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Details and Analysis of a Tax Reform Plan for Growth and Opportunity

41 min readBy: William McBride, Huaqun Li, Garrett Watson, Alex Durante, Erica York, Alex Muresianu

Economic and Revenue Effects

  • 10-Year Revenue (Billions) $523
  • Long-run GDP 2.5%
  • Long-Run Wages 1.4%
  • Long-Run FTE Jobs 1.3M

Tax Foundation General Equilibrium Model, June 2023

Latest Updates

  1. This analysis was updated to account for the latest modeling updates and federal tax policy developments.
  2. Original analysis was published.
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Key Findings

  • The 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. code remains a major source of frustration and controversy for Americans, and a hindrance to economic growth and opportunity. Other countries, such as Estonia, have proven that sufficient tax revenue can be collected in a less frustrating and more efficient way.
  • This report provides an analysis of the key features of the Estonian income tax system—a simple, flat individual income taxAn 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. combined with a distributed profits taxA distributed profits tax is a business-level tax levied on companies when they distribute profits to shareholders, including through dividends and net share repurchases (stock buybacks). —and its potential effects if implemented in the United States.
  • By simplifying the federal tax code, the reform would substantially reduce compliance costs, potentially saving U.S. taxpayers more than $100 billion annually.
  • By improving work and investment incentives and eliminating the double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of business income, we estimate the reform would boost long-run GDP by 2.5 percent, grow wages by 1.4 percent, and add 1.3 million full-time equivalent jobs.
  • The plan would increase average after-tax incomes by 1.1 percent in the long run on a conventional basis. When including the benefit of higher economic output, average after-tax incomes would rise by 3.5 percent in the long run.
  • By collecting a similar amount of tax revenue as the current tax code and increasing GDP, the reform would reduce the debt burden as measured by the debt-to-GDP ratio by 9.2 percentage points over the long run.
Table 1. Combined Long-Run Effects of the Growth & Opportunity Tax Provisions
Gross Domestic Product (GDP) +2.5%
Capital Stock +3.4%
Wage Rate +1.4%
Full-Time Equivalent Jobs +1.3 million
Source: Tax Foundation General Equilibrium Model, June 2023.

Introduction

Despite many attempts at reform, the federal tax code remains a major source of frustration and controversy for Americans, and an undue burden on economic growth and opportunity. More than one hundred years of tinkering and well-intentioned efforts to address a range of social and economic problems have produced a bewildering array of penalties and subsidies—a system that pleases no one, though it occasionally advantages various special interests and power brokers.

While any one provision may be justified as supportive of one group or another, like an incumbent industry or an established subset of taxpayers, the accumulation of complicated preferences combined with high income tax rates is not supportive of newcomers or new sources of economic growth. Rather, it suppresses the dynamic forces of a healthy economy, reducing incentives to work, save, and invest.

The burden of complying with the tax code is staggering, currently estimated to consume 6.5 billion hours at a cost of about $313 billion per year, equal to 1.4 percent of GDP.[1] Most of the burden is due to complicated business taxes that consume the time and energy of entrepreneurs and small business owners as well as massive tax departments at many large businesses. The estimate does not include the cost of tax planning, which is a significant industry on its own. Nor does it include the administrative costs and challenges that have clearly overwhelmed the IRS in recent years. Last year, for instance, the IRS answered only about 13 percent of the 173 million phone calls it received from taxpayers asking for help.[2]

It does not have to be this way. Other countries have proven that sufficient tax revenue can be collected in a less frustrating and more efficient manner. A particularly compelling example is Estonia’s tax system, where taxes are so simple they are typically filed online in about five minutes.[3]

Estonia also tops Tax Foundation’s annual ranking of most competitive tax systems, in part because it avoids double-taxing corporate income through taxes at both the entity and shareholder levels.[4] While the tax burden is neutral and simple, Estonia’s income tax system generates substantial revenue comparable to other developed countries.[5] It may sound like an impossible dream to Americans, but it is a dream come true for the more than one million Estonians who have thrived under this regime for the last 22 years.[6]

Drawing on the Estonian experience and building on ideas from our initial study on reform options,[7] we present here a plan for reforming the U.S. tax code that focuses on simplicity.[8] The plan is approximately revenue neutral and consists of two main components that apply to individual and business income, plus offsetting changes to the treatment of estates and capital gains that avoids our current death tax. The reforms include:

  • A flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. of 20 percent on individual income combined with a generous family allowance to protect low-income households. All other major credits, deductions, and preferences would be eliminated except the current-law Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (EITC), a more stable Child Tax Credit (CTC), and tax-preferred savings accounts.
  • A distributed profits tax of 20 percent in lieu of our current overly complex regime for taxing domestic and foreign profits earned by corporations and pass-through businesses.
  • Elimination of taxes at death and simplified treatment of capital gains to remove the burden of unnecessary compliance and administrative costs.

By simplifying the federal tax code, the reform would substantially reduce compliance costs, potentially saving U.S. taxpayers more than $100 billion annually, comprised of more than $70 billion in reduced compliance costs for businesses and more than $30 billion in reduced compliance costs for individuals related to individual income and estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. returns.

We estimate that the reform would increase long-run GDP by 2.5 percent, raise wages by 1.4 percent, and add 1.3 million full-time equivalent jobs.

The plan would increase average after-tax incomeAfter-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. s by 1.1 percent in the long run on a conventional basis. When including the benefit of higher economic growth, average after-tax incomes would rise by 3.5 percent in the long run. Though after-tax incomes increase on average, in any revenue-neutral reform, tax relief for one group of taxpayers necessitates tax increases for another group of taxpayers. Various aspects of the plan could be altered to achieve different distributional results.

By increasing GDP, the reform would reduce the debt burden as measured by the debt-to-GDP ratio by 9.2 percentage points over the long run.[9]

The policies outlined in the reform are to be considered as a whole; any one change in isolation may not necessarily be recommended.

Background on Tax Reform

The idea of tax reform has always been about reassessing accumulated provisions, clearing out what is ineffective, and reducing the economic harm of high marginal tax rates consistent with the principles of sound tax policy.[10] Most tax policy experts agree taxes should be simple, transparent, and stable over time so they are easy to understand, comply with, and administer.

Another element of sound tax policy is neutrality: the tax code should generally treat taxpayers equally with minimum preferences, which extends to equal treatment of immediate versus delayed consumption via saving. A tax code that embodies these principles naturally supports economic flourishing, including plentiful jobs, growing wages, upward mobility, innovation and progress, and higher standards of living.

Our tax code is far from this ideal. By taxing income, it systematically discourages saving, as it taxes income saved and the returns to saving that compensate for delayed consumption. Income saved and invested in corporate form is additionally subject to the corporate income taxA 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. . The estate tax is a final layer of tax on saving. To offset the inherent bias against saving and investment, lawmakers have enacted a patchwork of provisions that offer limited relief, including widely utilized provisions such as 401(k) retirement accounts for individuals and bonus 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. for businesses, as well as dozens of other more specialized and complicated carveouts that benefit a select few.

The tax code has become a major conduit for redistribution and subsidy of not just low-income households but virtually all households—effectively supplanting economic growth and opportunity with political favors. In total, the tax code contains more than 200 so-called tax expenditures, consisting of various credits, deductions, and other special provisions estimated to cost about $2 trillion annually (including reduced income and 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. revenues and increased outlays).[11] In the last three years alone, more than 100 tax expenditures have been created or amended.[12]

While some tax expenditures are important structural elements of the tax code, many are complicated and disproportionately benefit specific industries or types of households. The Congressional Budget Office (CBO) finds about half of the total income tax benefits of expenditures go to high-income households.[13] Eliminating such provisions would be among the least economically harmful ways to raise revenue.[14]

The last major tax reform, the Tax Cuts and Jobs Acts (TCJA) of 2017, made important improvements to the tax code, particularly by reducing income tax rates and expanding expensing for businesses while curtailing some of the major tax expenditures.[15] However, it left much of the complexity of the tax code intact and in some ways made it worse. For example, the Section 199A pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. deduction and the Global Intangible Low Tax Income (GILTI) provision that applies to foreign income made some businesses worse off.

