October 10, 2012

In a speech Tuesday at the National Press Club, U.S. Senator Charles E. Schumer (D-NY) said federal policymakers eyeing an overhaul of the U.S. tax code in the coming months should abandon President Reagan’s model of tax reform that calls for reducing rates for the wealthiest Americans.

The 1986 model—which seeks to eliminate tax credits and deductions in order to pay for across-the-board rate cuts—is the basis for both the Simpson-Bowles framework and the outline released last year by the so-called “Gang of Six.”

Breaking with those proposals, Schumer called for applying 100 percent of the savings from loophole closures towards deficit reduction, rather than a reduction in the top rate for the wealthiest Americans.

“Tax reform 25 years ago was revenue-neutral. It did not strive to cut the debt. Today, we can’t afford for it not to,” Schumer said. “It would be a huge mistake to take the dollars we gain from closing loopholes and put them into reducing rates for the highest income brackets, rather than into reducing the deficit.”

As a House member in 1986, Schumer voted for the landmark tax agreement negotiated by President Reagan and congressional Democrats. But he said upfront rate cuts this time around would make it impossible to reduce the deficit without increasing the tax burden on middle-income earners.

“A 1986-style approach that promises upfront rate cuts to the wealthy is almost guaranteed to give middle-income earners the short end of the stick,” Schumer said. “The reason is, in order to raise enough money to both reduce tax rates and cut the deficit, you would need to slash deductions and credits on a far greater scale than we ever did in 1986. Middle-income earners would not be spared.”

Schumer pointed out that it was a contradiction for some in his party to oppose a lower rate for top earners in the debate over extending the Bush tax cuts, but then endorse the same concept when it is dubbed “tax reform.”

Instead of luring Republicans to the table on a grand bargain with the promise of lower tax rates for the wealthy, Schumer said Democrats should be prepared to offer to make significant reforms to entitlements.

A copy of Schumer’s remarks, as prepared for delivery, appears below.

Remarks by U.S. Senator Charles E. Schumer on Tax Reform

National Press Club

Washington, DC

October 9, 2012

As Prepared for Delivery

There is perhaps no issue facing Congress that is more complex than tax reform. But for all the disagreement on taxes, ask most policymakers—Democrats, Republicans and independents alike—what the broad outlines of tax reform might look like, and you get a startlingly consistent answer: dramatically lower the rates, and broaden the tax base by getting rid of loopholes in the tax code.

This approach has a distinguished lineage: Ronald Reagan and the 1986 Democratic Congress invented it. Simpson-Bowles validated it. The Gang of Six endorsed it.

But in the upcoming talks on the fiscal cliff, we ought to scrap it.

The reason is simple. The old style of tax reform is obsolete in a 2012 world. It just doesn’t fit the times because there are two new conditions that didn’t exist in 1986, but that are staring us in the face today: a much larger, more dangerous deficit, and a dramatic increase in income inequality. Old-style tax reform could make both conditions worse.

Now, I do not dismiss the old framework lightly. The credit for the 1986 tax reform law belongs to Democrats like Bill Bradley in the Senate and Dick Gephardt in the House just as much as President Reagan. As a member of the House back then, I not only voted for it, I whipped votes to make sure it passed.

The approach made a good deal of sense at that time. Then, as now, the code was littered with egregious loopholes that needed to be reformed.

Recall, for example, the so-called “passive loss” rules in place back then. They allowed wealthy taxpayers to legally game the system. Someone could invest in a bowling alley and then, if the bowling alley lost money, take a write-off many times larger than their initial investment and wipe out their entire income tax liability. We needed to get rid of such gimmicky tax shelters.

Pruning these loopholes allowed us, in turn, to cut rates. At the time, that made sense, too. While it is critically important to ensure everyone, especially those at the very top, pays their fair share, a 50 percent top tax rate—which is what we had up until 1986—was admittedly too high.

So yes, Reagan-style tax reform worked over 25 years ago. As a result, it has a great deal of appeal to some of the most serious fiscal thinkers in Washington.

This includes the Gang of Six—recently expanded to a Gang of Eight—which last year published a white paper based largely on the 1986 model. Let me say this about the Gang of Eight. Some of them are among my best friends in the Senate. Leaders on both sides are actively encouraging their talks. I certainly am.

But I hope they can revisit their approach to tax reform.

Our needs today are different compared to 1986, and we cannot take the same approach we did then. We must reduce the deficit, which is strangling our economic growth. And we must seek to control the rise in income inequality, which is hollowing out the middle class. The 1986 model would be ineffective—if not counterproductive—to solving these two challenges.

Let me explain why.

