Tax Reform



The Issue


America needs tax reform because the current tax code stifles economic freedom, ‌preventing the economy from being vibrant and prosperous. Fundamental tax reform would alleviate the harm caused by the tax system and significantly strengthen the economy. This stronger economic growth would substantially improve the incomes of all Americans and enhance economic opportunities.

The current tax system harms the economy for many reasons—tax reform based on sound principles would address each of them.

Tax rates for families, individuals, businesses, and investors are too high. After the fiscal cliff tax increase in early 2013, Americans in some states now pay marginal tax rates exceeding 50 percent. Such high marginal rates discourage work, savings, investment, and entrepreneurial risk taking—the building blocks of economic growth. By reducing incentives to engage in these activities, the tax code reduces the strength of the economy.

The current tax base causes double taxation of savings and investment and is therefore biased against savings and investment. This bias reduces the amount of investment in the economy, which reduces productivity growth, real wages, and employment.

An additional problem with the tax base is that Congress has glutted it with politically motivated credits, deductions, and exemptions. These provisions inhibit economic growth by eroding the tax base, which necessitates higher tax rates for other activities in order to raise a certain level of revenue. When government policy picks winners and losers in such a way, it reduces economic efficiency because resources are not put to their highest-valued use. The economy suffers because of the distortion. The most glaring example of such policies is the myriad of tax breaks for the production and consumption of politically favored types of energy and energy-efficient products.

Finally, the way the tax code treats business is the biggest inhibitor of growth in the tax code today. The U.S. has the highest corporate tax rate of any country in the Organization for Economic Co-operation and Development (OECD)—the 34 most industrialized countries in the world.

Further inhibiting investment is the fact that the U.S. is effectively the only major nation that taxes its businesses on the income they earn in foreign countries. This taxation creates another disincentive for U.S. businesses to invest, which further suppresses wage growth and job creation for American workers. The worldwide system also makes it attractive for foreign firms to buy U.S. firms, or for U.S. firms to merge with foreign corporations and move the new company’s headquarters abroad—as was the case in the spate of inversions in 2014.

The U.S. also has one of the worst systems in the industrialized world for businesses to deduct the cost of investments. The U.S. tax code denies businesses the ability to deduct the full cost of investments at the time businesses make them. Instead, the code applies a cumbersome depreciation system that forces businesses to deduct the cost of investment over many years—sometimes as many as 39. This raises the cost of investing because of the time value of money. Less investment due to those higher costs hurts productivity gains, wage growth, and job creation.


Recommendations


Tax reform would greatly enhance economic performance by fixing these problems. It can fix them by accomplishing five major economic objectives:

  1. Lower Individual and Business Tax Rates. Tax reform must lower rates, in particular the top marginal rates, to strengthen the economy by improving incentives to work, save, and invest.
  2. Establish the Right Tax Base. Defining the tax base (that is, what the tax code taxes) is as important as lowering the tax rate. The right tax base is consumption, rather than the hybrid income–consumption tax base the current system uses.
  3. Eliminate the Bias Against Saving and Investment. Tax reform must reduce, and ideally eliminate, the bias against saving and investing caused by double taxation. Taxing the right consumption tax base would go a long way toward accomplishing this since it should eliminate the double taxation of capital gains and dividends, and allow businesses to deduct their capital costs when incurred.
  4. Eliminate Tax Preferences. More work is necessary to ensure that the base is neutral and does not pick winners and losers.
  5. Simplify the Tax System and Make It More Transparent so that Taxpayers Understand How Much They Pay to Fund the Federal Government. The sheer complexity of the system makes it difficult to understand the true impact of the tax system, including how much taxpayers are paying to the federal government. Tax reform should strive to make that cost explicit to taxpayers. Once taxpayers know how much of their hard-earned income goes to the federal government, they will be more willing to reduce the size of government since they will better understand how it negatively affects them. A transparent code would be simpler than the current system.

Top 10 Percent of Earners Paid 68 Percent of Federal Income Taxes

Four Ways to Achieve Conservative Fundamental Tax Reform. There are long-standing debates about which type of tax reform plan can best deliver the objectives laid out above. Those plans generally have more in common with each other than is usually understood. In fact, the best and most popular tax reform plans use the correct consumption tax base and have identical economic effects. They vary only in how taxpayers pay them. A useful way to understand their variations is to think of them as distinct software programs used to execute the same function. They all execute that function equally well, but they interact with their users (taxpayers) differently.

For many, a consumption tax means a retail sales tax such as the one that most states levy. However, a consumption tax is any tax on income that is spent on consumption, and excludes income that is saved or invested. There are several plans that fit this mold, including:

  1. The traditional flat tax (often referred to as the Hall–Rabushka flat tax);
  2. The New Flat Tax (also known as an expenditure, or consumed-income, tax);
  3. A business transfer tax (BTT); and
  4. A national sales tax.

Any sound tax reform plan will either adopt one of these approaches or a combination of two approaches or move the current tax system substantially in that direction.


Facts and Figures


  • If tax reform achieved the objectives laid out above, the economy and American families would enjoy sizeable gains. A recent analysis by the Tax Foundation shows the economy could grow as much as 15 percent over 10 years because of tax reform. After those 10 years, the average American family’s wages would rise by almost 10 percent.
  • According to the Congressional Budget Office, tax revenues are now above their historical average as a percentage of gross domestic product and will keep climbing higher. There is plenty of revenue coming into Washington. In fact, the revenue is so great that there is ample room for a large tax cut to return revenues to their historical norm. However, spending will continue to far exceed that unless policy changes are made. Washington has a deficit and debt problem because it spends too much, not because it collects too little in taxes.
  • Despite incessant claims that the tax code is unfair and the rich do not pay their “fair share,” the facts show that the contrary holds true. The U.S. tax system is in fact highly progressive. The top 1 percent of income earners paid 35 percent of all federal income taxes in 2011 (the most recent year for which data are available) while earning about 19 percent of all income. The bottom half of taxpayers paid only 3 percent of federal income taxes. When looking at all federal taxes the story remains similar. The top 1 percent paid 24 percent of all federal taxes in 2011.
  • The combined federal and state corporate income tax rate averageis over 39 percent. The average of other developed nations in the OECD is 25 percent. The U.S. rate is far from being competitive and is driving investment to other countries that have lower tax rates.

Selected Additional Resources


Curtis S. Dubay and David R. Burton, “A Tax Reform Primer for the 2016 Presidential Candidates,” Heritage Foundation Backgrounder No. 3009, April 7, 2015.

David R. Burton, “Four Conservative Tax Plans with Equivalent Economic Results,” Heritage Foundation Backgrounder No. 2978, December 15, 2014.

Curtis S. Dubay, “How Tax Reform Would Help American Families,” Heritage Foundation Backgrounder No. 2963, October 20, 2014.

Curtis S. Dubay, “New Generation of Tax Reform Offers Greater Potential for Growth,” Heritage Foundation Backgrounder No. 3014, August 3, 2015.

Curtis S. Dubay and David R. Burton, “How Congress Should Reform Business Taxes,” Heritage Foundation Backgrounder No. 3022, June 4, 2015.