Our current tax system is a toxic legacy of the George W. Bush years. It loomed over Obama's first four years, bearing deficits that limited the scope of economic stimulus, drove inequality to astonishing levels, and led directly to the debt limit showdown of the summer of 2011 that forced us into even more dangerous policies. President Obama's second term offers a long overdue opportunity to restore the promise of progressive taxation and revenues that are adequate to our long-term economic priorities. It requires both short-term and long-term action.
The greatest failure of the tax system is not that it’s too complicated or inefficient or that there are too many “special-interest loopholes,” as House Speaker John Boehner put it on the day after the election. It's that it doesn't raise enough money and it encourages all sorts of manipulation because of the differential rates for investment income and income from work. These are not things that developed over time, as if by some natural process – they are the product of specific decisions made in 2001 and 2003 by Republican-controlled Congresses that used the budget reconciliation process to avoid any bipartisan compromise.
Here are some principles that the administration should hold to in restoring adequate and progressive taxation:
1. Start from the law, not current tax policy. Under the law, the Bush tax cuts expire on January 2, 2013 and revert to their levels at the prosperous end of the 1990s. This expiration along with several temporary tax cuts that expire at the same time and the budget sequester devised to escape the House GOP blackmail on the debt ceiling in 2011 is what's known as “the fiscal cliff.” There will be an effort to negotiate a deal on taxes and spending before we hit the cliff out of fear that expiration of all the cuts at once would tip the country back into recession. But the effect won't be felt at once, and there's plenty of time to negotiate a new round of cuts once the law as written goes into effect. There is no reason to negotiate based on rates that are set to expire within weeks or days.
Under the law, capital gains rates will rise to 20 percent from 15 percent, dividends will be taxed at the same rate as regular income, and two provisions that limit personal deductions and exemptions for the wealthy will come back into effect. All tax rates will rise, but the tax code will instantly be fairer, by every definition, than it was in December. From that baseline – which is not some accident; it's what the law calls for – we can have a debate about which rates should be permanently lowered. There's a strong argument, for example, for bringing the bottom rate back down to 10 percent, given that these are the households that were hit hardest during the recession and saw few gains even during the prosperous years before 2008.
2. Don't try to define “the rich” with arbitrary thresholds. In its first four years, the Obama administration's tax policy was hamstrung by its commitment to the $250,000 line – that no household with taxable income lower than a quarter of a million dollars should face any kind of tax increase and any increase should apply only to the income above $250,000. Later, the line became a million dollars as the administration tried to craft what it called “The Buffett Rule” to remedy Warren Buffett's recognition of the absurdity that he paid a lower tax rate than his secretary. These new thresholds would be grafted onto the tax code on top of the existing rate brackets. For example, households with incomes below the quarter-million line would keep the preferential rates for capital gains and dividends, while it would go up for those above it. These thresholds would add a new level of complexity to the tax code, sharply reduce the revenues that could be gained, and reinforce the impression that taxes are a sort of punishment for the rich. It's a lot simpler, more efficient, and infinitely fairer to say that a single person who makes, say, $80,000 from capital gains alone should pay the same rate, no more and no less, than a comparable household that earns $80,000 from work. Right now, the first household would pay less. With the same rates for all income, rates can be held down and we can maintain the low-end cuts, such as the 10 percent rate for middle-class households, and gain enough revenue for the future. Artificial new thresholds, which would apply to some forms of income and not others, will make this much more difficult.
3. Consider one new source of revenue – and make it a “Pigovian” one. Even an ideal income tax system, one in which income from any source is taxed in the same way and distorting deductions are kept to a minimum, is unlikely to raise sufficient revenues to support the level of investment the country needs in the long run. Adding one additional source of revenue will not only help to close the revenue gap, but it can serve vital purposes as well. (Such taxes, which have a dual purpose of raising revenue and reducing some undesirable activity, such as smoking, are known as “Pigovian,” after the Cambridge economist Arthur Pigou.) The two leading candidates would be a tax on carbon and a very small tax on financial transactions. The former would have some of the same effect as a cap-and-trade system to reduce emissions that cause climate change, with less complexity, and could also fund clean energy research and job creation. The latter would generate revenue from the still thriving financial industry, while putting a little bit of friction into transactions and reducing the payoff – and the risk – created by strategies that rely on massive, fast trading. While those strategies weren't the main cause of the 2008 financial meltdown, they do play a role in creating instability (such as the “flash crash” of 2010). Either of these, or both, would helpfully supplement the income tax, the payroll tax (which supports Social Security and Medicare), the corporate income tax, and federal excise taxes.