Low-Tax but High-Integrity System

andrea scharfen - Sep 14, 2011 -
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Closed Loopholes Are Not Higher Taxes - FrumForum

Obama proposes to raise revenue without increasing tax rates at all, yet Republicans accuse him of trying to raise taxes. The GOP’s logic? Under Obama’s proposals, more tax revenue would be collected. Therefore, it counts as a tax increase.

The Republican response to Obama’s tax reform ideas is false, damaging to the country, and, if you really think about it, inconsistent with their own low-tax philosophy.

First, it is not true that any effort to increase tax revenue amounts to a “tax increase.” Suppose that Congress took away all of the IRS’s funding, so that it effectively couldn’t collect tax. Honest taxpayers would still report and pay their taxes. Less scrupulous taxpayers wouldn’t bother. If Congress later restores the IRS’s funding, does that count as a tax increase?Hardly. It just means that what was in effect a “loophole” for dishonest taxpayers gets closed.

Similarly, legislation to close loopholes currently authorized in the tax code should not be called a “tax increase.” A “loophole” is just another name for a tax subsidy. Courageously, Obama has proposed closing some of the most notorious and entrenched loopholes in the Internal Revenue Code.

For example, Obama wants to curtail the tax exclusion for bonds issued by state and local governments. The tax exclusion for municipal bond interest is little more than a subsidy of state and local government. If you borrow money, the lender will have to pay income tax on the interest that you pay. All else being equal, that will increase your borrowing costs.

If a state or city government borrows money, by contrast, lenders don’t have to pay income tax on the interest they receive. Consequently, state and local governments can finance more spending than they otherwise could. The tax code artificially lowers the borrowing costs of government.

That’s right: The tax code subsidizes the growth of government. Obama wants to reduce this subsidy, yet Republicans, betraying their own small-government principles, are jumping all over him. The hostility of today’s GOP to taxes has become so extreme that it trumps their commitment to limited government.

Second, GOP opposition to closing tax loopholes is damaging to the country. For example, Obama wants to tax “carried interests” held by hedge fund managers at the same rate that employees’ salaries are taxed. From a purely Machiavellian perspective, Republican resistance makes no sense: for the most part, hedge fund managers are liberal blue-state Democrats. Republicans should want to tax them more so they have less money with which to fund the opposition.

In any case, there is no principled reason to tax hedge fund managers’ so-called “carried interests” more favorably than the salaries that constitute the incomes of the vast majority of Americans. A “carried interest” is a simply a performance bonus for a hedge fund manager’s work. If you receive a bonus, you will have to pay tax on it at a marginal rate as high as 35%. Yet a hedge fund manager’s bonus is currently taxed at a maximum of only 15%.

Not only are hedge fund managers’ bonuses taxed more favorably than bonuses received by other workers, but their “work” doesn’t even produce anything. A successful hedge fund guy is just someone who happens to be skilled at convincing others to invest money with him. If a hedge fund manager is lucky to have just one good year, he makes a huge fortune, and his reputation is made. If he’s not lucky, well, there’s always next year. It is statistically certain that, every year, some over-confident hedge fund guy will happen to have chosen just the right mix of investments and made a killing.

Bully for him: he now joins the ranks of superrich Wall Street all-stars. That doesn’t mean that government should give him that added perquisite of favorable tax rates.

Republicans nevertheless want to subsidize the hedge fund industry because they conflate any increase in the integrity of the tax system with an increase in tax rates. But it is crucial to distinguish the two. Someone truly committed to limited government would actually favor a low-tax but high-integrity system.

By “high integrity,” I mean a system characterized by faithful compliance, few loopholes, and effective enforcement. A low-integrity system, by contrasts, suffers from low compliance, many loopholes, and ineffective enforcement.

Put it this way: Either you can have a (I) a high-tax, high-integrity system, (II) a high tax, low-integrity system, (III) a low-tax, high-integrity system, or (IV) a low tax, low-integrity system. The following table summarizes the options:



These day, Republicans favor tax system IV, which has both low rates and low integrity. The low integrity that Republicans favor punishes honesty, rewards scofflaws, and diverts work and investment into unproductive activities. It is not the lowest tax system at all. On the contrary, its low integrity represents an indirect tax on the public.

A truly low tax system would be tax system III, which has both low rates and high integrity. This was the system that was achieved by Ronald Reagan in the Tax Reform Act of 1986. It is the system that Republicans should be calling for today, even if it does mean agreeing with President Obama.