Unless Americans are willing to live with a substantially smaller military, reduced Social Security payments, more crowded classrooms and other diminishments in what their government provides, lawmakers need to find about $2 trillion in additional tax revenue over the coming decade, on top of the money-saving budget reforms that we have detailed elsewhere. Congress’s task is to raise the money without dulling efficiency and warping incentives to grow, innovate and work.
As we noted in our recommendations for shoring up entitlement programs, one potential reform is raising the cap on wage earnings subject to Social Security taxes. Another is closing a loophole exempting pass-through businesses — such as sole proprietorships, partnerships and S corporations, which are not subject to corporate income taxes — from paying Medicare taxes on their investment profits. Here are some other ideas:
Close loopholes
The most effective tax systems have limited exemptions. An abundance of exemptions can distort investment decisions and give a leg up to those who can afford expensive tax advice. Take the estate tax. Currently, individuals may pass up to about $13 million of stock, real estate or other assets to heirs tax-free, an amount that would have been inconceivable in the 1990s. Moving the line back to $5 million, where it was in 2010, would raise more than $100 billion in revenue in the next decade, while still exempting all but less than one-half of 1 percent of estates.
Similarly, lawmakers could end the “stepped-up basis loophole.” This allows a person inheriting an asset — say, a share of stock — to pay tax only on the asset’s gains in value since the death of the person who passed it on. A family, therefore, could hold on to that share for decades, even as it rose in value, but then pay tax on only a fraction of the accumulated gains at selling. Ending this loophole would generate more than $100 billion in the next decade.
Congress could eliminate the “carried interest loophole,” too. This allows private equity and hedge fund managers to treat their incomes as investment profits, so they get to pay the far-lower capital gains tax on their incomes rather than the income tax that ordinary wage-earners do. Taxing gains as income would raise about $14 billion over the next decade and promote fairness in the tax system.
Hardest would be for Congress to revisit itemized deductions, which are heavily used by households earning more than $500,000 a year. One option is to eliminate the state-and-local tax deduction entirely (it was capped at $10,000 under President Donald Trump’s 2017 tax overhaul), which would cut a subsidy primarily benefiting those with high tax bills — that is, the well-to-do. Another idea is capping all itemized deductions, which would allow taxpayers to claim some credit on their returns for things such as charitable contributions and mortgage interest, but only up to a point. These changes could generate substantial revenue and reduce tax-code incentives to invest in specific assets, such as real estate.
Let most Trump tax cuts expire
President Biden has already announced his support for allowing some of Mr. Trump’s 2017 tax cuts to expire on time in 2025, letting the marginal income tax rate on the top earners return to 39.6 percent. This is the same rate that was in place for much of the 1990s. Reversing tax cuts for some of those a little lower on the income scale could raise more revenue. Boosting rates for those in the top three tax brackets would call on married couples making more than about $364,000 a year to contribute more. For context: Lawmakers set the income cutoff to receive the first round of covid relief payments at $150,000 for a married couple.
Mr. Trump also gave companies the largest cut to the corporate income tax rate in U.S. history. Even many business leaders were surprised when Republicans reduced it from 35 percent to 21 percent. A rate in the 25 to 28 percent range would keep the United States competitive with global rivals. Going to 25 percent would bring in roughly $500 billion over the next decade.
Put a tax on carbon
A carbon tax would raise revenue and help shift society away from carbon-intensive products by making them more expensive, spurring businesses and consumers to find the cheapest and easiest way to avoid polluting. Some kind of mass rebate system would have to accompany a carbon tax to ensure that it does not fall hardest on low-income earners. But many plausible carbon tax proposals include such a rebate and would still generate large amounts of money for deficit-cutting. Discouraging pollution and raising money, a carbon tax would be economically efficient and fair, asking those responsible for emissions to bear some of the social costs of pollution.
No one likes to pay higher taxes. But wise and targeted increases are essential to fiscal stability. Changes are clear and within reach. The longer Congress waits, the harder it will be to repair the compounding damage.