First, with regard to deficit reduction: Tax reform 25 years ago was revenue-neutral. It did not strive to cut the debt. Today, we can’t afford for it not to. Our national debt today is approximately 73 percent of GDP—that’s nearly double what it was in 1986.

It would be a huge mistake to take the dollars we gain from closing loopholes and put them into reducing rates for the highest income brackets, rather than into reducing the deficit.

To fix the deficit, we of course need to cut spending. The Budget Control Act made a down payment of $900 billion in domestic discretionary cuts. On top of that, most Democrats are committed to finding significantly more savings as part of a grand bargain, including through reforms to entitlements.

But in addition to more cuts, we also need to bring in more money. The President’s budget has called for around $1.5 trillion or so in revenues over the next decade.

The revenues side of the federal ledger is underperforming by historical standards. For three straight years, we’ve had revenues coming into the federal government at a level of around 15 percent of GDP. That’s a 60-year low. Since 1960, we’ve never had a balanced budget in a year when revenues were less than 18 percent of GDP. In 2001, the last year we had a surplus, revenues were at 19.5 percent of GDP.

So we have a revenue problem. We need tax reform to help solve it.

Some on the left have suggested corporate tax reform could be a source for new revenue, but I disagree. To preserve our international competitiveness, it is imperative that we seek to reduce the corporate tax rate from 35 percent and do it on a revenue-neutral basis. This will boost growth and encourage more companies to reinvest in the United States.

Corporate tax reform, under the leadership of Chairman Baucus and Senator Hatch on the Finance Committee, should be treated separately from our attempt to get a handle on the deficit.

But when it comes to the individual side of the code, our approach must be different.

In this part of reform, the new money we collect through broadening the tax base can’t all be applied towards reducing rates or else we won’t be able to get enough revenues to strike an agreement on deficit reduction.

Using tax reform to produce revenue departs from the 1986 model. Some still haven’t accepted this reality. They believe that the dollars from loophole-closing should all be used for rate reduction, rather than deficit reduction.

Edward Kleinbard, former chief of staff at the Joint Committee on Taxation, recently had a message for these holdouts. He said: “We have to abandon our nostalgia for the Tax Reform Act of 1986. That tax reform effort was revenue neutral because it could afford to be. … The fact that we have to raise revenue today means that this tax reform effort will look different.”

Kleinbard is right. In 1986, tax reform was an end unto itself—designed to make the code simpler and flatter. This time, it cannot ignore the most dangerous fiscal problem we face: our mounting deficit.

“OK, fine,” say some well-meaning conservatives. “All we have to do is broaden the base enough to both reduce rates and reduce the deficit. The 1986 model can still apply.”

But hold on a minute. There is a second factor we must consider as we approach tax reform. It is the staggering rise in income inequality. In 1986, there was certainly wealth agglomeration at the top, but not nearly to the degree as is true now.

In the mid-1980s, we had just come off a period dating back to World War II that saw the largest expansion of the middle class in American history. Since then, however, middle class wages have stagnated—in fact, the last decade was the first since World War II when the median family income actually declined.

According to the Congressional Budget Office, thirty years ago, the top one percent of households received 7.4 percent of total national income. Today, the share of income going to those same households has jumped more than 50 percent, to 11.5 percent.

According to one study looking at data up to 2007—just before the recession hit—the average income for the top one percent of taxpayers grew by a whopping 241 percent over the last 30 years. The average income for the bottom fifth grew by merely 11 percent.

According to a 2011 study, the net worth of the Waltons alone is equal to that of the bottom 30 percent of the country.

The 1986 tax reform law actually did work to make the code somewhat more progressive by, among other steps, reducing the tax preference for investment income. But subsequent changes to the code—in particular, the 2001 and 2003 tax cuts—undid that work. The capital gains rate was reduced all the way to 15 percent, giving a large advantage to those in the highest brackets.

High-income earners also gained the most from President Bush’s across-the-board rate cuts. According to the Tax Policy Center, last year the Bush tax cuts increased after-tax incomes for people making over $1 million by an average of 6.2 percent — about $129,000 per household. But for those with incomes between $40,000 and $50,000, the increase was just 2.2 percent — or about $830 per household.

Over time, our tax code has widened the nation’s wealth gap. Reversing this trend ought to be a top goal of tax reform; at a minimum, we certainly should not make the tax code any less progressive than it would be if the high-income tax cuts expired.

But a 1986-style approach that promises upfront rate cuts to the wealthy is almost guaranteed to give middle-income earners the short end of the stick.

The reason is, in order to raise enough money to both reduce tax rates AND cut the deficit, you would need to slash deductions and credits on a far greater scale than we ever did in 1986. Middle-income earners would not be spared.

And because middle-income earners so rely on these expenditures, the cost of losing them would likely exceed the benefit they would receive from a lowered rate.

Multiple experts have verified this. The Joint Economic Committee analyzed the tax reform plan contained in the House Republican budget authored by Paul Ryan. It found that, in order to provide a lower top rate of 25 percent for high-income taxpayers in a way that doesn’t add to the deficit, the elimination of expenditures would result in a $2,681 annual tax increase for a married couple with joint income of $100,000. That’s unacceptable.

The nonpartisan Tax Policy Center reached the same conclusion about a similar plan promising a 20-percent across-the-board tax cut.

Under such a plan, the Center said, the average household with children earning $200,000 or less would face an effective tax increase of $2,041.

There is a lesson to absorb from these studies: Beware tax reform plans that only get specific about what top rate they want to lock in. It’s also generally true that the lower the rate that gets promised, the fewer details that get provided about the rest of their plan.

Simpson-Bowles promised a top rate between 23 and 29 percent. But take a hard look at how this might be accomplished. They presented an “illustrative plan” with a top rate of 28 percent paid for by deep cuts in deductions. The plan did raise significant revenue, so would genuinely help address our deficits. But it also raised taxes on middle class families, with households making around $100,000 getting a tax increase of over $1,000.

And under the Simpson-Bowles plan, high-income households would face a smaller tax increase than they would if the tax cuts simply expired.

Senator Toomey last year offered a plan that claimed a 28 percent top rate with few details on what would happen to expenditures.

And the House Republican budget, authored by Ryan, proposes the lowest top rate of all—25 percent—and left huge holes in the rest of the plan, the better to disguise its impact on the deficit and the middle class.

These promises of lower rates amount to little more than happy talk when the math behind them doesn’t add up. And the risk for serious policymakers is, if upfront rate cuts are the starting point for negotiations on tax reform, it will box us in on what else we can achieve. Certain lawmakers will pocket the rate reductions and never follow through on finding enough revenue elsewhere in the code to reduce the deficit. Or, if they do, it will almost certainly come out of the pockets of middle-income earners.

This is the trap of tax reform, and we must not fall for it. It is an alluring prospect to cut taxes on the wealthiest people, reduce the deficit and hold the middle class harmless, but the math dictates you can’t have it all.

The reality is, any path forward on tax reform that promises to cut rates will end up either failing to reduce the deficit or failing to protect the middle class from a net tax increase. You can, at most, achieve two of these goals; anyone pushing a plan purporting to accomplish all three isn’t telling the truth. The sooner we are honest with ourselves about this, the easier it will be to negotiate a compromise on taxes.

In 1986, we chose to cut the top rate and protected the middle class. We didn’t seek to reduce the deficit.

Simpson-Bowles seeks to cut the top rate and reduce the deficit, but doesn’t seek to shield the middle class from a net tax increase.

We need a third approach that prioritizes reducing the deficit and protecting the middle class, and is willing to forego a reduction in the top rate. That’s what I am proposing today.

What would this proposal look like? It would have three principles.

First, as in 1986, it still makes sense to reduce the number of expenditures in the code to the extent possible. But in figuring out which credits and deductions to eliminate, we must draw a line when it comes to protecting the middle class.

We must understand that many of the expenditures in the tax code are not loopholes at all. Tax preferences for things like a college education and retirement savings belong in the tax code even after reform happens. They were put in the code on purpose to make a middle-class lifestyle accessible and sustainable for more American families.

We recognized this in 1986. Even as we cleared out an underbrush of loopholes, we preserved versions of the mortgage interest deduction, the charitable deduction, and the state and local property tax deduction. We realized that as much as we wanted to make the code more efficient, these provisions were too essential to middle-class households. We must abide by the same principle today.

So, if we seek to protect the expenditures that are most essential to the middle class, and we still hope to reduce the deficit, we will need to find alternative revenue sources.

This leads to the second principle of this new model for tax reform: the top rate for the highest earners should probably return to Clinton-era levels, and stay somewhere around there.

This will come as heresy to some of those on the other side, who not only wish to extend the current rates in the upcoming lame duck, but also hope to cut rates even further in tax reform. These folks believe cutting the top rate as low as 25 percent is a necessary ingredient to spurring an economic recovery.

But a Congressional Research Service analysis released last month suggests otherwise. In a survey of the last 65 years of fiscal policy in America, the report concluded that tax cuts “do not appear correlated with economic growth.”

