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The Importance of Broadening the U.S. Tax Base

3 min readBy: Scott Greenberg

Over the past few years, politicians in both parties have expressed enthusiasm for lowering federal taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rates. This makes sense: many economists have found that high tax rates hurt economic growth and international competitiveness. Meanwhile, the U.S. levies some of the highest rates in the world on corporations, capital gains, and dividends.

Lowering federal tax rates would be easy, if it weren’t so expensive: lower rates means less revenue that the federal government is able to collect, leading to a larger budget deficit. Many politicians promise to pay for rate cuts with equally large spending cuts, but these promises seem unrealistic in the current political climate.

As a result, the only practical way to cut tax rates significantly without increasing the deficit is by broadening the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. : eliminating tax preferences (such as deductions, exclusions, and other narrow provisions) that reduce federal revenue. These tax preferences are often inefficient, unfair, and complex – which makes “broadening the base and lowering rates” a win-win strategy for tax reform.

As a general rule, recent tax reform plans have not been nearly imaginative enough in proposing measures to broaden the U.S. tax base. Congressman Dave Camp’s tax reform proposal contained dozens of small base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. measures, which would only have raised enough revenue for modest rate cuts. Meanwhile, most of the 2016 presidential candidate plans are estimated to cost over $1 trillion – which means that candidates have pursued ambitious rate cuts without proposing equally ambitious base-broadening measures.

In a paper published today by the Tax Foundation, I identify three promising directions for lawmakers seeking to broaden the U.S. tax base:

  • Ending the tax exclusion of employer-sponsored healthcare. For over a century, individuals have not been required to pay taxes on the value of their employer-provided health plans. Health economists have long argued that this exclusion distorts the insurance market and drives up healthcare costs. Ending the tax exclusion of employer-sponsored health insurance would broaden the tax base by treating all worker compensation equally.
  • Removing the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. cap. The Social Security payroll tax only applies to the first $118,500 of an individual’s wages. Removing this cap would broaden the tax base by increasing the share of wages and salaries subject to the payroll tax.
  • Capping itemized deductions. In 2013, high- and middle- income taxpayers claimed $1.19 trillion in itemized deductions. Most of these deductions are arbitrary preferences for specific economic activities, such as owner-occupied housing. Capping itemized deductions would broaden the tax base by expanding the amount of personal income subject to taxes.

Lawmakers are always looking for “pay-fors”: provisions that can be tacked on to unrelated bills to raise additional revenue. Many “pay-fors” are silly or economically harmful, like pension smoothing or longer depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. schedules. But the three options outlined above are basically ideal “pay-fors”: they would simplify the tax code, end unfair tax preferences, and cause minimal economic harm.

As Congress moves towards comprehensive tax reform in 2016 and 2017, it should not be shy about seeking creative and ambitious measures to broaden the U.S. tax base. The more determined Congress is to broaden the tax base, the more it will be able to cut tax rates without increasing the deficit.

My full report on broadening the U.S. tax base can be found here.