A simpler, fairer, and more efficient tax system is critical to achieving many of the President’s fiscal and economic goals. At a time when middle class and working parents remain anxious about how they will meet their families’ needs, the tax system does not do enough to reward hard work, support working families, or create opportunity. After decades of rising income and wealth inequality, the tax system continues to favor unearned over earned income, and a porous capital gains tax system lets the wealthy shelter hundreds of billions of dollars from taxes each year. In a period where an aging population will put increasing pressure on the Federal budget, a wide range of inefficient tax breaks prevent the tax system from raising the level of revenue the Nation needs. While commerce around the world is increasingly interconnected, an out-of-date, loophole-ridden business tax system puts U.S. companies at a disadvantage relative to their competitors, while also failing to encourage investment in the United States.
The Budget addresses each of these challenges. It reforms and simplifies tax incentives that help families afford child care, pay for college, and save for retirement, while expanding tax benefits that support and reward work. It pays for these changes by reforming the system of capital gains taxation and by imposing a new fee on large, heavily-leveraged financial firms. It raises revenue for deficit reduction by curbing high-income tax benefits and closing loopholes and reforms the business tax system to make it fairer and more pro-growth. It also reinvests in the Internal Revenue Service (IRS), reversing the sharp funding reductions of recent years and improving customer service and tax enforcement.
2.8.1
Supporting Middle Class and Working Families through the Tax Code
The President’s tax proposals would simplify and improve tax benefits that help middle class families afford quality child care, pay for college, and save for retirement, as well as tax benefits that support work and keep millions of children from growing up in poverty. The Budget also proposes the creation of a new “second earner” tax credit benefiting middle-income couples where both spouses work.
Expanding Access to Affordable Child Care. The cost of child care is a major barrier to work for many parents, especially parents of young children, and can put a real strain on the budgets of working families. Through a combination of tax credits and direct subsidies, the Budget would make a major investment in quality, affordable child care for infants and toddlers. Specifically, the Budget would triple the maximum Child and Dependent Care Tax Credit (CDCTC) for families with children under age five. It would also make the full CDCTC available to families with incomes of up to $120,000, benefiting families with young children, older children, and elderly or disabled dependents. Meanwhile, the Budget would eliminate tax preferences for flexible spending accounts for child care expenses, which are poorly targeted and complex, reinvesting the savings in the improved CDCTC. The child care tax reforms would benefit 5.1 million families, helping them cover costs for 6.7 million children. They would complement a proposal, described above, to make direct child care subsidies universally available for young children in lower-income working families.
Simplifying and Improving Education Tax Benefits. A significant portion of Federal spending on higher education occurs through the tax code. But navigating current higher education tax benefits is so complicated that the GAO found that 27 percent of families who claimed one benefit would have been better off claiming another, while 14 percent of eligible families failed to claim any benefit at all. Higher education tax benefits also do not provide enough help for low-and middle-income families that struggle to afford college. Building on bipartisan congressional reform proposals, the Budget proposes to simplify and better target higher education tax benefits, including by consolidating six education tax benefits into just two. The Budget would repeal or let expire duplicative and less effective provisions, including the Lifetime Learning Credit, the tuition and fees deduction, the student loan interest deduction (for new borrowers), and Coverdell accounts (for new contributions), and it would roll back a portion of the subsidy for 529 savings plan (for new contributions). Meanwhile, it would make permanent and expand the American Opportunity Tax Credit, including by indexing the maximum credit amount for inflation, making the credit available for a fifth year of higher education, providing a partial credit to part-time students, and increasing the amount of the credit available to low-income students without income tax liability. To help struggling borrowers, the Budget would also eliminate tax on debt forgiven under Pay-as-You-Earn or other income-based repayment plans. Overall, these reforms would cut taxes for 8.5 million families and students and simplify taxes for more than 25 million families and students that claim education tax benefits.
Expanding Access to Workplace Savings Opportunities. Workers with an easy way to save for retirement through their employer overwhelmingly do so, while tens of millions of American workers without such access by and large do not. Small business and part-time employees are especially unlikely to have access to an employer retirement plan. The Budget proposes to automatically enroll workers without access to employer-based retirement plans in IRAs through payroll deposit contributions at their workplace (with an option to opt out). This proposal would give 30 million more workers access to a workplace saving opportunity. The Budget also proposes to expand the tax credits available to small businesses who set up automatic enrollment IRAs, set up 401(k)s or other employer plans, or start automatically enrolling workers in their existing retirement plans.
Supporting Work and Addressing the Challenges of Dual-Earner Couples. Two earner couples face unique challenges in the workforce. When both spouses work, the family incurs additional costs: commuting; professional expenses; child care; and increasingly, elder care. On top of explicit Federal and State taxes, these work-related costs can be quite burdensome and can contribute to a sense that work is not worth it. To address these challenges, the Budget proposes a new second earner credit of up to $500 for families where both spouses work. The new credit would benefit 24 million couples.
Expanding the Earned Income Tax Credit (EITC) for Workers without Children and Non-Custodial Parents. The EITC is among the Nation’s most effective tools for reducing poverty and encouraging people to enter the workforce. But because the EITC available to them is so small, workers without children and non-custodial parents miss out on these anti-poverty and employment effects of the EITC. The Budget would double the “childless worker” EITC and make the credit available to workers with earnings up to about 150 percent of the poverty line. It would also expand eligibility to workers age 21–24 and age 65–66, so that the EITC can encourage employment and on-the-job experience for young adults, as well as to older workers, harmonizing the EITC rules with ongoing increases in the Social Security full retirement age. The proposal would directly reduce poverty and hardship for 13.2 million low-income workers struggling to make ends meet, and would encourage and support work.
Continuing EITC and Child Tax Credit (CTC) Improvements that Benefit 16 Million Working Families with Children. The Budget starts from a baseline that makes permanent the improvements to the EITC and Child Tax Credit enacted in 2009 and extended in 2010 and 2013. The baseline also makes permanent the American Opportunity Tax Credit, discussed above. The EITC and CTC provisions benefit 16 million families with 29 million children and have likely encouraged thousands of parents to enter or remain in the workforce. In addition to their direct effects in reducing poverty and supporting work, the EITC and the Child Tax Credit have also been found to improve health and educational outcomes for the children whose families receive them. For example, recent research suggests that the 2009 EITC and Child Tax Credit expansions may have boosted college enrollment by two to three percentage points for high school seniors in eligible families.
2.8.2
Reforming Capital Gains Taxation, Imposing a Fee on Large Financial Firms, and Closing Tax Loopholes
Since the 1970s, income concentration in the United States has surged. In the most recent decade and for the highest income groups, much of that surge resulted from growing concentration of capital income and wealth. Today, the top one percent holds more than 40 percent of the Nation’s wealth, and the top 0.1 percent holds more than 20 percent — levels not seen since the 1930s. Meanwhile, the bottom 90 percent has lost ground, with its share of wealth falling since the mid-1980s, and its average wealth falling sharply in the last decade.
A contributing factor in these shifts has been falling tax rates on capital income. While the fiscal cliff deal raised the total capital gains and dividend tax rates to 23.8 percent for high-income households, that is still well below tax rates on earned income and tax rates on capital gains and dividends in earlier decades. Meanwhile, current rules let substantial capital income escape tax altogether.
One of the largest holes in the existing system is what is known as “stepped-up basis.” Under current law, capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the basis of inherited assets is immediately increased (“stepped up”) to the value at the date of death. For example, suppose an individual bequeaths stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is the $50 million when he inherited it — so he owes no tax on the sale.
Each year, hundreds of billions in capital gains escape income tax due to the non-taxation of gains on bequests. Stepped-up basis perpetuates inequality of wealth and opportunity, since the vast majority of the tax benefits accrue to the wealthiest of decedents and their heirs. It also creates a more basic inequity. Retirees who need to spend down their assets in retirement pay tax on their capital gains. But the small minority that can afford to hold onto appreciated assets until death can pass them onto their heirs tax-free.
The Budget would reform the taxation of capital income through two important changes. First, it would increase the capital gains and dividend rate to 28 percent (inclusive of the net investment income tax), the rate at which capital gains were taxed under President Reagan, for the highest-income households. Second, it would end stepped-up basis by treating bequests and gifts as realization events that would trigger tax liability for capital gains. To ensure the proposal creates neither tax nor compliance burdens for middle class families, decedents would be allowed a $200,000 per couple ($100,000 per individual) exclusion for capital gains income, along with a $500,000 per couple ($250,000 per individual) exclusion for personal residences. Tangible personal property other than art and similar collectibles (e.g., bequests or gifts of furniture or other household items) would also be excluded. In addition, family members that inherited small, family-owned and operated businesses would not owe tax on the gains unless and until the asset were sold, and closely-held businesses would have the option to pay tax on gains over 15 years.
