By James Pethokoukis and Kyle Pomerleau

Democrats in Congress are eyeing America’s wealthiest individuals and most successful companies as they devise a tax program to pay for their reconciliation spending plans. With proposals to expand taxable income to include corporate book earnings and unrealized capital gains, these tax plans aim to make the rich pay their “fair share.” In this special episode of “Political Economy,” Kyle Pomerleau joins me to explain how these tax proposals work and what economic effects they might have.

Kyle is a senior fellow at the American Enterprise Institute, where he studies federal tax policy.

What follows is a lightly edited transcript of our conversation. You can download the episode here, and don’t forget to subscribe to my podcast on iTunes or Stitcher. Tell your friends, leave a review.

Pethokoukis: Democrats are trying to pay for President Biden’s Build Back Better bill. And there seems to be some new ideas. First, let me ask you about a different version of the corporate tax. They want to create a minimum tax for companies. Now, what’s that all about?

Pomerleau: So this proposal would enact a 15 percent minimum book tax on the largest corporations, or corporations that earn $1 billion or more in annual profits. Now, this proposal has actually been around for quite a while. Biden proposed this during the campaign; it was in the Treasury proposal that they released. And for a while we thought, “Maybe they’re not going to go for something like this.” But this week it’s been revived. And now, as an alternative to raising the corporate tax rate directly, they’re looking to enact this tax.

So how would this proposal work? Well, under the system, large enough companies would be subject to two parallel tax systems. So companies would pay the greater of either their ordinary corporate tax liability, under the current rules with the 21 percent tax rate, or 15 percent of their book income with some adjustments.

They would still get the research and development credit. They’d still get other general business tax credits. They’d be able to use loss carryforwards. And they’d also generate tax credits for paying the book tax that they could then carry forward into future years. And we don’t have to get into why those credits exist, but they’re an important component of them.

So the idea here is that, without really going after specific proposals in the tax code like accelerated depreciation, this is the back doorway to reduce the value of those provisions and raise anywhere between $100 billion and $300 billion over a decade.

Now, I know you’re not the Amazon analyst at Goldman Sachs or something, but Amazon is a super valuable company. It seems to make a lot of money. But people say, “Well, it doesn’t pay very much in taxes.” Do you have any idea how this kind of proposal would affect a company like Amazon?

Yeah. So what’s maybe driving a lot of these results, where you see low effective tax rates or no tax burden at all, relative to book profits, is something analysts call book-tax differences. So when companies prepare their financial statements, they’re using a different definition of income than the IRS uses for determining tax liability.

And there are good reasons for that. Books are supposed to tell investors how well a company is doing. Taxable income is supposed to fairly distribute the tax burden to companies. So differences can arise between these two. And companies that are growing, under current law, like Amazon, can face low taxes because their investments can receive larger deductions for taxable income than they can under book income.

And what the book tax would do to companies like that is that it would scale back the benefit of these accelerated depreciations for investment. So if I’m a company that’s going to build a factory or invest in a bunch of machines, the tax code — without the book tax — would allow me to fully expense a lot of these assets and get deductions larger than what I’d get for book purposes. But if that pushes my effective tax rate down enough, I could be pushed into the book tax, and that could then offset some of the benefits of that accelerated depreciation.

So a big reason why Amazon seems to pay a low tax rate is because it invests a lot. Is that too simple?

No, that is a simple and correct explanation for what drives a lot of these differences. Now, each company is different. Each company has a different profile, in terms of what they’re earning here or overseas. And I don’t want to speak for any company, but one of the big drivers here is a growing company that invests a lot may have low taxable income.

So is there a potential trade-off here, in which government might raise more money but those companies might invest less? Is that a potential trade-off?

That’s a potential. The investment incentives under a book tax are actually somewhat complicated, because companies are not always going to be subject to the book tax or always subject to the ordinary tax. Companies can bounce between them. And if you’re Amazon and you’re looking forward and saying, “Well, I’m going to be subject to the ordinary tax this year, but two years from now we’re going to be subject the book tax,” that could impact investment decisions much differently than a company that’s perpetually subject to the book tax.

But for some companies, yes, it could raise the tax burden on new investments. It could have an impact on investment in the US economy, generally.

I mean, ideally, do we want companies to make investments based on what they think the return on that investment will be over the long-term, not based on how it can try to game a system it sounds like will have an added level of complexity? As a tax economist, I would assume that you’d like the ideal tax code to be certain, to be understandable, to raise enough money, to be efficient. Would this create a better corporate tax code?