Since the TCJA, the ethos of subsidy, penalty, and micromanagement through the tax code has grown stronger. For example, last year’s InflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. Reduction Act layered on another complicated minimum tax for large companies as well as an array of subsidies for green energy, introducing new uncertainties that will require intensive guidance from the Treasury Department and inevitably entail unintended consequences related to tax planning and distortionary behavior.[16]

Furthermore, due to the TCJA, much of the individual income tax code is set to expire after the end of 2025, while several business tax increases have already begun to take effect, including the phasedown of bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. beginning this year, making now an opportune time to consider fundamental tax reform. The weakening economy, high interest rates and inflation, and severe fiscal challenges ahead also make fundamental and pro-growth tax reform more important than ever.

Flat Tax of 20 Percent with a Generous Family Allowance

Following the Estonian system, the proposed reform provides a much simpler income tax system for individuals, with a flat tax rate of 20 percent on all income (except dividends) combined with an expanded standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. per filer and a personal exemption per household member.

Income subject to the flat rate includes wages, salaries, capital gains, pension and annuities, taxable Social Security benefits, taxable interest, rent and royalty net income, and taxable individual retirement account (IRA) distributions. Dividends would be exempt from income tax.

Most credits, deductions, and other preferences would be eliminated, including:

  • The itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. for mortgage interest
  • The itemized deduction for state and local taxes (SALT) paid
  • The itemized deduction for charitable contributions
  • The exclusion for capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. on principal residences for gains up to $250,000 (single)/$500,000 (joint)
  • Tax expenditures including the exclusion of capital gains tax for small corporate stock, the exemption on interest earned on municipal bonds, credits for green energy, the deduction for interest on student loans, the deduction for medical expenses, and credits for post-secondary education tuition
Table 2. Summary of Individual Tax Changes
Current Law Reform Option
Ordinary income tax schedule Seven brackets in 2024: 10%, 12%, 22%, 24%, 32%, 35%, 37%. Seven brackets beginning in 2026: 10%, 15%, 25%, 28%, 33%, 35%, 39.6% 20% on taxable income
Tax schedule for long-term capital gains Three brackets: 0%, 15%, 20% 20% on taxable income
Standard deduction Standard deduction of $13,850 (single)/$27,700 (joint) in 2023 and indexed to inflation. Starting in 2026, standard deduction is reduced to $8,000 (single)/$16,000 (joint) and indexed to inflation Expand the standard deduction to $19,500 (double for joint filers) starting in 2024 and eliminate Head of Household filing status
Personal exemption Personal exemption of $0 until 2026; the exemption returns in 2026 and equals $5,800 in 2033 Personal exemption is retained under current law parameters.
Child Tax Credit (CTC) $2,000 CTC with a refundability limit of $1,600 in 2024, a 15% refundability phase-in, and a $2,500 earnings requirement. Phaseout begins at $200,000 (single)/$400,000 (joint). After 2025, the CTC returns to $1,000 with a $3,000 earnings requirement, and a phaseout starting at $75,000 (single)/$110,000 (joint) Permanent $2,000 CTC with a $2,500 earnings requirement, both indexed to inflation, and full refundability. Phaseout begins at $50,000 (single)/$100,000 (joint), indexed to inflation. Phase-in and phaseout rates remain as under current law.
Earned Income Tax Credit (EITC) Refundable tax credit accrued based on earned income and targeted at low-income workers EITC is retained under current law parameters
Alternative Minimum Tax (AMT) Second set of income tax rules subjecting some taxpayers to AMT tax liability at rates of 26 percent or 28 percent The AMT is repealed
Net Investment Income Tax (NIIT) 3.8 percent tax on certain passive investment income earned by those with modified adjusted gross income over $200,000 (single)/$250,000 (joint) The NIIT is repealed
Tax-preferred savings accounts Taxpayers may contribute to traditional accounts that provide a deduction for contributions and earnings are taxed upon distribution, or Roth-style accounts where contributions are taxed upfront and earnings are distributed tax-free Tax-preferred savings accounts are retained under current law parameters
Source: Internal Revenue Service (IRS), Tax Foundation research.

The reform would tax capital gains as ordinary income, rather than under a separate schedule as under current law. It would eliminate all exclusions for capital gains and interest such as the exclusion for small corporation stock and remove the additional 3.8 percent Net Investment Income Tax (NIIT) that currently applies to capital gains and other investment income above $250,000. These changes simplify the tax code and eliminate the avoidance, games, confusion, and controversy around preferential tax rates for investment income.[17]

The combination of an expanded standard deduction (equal to $19,500 for singles and $39,000 for joint filers in 2024) and the return of the current law personal exemption in 2026, both indexed to inflation, provides a large zero bracket shielding low-income households from the flat tax. Furthermore, the reform would stabilize the CTC, providing a maximum of $2,000 per child that begins phasing out at $50,000 for single filers and $100,000 for joint filers. The credit would continue to phase in with earned income above $2,500 at 15 percent, with the full amount refundable. The $2,000 maximum credit as well as phase-in and phaseout thresholds would be inflation-indexed moving forward. The CTC and retention of the EITC mean most households earning under $50,000 see little to no tax increase.[18]

Additionally, the reform retains tax-preferred savings accounts such as 401(k)s and IRAs as they provide an important incentive to save and shield many middle-income households from tax increases.[19]

Replacing the current progressive income tax structure—characterized by seven income tax brackets and a slew of exclusions, exemptions, credits, and deductions—with a flat tax has several benefits.[20] First, it greatly simplifies the tax code, minimizing tax planning and avoidance as well as the costs associated with compliance and administration. It currently takes about 12 hours on average for U.S. taxpayers to comply with the individual income tax code and the annual aggregate compliance cost totals more than $75 billion. Based on the Estonian experience, where it takes a few minutes to comply, this reform would likely save U.S. taxpayers tens of billions of dollars annually in reduced compliance costs.[21]

Second, the reform reduces marginal income tax rates, moderately for many middle-income taxpayers currently in the 22 and 24 percent brackets and by about half for many high-income taxpayers, which boosts economic growth by incentivizing work, saving, and investment.[22] For example, the reform would reduce the average federal marginal tax rateThe 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. on wage income from 23.2 percent to 19.9 percent.

The CBO found that by reducing marginal income tax rates, a flat tax would be substantially less harmful to the economy than a progressive income tax, resulting in more economic output in the long run with the benefits especially large for younger households as measured by increased lifetime consumption and hours worked.[23]

Distributed Profits Tax of 20 Percent

Regarding business income, the reform applies a distributed profits tax like Estonia’s to all domestic companies including corporations and pass-through businesses. This regime completely avoids the laborious process of calculating taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. after deductions, applying tax, and computing applicable tax credits and other preferences and replaces it with an entity-level tax of 20 percent on distributed profits, including dividends and net share repurchases. To avoid double taxation, dividends received by individuals are excluded from individual income tax.

