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.