Americans are suffering under the current tax code. It rewards special interests while increasing costs for everyone else. Its complexity makes compliance nearly impossible for law-abiding citizens, while creating untold opportunities for a privileged few. The powerful can afford accountants and lawyers to navigate the code’s bureaucratic morass while every other American can only file taxes and hope for the best.
The result is anxiety for most Americans and great economic consequence for the economy. Wages are lower, there are fewer jobs, and U.S. businesses are less competitive because of the tax code. 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, enhance economic opportunities for everyone, and make American business more competitive.
The average American household pays over $20,000 in taxes every year. The revenue is raised through three primary taxes: (1) The individual income tax raises 47 percent of federal revenue, including taxes paid on investments (capital gains and dividends) and business taxes paid by owners on profits that are “passed-through” to individuals; this tax is followed by (2) payroll taxes, which make up 34 percent of all revenues; and (3) the corporate income tax, which makes up just over 9 percent. The remaining 10 percent come from various other smaller provisions, such as excise taxes.
The current tax system harms the economy in many different ways—tax reform based on sound principles would address each of them.
Tax rates for families, individuals, businesses, and investors are simply too high. Americans in many states, such as California and Minnesota, 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 and prosperity. By reducing incentives to engage in these activities, the tax code reduces the strength of the economy.
The tax code is also glutted with set-asides for the politically connected. These credits, deductions, and exemptions inhibit economic growth by transferring the tax burden from activities supported by special interests to everyone else. This cronyism slows down economic growth as people’s time and investments are wasted on politically favored projects at the expense of those valued by consumers. The economy suffers because of the distortion. Such tax preferences create the illusion of a product being competitive, when in reality preferences only create dependence. Once the tax preference is removed, the supported industry generally fails and all of the resources dedicated to those activities will have been wasted. One glaring example of such policies is the myriad tax breaks for the production and consumption of politically favored types of energy and so-called energy-efficient products. There is, for example, a wind-electricity-production tax credit that subsidizes electricity produced by wind farms that were constructed in certain years.
Despite the relatively small share of revenue raised by the corporate income tax, the tax treatment of business is one of the biggest roadblocks to economic growth. The U.S. has the highest corporate tax rate in the developed world, with an average combined federal and state rate of 38.9 percent. Compared to China’s 25 percent or Ireland’s 12.5 percent, and the world average of 22.5 percent, the U.S. offers one of the least attractive tax business environments in the world.
Contributing to the anachronistic business tax system, the U.S. is one of a small and shrinking number of nations that attempt to tax its businesses on income they earned in foreign countries. This worldwide tax system makes U.S. businesses less competitive. This system incentivizes so-called inversions—whereby foreign firms buy U.S. firms, or U.S. firms merge with foreign corporations and move the new company’s headquarters abroad. Indeed, the number of inversions has increased from almost none to as many as 10 per year. Inversions have increased as world tax rates have systematically decreased over time, leaving the U.S. with an increasingly uncompetitive, high tax rate. Recent prominent examples include the acquisition of Anheuser-Busch by Belgian brewer InBev, and Burger King’s buyout by Canada’s Tim Hortons—both firms are no longer headquartered in the U.S.
Additionally, the U.S. has an outdated and overly complex system that businesses must comply with in order to deduct the cost of investments. The U.S. tax code denies businesses the ability to deduct the full cost of new investments. 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 artificially raises the cost of investing, resulting in less investment, lower productivity gains, less wage growth, and less job creation.
In September 2017, Republicans in the House and Senate, and the President, released a framework for their tax reform initiative. The “Unified Framework for Fixing Our Broken Tax Code” would provide the lowest marginal tax rates since the 1930s, and provide for temporary expensing. The top individual tax rate would be 35 percent (compared to 39.6 percent today); the top tax rate on corporations would be 20 percent (compared to 35 percent today); and the top tax rate on other businesses would be 25 percent (compared to 39.6 percent today). It would have a dramatic positive economic impact, significantly increasing output over the next 10 years.
Tax reform will need to address many different issues, big and small. No aspect of the existing tax system should be immune to change, given the complexity and economic incoherence of the existing system. Tax reform must include lower tax rates, more subtle structural reforms, such as full expensing, and politically difficult removal of tax subsidies.
Lower Individual and Business Tax Rates. Tax reform must lower tax rates for businesses and individuals. Lower rates strengthen the economy by improving incentives to work, save, and invest.