By treating corporations and pass-through businesses equally, the approach avoids the complexity of the current U.S. business tax system, which applies different tax regimes to different types of businesses, such as C corporations, S corporations, partnerships, and sole proprietors.[24]

Table 3. Summary of Business Tax Changes
Current Law Reform Option
Taxes on C corporations and shareholder income Corporations are subject to the 21% corporate income tax as well as the corporate alternative minimum tax (or book minimum tax) and stock buyback tax. Dividends received are subject to individual income tax. Owners of corporate equity are subject to capital gains tax upon realization Corporate income tax is repealed, along with the book minimum tax and stock buyback tax, and replaced with a 20% entity-level tax on distributed profits. Dividends received are not subject to individual income tax. Owners of corporate equity are subject to capital gains tax upon realization.
Taxes on pass-through firms (partnerships, sole proprietorships, S corporations) and shareholder income Profits are “passed through” to individual owners and subject to individual income tax at statutory rates of up to 37% through 2025 and 39.6% after that Through 2025, owners can deduct a portion of qualified business income. Owners of pass-through equity are subject to capital gains tax upon realization Pass-through firms receive the same tax treatment as C corporations, i.e., they are subject to a 20% entity-level tax on distributed profits, and dividends received are not subject to individual income tax. Owners of pass-through equity are subject to capital gains tax upon realization
Fringe benefits Some fringe benefits, such as employer-sponsored health insurance, are deductible at the firm level and excluded from individual income tax and payroll taxes All fringe benefits are subject to the 20% entity-level distributed profits taxes and payroll taxes. Fringe benefits received are not subject to individual income tax
Taxes on foreign and cross-border income Multinational corporations are subject to a complex set of rules and tax rates, including Subpart F, foreign tax credits, Global Intangible Low Tax Income (GILTI), Foreign-Derived Intangible Income (FDII), and Base Erosion and Anti-Abuse Tax (BEAT) Foreign and cross-border income is exempt from tax, so long as it is subject to corporate tax in its foreign location
Source: Internal Revenue Service (IRS), Tax Foundation research.

Fringe benefits, such as employer-provided health insurance, would be subject to the 20 percent distributed profits tax and payroll taxes.[25] Compensation in the form of fringe benefits currently enjoys a deduction at the firm level and an exclusion from individual income and payroll taxes, representing the single largest tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit (EITC), child tax credit (CTC), deduction for employer health-care contributions, and tax-advantaged savings plans. in the tax code. Subjecting fringe benefits to tax (20 percent income tax plus payroll taxes) would result in a neutral treatment of various types of compensation, improving efficiency and avoiding a major distortion in the health insurance market that favors employer-provided health insurance and third-party payers.[26]

The proposal requires rules to avoid abuse, but overall, relatively little is required for administration or compliance relative to current law. The entire system of international provisions dealing with foreign income under current law in the U.S., including the highly complex Subpart F and GILTI regimes, would be unnecessary. Instead, the system would consist of a simple 20 percent tax applied to distributed profits of domestic firms, with a test applied to distributions received by U.S. companies from foreign firms that requires no further tax so long as the foreign distributions are subject to sufficient tax in foreign jurisdictions.

The proposal also takes a simple approach to the global minimum tax for large multinational companies under negotiation by the OECD and some 140 countries.[27] Companies could avoid a top-up tax from the minimum tax rules if their profit distributions are sufficiently high to satisfy the 15 percent minimum tax relative to the income definition in the model rules. This is similar to the reality that Estonian businesses will face when the minimum tax rules are adopted.

Under current law, U.S. companies must maintain multiple sets of books to satisfy stakeholder needs and comply with various taxes. Shareholders and investors primarily use regular book accounting to evaluate the financial health of the company. Tax accounting is used to comply with the taxes applied to corporate income and pass-through business income. Large companies must also comply with the new book minimum tax implemented last year as part of the Inflation Reduction Act, requiring an alternative book accounting. As various countries implement the global minimum tax, large companies will have another set of rules to comply with, requiring yet another alternative book accounting.

One goal of the reform is to reduce the compliance burden by reducing the need for so many different sets of books. With the distributed profits tax, the expense and controversy of tax accounting for the corporate and pass-through business income taxes is largely gone, replaced with simple accounting related to distributed profits, which is already maintained as part of regular book accounting. The only other accounting required relates to the global minimum tax rules that may be implemented in various countries, and these rules also largely rely on regular book accounting principles. Lastly, it should be noted that regular book accounting is also sufficient to satisfy the needs of tax authorities regarding auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. s, such as determining the legitimacy of reported income and assets.

The administrative and compliance cost of the Estonian business tax system is among the lowest in the developed world, which is particularly beneficial to entrepreneurs, startups, and small businesses that cannot otherwise afford the excessive compliance costs of the current system, estimated at more than $150 billion annually.[28] The reduction in business compliance costs would be considerable under the reform, though difficult to quantify. Certainly, the cost of complying with complicated depreciation and amortization forms, estimated at $24 billion, would be eliminated, as would the costs associated with forms relating to the deduction for qualified business income, estimated at $18 billion. And much of the compliance costs associated with forms 1120 and other business income tax returns, estimated at more than $60 billion, would be eliminated as well, such that total business compliance costs savings under the reform would likely exceed $70 billion annually.[29] By reducing the compliance burden of business taxes, entrepreneurs and business decision-makers can redirect resources toward more productive activities and otherwise grow their businesses.

Beyond compliance cost savings, the economic benefits of the Estonian business tax reform are evident both in empirical and theoretical research. The structure of the distributed profits tax, with no tax on retained earnings, provides a powerful and general incentive for entrepreneurs and businesses to grow and invest. The incentive is particularly beneficial to startups and small businesses that are credit- and liquidity-constrained since they rely on self-financing through retained earnings.[30]

Due to the superior design, one study found the distributed profits tax increases the overall value of existing firms and new entrants by 7 percent compared to a corporate income tax that collects the same amount of tax revenue.[31] Another study found that Estonia’s distributed profits tax incentivizes companies to retain a higher share of earnings, reduce debt, and increase investment, such that in the long run the country’s capital stock increases by 10 percent and output by 4 percent.[32] The simplicity and pro-growth design of its business tax system puts Estonia at the top of Tax Foundation’s international ranking of the most competitive tax systems in the developed world.[33]

Empirically, researchers found the reform, which replaced a corporate income tax similar to ours with a distributed profits tax, substantially increased retained earnings and liquidity while reducing the use of debt, especially among smaller companies affected by liquidity constraints, a change which has improved resilience in economic downturns. These studies also indicate the reform increased investment and labor productivity.[34]

Estonia’s tax system contributes to an economic environment that is among the most entrepreneurial and dynamic in Europe.[35] For example, Estonia leads Europe in terms of startups per capita (including “unicorns” or startups valued at $1 billion or more), venture capital funding per capita, and capital investment per capita.[36] Since the financial crisis in 2009, Estonia has recovered strongly as a center of innovation and startups in Europe, with venture capital invested in early-stage startups growing from $4 million in 2009 to almost $1 billion in 2021.[37]

Over that 12-year span, real GDP per capita in Estonia has grown 53 percent, compared to 19 percent in the U.S. and 17 percent on average across the OECD. Since the tax reform in 2000, Estonia’s GDP per capita has grown 119 percent, while U.S. GDP per capita has grown 27 percent and the OECD average has grown 26 percent.[38]

Elimination of Taxes at Death

Under current law in the U.S., the estate tax raises little revenue, discourages capital investment, and hinders economic growth.[39] It represents a final layer of tax on already over-burdened saving and investment.[40] It also involves an extraordinary amount of compliance and administrative costs related to the valuation of estates and encourages a great deal of tax planning (with the tax code providing many opportunities to avoid paying). Research has shown the compliance costs associated with the estate tax, currently estimated at $18 billion annually, approach and often exceed the amount of tax revenue collected.[41]

As might be expected, Estonia has a much simpler alternative.[42] Instead of an estate tax, or any tax at death, Estonia subjects the heir of the inherited asset to capital gains tax when the asset is sold and the gain is realized. The inherited asset receives a zero basis when it is inherited, eliminating the need to track the original basis (the original cost of the purchase) from the decedent or any of the associated paperwork. In other words, upon inheritance, the asset is treated as any other asset with the deductible basis determined by the costs incurred by the inheritor.

For example, consider an inherited property worth $1 million. The inheritor would not owe any tax upon inheritance and would only report taxable income upon the sale of the property. At that time, the inheritor would pay tax on the full value of the property minus any deductible costs, such as improvements made to the property post-inheritance.

Table 4. Summary of Estate and Gift Tax Changes
Current Law Reform Option
Estate tax Tax rate on net estate value up to 40% for assets over $12.92 million in 2023. Exemption value is scheduled to fall to about $6 million in 2026, indexed to inflation thereafter Estate tax is repealed
Gift tax Tax rate on gifts up to 40% for gifts worth over $17,000 in 2023 Gift tax is repealed
Step-up in basis Asset cost basis is adjusted to fair market value for the inheritor Asset cost basis is set at zero for the inheritor
Source: Internal Revenue Service (IRS), Tax Foundation research.

By eliminating the incentive under current law to pass assets on to heirs along with a “stepped-up” basis, this reform encourages the realization of capital gains within one’s lifetime, thus boosting tax revenue from capital gains.[43] That is, the reform effectively removes the need for tax planning around death. It also eliminates the administrative challenge and controversy around valuing assets at death, where disputes with tax authorities can take a decade or more to resolve.[44] Much, if not all, of the $18 billion of compliance costs associated with the current law estate tax would be eliminated under this reform.

Replacing the estate tax with a zero-basis transfer of capital gains at death certainly has downsides. For the most part, the downsides relate to the problems of taxing capital gains in general, namely that it punishes saving and entrepreneurship, a problem made worse by inflation, and encourages tax-driven decisions regarding realizations.[45] That is why it is important to keep the tax rate as low as possible and broaden the base to maintain sufficient tax revenue.[46]

The estate tax as currently structured takes the opposite approach, with a narrow base and a top tax rate of 40 percent (compared to 20 percent on capital gains under the proposal). As such, the estate tax is relatively more economically damaging and entails more avoidance, tax planning, complexity, and compliance and administrative costs per dollar of revenue raised.

Likewise, alternatives such as capital gains treatment with carryover of basis or stepped-up basis would entail substantially more compliance and administrative costs.[47] Overall, the proposed reform is recommended due to its simplicity, low compliance and administrative costs, and reduced economic harm relative to current law.

Economic Effects

We estimate that implementing the reform outlined above in the U.S. would increase GDP by 2.5 percent in the long run, amounting to about $402 billion in additional annual output by 2033 and $683 billion in the long run (both in 2024 dollars).[48] The reform would increase the long-run capital stock by 3.4 percent, amounting to $1.9 trillion in 2024 dollars. Additionally, we estimate the reform would add 1.3 million full-time equivalent (FTE) jobs and raise wages by 1.4 percent.

Two major changes drive the economic results: the replacement of the current progressive income tax structure with a flat 20 percent tax on individual income, which raises GDP by 1.3 percent and adds 1.2 million FTE jobs, and the replacement of current business income taxes with a 20 percent distributed profits tax, which raises GDP by 1.8 percent and adds 429,000 FTE jobs.

For context, we estimated the TCJA would increase GDP by 1.7 percent in the long run and add 339,000 jobs, indicating the proposed reform would have a substantially larger positive impact on the economy.[49]

Table 5. Long-Run Economic Effects of the Proposed Tax Reform
Provision Change in GDP Change in Capital Stock Change in Wages Change in Full-time Equivalent Jobs
Repeal the Alternative Minimum Tax (AMT) -0.1% Less than +0.05% Less than +0.05% -112,000
Exempt dividends from individual income tax +0.2% +0.3% +0.1% +42,000
Replace individual income tax with a flat 20% tax on ordinary income +1.3% +1.6% +0.2% +1.2 million
Expand the standard deduction to $19,500 (double for joint filers) starting in 2024 and eliminate Head of Household filing status +0.1% -0.4% -0.2% +289,000
Tax capital gains at a flat 20% rate and set zero basis for inherited assets -0.1% -0.2% -0.1% -33,000
Eliminate most individual tax expenditures* -0.5% -1.3% -0.3% -222,000
Repeal the Net Investment Income Tax (NIIT) Less than +0.05% +0.1% Less than +0.05% +8,000
Repeal estate tax and gift taxes +0.1% +0.3% +0.1% +22,000
Reform the Child Tax Credit (CTC) and repeal the Child and Dependent Care Tax Credit (CDCTC) Less than -0.05% Less than -0.05% Less than +0.05% -40,000
Repeal the corporate income tax and replace it with a 20% entity-level tax on distributed corporate profits. Tax pass-through firms as C corporations through the 20% entity-level tax on distributed profits. Repeal the book minimum tax. +1.8% +3.4% +1.4% +429,000
Repeal Stock Buyback Tax Less than +0.05% +0.1% Less than +0.05% +7,200
Subject employer-sponsored health insurance and fringe benefits to 20% entity-level tax on distributed profits and subject benefits to payroll tax -0.3% -0.3% Less than -0.05% -332,000
Impact of budget deficit reduction 0% 0% 0% 0
Total Economic Effect +2.5% +3.4% +1.4% +1.3 million

Revenue Effects

On a conventional basis, we estimate the reform would raise $523 billion in federal tax revenue from 2024 to 2033 (the 10-year budget window), relative to the baseline.[50] The plan raises about $1.2 trillion in the first two years, during which the baseline reflects the TCJA individual provisions, and loses revenue after 2025 as the baseline reflects higher tax collections after the expiration of the TJCA provisions. At the end of the budget window, the plan loses about $100 billion in 2033 on a conventional basis.

On a dynamic basis, accounting for economic growth resulting from the reform, we estimate the plan raises $1.4 trillion over the budget window. The extra gain in dynamic revenue is due to the larger economy and correspondingly higher income and payroll tax revenue.

