There's a big loophole in President Trump's tax reform plan, and the White House knows it.
The problem can be found in one of the plan's signature items: cutting the top tax rate for all businesses to 15 percent. Right now, a business can be taxed one of two ways. If it incorporates as a traditional C-corporation, it pays the federal corporate tax on its profits. But if it incorporates as an S-corporation, a partnership, or a sole proprietorship — i.e. a "pass-through" business — its profits are hit instead by the regular income tax. The reason for Trump's change is that a lot of small businesses and the self-employed are in the latter group, and it wouldn't be fair for, say, Sam the carpenter to face the income tax's higher rate if the corporate tax for a giant company like Home Depot was just cut.
But here's the problem with Trump's simplification: If you're a rich person who pays the top income tax rate of 39.6 percent on his income, you could cut it to 15 percent by refiling as a sole proprietorship or whatnot. The change would allow well-off Americans — who have the time, resources, and incentive to play games with their tax paperwork — to avoid paying the same rates the vast majority of less-privileged Americans pay.
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The New York Times reports that this problem is not lost on the Trump administration; plenty of officials, including Treasury Secretary Steven Mnuchin, acknowledge that it's a huge potential loophole in the plan, but they just don't know what to do about it.
So let me offer a very simple, yet very radical solution: Make everyone in America pay the old-fashioned individual income tax on everything.
Forget taxing corporations. Forget taxing the way money is made differently. Just create one system of federal taxation for all the money in the economy, applied at the moment the money lands in some individual's pocket. And then tax it the way it was taxed back in the boom time of the mid-century.
How would that work in practice?
First, let's go through all the federal government's major taxes.
There's the individual income tax, which has seven brackets, each with a progressively higher tax rate. So for all the money you make between $0 and $9,325, you give 10 percent to the government. Between $9,325 and $37,950, you give the government 15 percent. This continues until you're giving the government 39.6 percent of all the money you make above $418,400.
Then there's the payroll tax. It's a flat-tax rate on wages, instead of a progressive bracket system. And it only applies to the first $118,500 you make.
Next, there's the tax on the profits of C-corporations: also a progressive structure of four brackets, topping out at 35 percent.
Finally, there are taxes on dividends and other capital gains, like the money you make when you sell stock. Some of this money is taxed as regular income. But a lot of qualifying dividends and capital gains from assets held over one year are taxed at 15 percent or 20 percent, depending.
The problem with dividing tax revenues into all these different buckets is that it invites people to game the tax system. Lots of corporations that only make a few hundred thousand dollars in profit would actually pay more as C-corporations, so they incorporate differently. Then there's the long tradition of companies compensating upper management with stock, because millions in capital gains are taxed at far lower rates than millions in normal paychecks. Trump's big tax break to people who can rejigger their filings is just a particularly brazen example. All this in turn sows confusion and resentment among American voters, because it's never clear who's paying what and whether they're paying their fair share.
So how could it be changed?
Many of the changes would actually be straightforward. We already treat some dividend and capital gains as regular income, so treating them all that way wouldn't be too complicated. S-corporations already pay the regular income tax as well, so there's no change there.
But there would be very difficult changes, too.
First off, the payroll tax would need to be cut entirely. It hits the poor far harder than the regular income tax does, and the idea that it's necessary to fund Social Security and Medicare is a myth. We should rely on the regular income tax to supply that money instead.
The tax on the profits of C-corporations should also be scrapped entirely. That might freak a lot of people out because it sounds like the rich would get away with something. But remember: Corporate profits are ultimately used to pay dividends and stock buybacks and such — and by taxing capital gains as regular income, we're raising their tax rate quite a bit. Meanwhile, you know what isn't taxed? Corporate revenue that gets plowed into higher wages for workers or investment in new jobs. Presto-chango! More jobs and higher wages for everyone.
One last point: If we were to do this, the design of the income tax would need to change. We'd be relying on it for all tax revenue, after all.
So first, we should vastly increase the number of brackets. Contrary to popular wisdom, this would not make doing your taxes more complicated. (The complexities come with loopholes and deductions.) Next, the tax rates on the highest brackets should be way higher than they are now. In 1960, for example, there were 26 income tax brackets. The top bracket began at $1,551,311, and you paid a whopping tax rate of 91 percent on it.
Most of America's inequality problem is money going to the tippy top: people in the top 5 percent or top 1 percent. With way more tax brackets we could target those incomes with a lot more precision, creating a more equitable economy and tax code. That's doubly important because we'd be applying the income tax brackets to capital gains, the single biggest driver of rising inequality.
Now, could an income-tax-on-everything scheme actually happen? Well, the idea of returning to post-New Deal income tax rates and applying them to everything would probably horrify Republicans. On the other hand, they'd love the idea of killing the corporate profits tax entirely. You could probably pull in some centrists with the promise of simplifying the tax code. Eliminating the payroll tax would create as much bipartisan appeal as horror. Throw in a broad effort to clean out the code's various loopholes, and you might have something that could pass.
The first step to solving your problems is often the willingness to think big.
