Fiscal Fact No. 40
The newly released report of the President’s Panel on 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. Reform represents a big step toward simplifying the current system and moving away from taxing income to a consumption-based system. However, these plans do fall far short of the complete overhaul of the tax system that most reform advocates had hoped for. Moreover, because the panel was required to produce a “revenue neutral” plan and constrained itself to be distributionally neutral, both plans may not contain enough sweeteners to overcome the intense political opposition nor enough to build a groundswell of grassroots support across the country.
The panel is recommending two proposals to the Secretary of Treasury who will make the final recommendation to the President.
Plan A works within the current income tax system to:
• Simplify the current tax code from six tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s to four (15%, 25%, 30% and 33%);
• Replace the current low-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. s with a family credit and a work credit;
• Fold the individual Alternative Minimum Tax into the current system by repealing the AMT, while repealing the deduction for state and local taxes;
• Replacing the home mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction. with a limited credit;
• Limit the tax exclusion for employer-provided health insurance to $11,500 for families and $5000 for singles;
• Consolidate the various savings vehicles into three simple savings plans while eliminating the tax on dividends paid by corporations from domestic profits and providing a 75 percent exclusion for capital gains; and
• Cut the top 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. rates to 31.5 percent from 35 percent, move to a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , and repeal the corporate AMT.
The more ambitious Plan B would keep most of the Plan A provisions and:
• Move toward a progressive “hybrid” income-consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. with three individual rates (15%, 25% and 30%);
• Tax all capital income (dividends, capital gains, and interest) at a uniform 15 percent;
• Replace the corporate income tax system with a “cash-flow” tax at a rate of 30 percent;
• Allowing full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It 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. of capital investments; and
• Eliminate the deduction for interest payments for businesses.
While simplifying the tax system is a worthy objective, the ultimate goal of fundamental tax reform is to improve the economy’s performance by ridding the tax system of policies and provisions that distort economic behavior and impair economic growth. Moreover, eliminating these preferences in the code—and, thus, 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. —should allow lawmakers to lower tax rates for all taxpayers.
Measured on this basis, both plans contain some good reforms but fall short in other important areas.
Recommendations Deserving Special Merit:
Simplify the number of tax brackets and reduce the top tax rates
Both plans reduce the number of tax brackets and the top tax rate. Plan A reduces the number of brackets from six to four and lowers the top rate from 35 percent to 33 percent. Plan B reduces the number of brackets to three and lowers the top rate 30 percent. The ideal tax system is a single-rate system that treats all taxpayers equally. Moreover, most taxpayers expect tax reform to deliver them dramatically lower tax rates in exchange for giving up their favorite credits and deductions. For example, in exchange for fewer deductions, the Tax Reform Act of 1986 reduced the number of tax brackets from fifteen to two with a top rate of 28 percent.
The Panel’s proposed progressive rate structure is no doubt a concession to political and distributional reality. Today, some 43 million tax filers (one-third of all filers) have no tax liability after taking their credits and deductions. Millions more pay almost nothing in income taxes. As a result, the top 20 percent of taxpayers pay 84 percent of the income taxes. The Panel was clearly caught in a dilemma: expand the tax base and, thus, raise taxes on millions who now pay nothing; or, cut top tax rates and, thus, “cut taxes for the rich” who now pay most of the taxes. The only way to build broad enthusiasm for fundamental tax reform is to offer people the promise of dramatically lower tax rates in exchange for the loss of various deductions.
Reduce the top corporate income tax rate
The U.S. has the highest overall corporate income tax rate among OECD nations (39.3 percent combined federal-state rate). Plan A would reduce the top federal corporate income rate to 31.5 percent and Plan B would lower the rate 30 percent. Both of these plans would improve the U.S. world-wide ranking but short of the rate reduction that is needed. Indeed, for manufacturers it would amount to a small change since the American Jobs Creation Act of 2004 effectively lowered the rate on manufacturers to 32 percent after 2009. Lawmakers should consider reducing the federal rate to 25 percent which, when coupled with state corporate income taxes, would almost bring the U.S. rate down to the OECD average of 29 percent. Moreover, a 25 percent rate in conjunction with a switch to a territorial tax system would greatly enhance U.S. competitiveness.
Repeal of the Individual alternative minimum tax
The individual alternative minimum tax (AMT)The Alternative Minimum Tax (AMT) is a separate tax system that requires some taxpayers to calculate their tax liability twice—first, under ordinary income tax rules, then under the AMT—and pay whichever amount is highest. The AMT has fewer preferences and different exemptions and rates than the ordinary system. would be abolished under either of the panel’s two reform plans. The AMT, designed to prevent people from greatly reducing their 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. with tax preferences, is routinely pilloried in the press as the worst feature of our current tax system. That’s because it forces taxpayers with high deductions, especially in states with high state-local taxes, to recalculate their tax returns without those deductions.
The number of people snagged by the AMT has grown recently and, absent reform, is expected to explode over the next several years. However, the high-cost, blue-state taxpayers who file most of the AMT returns may not be as thrilled with its repeal as one might expect. That’s because some of the same deductions that pushed them into the AMT will be curtailed or eliminated as part of reform. The deduction for state-local taxes would be repealed entirely, and when all the changes are counted, many of the same people who benefit from AMT repeal will bear the brunt of these curtailed deductions. As an economic matter, then, AMT repeal may not be as significant as usually portrayed, but as an administrative matter, it is a great simplification.