Table 6. Revenue Effects of the Growth & Opportunity Tax Plan (Billions of Dollars)
Provision (Billions of Dollars) 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2024-2033
Individual Provisions
Replace current law individual income tax schedule with a flat 20% ordinary income tax $343.8 $351.0 $41.4 $45.1 $46.6 $48.3 $50.3 $52.4 $54.4 $57.1 $1,090.3
Repeal the Alternative Minimum Tax (AMT) -$18.5 -$18.8 -$55.5 -$60.5 -$62.6 -$65.0 -$67.5 -$70.1 -$72.6 -$75.5 -$566.5
Tax capital gains at a flat 20% rate and exempt dividends from individual income tax -$168.7 -$173.3 -$51.5 -$56.4 -$58.9 -$61.2 -$63.7 -$66.2 -$68.8 -$71.6 -$840.2
Expand the standard deduction from $13,850 to $19,500 (double for joint filers) starting in 2023 and eliminate Head of Household filing status -$168.8 -$173.3 -$385.8 -$422.2 -$436.7 -$453.9 -$470.9 -$490.2 -$507.4 -$529.5 -$4,038.7
Make permenant the $2,000 TCJA Child Tax Credit with a $2,500 earnings requirement, full refundability, and a phaseout of $50,000 (single)/ $100,000 (joint). Index the CTC earnings requirement, phaseout amounts, and credit amount to inflation. Repeal the Child and Dependent Care Tax Credit (CDCTC). $52.9 $49.9 -$49.6 -$55.2 -$59.7 -$64.4 -$69.4 -$74.6 -$79.9 -$85.7 -$435.6
Repeal the Net Investment Income Tax (NIIT) -$49.2 -$49.5 -$49.6 -$53.4 -$54.6 -$57.0 -$59.5 -$62.2 -$64.9 -$67.8 -$567.6
Eliminate most individual and business tax expenditures* $226.1 $235.7 $248.6 $275.5 $288.1 $302.2 $316.7 $331.4 $345.7 $360.9 $2,931.0
Business Provisions
Repeal the corporate income tax and replace it with a 20% entity-level tax on distributed corporate profits. Tax pass-through firms as C corporations through the 20% entity-level tax on distributed profits. Repeal book minimum tax. -$25.7 -$35.4 -$140.1 -$168.0 -$158.5 -$151.7 -$149.4 -$152.9 -$156.4 -$156.7 -$1,294.7
Repeal stock buyback tax -$3.5 -$4.4 -$4.9 -$6.0 -$7.1 -$7.2 -$7.5 -$8.1 -$9.4 -$8.4 -$66.5
Subject employer-sponsored health insurance to 20% entity-level tax on distributed profits and subject benefits to payroll tax $389.9 $393.3 $370.1 $399.5 $409.6 $421.4 $433.7 $446.5 $458.7 $472.6 $4,195.2
Subject all fringe benefits to the 20% entity-level tax on distributed profits and payroll taxes $26.6 $27.6 $31.9 $34.6 $35.8 $37.0 $38.3 $39.6 $41.1 $42.4 $354.9
Estate Tax, Gift Tax, and Step-up in Basis Provisions
Repeal estate tax and gift taxes -$21.0 -$22.0 -$23.0 -$34.0 -$38.0 -$41.0 -$44.0 -$48.0 -$51.0 -$54.0 -$376.0
Set zero basis for inherited assets $12.0 $12.2 $12.5 $12.4 $13.4 $13.6 $14.2 $14.8 $15.6 $16.5 $137.1
Total Conventional Revenue $596.1 $593.0 -$55.5 -$88.7 -$82.5 -$78.9 -$78.6 -$87.6 -$94.8 -$99.8 $522.6
Total Dynamic Revenue $595.9 $594.0 $20.4 $0.6 $16.4 $28.1 $38.0 $38.9 $39.5 $46.0 $1,417.8

Source: Tax Foundation General Equilibrium Model, June 2023.

*Note: “Eliminate most individual tax expenditures” includes the repeal of the state and local tax deduction (SALT), the charitable contribution deduction, the mortgage interest deduction, the exclusion for capital gains on principal residences, and the exemption for municipal bond interest. Also includes smaller items like the deduction or interest on student loans, credits for post-secondary education tuition, renewable energy tax credits, the exclusion for credit union income and the exclusion of capital gains tax for small corporate stock.

The expanded standard deduction reduces revenue by $4.0 trillion and over 10 years, providing large tax cuts for individuals. The repeal of the Net Investment Income Tax (NIIT) and the Alternative Minimum Tax (AMT) also reduce revenue by about $1.1 trillion.

Tax collections from C corporations and pass-through firms would fall by about $1.4 trillion over 10 years, a result that includes an offsetting effect of higher capital gains revenue due to higher retained earnings increasing the value of firms.

Eliminating most individual tax expenditures, taxing employer-sponsored health insurance and fringe benefits, and moving to a 20 percent flat tax on ordinary income raise a combined $8.6 trillion in the budget window, largely offsetting the reductions in revenue.

The plan would increase the debt-to-GDP ratio by 2064 from 231.8 percent to 236.4 percent on a conventional basis, costing about $4 trillion over the next 40 years after interest costs.

On a dynamic basis, a larger economy and the resulting net revenue increase would reduce the debt-to-GDP ratio from 231.8 percent to 222.6 percent in 2064, a difference of 9.2 percentage points.

Distributional Effects

Over the long run, the reform would raise average after-tax incomes by about 1.1 percent conventionally. The bottom quintile would see a 2.0 percent increase in after-tax income and the second quintile would see a 2.1 percent increase, partly due to the expanded standard deduction and permanent Child Tax Credit.

Taxpayers in middle and upper-middle quintiles would see a decrease in after-tax incomes, driven by the base broadeners within the reform. The top 1 percent of earners would see a 17.0 percent increase in after-tax income.

On a long-run dynamic basis, the larger economy increases after-tax incomes relative to the conventional analysis, resulting in a 3.5 percent increase in after-tax incomes on average. The bottom quintile sees a 4.3 percent increase in after-tax income, while the second quintile sees a 4.7 percent increase. The middle quintile experiences an income gain of 0.8 percent and the decline in incomes for the fourth quintile is smaller compared to the conventional estimates.

Though after-tax incomes increase on average, in any revenue-neutral reform, tax reductions for one group of taxpayers necessitate tax increases for another group of taxpayers. Altering various aspects could achieve different distributional results.

Table 7. Distributional Effects of the Proposed Tax Reform (Percent Change in After-Tax Income)
Income Group Conventional, Long-Run Dynamic, Long-Run
0% to 20% 2.0% 4.3%
20% to 40% 2.1% 4.7%
40% to 60% -1.9% 0.8%
60% to 80% -4.1% -1.7%
80% to 90% -3.3% -1.1%
90% to 95% -2.6% -0.4%
95% to 99% 3.0% 5.1%
99% to 100% 17.0% 19.3%
Total 1.1% 3.5%
Source: Tax Foundation General Equilibrium Model, June 2023.

Modeling Notes

To estimate tax revenue effects associated with the 20 percent distributed profits tax, we used data on corporate and pass-through business profits from the National Income and Product Accounts (NIPA) to estimate 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. .[52] A key assumption concerns the share of profits that businesses will retain in response to the new entity-level tax. We assume that under current law, companies retain 50 percent of their profits, based on historical averages from NIPA. Empirical estimates of the effect of the distributed profits tax in Estonia, which replaced a corporate income tax similar to ours, indicate retained earnings increased by about 11 percentage points as a result of the reform, with a larger effect for small firms.[53] We assume that the share of profits U.S. firms retain will rise by 10 percentage points under the reform, from 50 percent to 60 percent, which accordingly reduces tax revenue from the distributed profits tax.

However, as firms retain a larger share of earnings, firm value increases, which consequently increases capital gains and tax revenue from capital gains. The effective capital gains tax rate is substantially lower than 20 percent since it is adjusted for deferral and the share of assets held by foreigners and in tax-exempt accounts. Eliminating step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair market. This eliminates the capital gain that occurred between the original purchase of the asset and the heir’s acquisition, reducing the heir’s tax liability. reduces the effect of deferral.

To model the tax revenue and distributional effects associated with eliminating the exclusion for employer-sponsored health insurance (HI), we used the tax expenditure estimates provided by the Treasury Department, the HI benefit amounts provided by the Bureau of Economic Analysis, and the distributional analysis provided by the Congressional Budget Office.[54] We then estimated the HI benefit as a share of wages and added it as an additional source of income in our modeling of individual income items and the taxes that apply to them throughout the budget window, also including it in our economic and distributional analysis. We assume that under the reform, firms shift compensation away from HI and other fringe benefits towards cash compensation, such that in the 10th year all compensation is in cash.

For other fringe benefits besides HI, which are relatively small, our estimates reflect only the income tax exclusion under current law.

We model the economic effects of the business provisions by changing the calculation of the service price of capital for the business sector. Under the Estonian tax system, business profits are only taxed when distributed. Shareholders do not face any additional tax on dividends. Capital gains from the disposition of shares are taxed as ordinary income. Interest payments are ignored (no deduction or tax) but interest income is taxed as ordinary income in the hand of the bondholder.

The service price of capital is the weighted average of two forms of finance: debt and equity. Equity is then split again into 60 percent retained earnings and 40 percent distributed earnings.

