Off the Charts Blog | Center on Budget and Policy Priorities

As our new report explains, some senators are proposing amendments to the immigration bill that would make its long and difficult path to citizenship far more difficult — in some cases undermining the fundamental goal of enabling undocumented workers to legalize their status.

One such proposal, from Senators Orrin Hatch (R-UT) and Marco Rubio (R-FL), would require immigrants seeking legal status to prove they have paid all of their taxes since they entered the country before adjusting to a legal status.

On the Senate floor Wednesday, Senator Hatch claimed that the IRS is well-positioned to determine such individuals’ tax liability, even when workers lack earnings and tax records:

The IRS is well experienced at estimating the tax liabilities for people who, for whatever reason, lack the records that normally support a tax return. . . .  Using bank records, credit card statements, housing records, and other evidence of an individual’s lifestyle, the IRS is able to construct returns and estimate tax liabilities for nonfilers who are U.S. citizens and resident aliens.  The same process can be used for immigrants looking to certify they no longer owe any Federal taxes.  That is not a tough thing to do…

But the IRS does not routinely try to use such records to guesstimate people’s incomes.  These are extreme methods, which it resorts to in only a very small number of cases each year.

Senator Hatch is essentially arguing that it would be workable — and a good use of taxpayer money — to require the IRS to conduct extensive field audits of very large numbers of undocumented immigrants seeking legal status.

The audits would be very complicated in many cases; many of these workers’ past employers will be difficult to locate, will not have records for cash transactions made years ago, and (for obvious reasons) may be reluctant to cooperate.  Moreover, many of these immigrants likely will not have bank records or credit cards, will have moved many times, and will have been working in the United States for many years or even decades, so reconstructing their records for this entire period could prove extremely difficult.

The IRS’s experience in estimating a family’s income based on its “lifestyle” is largely restricted to a very small number of generally high-income people and small businesses where there is a large disconnect between their reported income and the person’s lifestyle or the business’s spending and the IRS has reason to believe large-scale tax evasion may have occurred.  The IRS has never used this method for large numbers of low-income workers.

Given that an estimated 11 million people are eligible to legalize under the bill, the increased workload for the IRS would be tremendous.  Of the 187 million individual and business tax returns filed in 2011, the IRS examined just 1.7 million — fewer than 1 percent.  Moreover, over 70 percent of these audits were conducted by mail (where information is requested and provided by mail) and were not the complex, intensive audits that Senator Hatch envisions.

Based on the total cost of current IRS enforcement efforts and the number of returns examined each year, each field examination would clearly cost thousands of dollars.  This means that the cost of conducting vast numbers of complicated audits, as Senator Hatch evidently envisions, would run into the billions.

Senator Hatch has not proposed any new funding for the IRS to conduct such audits or indicated that large numbers of new IRS staff would be hired.  If the IRS tried to implement his proposal, it would have to divert a very large portion of its total enforcement resources, probably for a number of years, from enforcement activities that yield a much higher return for the Treasury to auditing millions of legalizing workers, most of whom have modest incomes.

In 2012, the IRS conducted 31,700 field audits of corporations, leading to a total of $20 billion in recommended additional tax assessments — an average of more than $600,000 per review.  When both individual and business field audits are considered, the average tax assessment is close to $60,000.  Diverting IRS resources away from these high-return audits to try to reconstruct earnings records from modest-earning immigrants almost surely would result in a net loss of revenues to the Treasury, not the gain that Senator Hatch suggests.

More realistically, the IRS would never be able to conduct the required audits, so the process of legalizing undocumented workers would grind to a halt for many — leaving the basic goal of the legislation in tatters.  Undocumented workers would remain undocumented and the Treasury would collect less in taxes going forward than if these workers were allowed to come out of the shadows.

As our loyal readers surely know, House Republicans have proposed a budget calling for up to $5.7 trillion in tax cuts as part of deficit-neutral tax reform, but they have yet to propose a single cut in tax expenditures (credits, deductions, and other tax preferences) to begin filling this huge revenue hole.

Now, Ways and Means Committee Chairman Dave Camp (R-MI) has taken a major tax expenditure off the table:  the deduction for charitable donations.  “I think it is important not to cap that area,” he said yesterday in response to a question, Tax Notes Today reports.

This isn’t the Republican plan’s first political reality check.  As we noted in April, a Ways and Means hearing examined the mortgage interest deduction, one of the largest tax expenditures (as is the charitable deduction) and considered ripe for reform across the political spectrum.  But top Republicans on the committee “made clear . . . that they plan to proceed with caution when it comes to deciding [its] fate,” according to Politico.

The mortgage interest and charitable deductions benefit a wide cross-section of American taxpayers so, not surprisingly, they enjoy broad public support.  That’s true, as well, of the other leading tax expenditures (such as the tax-free treatment of employer-provided health care) that policymakers would have to scale back significantly to have any hope of offsetting the huge proposed tax cuts.

Chairman Camp’s statement is just the latest sign of how at odds with political reality the Republican plan is.

The new Congressional Budget Office (CBO) report on tax expenditures (credits, deductions, and other tax preferences) and a recent column by Bruce Bartlett, former adviser to presidents Reagan and George H.W. Bush, add up to three strikes against the tax code’s favorable treatment of capital gains and dividends, which face much lower tax rates than wages and salaries.

