Reviewing Options to Raise Tax Revenue and the Trade-offs for Economic Growth and Progressivity

May 3, 2021

As 17th century French finance minister Jean-Baptiste Colbert once said, “Taxation is the art of plucking the goose as to obtain the maximum number of feathers, with the smallest possible amount of hissing.”

In Tax Foundation’s new book, Options for Reforming America’s Tax Code 2.0, we modeled 70 possible reforms to the U.S. tax code. There are several ways to measure the “hissing” cost of taxation: examine a revenue raiser’s impact on economic growth and job creation, or according to how it changes the progressivity of the tax code.

Here we review tax options that raise revenue but have different impacts on economic growth and progressivity. Of course, even the more efficient options come with trade-offs. While it is not always the case, options that increase progressivity usually have a more negative impact on the economy than proportional or regressive taxes.

The distribution of the tax burden and how that tax revenue is spent both matter.  A proportional or slightly regressive tax like a carbon tax or a value-added tax could raise significant revenue with a relatively small economic cost, and the distribution of the spending could more than alleviate an unwanted distribution of the tax burden.

 Some tax options impose a large economic cost for the revenue they raise. For example, forcing companies to spread out deductions for capital investment is one of the worst ways to raise revenue. Currently, businesses deduct the cost of their investments according to the Modified Accelerated Cost Recovery System (MACRS), which allows larger depreciation deductions in the early years of an asset’s life. Returning to the Alternative Depreciation Schedule (ADS) would require businesses take depreciation deductions in equal increments under the straight-line method.

Thanks to inflation and the time value of money, companies would not deduct the full real value of their investment, raising the cost of capital and reducing capital expenditures. Extending cost recovery schedules is also a worse way to raise revenue than just raising the corporate income tax rate, as extending cost recovery schedules primarily punishes future investment.

There are other problems with returning to the ADS: first, the revenue for this option is heavily frontloaded, meaning that in the long term it will raise less annually than it would in the first few years after it is enacted. Second, by not letting companies deduct the full real value of their capital investments, this would worsen a tax bias against companies in more capital-intensive industries.

A superior alternative would be repealing business tax expenditures. Tax expenditures are provisions that deviate from a “normal income tax structure” and generally favor a specific industry or activity. This option would broaden the tax base by repealing most business tax expenditures, but retaining those related to deferral, cost recovery, and foreign income. The simplest way to describe this position would be “eliminating special tax breaks for businesses.”

This option is relatively unique, as a corporate tax increase with relatively small economic costs for the revenue it raises. Two factors limit the impact: some expenditures incentivize switching from one activity to another, rather than increasing the overall level of activity, and some are temporary, so bringing forward their scheduled expiration does not impact long-run decision-making.

There are downsides. Some of the permanent expenditures lower the cost of capital, so repealing them would raise the cost of investment and thus reduce growth. Additionally, many of these expenditures are temporary, so in the long term, this option will also raise less per year than it does initially.

Table 1. Eliminating Business Tax Expenditures Raises More Revenue than Lengthening Depreciation Schedules, Without Hurting Growth As Much
  Return to the Alternative Depreciation Schedule (ADS Eliminate Various Business Tax Expenditures
GDP -0.6% -0.2%
GNP -0.5% -0.2%
Capital Stock -1.1% -0.4%
Wage Rate -0.5% -0.2%
Jobs -109,000 -33,000
10-Year Conventional Revenue $603.40 billion $985.60 billion
10-Year Dynamic Revenue $421.25 billion $926.43 billion
Dynamic Long-Run Change in After-Tax Income, Bottom 20 Percent -0.6 percent -1.1 percent
Dynamic Long-Run Change in After-Tax Income, Top 20 Percent -0.8 percent -1.8 percent

Source: Tax Foundation, Options for Reforming America’s Tax Code 2.0, April 2021.

There’s a useful contrast between two revenue options related to President Biden’s infrastructure push. The president’s American Jobs Plan includes a proposal to raise the corporate tax rate to 28 percent. Meanwhile, historically, the gas tax is the main revenue source for transportation funding.

A higher corporate income tax rate would hinder capital formation by increasing the cost of capital. A higher cost of capital would make some investments unviable as they would no longer meet the required after-tax rate of return. The problem with taxes on capital is that capital tends to be more responsive to taxation than labor, meaning that generally, taxes on capital have higher economic costs per dollar of revenue raised.