The calculation of the service price starts with the firm’s real discount rate. The firm’s discount rate is equal to the expected after-tax rate of return, r, grossed up for any taxes the firm or shareholders face. For distributed profits: r/(1-t_w), where t_w is the tax on distributed profits. For retained earnings: r/(1-t_cg), where t_cg is the effective capital gains tax rate, adjusted for deferral and the share of assets held by foreigners and in tax-exempt accounts. For debt: r/(1-t_i) where t_i is the effective tax rate on interest income, adjusted for assets held by foreigners. The simulated service price is then calculated in the same way as our current model, only with an updated discount rate, as well as an updated net present value of depreciation allowance due to zero income tax.

All firms in the reform are treated the same. As such, the service price is the same for both corporate and noncorporate businesses.

We have not attempted to model the reform’s impacts on firm behavior regarding the shifting of the location of profits or economic activity across borders. It is likely that many multinational companies would find the reform attractive, resulting in substantial onshoring or reshoring of foreign operations and profits over time. However, due to a lack of empirical studies of this effect under a distributed profits tax, we have not included it in the results.

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The authors would like to thank Kyle Pomerleau, Stephen J. Entin, and Gary Robbins for their contributions.

[1] Scott Hodge, “The Compliance Costs of IRS Regulations,” Tax Foundation, Aug. 23, 2022, https://taxfoundation.org/tax-compliance-costs-irs-regulations/.

[2] Internal Revenue Service National Taxpayer Advocate, “2022 Annual Report to Congress,” Jan. 11, 2023, https://www.taxpayeradvocate.irs.gov/news/national-taxpayer-advocate-delivers-2022-annual-report-to-congress/; see also Erica York and Alex Muresianu, “Reviewing Different Methods of Calculating Tax Compliance Costs,” Aug. 21, 2018, https://taxfoundation.org/different-methods-calculating-tax-compliance-costs/.

[3] Kyle Pomerleau, “The Best Part of the Estonian Tax Code Is Not 5 Minute Tax Filing,” Tax Foundation, Jul. 21, 2015, https://taxfoundation.org/best-part-estonian-tax-code-not-5-minute-tax-filing/.

[4] Daniel Bunn and Lisa Hogreve, “International Tax Competitiveness Index, 2022,” Tax Foundation, Oct. 17, 2022, https://taxfoundation.org/2022-international-tax-competitiveness-index/.

[5] Over the last 10 years, Estonia’s central government tax collections from income and profit amount to about 7.4 percent of GDP, compared to 7.3 percent for the median OECD country and 8.4 percent averaged across OECD countries. See OECD Tax Revenue Statistics, https://stats.oecd.org/Index.aspx.

[6] Estonia’s simple approach to taxing business and individual income has also been implemented in Latvia and Georgia. Daniel Bunn, “Better than the Rest,” Tax Foundation, October 9, 2019, https://taxfoundation.org/estonia-tax-system-latvia-tax-system/; Gia Jandieri, “Tax Reform in Georgia 2004-2012,” Tax Foundation, July 17, 2019, https://taxfoundation.org/tax-reforms-in-georgia-2004-2012/.

[7] Erica York, William McBride, Garrett Watson, Alex Muresianu, Alex Durante, and Daniel Bunn, “10 Tax Reforms for Growth and Opportunity,” Tax Foundation, Feb. 22, 2022, https://taxfoundation.org/economic-growth-opportunity-tax-reforms/.

[8] It is not the only way to vastly improve the tax code, but historical experience as well as our modeling results show this option lives up to the promise and potential of fundamental and pro-growth tax reform. In subsequent analysis, we will explore other options to improve the tax code by enhancing incentives to save and by moving towards a consumption, or consumed income, tax base.

[9] These results are relative to a baseline defined by U.S. law prior to the enactment of the Inflation Reduction Act, which went into effect this year and includes a new book minimum tax, stock buyback tax, and green energy incentives. Rolling back the Inflation Reduction Act policies would have additional effects on the economy, the budget, and the distribution of the tax burden, as indicated by our earlier analysis of the bill. See Alex Durante, Cody Kallen, Huaqun Li, William McBride, and Garrett Watson, “Details & Analysis of the Inflation Reduction Act Tax Provisions,” Tax Foundation, August 12, 2022, https://taxfoundation.org/inflation-reduction-act/.

[10] See, for instance, the debates in the 1980s around the idea of a flat tax: Robert Hall and Alvin Rabushka, “The Route to a Progressive Flat Tax,” Cato Journal 5 (Fall 1985), https://www.cato.org/sites/cato.org/files/serials/files/cato-journal/1985/11/cj5n2-6.pdf; see also “Comprehensive Tax Reform for 2015 and Beyond,” Committee on Finance, United States Senate, December 2014, https://www.finance.senate.gov/download/comprehensive-tax-reform-for-2015; our principles of sound tax policy: https://taxfoundation.org/principles/.

[11] The Joint Committee on Taxation, “Estimates of Federal Tax Expenditures for Fiscal Years 2022-2026,” Dec. 22, 2022, https://www.jct.gov/publications/2022/jcx-22-22/; Treasury Department, “Tax Expenditures,” https://home.treasury.gov/policy-issues/tax-policy/tax-expenditures.

[12] The Joint Committee on Taxation, “Estimates of Federal Tax Expenditures for Fiscal Years 2022-2026,” Dec. 22, 2022, https://www.jct.gov/publications/2022/jcx-22-22/.

[13] Congressional Budget Office, “Distribution of Major Expenditures in 2019,” October 2021, https://www.cbo.gov/system/files/2021-10/57413-TaxExpenditures.pdf.

[14] Alex Muresianu, “JCT Tax Expenditure Report: Not All Expenditures Are Created Equal,” Tax Foundation, Feb. 13, 2023, https://taxfoundation.org/largest-tax-expenditures-saving-investment-tax/; Erica York and William McBride, “Lawmakers Could Pay for Reconciliation While Improving the Tax Code,” Tax Foundation, Oct. 25, 2021, https://taxfoundation.org/pay-for-reconciliation-tax/.

[15] Erica York and Alex Muresianu, “Reviewing Different Methods of Calculating Tax Compliance Costs,” Tax Foundation, Aug. 21, 2018, https://taxfoundation.org/different-methods-calculating-tax-compliance-costs/.

[16] Cody Kallen, William McBride, and Garrett Watson, “Minimum Book Tax: Flawed Revenue Source, Penalizes Pro-Growth Cost RecoveryCost 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. ,” Tax Foundation, Aug. 5, 2022, https://taxfoundation.org/inflation-reduction-act-accelerated-depreciation/; see also Daniel Bunn, “How Does the Inflation Reduction Act Minimum Tax Compare to the Global Minimum Tax,” Tax Foundation, Aug. 2, 2022, https://taxfoundation.org/inflation-reduction-act-minimum-tax/; and Alex Muresianu, “Breaking Down the Inflation Reduction Act’s Green Energy Tax Credits,” Tax Foundation, Sep. 14, 2022, https://taxfoundation.org/inflation-reduction-act-green-energy-tax-credits/.

[17] Scott Greenberg, “The Carried Interest Debate is Mostly Overblown,” Tax Foundation, Sep. 8, 2015, https://taxfoundation.org/carried-interest-debate-mostly-overblown/.

