December 16, 2012

Lawrence Summers, a professor and past president at Harvard University, was Treasury secretary in the Clinton administration and economic adviser to President Obama from 2009 through 2010.

Sooner or later the U.S. tax code will be reformed. Probably sooner. Raising revenue will be the main motivation, but issues of fairness as well as the complexity of current tax rules and their adverse effects on the economy will also be prominent.

So far the debate has focused on scaling back provisions of the tax code that have favored activities traditionally deemed valuable. There is talk of reducing relief for charitable contributions, taxes paid to state and local governments, home mortgages, employer-provided health insurance and more.

Reasonable arguments can be made in each case. But taking only the “limit tax incentives” approach to reform has several major defects.

First, if reform is designed to avoid perverse outcomes, such as the crushing of charitable contributions or more pressure on state budgets, then it will raise only limited amounts of revenue.

Second, this approach will address very little of the code’s complexity and is unlikely to do much for recovery, as it will do little to increase demand.

Third, it will do little to address concerns about fairness because the richest taxpayers actually make relatively little use of deductions and credits.

What’s needed is an element that has largely been absent to date: the numerous exclusions from the definition of adjusted gross income that enable the accumulation of great wealth with the payment of little or no taxes. The issue of the special capital gains treatment of carried interest — performance fee income for investment managers — is only the tip of a very large iceberg. Far too many provisions favor a small minority of very fortunate taxpayers. They effectively permit the accumulation of wealth to go substantially underreported on income and estate tax returns, which forces the federal government to consider excessive increases in tax rates if it is to reach any given revenue target.

Whether their primary concern is preserving incentives for small businesses, closing prospective budget deficits or protecting the social safety net, all parties should be able to agree that it should not be possible to accumulate and transfer large fortunes while almost entirely avoiding taxation. Yet this is all too possible today.

Here are some issues the Obama administration and Congress should consider in light of the magnitude of prospective deficits and the extraordinary good fortune of those at the top of the income distribution:

Current valuation practices built into the tax code make it possible for investment partners to end up with $50 million or more in tax-free individual retirement accounts when most Americans are constrained by a $5,000 annual contribution limit.

Our estate tax system is broken. Assets passed to relatives or other personal relations are often badly misvalued relative to what they cost on an open market. The total wealth of American households is estimated at more than $60 trillion. It is heavily concentrated in very few hands. An estimated $1.2 trillion, or 2 percent, is passed down each year, mostly from the very rich. Yet estate and gift taxes raise less than $12 billion, or 1 percent of this figure, annually.

If a family’s home rises in value by more than a $500,000 exclusion over the course of its dwelling, then the owners pay capital gains tax on the difference between the value now and the value at purchase. But real estate investment operators, who sell properties whose value is measured in the hundreds of millions — if not billions — of dollars, are able to take tax deductions for “depreciation” on their properties. They are then able to sell these properties at an appreciated price while avoiding capital gains tax through what is known as a “like kind exchange.” This is in fact a sale.

Why should international companies be able to locate the lion’s share of their foreign income in low-tax jurisdictions such as Bermuda, the Netherlands and Ireland and avoid paying taxes?

There are sound arguments for a preferential rate on capital gains. But is there real justification for allowing those who do not need to sell their assets to finance retirement to avoid capital gains taxes entirely by including them in their estates?

These rules that permit the taxes of the most fortunate Americans to be far less than commensurate with their good fortune have the virtue of being relatively comprehensible. Many others, involving issues such as derivative accounting, pooled interests and leveraged leases, are neither easily explainable nor easily justified.

The failure to tax capital gains at the point of death costs the federal government about $50 billion a year. Since its removal would raise money in the future, and induce earlier and greater realizations of capital gains in the short term, its removal would probably add more than $500 billion over a 10-year period. I believe it is plausible to raise $1 trillion over the next 10 years by going after provisions that cause what adds to wealth and spending not to be regarded as income.

It is said that the greatest scandals are not the illegal things that people do but the things that are legal. This is surely true with respect to a tax code in urgent need of reform.