Recent experience, of course, suggests we have nothing at all to fear from a return to Clinton-era rates on the wealthiest Americans. The 1993 balanced budget agreement, which was signed by Bill Clinton and set a higher top rate, produced five years of GDP growth and the greatest peacetime expansion of our economy in the nation’s history.

By contrast, as we all know, the decade shaped by the Bush tax rates squandered our budget surpluses, produced net-negative jobs and culminated in the Great Recession.

The lesson here is that contrary to the view of the supply-siders, the level of the top rate does not, by itself, dictate what happens to GDP. But a balanced budget—aided by increased revenues—just might restore confidence to investors and jumpstart our economy.

For the third and final element of this tax reform model, we turn to investment income. It’s time to reduce the sizable differential in the tax treatment of earned and unearned income.

The reduction in the capital gains rate to 15 percent under President Bush tax was a major contributor to the growth in wealth disparity we see today.

Today the top 1 percent on average receives 20 percent of its income from capital gains—10 times as much as the rest of the country. Capital gains makes up 60 percent of the income reported by the Forbes 400.

The extremely low 15 percent rate in effect today is an outlier. It is the lowest rate on investment income since the Great Depression.

Republicans have understood the need to raise it before. As part of the 1986 reform, Reagan raised it to 28 percent. Simpson-Bowles—which was supported by good Republicans like Tom Coburn—endorsed raising it too, all the way to the same level as ordinary income.

Now, if you are returning the top income rate to Clinton-era levels, as I have proposed, I do think it is too much to treat capital gains the same as ordinary income. We don’t need a 39.6 percent rate on capital gains.

But without question, we need a narrower differential between earned and unearned income than we have today. This will bring more fairness to the code—Warren Buffett will have a harder time paying a lower effective rate than his secretary—and also deliver more revenue to reduce the deficit.

These three principles—curtailing tax expenditures, returning to a Clinton-era top rate, and reducing but not eliminating the tax preference for investment income—provide a foundation for a tax reform plan that would reduce the deficit without hurting the middle class.

Now, you may ask, “Hey, what’s in this for Republicans? Why would they come to the table around a proposal that doesn’t cut rates?”

For one thing, they get serious deficit reduction—which will matter to the true budget hawks left within the Republican Party. That is no small achievement.

What else besides deficit reduction would Republicans quote-unquote “get” out of tax reform? Well, that’s the wrong way to think about it. The lure for Republicans to come to the table around a grand bargain should be the potential for serious entitlement reform, not the promise of a lower top rate in tax reform.

Democrats will never sign on to a shredding of the safety net because it isn’t necessary to change the fundamental way Medicare works. But we can find ways to reduce Medicare costs by hundreds of billions of dollars. That is tough medicine but still preserves the safety net.

That is how a grand bargain can be had: Republicans get entitlement reform, while Democrats get revenue.

One last note on the prospects for a deal of this kind. Republicans may not be as far as you think from accepting the need for revenues out of tax reform. There are two reasons for optimism.

For one thing, the public is indicating it favors our side’s approach on taxes. A Washington-Post poll last week showed voters trust the President’s handling on taxes more than Mitt Romney’s. An NBC-Wall Street Journal poll also gave the President the edge on that issue. This is the first time that Democrats have had the upper hand on taxes in thirty years, and this represents a sea change.

This is causing Republicans to rethink their approach. Just look at Governor Romney. In recent weeks, he has gone to great lengths to moderate his tax proposal to appeal to a broader audience – going so far as to promise in last week’s debate that he would not reduce the net tax burden on the wealthy at all.

The second reason for optimism is because as hard as it may be for Republicans to compromise on taxes, they may find the result of not compromising to be even worse.

The scheduled expiration of all the tax breaks at year’s end gives Republicans incentive to act. President Obama has stated with equivocation that he will veto any extension of the tax cuts for the uppermost brackets. Republicans may soon realize that is far better to extend 98 percent of the tax cuts than none at all.

A story in today’s Financial Times – headlined “Republicans shift tone on taxing the rich” – suggests many Republicans are reaching that exact conclusion.

That would be the breakthrough tax reform needs—and Democrats should seize upon it.

You know, it’s interesting. For years, many of my colleagues have fought to end the reduced rate on the wealthiest Americans in the context of the Bush tax cut debate.

Yet suddenly, when the same idea of cutting tax rates for the wealthy is peddled under the guise of “tax reform,” too many people forget their opposition to it. This doesn’t make sense.

The contradiction just goes to show how deep the nostalgia is for the 1986 tax reform agreement, and the bipartisan cooperation that made it possible. But in the face of today’s yawning deficits, that framework is past its prime.

In an earlier era, Reagan’s approach was the gold standard of tax reform. But it’s long past time we moved off the gold standard.

Thank you.

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