[18] We will consider more comprehensive reforms to the CTC and EITC in a subsequent analysis. While the credits provide substantial tax decreases and subsidies for low- and middle-income households, they are excessively complex and poorly targeted, resulting in high payment error rates while penalizing marriage and work for taxpayers in the phaseout range. See “10 Tax Reforms for Growth and Opportunity,” Tax Foundation, Feb. 22, 2022, https://taxfoundation.org/economic-growth-opportunity-tax-reforms/ Treasury Inspector General for Tax Administration, “Authorities Provided by the Internal Revenue Code Are Not Effectively Used to Address Erroneous Refundable Credit and WithholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. Credit Claims”; Internal Revenue Service, “IRS Update on Audits,” May 31, 2022, https://www.irs.gov/newsroom/irs-update-on-audits; Margot L. Crandall-Hollick, “The Earned Income Tax Credit (EITC): Administrative and Compliance Challenges,” Congressional Research Service, Apr. 23, 2018, https://crsreports.congress.gov/product/pdf/R/R43873; Matt Bruenig, “The Myths of the Earned Income Tax Credit,” People’s Policy Project, May 18, 2020, https://www.peoplespolicyproject.org/project/the-myths-of-the-earned-income-tax-credit/; Henrik Kleven, “The EITC and the Extensive Margin: A Reappraisal,” https://www.henrikkleven.com/uploads/3/7/3/1/37310663/kleven_eitc_sep2019.pdf; Chris Edwards, “Cut the Earned Income Tax Credit,” Cato Institute, Nov. 29, 2022, https://www.cato.org/blog/cut-earned-income-tax-credit.

[19] We will consider reforms to the tax code’s saving incentives in a subsequent analysis, including the addition of Universal Savings Accounts and the consolidation of some of the current-law, tax-preferred saving options. Christina King, “Saving for Social Capital,” Joint Economic Committee Republicans, May 26, 2020, https://www.jec.senate.gov/public/index.cfm/republicans/2020/5/saving-for-social-capital; Robert Bellafiore, “The Case for Universal Savings Accounts,” Tax Foundation, Feb. 26, 2019, https://taxfoundation.org/case-for-universal-savings-accounts/.

[20] Alex Durante, “2023 Tax Brackets,” Tax Foundation, Oct. 18, 2022, https://taxfoundation.org/2023-tax-brackets/.

[21] As in Estonia, most individual income could be withheld at the source, so individuals could be sent tax forms mostly filled out. Some taxpayers (e.g., some parents, low-income individuals, and retirement savers), would need to fill out additional forms to get a refund. For compliance costs estimates, see Erica York and Alex Muresianu, “Reviewing Different Methods of Calculating Tax Compliance Costs,” Aug. 21, 2018, https://taxfoundation.org/different-methods-calculating-tax-compliance-costs/; Scott Hodge, “The Compliance Costs of IRS Regulations,” Tax Foundation, Aug. 23, 2022, https://taxfoundation.org/tax-compliance-costs-irs-regulations/; Kyle Pomerleau, “The Best Part of the Estonian Tax Code is Not 5 Minute Tax Filing,” Tax Foundation, Jul. 21, 2015, https://taxfoundation.org/best-part-estonian-tax-code-not-5-minute-tax-filing/; See also, Alex Muresianu, “Return-Free Filing: A Better Fit for a Better Tax Code,” Tax Foundation, August 5, 2021, https://taxfoundation.org/return-free-filing/.

[22] The economic harm of income taxes increases with the square of the tax rate, meaning high income tax rates come with a disproportionately large additional excess burden. This burden is over and above the tax revenue collected, as measured, for instance, by reduced economic growth, less investment, fewer jobs, and lower wages. Robert Carroll, “The Excess Burden of Taxes and the Economic Cost of High Tax Rates,” Tax Foundation, August 2009, https://files.taxfoundation.org/legacy/docs/sr170.pdf; Martin Feldstein, “Tax Avoidance and the Deadweight Loss of the Income Tax,” The Review of Economics and Statistics 81:4 (November 1999): 674-680, https://www.jstor.org/stable/2646716; William McBride, “What Is the Evidence on Taxes and Growth,” Tax Foundation, Dec. 18, 2012, https://www.taxfoundation.org/what-evidence-taxes-and-growth/; Alex Durante, “Reviewing Recent Evidence of the Effect of Taxes on Economic Growth,” Tax Foundation, May 21, 2021, https://taxfoundation.org/reviewing-recent-evidence-effect-taxes-economic-growth/; Timothy Vermeer, “The Impact of Individual Income Tax Changes on Economic Growth,” Tax Foundation, June 14, 2022, https://taxfoundation.org/income-taxes-affect-economy/.

[23] Congressional Budget Office, “The Economics of Financing a Large and Permanent Increase in Government Spending: Working Paper 2021-03,” Mar. 22, 2021, https://www.cbo.gov/publication/57021; see also Garrett Watson, “Congressional Budget Office and Tax Foundation Modeling Show That Some Tax Hikes Are More Damaging Than Others,” Tax Foundation, Mar. 26, 2021, https://www.taxfoundation.org/tax-hikes-are-more-damaging-than-others-analysis/.

[24] The proposal also applies the distributed profits tax to credit unions, which under current law are exempt from entity-level business income tax.

[25] The policy is meant to generally mirror Estonia’s, where essentially all fringe benefits are subject to the distributed profits tax and payroll taxes. See Republic of Estonia, Estonian Tax and Customs Board, https://www.emta.ee/en/business-client/taxes-and-payment/income-and-social-taxes/fringe-benefits.

[26] Michael Cannon, “Tackling America’s Fundamental Health Care Problem,” Cato Institute, July/August 2020, https://www.cato.org/policy-report/july/august-2022/tackling-americas-fundamental-health-care-problem; Congressional Budget Office, “Reduce Tax Subsidies for Employment-Based Health Insurance,” Dec. 7, 2022, https://www.cbo.gov/budget-options/58627.

[27] Daniel Bunn and Sean Bray, “The Latest on the Global Tax Agreement: The EU Adopts Pillar Two,” Tax Foundation, December 15, 2022, https://taxfoundation.org/global-tax-agreement/; Daniel Bunn, “What the OECD’s Pillar Two Impact Assessment Misses,” Tax Foundation, January 23, 2023, https://taxfoundation.org/global-minimum-tax-revenue-impact-assessment/.

[28] Paul Gordon Dickinson, “SMEs and the business reality of Estonia’s tax regulation environment”, International Journal of Law and Management 55:4 (2013): 273-294,

https://doi.org/10.1108/IJLMA-04-2012-0011; Scott Hodge, “The Compliance Costs of IRS Regulations,” Tax Foundation, Aug. 23, 2022, https://taxfoundation.org/tax-compliance-costs-irs-regulations/

[29] Scott Hodge, “The Compliance Costs of IRS Regulations,” Tax Foundation, Aug. 23, 2022, https://taxfoundation.org/tax-compliance-costs-irs-regulations/

[30] Jaan Maaso, Jaanika Meriküll, and Priit Vahter, “Gross Profit Taxation Versus Distributed Profit Taxation and Firm Performance: Effects of Estonia’s Corporate Income Tax Reform,” The University of Tartu Faculty of Economics and Business Administration Working Paper No. 81-2011, March 23, 2011, https://ssrn.com/abstract=1793143 or http://dx.doi.org/10.2139/ssrn.1793143.

[31] Eduardo Davila and Benjamin Hebert, “Optimal Corporate Taxation under Financial Frictions,” NBER Working Paper No. 25520, October 2021, https://www.nber.org/papers/w25520.

[32] Jaan Masso and Jaanika Merikull, “Macroeconomic Effects of Zero Corporate Income Tax on Retained Earnings,” Baltic Journal of Economics, 11:2 (2011): 81-99, https://www.tandfonline.com/doi/pdf/10.1080/1406099X.2011.10840502.

[33] Daniel Bunn and Lisa Hogreve, “International Tax Competitiveness Index, 2022,” Tax Foundation, Oct. 17, 2022, https://taxfoundation.org/2022-international-tax-competitiveness-index/.

