Economic Forecasts

What to Do About Tax Reform

You can't keep marginal rates low if you allow deductions for such items as mortgage interest.

Tax reform is the number-one concern of financial markets.

The first big item is how we should tax the returns on savings, specifically dividends and capital gains. Some argue that we should exempt these sources of income because saving is necessary for economic growth and because the income that investors receive has already been taxed, when it was earned by the company.

I believe that investors who accumulate huge fortunes should pay some taxes on their investment income. But a strong argument can be made that income generated from wealth, particularly dividends and capital gains, should be taxed at a preferential rate. That's because, unlike interest, dividends are not deductible from the corporate tax. Dividends are first taxed as corporate earnings, and taxing them again at the full rates for ordinary income would be double taxation.

Some preference should be given to risk-takers, so capital gains should also qualify for lower tax rates. The tax code greatly restricts the ability of investors to deduct capital losses in excess of gains. As a result, risk-taking would be reduced if some break isn't given to an investor who turns up on the winning side of an investment.

The Republicans want to retain the 15% rate on capital gains and dividends, while the Democrats want to raise it to its former level of 20%. A compromise of 17.5% sounds reasonable, although high-income investors will also pay an extra 3.8% to help finance the new health care law. That would bring the total to above 20%, but that is still below the Clinton-era capital-gains rate of 28%.

Keeping rates low. When it comes to ordinary income, economists want to keep marginal tax rates as low as possible so that workers have an incentive to earn more. But you can't keep marginal rates low if you allow deductions for such items as mortgage interest, taxes and charitable giving. Many people favor eliminating the mortgage deduction because mortgage payments don't benefit the public at large. Furthermore, given today's extra-ordinarily low rates, the write-off is worth comparatively less, so I don't believe that disallowing the interest deduction would restrain the housing recovery.

Instead of trying to decide which deductions are justified, perhaps the best solution is to cap the total amount of deductions taxpayers are allowed, with a five-year phaseout of the mortgage deduction. I would cap total deductions at, say, $20,000 or 10% of adjusted gross income, whichever is higher. The one exception I might make is for charitable giving. It's difficult to say how much of the hundreds of billions of dollars donated to charitable causes by very-high-income individuals would disappear if the deduction did not exist. My recommendation: Allow an additional deduction for charitable contributions equal to 10% of income.

I'm not persuaded by arguments calling for the complete elimination of the estate tax on the grounds that income that has already been taxed once should not be taxed again. That's because the wealth in most large estates has been created by the accumulation of substantial capital gains. I do favor reducing the tax rates and providing an estate-tax exemption of about $4 million, but there is a good argument that large amounts of wealth should not be passed down without some of it going to the public coffers, either through taxes or charitable giving. Another idea with merit is to allow lifetime charitable contributions to be deductible against the estate tax instead of against ordinary income.

I recall Milton Friedman once saying that major tax reforms that eliminate special deductions and subsidies come once every 30 or 40 years -- so politicians can give them away again in the future. Perhaps, but we all have to clean out our closets occasionally.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.

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