Currently the highest rate in the developed world, lowering the U.S. corporate income tax rate is necessary for U.S. business competitiveness. Lowering the corporate tax rate to, or below, the international average would largely even the playing field, allowing U.S. firms to compete with foreign firms.
A U.S. federal corporate tax rate of 20 percent—down from the current federal rate of 35 percent—is the upper bound for global tax competitiveness. The corporate income tax should ultimately be eliminated or integrated into the individual income tax, but a federal rate lower than the 12.5 percent of Ireland (lowest in the OECD) would make America a leader in business tax rates and go a long way toward benefiting U.S. consumers, workers, and investors.
The corporate income tax is an inefficient and economically destructive mechanism for raising revenue. In addition to lost economic activity, the burden of the tax falls almost entirely on workers through lower wages. Businesses invest so that their employees can be more productive. More productive employees earn higher wages, produce more output, allowing businesses to hire additional workers as profit and demand increase. High corporate taxes discourage investment in the U.S., which is ultimately felt by workers through lower wages and fewer jobs. This means that the average American household will share the benefits of a corporate rate cut through higher wages. A corporate-tax-rate cut could benefit those at the bottom of the income distribution the most because a larger share of their income comes from wages than from investments.
To further help individuals through tax reform, lowering top marginal individual-income-tax rates and consolidating income brackets is also essential. For individuals and most small businesses, the top marginal federal tax rate is 43.4 percent, a combination of a top income-tax rate of 39.6 percent and an additional 3.8 percent Obamacare tax on net investment. Despite the top individual tax rate fluctuating between 91 percent and 28 percent over the past 50 years, total individual tax receipts have remained fairly stable. Lowering marginal rates is important for economic growth, as high rates discourage work and entrepreneurship. Tax reform should, in conjunction with lowering rates, consolidate tax brackets to simplify tax paying and treat taxpayers more equally.
Recent plans from both the House and the Administration propose increasing the standard deduction (the amount of income that is exempt from taxation), which effectively expands a zero percent income tax rate. Taxpayers are able to choose between the standard deduction and a collection of other “itemized deductions” when filing their taxes. A larger standard deduction decreases the relative value of electing itemized deductions, which are more complex and often include special interest benefits that are only available to a minority of taxpayers.
Allow Full Expensing. Full expensing would allow businesses to deduct all investment expenses from their taxable income immediately. Expensing should be a primary component of any tax reform plan in order to emphasize economic growth and job expansion. Full expensing reverses the current procedure, which only allows businesses to deduct a portion of their new investments. This artificially raises the cost of investment and job creation.
Imagine a local business that wants to expand by hiring 20 new employees. The business knows it can pay the new employee salaries, but can it afford to expand office space and buy new equipment for the new employees? The current tax code artificially makes the investment in new office space more expensive by not letting the business deduct the full cost of the expansion in the year that the investment was made.
Full expensing alone could grow the economy by more than 5 percent over 10 years by lowering the cost of investment. Removing any source of bias against investment in the U.S. will increase the level of domestic investment, permanently increasing the demand for labor, boosting job creation and wage growth. Additional investments in new warehouses and factories are especially needed to create entry-level and middle-class jobs. The benefits of expensing would be shared by Americans at all income levels, especially those who need it the most.
Full expensing would also greatly simplify tax paying, as businesses would no longer have to track investments over many years for tax purposes, a requirement that costs businesses over $23 billion annually. The benefits of expensing are not just for large corporations, but accessible to all businesses, big and small. Small businesses and those who work in the emerging gig economy that cannot afford the complexity of the current system stand to gain the most.
Move to a Territorial Corporate Tax. The U.S. is one of only a few nations that still attempts to tax business income earned in foreign countries. This tax creates another disincentive for U.S. businesses to invest both in the U.S. and in foreign markets, which suppresses wage growth and job creation for American workers.
The current system of worldwide taxation puts all U.S. firms that compete abroad at a disadvantage to similar firms in almost every other country because their income is ultimately taxable at the high U.S. corporate rate. The U.S. should move to a traditional territorial tax system under which the U.S. would not collect additional taxes on foreign-earned profits when distributed back to the U.S. headquarters. This simple change would allow U.S. firms to compete abroad without the additional burden of U.S. taxes.
Some have proposed adding a border adjustment to the corporate tax, which would replace the current worldwide system. The border adjustment tax (BAT) attempts to remove the U.S. corporate tax from exports, and adds a new tax on imports. Under most circumstances, the BAT is an overly complex, tariff-like impediment to trade, which carries the risk of being an economically destructive solution to a simple problem. The U.S. corporate income tax rate is simply too high and should not be levied on worldwide income. A simpler solution is a traditional territorial tax system and a low corporate tax rate.
Without a worldwide or border-adjusted corporate tax system, there will be continued pressure to include additional revenue-raising provisions to arbitrarily tax international business income. Often sold as a way to keep businesses from artificially moving profits overseas to avoid uncompetitively high U.S. taxes, so-called anti-base-erosion and earnings-stripping provisions will be important design components under a territorial system. The most effective way to limit such problems is through a low corporate tax rate.
A tax rate that is around 15 percent would go a long way toward reducing any incentive to artificially move profits overseas. Certain arbitrary anti-avoidance rules, such as minimum taxes and other formula-based approaches can be effective strategies for raising revenue, but they also have costs that undermine the benefits of a territorial system. Congress should focus on achieving a low corporate-income-tax rate rather than designing new mechanisms to force businesses to pay taxes at economically destructive and internationally high rates.
Repeal FATCA. Congress should repeal the Foreign Account Tax Compliance Act (FATCA), signed into law in 2010, which was intended to make it harder for Americans to keep money overseas and out of the reach of the IRS. FATCA requires foreign financial institutions, including banks, to identify and report to the United States most types of transactions for all American clients. These new regulations are enforced by the threat of applying a 30 percent withholding tax on revenues generated in the United States by the noncompliant foreign financial institution.
The reporting burden and withholding penalty faced by foreign banks trying to comply with FATCA regulations has made it easier for many Americans to renounce their citizenship than to find a bank that is willing to bear the bureaucratic costs of complying with the law. Last year, 5,411 Americans renounced their U.S. citizenship, the largest number of published U.S. expatriates in one year, continuing a four-year streak of record-breaking numbers. The compliance costs of these burdensome new rules—to the U.S. government as well as to American taxpayers—far outweigh any additional revenue the law brings in.
Get Interest Right. How the tax code handles interest is a frequent topic of misunderstanding. If interest income is taxable to lenders, it should be deductible to borrowers so that it is only taxed once. If interest is not taxable, it should not be deductible. Either treatment keeps taxes from influencing lenders’ decisions to issue debt, and borrowers’ decisions to take on debt. If done incorrectly, the tax treatment of debt could have serious negative ramifications for the economy, resulting in new forms of double taxation. Principled tax reform can employ either treatment.
Repeal the Estate and Gift Taxes. The federal estate and gift taxes (the “death tax”) should be repealed, as they are an additional layer of tax on saving and investment. Every dollar of an estate has either been previously taxed or will be taxed under some other provision of the tax code. The death tax always adds an extra layer of tax to a family’s savings. The tax often falls most heavily on inherited small family businesses, which can have large valuations, but little available cash to pay the tax, requiring the business to be sold or loans to be taken out.
In addition to confiscating generational bequests, the tax probably does not raises any net revenue as it slows growth, diminishing potential revenue collection and encouraging avoidance by giving assets to relatives in lower income-tax brackets, costing more in lost income-tax revenue.
Eliminate Tax Preferences. The tax code should not be used to pick winners and losers. That means that tax reform should eliminate, or at least substantially reduce, any individual and corporate deductions, credits, exclusions, and exemptions that are not economically justified. Tax reform should eliminate unjustified tax subsidies that benefit particular industries, such as the myriad tax breaks for the production and consumption of politically favored types of energy and energy-efficient products. Other examples of the hundreds of such preferences include the state and local tax deduction, the research and development tax credit, education tax credits, and the exclusion for municipal bond interest.
Federal and state tax codes are made excessively complex, and distort economic activity by picking winners and losers through special interest tax subsidies. The tax code should not treat different activities unequally, and should tax all final consumption at one low rate.
Repeal State and Local Tax Deductions. The state and local tax deduction and municipal-bond interest deductions encourage larger state and local governments while forcing federal taxpayers in low-tax states to subsidize taxpayers in high-tax states. Tax reform should repeal the deductions and use the revenue gained to reduce federal marginal tax rates. Federal income-tax rates could be reduced by as much as 16.4 percent if the state and local tax deduction is eliminated.