I’ve seen a lot of people conflate this with removing tax expenditures and making the tax code simpler. And I think they’re totally different policies. I think the minimum tax is an additional complexity and actually increases distortions of the tax code, relative to the current system.

And you’re right, a goal of tax reform should be to simplify the tax code, remove some of these provisions that distort investment decisions and distort the type of investments that companies would be making. So, yeah, I worry about policies that move in the wrong direction in this respect.

Broadly, how does the US corporate tax code compare to other rich countries? Do we do it completely differently? Do we raise a lot more? Do we raise a lot less? Can you give me any broad generalizations?

This has been central to the debate over corporate tax reform this time around. And in terms of the corporate tax, it depends on what statistic you’re looking at. So if you’re looking at just statutory tax rates, the US federal rate is 21 percent, add 5.8 percentage points for state and local taxes — we’re right about average. We’re above many small countries like Switzerland and Estonia. But we’re below many large countries such as Japan, Germany, and Australia. So we’re right around average in terms of statutory rate.

In terms of effective tax rates, interestingly, we are slightly above average. So we’re placing an above-average burden on new investments in the United States compared to other OECD countries. And one of the reasons for this is that while rates vary a lot throughout the OECD, tax bases vary just as much or even more than tax rates. And a lot of countries have reasonably generous provisions for new investment, which bring effective tax rates down quite a bit.

The last point I’d make, in terms of comparing the US with other countries, is that one of the favorite statistics of the administration is to compare corporate tax revenue collected as a percent of GDP in the United States versus other countries. And if you look at that statistic, the US is near the bottom of the list. We’re collecting very little in corporate revenue as a percent of GDP.

But I don’t think that this is a very good metric for evaluating the US tax burden on corporations, relative to other countries, because the corporate sector in different countries varies quite a bit. We actually have a relatively small corporate sector and corporate profits relative to other developed countries. And this is because we, in the United States, have a very large “pass-through sector.” We have businesses that are taxed through the individual income tax — partnerships, S corporations — to a much larger degree than other countries.

So I think that statistic is misleading. It’s not very helpful for this debate. I did some research that’s published in Bloomberg where my co-author and I adjusted the statistic and found that after you make adjustments, the US is closer to the top quarter of countries rather than the very bottom.

Is one reason for this idea to get at these super billionaires whose wealth is based on their ownership of these companies? Is that a reason at all? I’ve heard some people call this a “corporate billionaire tax.”

Oh, that’s interesting. So I understand where the talking point’s coming from, and it’s based on that $1 billion-in-profit threshold.

So in a way, yes. Raising taxes on corporations does impact the amount of taxes that the owners of these corporations pay. So if I’m Jeff Bezos and I have a huge stake in Amazon, raising the tax burden on Amazon is going to raise my tax burden as the owner.

Now, I’d be a little bit careful about conflating taxes on corporations with taxes on billionaires, however, because corporations’ owners are not just billionaires. If you’re a multinational corporation, you have owners that can range from a billionaire that owns a huge stake in your company, all the way down to the retiree that’s earning $30,000 a year in dividends off of your company.

So raising taxes on corporations is not a very targeted way to get at billionaires, although it does, I think, disproportionately impact billionaires at the end of the day.

Let’s jump to the one which is very directly targeted at billionaires, which would tax them on financial assets, not when they sell them, but every year based on their appreciation on paper. Is that basically it?

Yeah. Under current law, capital gains are taxed based on the realization principle. So when you sell a capital asset, you then need to take the market price, subtract the basis. That’s your capital gain. And you pay tax on that.

This would deviate from that principle for billionaires, or people that hit this income and wealth threshold that they’ve defined. And under their proposal, billionaires would have to pay tax on capital gains, not when realized, but when those gains accrue. Now, this is also called a mark-to-market tax on capital gains.

So these billionaires would face capital gains tax each and every year at the statutory tax rate, 23.8 percent — which is the 20 percent federal rate plus the 3.8 percent net investment income tax. They would face that tax on their capital gains each and every year.

Right. He’s in the news and he’s currently the world’s richest man: Elon Musk. So every year then, he would have to pay that tax on the gains of Tesla stock. He owns other assets, like SpaceX, but that’s not publicly traded. So would that be affected as well?

Yeah. The proposal makes a distinction between publicly traded assets and assets that are not publicly traded. And it comes down to administrability. With publicly traded assets, you can tell at any time of day what the value of those assets are, and it’s not very hard to track. So taxing those mark-to-market is pretty straightforward. For other assets that aren’t publicly traded, it’s harder to get a market value at any given time. And for some assets, you don’t know the market value until it’s sold. Say, you have a piece of artwork that you’ve been holding onto for 45 years. You don’t know what the market price is until you actually sell it.

