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What’s Still Missing In the Tax “Reform” Debate

ROSEANNE- "The Test" 9/18/90 Sara Gilbert, Alicia Goranson, Roseanne Barr, John Goodman (Photo by ABC Photo Archives/ABC via Getty Images)

Some 71% of Americans believe the economic system is rigged against them. They’re not wrong. The social mobility that once defined the “American dream” is no longer a reality: Americans born into the lower class today 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.

And 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.

The growing divergence between the ultra-rich and the rest of us is largely a product on our broken tax code. Middle class families work hard, struggle to pay their bills, and still end up forking over thousands of dollars to the IRS when April 17 rolls around. Meanwhile, many members of the billionaire class are able to avoid paying any federal income tax at all.

There are two basic ways of making money: you can work (as in, actively labor at a job), or you can invest (as in, passively put money into stocks, then sit back and watch your bank account grow). Increasingly, it is the middle class that works, and the ultra-rich that invest. In 2011, the richest 1% of Americans made 36% of their income from investments, not from working. The corresponding figure for the middle class, on the other hand, was less than 2%.

Perversely, the tax code rewards investing and punishes working, by taxing wages much more heavily than the most common types of income you make from investing. The type of investment income you hear about most is the “capital gain.” Capital gains are money you make when you sell something for more than you spent to buy it. So if I buy 100 shares of a stock for $20 per share, sit back and wait a year, and then sell those shares for $50 a share, my income — my “capital gain” — from that transaction is $3,000.

Now, wages are taxed at a maximum rate of 39.6%, while capital gains are taxed at a maximum rate of only 20%. Capital gains are also exempt from the pay-roll tax used to fund Social Security. So, just by virtue of their choice to invest rather to work, the ultra-rich receive a healthy tax break. But things are even more unfair in practice: thanks to lots of loopholes and expensive accountants, many people in the investment class are able to avoid paying any federal tax at all.

One of the reasons for that is the “angel-of-death” loophole, which can be used to avoid capital gains tax entirely. The loophole works like this: ordinarily, when an investor sells an asset (like those 100 shares of stock), he must pay his low, 20%-maximum tax on the difference between the sales price and the purchase price (the capital gain). When an investor dies, however, the angel-of-death loophole provides his heir with a “step up in basis,” which is a complicated way of saying that past capital gains or losses are ignored. It essentially allows the heir to pretend he bought the asset at its current market value: no capital gain, no tax.

Here’s an example of how this loophole is exploited by the investment class to get out of paying taxes: 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 $2 million—the difference between the purchase price ($1 million) and the sale price ($3 million). But if the investor bequeaths the stock to an investment bank in his will in exchange for a $2 million “loan,” no one will pay any tax on the $2 million gain. The investor won’t, because even though he came out $2 million ahead, 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, meaning that the bank now has $3 million in stock that, as far as the IRS is concerned, was always worth $3 million. (The angel-of-death loophole is the reason Facebook founder Mark Zuckerberg may never have to pay federal income tax again).

Among other tax reforms, we need to close the angel-of-death loophole 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.

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 helps preserve the American Dream by preventing the kind of extreme wealth-hoarding better suited to 17th century royalty. 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. As if all of that weren’t bad enough, the plan would increase taxes for many of the rest of us, all while adding $3.2 trillion to the national debt.

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. We should all unite in rejecting it.

Written by David Baake

David Baake is a Democratic candidate for Congress in New Mexico's 2nd District, a seat being vacated by Republican Steve Pearce. After graduating from Harvard Law School in 2014, David worked as a climate change attorney for the Natural Resources Defense Council, and later served as a law clerk for two federal judges.