The gas tax is the primary funding source for the Highway Trust Fund (HTF)—the channel the federal government uses to provide revenue for state and local highway spending. The HTF is projected to run out of money by the end of 2021. Currently at 18.4 cents per gallon of gasoline and 24.4 cents per gallon of diesel, this option would increase the tax by 35 cents and adjust it for inflation going forward.

This tax increase would raise a similar amount of revenue as raising the corporate tax rate to 28 percent, but with a much smaller economic cost. This is true for several reasons. While a small portion of the gas tax falls on the production process, as businesses use gas as an input, the tax mostly falls on consumers. The gas tax is also partly a user fee, as the people who pay the gas tax also directly benefit from the government service it funds, such as roads.

A higher gas tax would come with trade-offs, particularly in terms of distribution. A gas tax increase would fall disproportionately on lower-income households. Nonetheless, after accounting for the impact on economic growth, it would reduce long-run income for people at the bottom of the income spectrum less than a higher corporate income tax would.

Table 2. Raising the Gas Tax Would Cause Minimal Damage to Economic Growth Relative to a Corporate Tax Increase
  Raise the Corporate Income Tax to 28 Percent Raise the Gas Tax by 35 Cents and Index to Inflation
GDP -0.7% -0.1%
GNP -0.7% -0.1%
Capital Stock -1.4% -0.1%
Wage Rate -0.6% -0.5%
Jobs -138,000 -103,000
10-Year Conventional Revenue $886.27 billion $758.34 billion
10-Year Dynamic Revenue $693.90 billion $653.12 billion
Dynamic Long-Run Change in After-Tax Income, Bottom 20 Percent -1.5 percent -0.5 percent
Dynamic Long-Run Change in After-Tax Income, Top 20 Percent -2.0 percent -0.4 percent

Source: Tax Foundation, Options for Reforming America’s Tax Code 2.0, April 2021.

Another way to raise revenue is raising personal income taxes. Under this option, all seven income tax rates would increase by 10 percent. Under the current baseline, the top marginal rate would rise from 37 percent to 40.7 percent through 2025, and from 39.6 percent to 43.7 percent when the 2017 tax reform expires after 2025.

The burden of raising the personal income tax would fall on both labor and capital. Raising the marginal tax rate on income makes someone less likely to work more. However, raising the individual income tax also falls on capital, as a large portion of American businesses are pass-through entities and are taxed under the individual income tax. 

Alternatively, the carbon tax is designed to make businesses and individuals that benefit from burning fossil fuels shoulder the social cost of environmental damage. Taxing carbon emissions would raise the price of fossil fuels and any resulting goods or services, incentivizing producers and consumers to use less carbon-intensive goods. This option would enact a carbon tax of $50 per metric ton of carbon produced through fossil fuels combustion, increasing at 5 percent annually to $77.57 per metric ton by 2031.

A carbon tax would mostly fall on consumers, making it like a tax on labor. While that might sound counterintuitive, by raising prices, consumption taxes raise the cost of goods and services labor income can buy, essentially reducing the returns to labor. Furthermore, the flat structure of the carbon tax is less economically distortionary than higher marginal tax rates.

There are also several ways to offset the distributional impact of a carbon tax. For example, using part of the revenue the tax generates to fund cash rebates to every household could alleviate the burden for low-income households while still leaving revenue for other priorities to spare.

Table 3. A Carbon Tax Would Hurt Economic Growth Less than Higher Income Taxes Would
  Raise Individual Income Taxes by 10 Percentage Points Enact $50 Per Ton Carbon Tax
GDP -0.9% -0.4%
GNP -1.0% -0.4%
Capital Stock -1.0% -0.3%
Wage Rate -0.1% -1.3%
Jobs -961,000 -289,000
10-Year Conventional Revenue $2,103.78 billion $1,947.13 billion
10-Year Dynamic Revenue $1,515.02 billion $1,675.22 billion
Dynamic Long-Run Change in After-Tax Income, Bottom 20 Percent -0.7% -1.3%
Dynamic Long-Run Change in After-Tax Income, Top 20 Percent -2.6% -1.0%

Source: Tax Foundation, Options for Reforming America’s Tax Code 2.0, April 2021.

It’s crucial to keep in mind that not all taxes are created equal in terms of their impact on economic growth, and that each option for raising revenue comes with trade-offs related to efficiency and equity.

Options for Reforming America’s Tax Code 2.0

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A regressive tax is one where the average tax burden decreases with income. Low-income taxpayers pay a disproportionate share of the tax burden, while middle- and high-income taxpayers shoulder a relatively small tax burden.

The 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.

An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.

Depreciation 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.

Cost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. 

A corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.

A carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them.

After-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income.

The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax.