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 high rates discourage productive activities like working, saving, investing, and taking on new risk—activities that are the bedrocks of economic growth and are largely missing from the economy today. 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. In recent months, there has been bipartisan support for reforming the tax code. But the there is an intractable problem keeping both sides from engaging in a wholesale overhaul of the tax code: Neither side can agree 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. The new, improved tax code raises the same amount of revenue as the current tax system. This is known as “revenue neutrality.”
Some view tax reform 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 such changes. Others would partially lower rates but also “raise revenues.” This Trojan horse tax hike is 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 deteriorating condition of the economy should finally force caution against raising taxes and instead focus attention on sound policies to promote growth and create jobs.
- Make Bush-era tax cuts permanent. While tax reform should remain the ultimate goal for tax policy, there are important incremental steps that Congress should take while completing a thorough overhaul of the tax code. The first should be to make the Bush tax cuts permanent. The prospect of tax rates rising at the end of 2012, as they are scheduled to when the Bush tax cuts expire, is causing uncertainty for businesses, investors, entrepreneurs, and families. This uncertainty is causing them to delay important decisions about investing and taking on new risk. Until Congress makes the Bush tax cuts permanent, this uncertainty will linger and the economy will suffer.
- Lower the corporate income tax rate. Making the Bush tax cuts permanent would not be sufficient to remove all the impediments to economic growth imposed by the tax code. The U.S. has the highest corporate income tax rate in the industrialized world—almost 40 percent when combining the federal rate with the average rate the states add on—making it the least competitive developed country for businesses that wish to make new investments and create jobs. To revive the competitiveness of U.S. businesses in the global marketplace, the rate must come down to the average of other industrialized countries. The U.S. corporate tax rate should be set at (or ideally below) the Organisation 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.
- 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 would improve U.S. competitiveness abroad and in turn spur job creation. This is known as “territoriality.”
- Make immediate expensing of all capital purchases permanent. As part of the 2010 legislation to extend the Bush tax cuts, President Obama signed into law 100 percent expensing of all capital purchases for all businesses. 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 purchase. Making expensing permanent would eliminate the tax bias against business investment and increase business investment, competitiveness, and future wage growth through higher worker productivity.
- Stop taxing small businesses as individuals. Small businesses usually pay taxes through their owners’ individual tax returns. This generally subjects them to the high rates their owners pay. Instead, they should pay tax at the entity level so that Congress can lower their rate to make it equal to the reduced corporate income tax rate.
- Permanently eliminate the death tax. Another goal of tax reform should be to eliminate taxes on saving and investment. To meet that goal, the death tax must be abolished once and for all. Abolition of this harmful tax will help spur economic recovery, put unemployed Americans back to work, and increase the economy’s long-term growth potential.
- Eliminate the alternative minimum tax. Tax reform should also simplify the tax code. The alternative minimum tax (AMT) is a complicated secondary income tax system originally designed to raise the taxes of the rich by taking away certain deductions. Because Congress never indexed its income threshold to grow with inflation, the AMT now threatens to ensnare millions of middle-income families. Eliminating the AMT would simplify the tax code and prevent an unintended tax hike.
- Enact comprehensive tax reform. A reformed tax code should accomplish all of the items listed above and apply a dramatically lower and flat rate to a proper tax base not eroded by an overabundance of exemptions, credits, and deductions. The Heritage Foundation has crafted such a plan as part of its comprehensive fiscal plan Saving the American Dream. Instead of the vast array of deductions currently in the tax code, the Heritage tax reform plan has only three: mortgage interest, charitable contributions, and higher education expenses. It has just two credits: the earned income credit and a new health insurance credit in place of the current exclusion for employer-provided health insurance. 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, if not the entire plan, as a guide for tax reform.
Facts & Figures
- Under President Obama’s budget, tax revenues would quickly surpass their historical average of 18.3 percent of GDP, never fall below that level, and grow to record levels thereafter. These tax hikes would fall mainly on the most productive individuals and small businesses, which already pay the vast majority of all federal taxes, and permanently expand the size and scope of the federal government
- 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 about 40 percent of all federal income taxes in 2008 while earning around 23 percent of all income.
- At the other end of the spectrum, the bottom 50 percent of income earners took in 13 percent of income and paid less than 3 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 like the earned income tax credit and the child tax credit.
Selected Additional Resources
Stuart M. Butler, Alison Acosta Fraser, and William W. Beach, eds., Saving the American Dream: The Heritage Plan to Fix the Debt, Cut Spending, and Restore Prosperity, Heritage Foundation Special Report No. 91, 2011.
Curtis S. Dubay, “The 2010 Tax Deal: A Chance for Congress to Lay the Groundwork for Tax Reform,” Heritage Foundation Backgrounder No. 2569, June 13, 2011.
Curtis S. Dubay, “Corporate Tax Reform Should Focus on Rate Reduction,” Heritage Foundation WebMemo No. 3146, February 11, 2011.
Curtis S. Dubay, “How to Fix the Tax Code: Five Pro-Growth Policies for Congress,” Heritage Foundation Backgrounder No. 2502, December 14, 2010.
John Fleming, Emily Goff, and Kathryn Nix, “2011 Budget Chart Book”.
J. D. Foster, “A Rose by Any Other Name: Clarity on Tax Hikes,” Heritage Foundation WebMemo No. 3232, April 25, 2011.
J. D. Foster, “Obama Tax Hikes Defended by Myths and Straw Man Arguments: Summary,” Heritage Foundation WebMemo No. 3001, September 7, 2010.
Heritage Experts on Taxes