Strike 1:  High Cost

CBO estimates that the preferential rates for capital gains and dividends will cost $161 billion this year, making it the second-largest individual tax expenditure.

Moreover, this figure doesn’t include another costly tax break on capital gains:  capital gains tax is forgiven at death.  So, if a taxpayer holds on to an asset until she dies, neither her estate nor her heirs will ever pay tax on any increase in the asset’s value before her death. Nor does it include the plethora of other loopholes (such as “like-kind” exchanges and “inside buildup”) that wealthy people use to defer or avoid paying even these highly discounted capital gains rates.

Strike 2:  Extreme Tilt to the Wealthy

Since capital gains and dividends are heavily concentrated at the top of the income scale, so are the benefits of taxing them at preferential rates.  CBO estimates that fully 68 percent of the benefits go to the top 1 percent of households, while just 7 percent go to the bottom 80 percent of households (see graph).

Their extreme tilt to the top means that these tax breaks make the tax code much less progressive.

Strike 3: Little Economic Benefit

Proponents of preferential rates for capital gains and dividends — and further cuts in those rates, such as those enacted in 2003 — argue that they benefit the country as a whole by stimulating business activity.  But, as Bartlett explains, research by the Federal Reserve and others on the 2003 dividend rate cut shows that it did not produce the promised gains.

Similarly, research on the capital gains preference that we discuss here finds, as leading tax expert Joel Slemrod put it, that “there is no evidence that links aggregate economic performance to capital gains tax rates.”

A new Congressional Budget Office (CBO) report on major individual tax expenditures (the deductions, exclusions, and credits embedded in the tax code) shows why they are ripe for reform — a point that we have made as well.  Tax expenditures are:

1) Costly. Combined, the ten biggest individual tax expenditures cost more in lost federal revenues each year than defense, Medicare, or Social Security, as the first graph shows.

2) Often inefficient. Tax expenditures can distort the allocation of resources.  CBO notes, for example, that the mortgage interest deduction can convince people to “purchase more expensive homes, investing too much in housing and too little elsewhere relative to what they would do if all investments were treated equally.”  In addition, tax expenditures sometimes pay people to do something they would have done anyway.  For example, tax incentives for retirement saving may lead some people to simply “reallocate existing savings from accounts that are not tax-preferred to retirement accounts, rather than add to their savings.”

3) Tilted to high-income people. The value of many tax expenditures is tied to a taxpayer’s tax rate, so it rises as his or her income rises.  These tax expenditures thus are “upside down” — they deliver the biggest subsidies to the people who least need a subsidy to do whatever the tax break is designed to encourage (see second graph).

I’d add a fourth reason why tax expenditures are ripe for reform:  both sides have proposed tax expenditure reform as a core part of a long-term deficit reduction agreement.

President Obama proposes capping the value of large tax expenditures at 28 percent.  House Speaker John Boehner proposed cutting tax expenditures by nearly $1 trillion over ten years at the end of last year.  January’s “fiscal cliff” agreement raised much less revenue than the Boehner proposal ($561 billion over the same period) and didn’t include any tax expenditure limits.

As CBO’s new report highlights, tax expenditure reform remains a key piece of unfinished fiscal business.

Bloomberg’s Evan Soltas suggests eliminating the corporate income tax.  It’s a terrible idea that would:

• Create a huge incentive for individuals to shelter income by setting up a company to sell their services tax-free. For example, a chef at a restaurant could try to turn her salary from taxable individual income into tax-free corporate income by setting up a one-person cooking company and having the restaurant pay it rather than her.

• Blow out the deficit. The corporate income tax will bring in $4.8 trillion between 2014 and 2023, the Congressional Budget Office (CBO) estimates.  Eliminating the tax would cost much more than that because of all the sheltering activity that it would allow (see above), which would reduce personal income tax revenues.

  Soltas mentions that a carbon tax or value-added tax (VAT) could help fill the revenue hole.  But, given the need to reduce long-run deficits, eliminating the corporate income tax is hardly a good priority for any revenues that such policies would generate.

• Be regressive. The corporate income tax is one of the most progressive parts of the tax code, so eliminating it would give the wealthy a big new tax cut.  Some argue that a large share of the tax falls not on corporate shareholders (who tend to be high-income) but on workers (who tend to have more modest incomes), in the form of lower pay and higher prices.  But, based on the latest evidence, the Urban-Brookings Tax Policy Center finds that the bulk of the tax falls on the wealthy: the top 1 percent of filers bear more than half of the tax.

  Moreover, two a replacement for the corporate income tax that Soltas suggests — a carbon tax and VAT — is generally regressive, so the net result would be to shift tax burdens to low- and moderate-income people in order to cut taxes for the wealthiest.

Soltas also notes that we could replace the corporate income tax with higher taxes on individuals’ investment income, like dividends and capital gains.  But, that would give individuals a bigger incentive to delay those taxes for as long as possible by hoarding income in corporations or accumulating capital gains on corporate stock indefinitely.

Despite news stories about corporations running circles around the IRS, the truth is that the corporate income tax helps prevent cheating.  A public company may have thousands of shareholders; the tax aims to help ensure that all of them pay at least some tax on their corporate income.  While the corporate income tax could certainly be improved (see our six tests for corporate tax reform), it nonetheless plays an important role in fulfilling the tax system’s basic goal — raising revenue fairly and efficiently — while also reducing income inequality.