The proposed capital income reforms would raise $208 billion over the first 10 years, with larger revenue gains when fully implemented. Not only is the proposal highly progressive, with 99 percent of the revenue coming from the top 1 percent, it would also improve the efficiency of the tax system. By letting very wealthy investors make their capital gains disappear for tax purposes at death, stepped-up basis creates strong “lock-in” incentives to hold onto assets for generations, even when resources could be invested more productively elsewhere. Eliminating stepped-up basis would reduce lock-in and promote higher productivity and growth by encouraging more efficient capital allocation.
The Budget would also impose a new fee on large, highly-leveraged financial institutions. Specifically, the Budget would raise $112 billion over 10 years by imposing a seven basis point fee on the liabilities of large U.S. financial firms — the roughly 100 firms with assets over $50 billion. This fee will complement other Administration policies aimed at preventing future financial crises and making the economy more resilient. Even with the end of “too big to fail,” excessive leverage still creates risks for the broader economy. Alongside capital requirements and other tools that help rein in excessive leverage, a financial fee would improve economic stability by attaching a direct cost to leverage for large firms. The fee will also satisfy the statutory requirement for the President to propose a means to recoup any remaining costs of assistance provided through the Department of the Treasury’s Troubled Asset Relief Program.
The Budget would also close a number of inefficient, unintended, and unfair tax loopholes in the individual tax code. For example, it would end a loophole that lets some high-paid professional avoid Medicare and Social Security payroll taxes, costing the Trust Funds almost $10 billion a year by the end of the decade. It would also prevent wealthy individuals from using loopholes to accumulate huge amounts in tax-favored retirement accounts. While tax-preferred retirement plans are intended to help middle class workers prepare for retirement, loopholes in the tax system have let some wealthy individuals convert these accounts into tax shelters. The Budget would prohibit contributions to and accruals of additional benefits in tax-preferred retirement plans and IRAs once balances are about $3.4 million, enough to provide an annual income of $210,000 in retirement.
The combination of the capital gains reform package, the financial fee, and closing tax loopholes would pay for the pro-middle class, pro-work tax reforms described above, as well as for the complementary investments in child care access and quality, and for the Budget’s proposal to partner with States to make community college free for responsible students.
2.8.3
Making Sure Everyone Pays Their Fair Share and Reducing the Deficit
As described in the first chapter, the President’s Budget takes a number of steps to put the Nation on a sound fiscal footing. Building on the Affordable Care Act (ACA), it introduces additional health reforms that will help maintain the historic slow-down in health care cost and price growth over the last several years. It proposes comprehensive immigration reform that reduces deficits and strengthens Social Security, while also boosting growth by raising productivity. Even with proposed new investments, it would bring discretionary spending to its lowest level on record as a share of GDP.
But even with slower health care cost growth, immigration reform, and spending restraint, an aging population will put increasing pressures on the budget over the next several decades. For example, by the end of the 10-year budget window in 2025, the ratio of retirees to workers will be almost 50 percent higher than it was at the beginning of the 2000s, and it will increase further over the subsequent decade. Given these demographic shifts, the reality is that additional revenue is needed to maintain the Nation’s commitments to seniors without shortchanging investment in future generations.
In addition to raising revenue to pay for tax reforms that help middle class families and support work, as described above, the Budget would also raise an additional $638 billion in revenue for deficit reduction. Rather than obtaining this additional revenue by raising tax rates, the President’s tax reform proposals would reduce the deficit by reforming tax breaks and closing loopholes, making the tax code fairer, simpler and more efficient. Specifically, the Budget would:
Limit the Value of Itemized Deductions and Other Tax Preferences to 28 Percent. Currently, a millionaire who deducts a dollar of mortgage interest enjoys a tax benefit that is more than twice as generous as that received by a middle class family. The Budget would limit the value of most tax deductions and exclusions to 28 cents on the dollar, a limitation that would affect only couples with incomes over about $250,000 (singles with incomes over about $200,000). The limit would apply to all itemized deductions, as well as other tax benefits, such as tax-exempt interest and tax exclusions for retirement contributions and employer-sponsored health insurance.
Observe the “Buffett Rule.” As in past years, the Budget proposes to institute the Buffett Rule, requiring that wealthy millionaires pay no less than 30 percent of income — after charitable contributions — in taxes. This proposal will act as a backstop to prevent high-income households from using tax preferences to reduce their total tax bills to less than what many middle class families pay.
2.8.4
Fixing America’s Broken Business Tax System and Rebuilding Its Infrastructure
In February 2012, the President proposed a framework for business tax reform that would help create jobs and spur investment, while eliminating loopholes that let companies avoid paying their fair share. Consistent with that framework, the Budget includes a reserve for long-run revenue neutral reform, while detailing a number of specific proposals that the President believes should be part of reform, including a detailed international tax reform plan that is new to this year’s Budget.
Key features of the President’s plan include:
Cutting the Corporate Tax Rate and Broadening the Tax Base. The Budget would lower the corporate tax rate to 28 percent, with a 25 percent effective rate for domestic manufacturing, putting the United States in line with major competitor countries and encouraging greater investment here at home. The rate reduction would be paid for by eliminating dozens of inefficient tax expenditures and through additional structural reforms — addressing accelerated depreciation and reducing the tax preference for debt financed investment. Together, these reforms would help achievemore neutral tax treatment of different industries, types of investment, and means of financing, improving capital allocation and contributing to economic growth.
Improving Incentives for Research and Clean Energy. The Budget would make permanent — and pay for — important research and clean energy incentives that the Congress routinely extends on a year-to-year basis, including the Research and Experimentation Tax Credit, the Production Tax Credit, and the Investment Tax Credit. It would also reform these incentives to make them simpler and more efficient, for example by creating a single formula for calculating the Research and Experimentation Tax Credit and making the renewable energy Production Tax Credit refundable so innovative, growing firms can fully benefit.
Simplifying and Cutting Taxes for Small Business. The Budget includes new proposals to make tax filing simpler for small businesses and entrepreneurs so that they can focus on growing their business rather than filling out their tax returns. Building on bipartisan proposals, the Budget would let businesses with gross receipts of less than $25 million — more than 99 percent of all businesses — dispense with many of the tax system’s most complex rules and instead pay tax based on simpler, “cash” accounting. The Budget would also permanently extend and enhance Section 179 expensing to let small businesses write off up to $1 million of investments in equipment up front, so that the vast majority of firms would not have to deal with depreciation rules. The net result is that almost all small businesses would pay taxes based on an income measure much closer to their bank statement: deducting their expenses — including funds reinvested in their businesses — and paying tax based on their cash flow profits.
Reforming the International Tax System. The Budget details the President’s full plan for reforming and modernizing the international business tax system. The core of the President’s proposal is a 19 percent minimum tax on foreign earnings that would require U.S. companies to pay tax on all of their foreign earnings when earned — with no loopholes or opportunities for deferral — after which earnings could be reinvested in the United States without additional tax. Other proposals in the international reform plan would prevent U.S. companies from avoiding tax through “inversions” — transactions in which U.S. companies buy smaller foreign companies, then reorganize the combined firm to reduce U.S. tax liability — and prevent foreign companies operating in the United States from using excessive interest deductions to “strip” earnings out of the United States and avoid U.S. tax. The Department of the Treasury has taken initial steps to reduce the economic benefits of inversions, but the President has been clear that the only way to fully address the issue of inversions is through action by the Congress, preferably as part of broader tax reform.
Devoting One-Time Savings from International Reform to Investment in Infrastructure. As part of transitioning to a reformed international tax system, the Budget would impose a one-time transition toll charge of 14 percent on the up to $2 trillion of untaxed foreign earnings that U.S. companies have accumulated overseas. As explained above, the Budget would devote the one-time revenue from this toll charge to the Highway Trust Fund, financing the President’s six-year Surface Transportation Reauthorization proposal. Devoting one-time transition revenue to infrastructure investments is both pro-growth (see above, The Case for Investing in Infrastructure in Today’s Economy) and fiscally responsible, since — unlike using this temporary revenue for permanent tax cuts or spending increases — devoting it to one-time investments will not increase long-term deficits.
2.8.5
Investing in a High-Performing Internal Revenue Service
Middle class families and small businesses deserve a simpler tax system. But they also deserve an IRS with the resources to answer the phone when they call, promptly issue new guidance clarifying laws and regulations, and ensure that those who try to cheat the system are held accountable. Likewise, reforms to the business and — especially — international tax system depend on an IRS that is capable of going toe-to-toe with high-paid tax lawyers and accountants to enforce the law and make sure corporations, the wealthiest, and ordinary American workers all play by the same rules.
Unfortunately, congressional Republicans have insisted on cutting the IRS budget by about 10 percent since 2010 (adjusted for inflation), severely compromising both customer service and enforcement. The Budget would reinvest in taxpayer services, as well as other IRS responsibilities. Specifically, the Budget’s $12.9 billion investment in the IRS would greatly improve services for taxpayers, including through investments for digital services that will fundamentally change how taxpayers interact with the IRS, such as by creating new online tax filing status and payment options. It also makes investments for the IRS to adequately and fairly administer the tax code. More than $650 million of the Budget’s IRS total is provided through a program integrity cap adjustment for tax enforcement activities that return six times their value in increased revenue.
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