[34] Jaan Maaso, Jaanika Meriküll, and Priit Vahter, “Gross Profit Taxation Versus Distributed Profit Taxation and Firm Performance: Effects of Estonia’s Corporate Income Tax Reform,” The University of Tartu Faculty of Economics and Business Administration Working Paper No. 81-2011, March 23, 2011, https://ssrn.com/abstract=1793143 or http://dx.doi.org/10.2139/ssrn.1793143; Aaro Hazak, “Companies’ Financial Decisions Under the Distributed Profit Taxation Regime of Estonia,” Emerging Markets Finance & Trade 45:4 (2009): 4-12, https://www.jstor.org/stable/27750676.

[35] In addition to the appeal of its simple and pro-growth tax system, several other factors contribute to Estonia’s success as a hub for entrepreneurship, including various initiatives relating to education, digitization, and immigration. See, for example, Adi Gaskell, “Growing Entrepreneurs and Entrepreneurship: Lessons from Estonia,” Forbes, Sept. 20, 2021, https://www.forbes.com/sites/adigaskell/2021/09/20/growing-entrepreneurs-and-entrepreneurship-lessons-from-estonia/?sh=6afa52ac273c.

[36] Invest Estonia, “Estonia Leads Europe in Startups, Unicorns and Investments per Capita,” December 2022, https://investinestonia.com/estonia-leads-europe-in-startups-unicorns-and-investments-per-capita/; Sten-Kristian Saluveer and Maarika Truu, “Startup Estonia, White Paper, 2021-2027,” July 2020, https://media.voog.com/0000/0037/5345/files/SE_Whitepaper_Web%20(1)-1.pdf; Atomico, “State of European Tech 2021,” https://2021.stateofeuropeantech.com/chapter/word-our-sponsors/; “Coming of Age: Central and Eastern European Startups,” Google for Startups, Atomico, Dealroom, October 2021, https://dealroom.co/uploaded/2021/10/Dealroom-Google-Atomico-CEE-report-2021.pdf?x64504

[37] Camillo Padulli, “In Estonia, an Enterprising Spirit Thrives,” E21, January 18, 2023, https://economics21.org/estonia-enterprising-spirit-global-tech.

[38] To be clear, a multitude of non-tax factors explain differences in economic growth across countries. The two OECD countries that grew even faster than Estonia since 2000 are the neighboring Baltic countries of Latvia (147 percent increase in GDP per capita) and Lithuania (183 percent), indicating a regional factor. However, Latvia and Lithuania also have relatively competitive tax systems, with Latvia scoring 2nd and Lithuania scoring 8th in our most recent ranking of OECD countries. See OECD Statistics, “Gross Domestic Product (GDP): GDP per head, US $, constant prices, reference year 2015,” https://stats.oecd.org/; Daniel Bunn and Lisa Hogreve, “International Tax Competitiveness Index, 2022,” Tax Foundation, Oct. 17, 2022, https://taxfoundation.org/2022-international-tax-competitiveness-index/.

[39] Scott Hodge, “Putting a Face on America’s Estate Tax Returns,” Tax Foundation, Nov. 7, 2022, https://taxfoundation.org/estate-tax-returns-data/.

[40] Kyle Pomerleau, “The Estate Tax is Double Taxation,” Tax Foundation, Nov. 2, 2016, https://taxfoundation.org/estate-tax-double-taxation/.

[41] Kyle Pomerleau, “New Paper on Estate Tax Misses the Mark,” Tax Foundation, Jan. 15, 2013, https://taxfoundation.org/new-paper-estate-tax-misses-mark/; Scott Hodge, “The Compliance Costs of IRS Regulations,” Tax Foundation, Aug. 23, 2022, https://taxfoundation.org/tax-compliance-costs-irs-regulations/.

[42] Estonian Tax and Customs Board, “Inventory of an Estate,” last updated Sep. 9, 2022, https://www.emta.ee/en/private-client/taxes-and-payment/other-taxes/estate#inventory-of-an-estate; Estonian Tax and Customs Board, “Acquisition of Immovable Property by Inheritance or Gift,” last updated Aug. 24, 2022, https://www.emta.ee/en/private-client/taxes-and-payment/taxable-income/transfer-immovable-property/acquisition-immovable-property-inheritance-or-gift.

[43] TaxEDU, “Step-Up in Basis,” Tax Foundation, https://taxfoundation.org/tax-basics/step-up-in-basis/.

[44] For example, the estate of Michael Jackson was in legal limbo for 12 years after his death, with the final valuation at less than a quarter of the original estimated by the IRS. Anousha Sakoui, “Michael Jackson’s Estate Wins Court Battle with the IRS,” Los Angeles Times, May 3, 2021, https://www.latimes.com/entertainment-arts/business/story/2021-05-03/michael-jackson-estate-taxes-irs-lawsuit.

[45] Erica York, “An Overview of Capital Gains Taxes,” Tax Foundation, April 16, 2019, https://taxfoundation.org/capital-gains-taxes/.

[46] Robert Carroll, “The Excess Burden of Taxes and the Economic Cost of High Tax Rates,” Tax Foundation, August 2009, https://files.taxfoundation.org/legacy/docs/sr170.pdf.

[47] TaxEDU, “Step-Up in Basis,” Tax Foundation, https://taxfoundation.org/tax-basics/step-up-in-basis/; Garrett Watson, “History of Attempted Changes to Step-Up in Basis Shows Perilous Road Ahead,” Tax Foundation, September 28, 2021, https://taxfoundation.org/biden-estate-tax-unrealized-capital-gains-at-death/.

[48] The results do not reflect the effects of reduced compliance costs.

[49] Preliminary Details and Analysis of the Tax Cuts and Jobs Act,” Tax Foundation, Dec. 18, 2017, https://taxfoundation.org/final-tax-cuts-and-jobs-act-details-analysis/; see also Congressional Budget Office, “How the 2017 Tax Act Affects CBO’s Projections,” Apr. 20, 2018, https://www.cbo.gov/publication/53787.

[50] As stated earlier, the baseline reflects U.S. law prior to the Inflation Reduction Act.

[51] Alex Durante, Cody Kallen, Huaqun Li, William McBride, and Garrett Watson, “Details & Analysis of the Inflation Reduction Act Tax Provisions,” Tax Foundation, August 12, 2022, https://taxfoundation.org/inflation-reduction-act/.

[52] Bureau of Economic Analysis, Table 1.10 Gross Domestic Income by Type of Income, https://www.bea.gov/itable/national-gdp-and-personal-income.

[53] Jaan Maaso, Jaanika Meriküll, and Priit Vahter, “Gross Profit Taxation Versus Distributed Profit Taxation and Firm Performance: Effects of Estonia’s Corporate Income Tax Reform,” The University of Tartu Faculty of Economics and Business Administration Working Paper No. 81-2011, March 23, 2011, https://ssrn.com/abstract=1793143 or http://dx.doi.org/10.2139/ssrn.1793143; Aaro Hazak, “Companies’ Financial Decisions Under the Distributed Profit Taxation Regime of Estonia,” Emerging Markets Finance & Trade 45:4 (2009): 4-12, https://www.jstor.org/stable/27750676; Panu Pikkanen and Kaisa Vaino, “Long-Term Effects of Distributed Profit Taxation on Firms: Evidence from Estonia,” Master’s Thesis, Lund University, 2018, https://www.semanticscholar.org/paper/Long-Term-Effects-of-Distributed-Profit-Taxation-on-Pikkanen-Vaino/afd67fdc898219f789d7aa6f5a64879e6c8dda90.

[54] U.S. Treasury Department, “Tax Expenditures”; Bureau of Economic Analysis, Table 6.11D. Employer Contributions for Employee Pension and Insurance Funds by Industry and Type; Congressional Budget Office, “The Distribution of Major Tax Expenditures in 2019.”

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  1. This analysis was updated to account for the latest modeling updates and federal tax policy developments.
  2. Original analysis was published.
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