Repeal the Alternative Minimum Tax (AMT) and Reduce Other Sources of Complexity. The tax code is absurdly complicated. The arrival of personal computers and tax software has permitted the creativity of policymakers in Washington to run amok, creating tax complexities far beyond what even tax professionals could manage unaided by electronics. There are a multitude of credits, exemptions, exclusions, and deductions, many of which are subject to special rules, and phase out over different levels of income. As if this were not bad enough, there is also the AMT, a parallel tax, as well as the payroll and self-employment taxes that fund Social Security and part of Medicare.
All of this complexity imposed on individual taxpayers is relatively minor compared to the torturous rules that businesses suffer. These compliance costs have a disproportionately adverse impact on small and start-up businesses, which are ill-equipped to spend the resources necessary for dealing with such complexity. The compliance costs associated with the income tax have been estimated to be as high as $410 billion a year. These costs remove productive resources from the economy and must be recovered by businesses in the price of the goods and services they provide. They are a hidden tax on ordinary Americans. Tax reform should eliminate as many special tax preferences as possible and repeal the AMT for corporations and individuals.
Reject “Revenue Neutrality.” Systemic deficits and growing debt constrain tax reform efforts and unnecessarily turn any conversation on tax reform into a debate about how to achieve “revenue neutrality.” The ever-present constraint of revenue-neutral tax reform is dangerous. It forces Congress to make a false choice between otherwise pro-growth tax reform tied to additional revenue raisers, and no reform at all. Tax reform should not have to be revenue neutral.
Pro-growth tax cuts face political and procedural barriers to success. It is unlikely that a stand-alone bill subject to the 60-vote threshold in the Senate will gain sufficient support for passage. Most political observers see reconciliation as the most likely path for reform.
The reconciliation process enables Congress to fast-track reform in the Senate, limiting debate and lowering the necessary vote threshold to a simple majority, instead of requiring 60 votes. While reconciliation provides a route for the passage of tax reform, Members of Congress must pursue deficit reduction or deficit neutrality as part of the package. If used correctly, reconciliation can strengthen the durability of reform and increase the probability of success.
Congress has numerous options to meet the deficit neutrality requirements of reconciliation. For example, it is possible to balance the budget, continue to increase federal spending, and cut taxes by $3 trillion over 10 years. This can be accomplished by limiting the assumed increase in federal spending to 2 percent each year—down from the 5.2 percent growth assumed in baseline outlays.
The federal government is expected to raise $43 trillion in tax revenue over the next 10 years—about 18.2 percent of output, a full percentage point above the historical average. Federal spending is substantially above the historical average, and projected to increase to 23 percent of output by 2026.
Without major policy changes, spending will continue to far exceed tax revenue. The reason why Washington has a deficit and debt problem is because it spends too much, not because it collects too few taxes. Without spending-based reforms, deficits will continue to grow, requiring still higher taxes in the future. Congress must place meaningful constraints on federal spending, but reforming the tax code should not require finding new revenue sources. Tax cuts—allowing Americans to keep more of their own money—do not need to be paid for. It is spending that must be paid for.
Tax Each Dollar No More Than Once. The current tax code double-taxes many forms of savings and investment. Defining the right tax base (that is, what the tax code taxes) can remedy the bias against saving and investment, which is as important as lowering the tax rate.
Income that is saved or invested is taxed, and the return on that savings or investment is then taxed again. Moreover, income from investments in corporations is taxed yet again—first at the corporate level and then when individuals receive dividends or pay capital gains taxes on corporate stock. By taxing saving and investment multiple times at high rates, the tax code deters families from saving for retirement, education, a rainy day, or for any other purpose. This bias against savings and investment results in less capital formation, a less productive economy, and lower real wages.
Institute a Flat Tax on Consumption. Although a flat tax is not currently part of the tax reform discussion, most economists agree that a flat consumption tax should remain the ultimate goal of tax reform. A flat tax applies a single tax rate to all individual’s earnings and related benefits after subtracting net savings. Taxable income is reduced by the net amount contributed to savings, and savings is then only taxed when it is spent. This eliminates the current-law bias against saving by taxing each dollar only once, and ensures that tax is paid only on what individuals consume—not on the savings they make available for investment by others.
Reject Additional Tax Systems. There is frequent talk by some that the U.S. needs to levy a value-added tax (VAT), a carbon tax, or a BAT to raise additional revenue. In addition to not raising taxes, tax reform should not add new tax systems to existing ones. Another tax system would increase complexity and likely allow the federal government to extract even higher taxes from American taxpayers. A VAT, for instance, would potentially raise taxes by hundreds of billions, or even trillions, of dollars each year, enabling an expansion in the federal government’s size and scope while reducing the share of the earned income that Americans are allowed to keep and spend on what they see fit. In addition to expanding the size and scope of government, a carbon tax would drive up energy costs, reduce employment, and shrink incomes.
Facts and Figures
FACT: Tax reform can grow the economy by as much as 15 percent over 10 years.
- The current U.S. tax code stifles economic growth, making it harder for entrepreneurs and businesses to hire and invest.
- If tax reform achieved the objectives laid out above, fundamentally overhauling the tax code, the economy as a whole, and Americans individually, would enjoy sizable gains.
- A larger economy would also raise the average American family’s wages by more than 12 percent over the same 10 years, according to the Tax Foundation.
FACT: Tax revenue is higher than the historical average, and will continue to climb.
- Tax revenues are 0.2 percent above their historical average of 17.4 percent as a percentage of GDP. Revenue will keep climbing higher, toward 19.6 percent over the next 20 years, according to the Congressional Budget Office.
- Higher-than-average tax revenue shows that Washington is already collecting more than enough of Americans’ tax dollars.
- The revenue is so great that there is ample room for a large tax cut (if taxes are reduced so that revenue levels are restored to their lower historical norm).
- Without major policy changes, spending will continue to far exceed tax revenue. Washington has a deficit and debt problem because it spends too much, not because it collects too little in taxes.
FACT: The U.S. suffers from historically sluggish economic indicators.
- The economic recovery is complete, but the economy continues to underperform expectations. The slow rate of recovery broke a 100-year precedent of rapid rebounds.
- The new business start-up rate in the U.S. is stuck at 30 percent below its pre-2008 average.
- A smaller share of Americans are working now than before the Great Recession, even when excluding those likely to be retired or in school.
- Business tax reforms, most notably full expensing, lower the cost of capital and allow businesses to increase investment, jobs, and wages for U.S. workers.
FACT: The U.S. tax system is highly progressive.
- Despite incessant claims that the tax code is unfair and that the rich do not pay their “fair share,” the facts show that the contrary holds true.
- In 2013 (the most recent tax data), households in the lowest income quintile paid an average federal tax rate of about 3 percent.
- The middle and top quintiles paid an average rate of approximately 13 percent and 26 percent, respectively.
- The top quintile paid almost 70 percent of all federal income taxes.
FACT: U.S. businesses face the highest tax rates in the developed world.
- The combined U.S. federal and state corporate income tax rate averages over 39 percent.
- The average worldwide corporate tax rate is 22.5 percent, and the developed nations in the OECD have an average rate of 24.2 percent.
- The U.S. rate is far from being competitive, and drives investment and jobs overseas to countries with (often significantly) lower tax rates.
Selected Additional Resources
David R. Burton, “A Guide to Tax Reform in the 115th Congress,” Heritage Foundation Backgrounder No. 3192, February 10, 2017.
Romina Boccia and Adam N. Michel, “Pathways for Pro-Growth, Fiscally Responsible Tax Reform,” Heritage Foundation Backgrounder No. 3219, May 25, 2017.
Adam N. Michel, “Options for Pro-Growth Tax Reform Through Reconciliation,” Heritage Foundation Issue Brief No. 4731, July 11, 2017.
Adam N. Michel, “The U.S. Tax System Unfairly Burdens U.S. Business,” Heritage Foundation Backgrounder No. 3217, May 16, 2017.
Adam N. Michel, “Time to Move Past the Proposed Border Adjustment Tax,” Heritage Foundation Backgrounder No. 3222, June 8, 2017.
Adam N. Michel and Salim Furth, “For Pro-Growth Tax Reform, Expensing Should Be the Focus,” Heritage Foundation Issue Brief No. 4747, August 2, 2017.
Rachel Greszler, Kevin D. Dayaratna, and Michael Sargent, “Why Pro-Growth Federal Tax Reform Should Eliminate State and Local Tax Deductions,” Heritage Foundation Backgrounder No. 3256, October 17, 2017.