So what they’ve proposed to do for those assets is to maintain the realization principle. So you’re only going to be taxed on gains when you sell, but they’re going to change the tax burden and charge taxpayers interest for deferring that tax.

So, in essence, these taxpayers would pay a tax that would be equal to a mark-to-market tax, but they would still be taxed when they would realize the capital gains. This proposal has been around for a couple decades, and it’s meant to simplify the administration of mark-to-market when you don’t have obvious market prices.

The notion of being taxed on paper gains seems very different than what we’ve been doing. Would Elon Musk have to sell Tesla stock to pay the tax every year? How does that work in practice?

It’s going to depend on the taxpayer. So what’s going to happen is that these capital gains will be accruing, but you’ll be facing tax. So they’re going to accrue more slowly than they otherwise would have. Under current law, if you hold onto a growth stock, that’s going to grow at a faster rate than, say, if you held onto a stock that pays you dividends and you reinvest those dividends. So there’s going to be a difference in the rate of return on those for capital gains under this proposal. Now, whether that’s going to require taxpayers to sell, I think that will depend on the taxpayer.

I think one provision here that may surprise some, is that when you’re a taxpayer that gets pushed into this mark-to-market regime, you’re going to be subject to taxation on all of your unrealized gains, up to the point before you went into the system.

So if you’re Elon Musk and you’ve realized billions in gains over the last several years and you get pushed into this system, the system is going to require that, over a five year period, you pay tax on those gains. And then, going forward, you’d face tax on any additional gains in the future. And that could result in some pretty big tax bills for some of these billionaires.

To what extent are people paying attention to, or have they analyzed, the potential impacts on high-impact entrepreneurship, venture capital, and (further down the line) economic growth? Because it seems that a lot of the emphasis has been on how to extract this money in a way that is politically doable and is somewhat efficient — meaning administratively efficient. But what about economic efficiency?

So mark-to-market will increase the effective tax burden on income. You think of capital income as having a couple components. One of those components is just the returns to waiting — that you’re just being compensated for delaying your consumption. Another big component of capital income, however, is returns to entrepreneurship or returns to good ideas.

And a higher tax burden on capital gains through mark-to-market increases the effective tax rate on the returns to good ideas entrepreneurship. So all things equal, you’d expect that maybe there’s less of this activity when you’re going to a system like this.

I want more of that. I want more good ideas and to have those ideas turned into very successful companies.

Yeah, this is a trade-off with tax policy. This is why even when you go to, say, this ideal tax system, where you have a consumption-based tax and you’re not taxing saving whatsoever — totally neutral between saving and consumption — you still want to keep rates low. Because even under a system like that, you’re taxing the returns to entrepreneurship. And you don’t want to distort that decision. You don’t want all the good ideas to end up somewhere else or not happen at all.

Is that trade-off a part of the debate right now?

I think it should be. One of the concerns I have about introducing policy so quickly, right at the last minute, right before a bill may be passed, is that there isn’t enough time to debate this stuff. Yes, it can bring about drafting errors and you can make mistakes in that way, but also there’s less time to discuss some of the trade-offs you’re making in tax policy.

Yes, you’re raising something between $200–400 billion over a decade, but you’re also increasing the tax burden on a bunch of productive economic activity. You want to ask and study whether this trade-off is worth it.

It seemed for about 15 minutes, maybe a week or so ago, they started talking about a carbon tax. I don’t know if that’s still under discussion. Whether or not you agree with what they want to use the money to pay for, what about that idea? Is that just a fantasy idea that’s going to pop up every time there’s a difficult moment where they can’t figure out how to tax? If they talk to an economist, he’ll say, “Well, a carbon tax is a fantastic idea.” And they’ll consider it, but then they’ll view it as politically difficult? What about replacing those ideas with a carbon tax?

I think a carbon tax would be a good idea. I think it’s an efficient source of revenue. It doesn’t run into a lot of the distorting issues of, say, a corporate income tax. It doesn’t distort investment decisions in the same way as a corporate tax. It doesn’t encourage companies to shift certain types of production overseas, as long as it’s border adjusted. And it’s properly pricing a big externality, which is carbon emissions that lead to global climate change. So I think it is a great idea.

