they are talking about lifting the cap on an exemption from federal taxable income from funds used to pay state and local taxes. The cap was introduced in 2017 under Donald Trump. Abolition would continue to subsidize high-tax countries and benefit almost exclusively the rich. The Democrats would raise the top tax rates and at the same time narrow the tax base – the opposite of good taxation policy.
America’s economy would survive these proposals. But its creaky and cumbersome tax bill shouldn’t be asked to support the size of government that many Democrats want long-term, which includes state-funded universal health care, for example. Republicans know this is implausible. They usually reject VAT because they see it as too convenient a source of money. Democrats don’t like the tax because it’s easily regressive. But there is a reason VAT underpins the European welfare state: there is no desirable alternative. ■
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This article appeared in the Leaders section of the print edition under the heading “Ways and Means”