Taxes

Talking Points

  • America’s tax code is preventing the economy from reaching itspotential.
  • The tax code reduces opportunities for American families by reducing job creation and suppressing wages.
  • Tax reform should improve economic growth by reducing tax rates on working, saving, investing, and risk-taking while expanding the tax base so that the new tax system raises the same amount of revenue as the current system and taxpayers at all income levels continue to pay the same amount of tax.
  • Business tax reform is an important aspect of fundamental tax reform. The U.S. has the developed world’s highest corporate tax rate and is essentially the only country that taxes its businesses on their foreign income. As long as this is true, jobs and wages will suffer.
  • The Heritage Foundation’s New Flat Tax should serve as a guide to show Congress how to construct a successful tax reformplan.

The Issue

America needs a reformed tax code that facilitates, not inhibits, economic growth and job creation. The tax code has become an enormous albatross around the neck of a stagnant economy. Tax rates on families, businesses, and investment are too high. The top rate paid by families in some states now exceeds 50 percent after the “fiscal cliff” tax increase in early 2013. That rate includes just a family’s federal income taxes and their state’s income tax rate, not the myriad of other taxes they pay. The high rates discourage productive activities like working, saving, investing, and taking on new risk—activities that are the basis of economic growth and that have been weak in today’s economy. The tax code is littered with too many politically motivated credits, deductions, and exemptions that only serve to further inhibit economic growth.

Politicians in Washington are finally waking up to these facts. There has been a strong push within the tax-writing committees of Congress to reform the tax code. But there is an intractable problem keeping both sides from engaging in a wholesale overhaul of the tax code: Neither side can agree on what actually constitutes tax reform.

Done properly, tax reform helps to improve economic efficiency by eliminating economically unjustified deductions, credits, and exemptions. At the same time, tax rates should be lowered dramatically to increase the incentives to work, save, and invest. Tax reform should also repair the tax base so that it does not punish saving and investment. A tax code that raises the same amount of revenue as the current tax system is known as “revenue neutral.” Tax reform should produce a tax code that does not raise more revenue than the current tax code; indeed, it would preferably leave more money in the hands of those who earned it.

A pro-growth, job-creating tax reform plan should put the economy on a stronger growth path that would unlock opportunities for middle-class and low-income families that are not available to them today. However, not all see tax reform as a way to improve opportunity for those who are struggling to get ahead in today’s poor economy. Some view it as another way for Washington to end up with more of the taxpayers’ hard-earned income. President Barack Obama wants to close “loopholes for the rich” but almost never mentions reducing tax rates in conjunction with those changes. Others would partially lower rates but also “raise revenues.” These kinds of Trojan horse tax hikes are the wrong solution to the federal government’s spending crisis.

Congress has not enacted fundamental tax reform since 1986. The present terrible state of the tax code demands that Congress begin a long-overdue overhaul. The economy is still much too weak this far into a recovery, which should caution lawmakers against raising taxes and lead them instead to focus their attention on sound policies to promote growth and create jobs.


Recommendations

  1. Enact comprehensive tax reform. Tax reform should apply a dramatically lower and flat rate to a proper tax base not eroded by an overabundance of exemptions, credits, and deductions. The new tax code should do away with troublesome policies like the alternative minimum tax (AMT) and the death tax. The Heritage Foundation has crafted such a plan as part of its comprehensive fiscal plan Saving the American Dream. The Heritage plan has just one rate and eliminates payroll taxes, the AMT, nearly all excise taxes, capital gains taxes, dividends taxes, and the death tax. The Heritage plan is revenue-neutral. Congress should adopt this model, especially the elimination of taxes on saving and investment (including the death tax) and the AMT, as a guide for tax reform.
  2. Lower the corporate income tax rate. On the way to enacting full fundamental tax reform, there is a chance for business-only tax reform. President Obama has said he is interested in such an approach, and there is broad desire to reform business taxes because of the uncompetitive status of the current system. The U.S. has the highest corporate income tax rate in the industrialized world—almost 40 percent when the federal rate is combined with the average rate the states add—making it the highest-tax developed country for businesses wanting to make new investments and create jobs.

    To revive the competitiveness of U.S. businesses in the global marketplace, business tax reform must lower the rate to the average of other industrialized countries. The U.S. corporate tax rate should be set at (or, ideally, below) the Organization for Economic Co-operation and Development average of 25 percent to eliminate the incentive to locate businesses and jobs overseas instead of in the U.S.

  3. Shift to a territorial tax system. The U.S. is also the only developed country that taxes its businesses on the income they earn in other countries. This is known as a “worldwide” tax system. Taxing businesses only on the income earned within U.S. borders, known as “territoriality,” would improve U.S. competitiveness abroad and spur job creation.
  4. Make immediate expensing of all capital purchases permanent. Businesses typically must deduct the cost of investments in new plant and equipment over years using cumbersome depreciation schedules. This raises the cost of capital and reduces the amount of capital that businesses seek. Making expensing permanent would eliminate the tax bias against business investment and increase business investment, competitiveness, and future wage growth through higher worker productivity.
  5. Lower rates for small businesses. Small businesses often pay taxes through their owners’ individual tax returns. This generally subjects them to the high rates their owners pay. Instead, they should pay rates equal to the reduced rates that bigger corporations would pay as a result of corporate tax reform.

Facts & Figures

  • According to the Congressional Budget Office, on their current course, tax revenues will soon surpass their historical average as a percentage of GDP and keep climbing higher. But spending will continue to far exceed that. Washington has a deficit and debt problem because it spends too much, not because it collects too little in taxes.
  • Despite incessant liberal claims that the tax code is unfair and the rich do not pay their “fair share,” the facts show the contrary. The U.S. tax system is in fact highly progressive. The top 1 percent of income earners paid more than 37 percent of all federal income taxes in 2010 (the most recent year for which data are available) while earning about 19 percent of all income.
  • At the other end of the spectrum, the bottom 50 percent of income earners took in less than 12 percent of income and paid a little more than 2 percent of federal income taxes. More troubling, the bottom 40 percent of income earners actually received money from the IRS in excess of any taxes they owed through refundable credits such as the earned income tax credit and the child tax credit.
  • Due to the 2013 “fiscal cliff” tax increase and an increase in the Hospital Insurance (HI) portion of the payroll tax, the top federal marginal tax rate is 43.4 percent. As a result, taxpayers in the 18 states (plus the District of Columbia) with income tax rates over 6.6 percent now pay more than 50 percent of every additional dollar they earn to the government in income taxes.

Selected Additional Resources

Heritage Experts on Taxes


  • David Burton

    Senior Fellow in Economic Policy


  • Curtis Dubay

    Senior Policy Analyst, Tax Policy


  • Rea Hederman, Jr.

    Director, Center for Data Analysis and Lazof Family Fellow

To talk to one of our experts, please contact us by phone at 202-608-1515 or by email.