I’m disappointed that it hasn’t been central to the debate, especially when Democrats are looking for ways to address climate change in their reconciliation bill. But I understand that the politics are really difficult. It’s much easier to go after carbon emissions by saying that you’re going to give companies money for doing good stuff, rather than taxing companies for doing bad stuff. And I think that tax would be framed as something that trickles down and impacts consumers. The politics are obvious there, even though the results of those policies are very similar.

Do we have a long-term sustainable tax system if all we’re talking about is taxing a slice of the richest people or a slice of the most profitable companies? I know the president has said he doesn’t want to tax people who make, I think, under $400,000. Is that a sustainable promise over the long-term?

It is not sustainable. I think one of the biggest issues with the current tax debate is that pledge to not raise taxes on individuals making less than $400,000 a year. It’s really restrained what they’re able to do in tax policy.

I mean, one issue is that it reduces the potential tax base and it takes a lot of really good taxes off the table. A carbon tax is one of them we just discussed. A value-added tax is another. But it also encourages additional complexity in the tax code: Lawmakers will add complexity into the system in order to avoid raising taxes on people earning below $400,000. So you’ll see a lot of provisions that will say, “This only affects those that are above $400,000.” And they go about it in a number of different ways that increases the complexity of the tax system.

In the long run, I don’t think it is sustainable to only be looking at very high-income households and raising their rates higher and higher. There’s only so much money up there. And I think broader taxes, more efficient taxes, are a better way to go in the future.

My last point here is the political concern is always going to be raising the burden on low-income households. But I think any sort of tax reform that is going to propose a VAT or a carbon tax is going to do something to make whole those households that might lose some purchasing power because of the higher broad-based taxes.

I just want to jump back just for a quick second to the mark-to-market tax. What do you think about that idea, just broadly, as a way of taxing investments? Forget limiting it. Is that a more efficient or less efficient way of replacing the current capital gains tax, where you don’t pay until you sell the asset? What do you think about that idea more broadly, as a different kind of way of taxing capital?

Broadly speaking, it’s theoretically sound. It conforms to a pure income tax, that you’re taxing consumption plus the change in net worth for each taxpayer in the United States. And under a pure income tax, capital gains would be taxed mark-to-market.

Some of the things that are appealing about that are that you would be taxing all sorts of capital income in the same way. One downside of the current system is that capital gains are tax preferred, relative to dividends and interest. And that creates a distortion. Mark-to-market is one way to alleviate that distortion.

That said, there’s a trade-off to that. One downside, a big downside in my opinion, of an income tax is that it distorts an important decision that people have, which is the decision to save and invest. Income taxation creates a bigger burden on consumption that you defer by saving and putting money towards useful purposes, like building a factory that produces goods and services for Americans. And that’s a trade-off with going to the income tax. And I’d prefer that we move more towards a consumption tax that would exempt saving altogether.

But from a theoretical standpoint, to answer your question directly, yeah, mark-to-market makes sense, broadly speaking. But there are trade-offs with everything — this included.

Do you know if they’re still talking about any kind of an extra surtax on the wealthy? A 3 percent surtax on income, on wealth: Are those kinds of ideas still being floated around? Is that something that’s still in the ether?

It’s possible. So we know right now that Senator Sinema is not in favor of rate increases. But I don’t know if that applies to new taxes or if it only applies to existing taxes. We don’t really have a good handle on exactly what she wants.

The House Ways and Means did propose a 3 percent surtax on adjusted gross income of $5 million or more. What’s novel about this tax is that it applies to AGI and not taxable income. So its base is slightly broader than the ordinary income tax. And in some ways that makes it less distortive. So things that you would normally be able to deduct against your normal tax liability, like home mortgage interest, charitable contributions, $10,000 of state and local taxes, wouldn’t be deductible against the 3 percent surtax.

Whether that survives the debate . . . I will not make a prediction. This week taught me that I’ve been wrong about a couple important things and I’m not going to set myself up to be wrong again.

Is there anything you do feel confident about predicting on how this is going to end up? Do you have anything on which you’re over 50 percent confident?

Something that I’m over 50 percent confident: I do think that Democrats ultimately get something done. It’s not going to be the $3.5 trillion. It’s not going to result in $2.5 trillion to $3 trillion in tax increases. But something is going to be done. And those tax increases are going to include some increases on corporations.

I think what’s likely is that they pass some of their reforms to the global minimum tax, what’s called GILTI. I do think that they end up passing maybe some individual income tax increases. But as of today, it remains to be seen what those look like because they need to raise some amount of revenue. I think something gets done; it’s just going to be more modest than what I think the Biden administration wanted.

My guest today has been Kyle Pomerleau. Kyle, thanks for coming back on the podcast.

Thank you for having me.

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