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Our Broken Tax Code is Hurting the Middle Class. Trump’s Proposal Would Make It Worse

Oct 27, 2017

Credit David Baake

Commentary: Some 71 percent of Americans believe the economic system is rigged against them.  They’re not wrong.  In recent decades, middle class wages have stagnated, even as middle class costs have risen.  Social mobility is declining:  Americans born into the lower class are more likely to stay there than their counterparts in other rich countries.  About half of 30-year-olds are earning less than their parents did at the same age.

Even as the middle class has fallen behind, the ultra-rich has surged ahead.  Earners in the top one percent now take home over 20 percent of the country’s income.  Their incomes continue to grow at a staggering rate.

If it seems like Americans are living in two different economic worlds, that’s because they are.  There are two basic ways of making money:  you can work, or you can invest.  Increasingly, it is the middle class that works, and the ultra-rich that invests.  In 2011, the top one percent obtained 36 percent of its income from investments; the corresponding figure for the middle class was less than 2 percent.

Perversely, the tax code penalizes working people by taxing wages more heavily than the most common types of investment income.  Wages are taxed at a maximum rate of 39.6 percent, while capital gains and qualified dividends are taxed at a maximum rate of 20 percent.  The official rates understate the unfairness:  in practice, many people in the investment class pay tax rates that are closer to zero percent.

There are two reasons for that.  First, capital gains are taxed only when the underlying asset is sold, even though the investor can enjoy these gains (i.e., by borrowing against them) as soon as they occur.  Second, capital gains tax can be avoided entirely using the “angel-of-death” loophole.  Ordinarily, when an investor sells an asset, he must pay tax on the difference between the sales price and the purchase price.  When an investor dies, however, the angel-of-death loophole provides his heir with a “step up in basis,” which allows the heir to pretend he purchased the asset at its current market value.

An example will demonstrate how members of the investment class exploit this loophole.  Suppose an investor buys $1 million worth of stock, which later triples in value.  If the investor were to sell this stock, he would pay tax on a gain of $2 million—the difference between the sales price and the purchase price.  But if the investor bequeaths the stock to an investment bank in exchange for a $2 million loan, no one will pay any tax on the $2 million gain.  The investor won’t, because the IRS doesn’t treat borrowed money as income.  The bank won’t either; when it receives the stock upon the investor’s death, it can use the current market value as its basis.  (The angel-of-death loophole is the reason Facebook founder Mark Zuckerberg may never have to pay federal income tax again).

        We need to close the angel-of-death loophole, tax capital gains on an annual basis, and eliminate the distinction between earned income and capital gains.  If we did, we would raise hundreds of billions of dollars, which we could spend on programs that benefit the middle class, like health care, Social Security, and infrastructure.  Alternatively, we could use the revenue to pay down the national debt or cut middle class taxes.

  Unfortunately, Trump’s tax “reform” proposal does not include any of these ideas.  Instead of making the investment class pay its fair share, Trump’s proposal would stack the deck even more heavily in their favor.  He would eliminate the estate tax, which affects only the very wealthy and provides an essential bulwark against the formation of a hereditary aristocracy.  He would also slash corporate rates, further lining the pockets of the investment class without creating any new incentive to invest in the United States.  And he would make other changes, like eliminating the deduction for state and local income tax, that would increase rates for a sizable minority of middle class taxpayers.  As if all of that weren’t bad enough, the plan would increase the national debt by $3.2 trillion.

The middle class needs real tax reform—fiscally responsible reform that ends the era of “too-rich-to-tax” and lowers middle class rates.  Trump’s plan fails to meet these criteria.  Americans should unite in rejecting it.