Both plans would consolidate the myriad current savings incentives (traditional IRA, Roth IRA, 401(k), 403(b), Coverdell Education Accounts, etc.) into three new accounts—SaveAtWork, SaveForFamily, and SaveForRetirement. The Panel’s proposal shares many similiarities with the President’s initiative for Lifetime Savings Accounts. The SaveAtWork accounts will replace employer sponsored 401(k) plans, the the SaveForFamily accounts will replace traditional and Roth IRAs. SaveForFamily accounts will be capped at $10,000 annually—more than twice the current cap of $4,000 for Roth IRAs. Raising the caps is particularly important for capital formation and for lowering the effective tax rate on capital income, as lower caps favor current over future consumption. In this respect, the Panel’s recommendations can be considered pro-growth and efficiency-enhancing. The reduction of complexity in the savings system will also be pro-growth since it frees up resources that would otherwise be spent complying with the tax code.
Eliminate the deduction for state and local taxes
Both plans would eliminate the current tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. for state and local taxes which removes more than $320 billion from the federal tax base. The estimated value of these deductions in 2006 are $49.4 billion. This proposal will expand the tax base and reduce the tax code’s complexity. The common critique of these deductions is that they partially subsidize state and local spending; therefore states and localities do not fully realize their true costs. Without the deduction, this distortion is removed. Lastly, some argue that the deduction eliminates 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 income; however, allowing the deduction gives a greater benefit to those who live in high tax states and localities. It is more economically neutral to eliminate the deduction than to allow some groups to benefit more than others.
Full expensing for all businesses
Plan B proposes full expensing for all businesses. This is probably the most important change that the tax reform panel has offered. Since the enactment of the corporate income tax, the problem of how to treat depreciating assets has bedeviled the writers of tax law. Ideally, each year, the income that an asset generates should be matched up with the amount that the business has spent on that asset, including the amount that the asset has worn out or “depreciated.” But to do this, we would need to know at the time of purchase how long every business asset is going to last. Naturally, no one really knows, and of course an asset will last longer in the hands of an owner who takes good care of it. To make the guessing game even more impossible, some new invention might suddenly make other assets worthless, no matter how recently they’ve been purchased.
Nevertheless, the IRS is required to calculate a “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. schedule” for everything under the sun; and these schedules are inevitably wrong. Currently, for example, automobiles are all depreciated over a 5-year period, and rental real estate over 27.5 years. As a result of this impossible system, our income tax under-taxes some assets and overtaxes others. The tax reform panel has suggested jettisoning the entire concept of depreciation schedules and permitting businesses to deduct the full cost of all capital expenses in the year of purchase. This is known as expensing. It is simpler and easier to administer, and will greatly enhance capital investment and the long-term health of the economy.
Repealing the corporate alternative minimum tax
Both plans would repeal the corporate alternative minimum tax (AMT). The corporate AMT is a backstop to the corporate income tax, requiring corporate taxpayers who take too many deductions to recalculate their tax liability under the AMT. The AMT has a broader base and a lower rate (20 percent) than the regular system. It adds a layer of complexity as taxpayers have to calculate their liability under both systems and pay the higher tax. It is questionable whether the revenues collected by the corporate AMT exceed the cost of its complexity. Furthermore, the AMT can unfairly cause higher tax payments during economic downturns, when businesses are losing money and piling up deductions like net operating losses (NOLs) that it needs to deduct from income. If Congress simplifies the overall corporate income tax system, the AMT will no longer be needed as a backstop.
Moving to a territorial system for international taxation
Plan A proposes a territorial international tax system that would tax domestic but not foreign income. The U.S. currently has a worldwide international tax system, which taxes all income of U.S. corporations whether earned in the U.S. or abroad, while giving a foreign tax credit (up to the amount of U.S. tax due) for taxes paid to other nations. The worldwide system puts U.S. exporters at a disadvantage vis-à-vis their foreign competitors, and also embroils the U.S. in controversies in the World Trade Organization (WTO) over U.S. attempts to mitigate the anti-competitive impact of its worldwide system. The worldwide system is also extremely complicated, with various rules governing the repatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. of dividends from foreign subsidiaries. Indeed, many economists agree that the system actually discourages U.S. companies from bringing foreign profits home. Most of our major trading partners use this system. Moving to a territorial system would remove these disadvantages for U.S.-based companies.
Many in the business community have expressed concern that the move to a territorial tax system would actually lead to an increase in taxes, not a decrease. This is because most territorial proposals would apply to “active” income and not “passive” income such as royalties and licensing fees. Indeed, the Panel recommended that such passive income be included in U.S. income if it was deducted from the foreign income of a foreign subsidiary. Moreover, there is concern over how the income of service companies would be treated from that of manufacturing or sales.
Eliminating the deduction for business interest expenses
Currently, businesses can deduct the cost of borrowing which gives a tax preference to debt-financed investment rather than equity-financed investment. The Congressional Budget Office estimates that under current law, effective tax rates for debt financed investment are -6.4 percent, while equity financed investment faces an effective tax rate of 36.1 percent. Eliminating this deduction would make tax policy more neutral and businesses would be more responsive to the nature of the investment, not the tax benefits.
Recommendations in Need of Reevaluation:
Exclusion for employer-provided health insurance
Both plans would cap the tax exclusion for employer-provided health insurance at $11,500 for families and $5,000 for individuals. A vestige of World War II price controls, the exclusion for employer-provided health care is the largest preference in the tax code with an estimated 2006 value of roughly $126 billion. This exclusion has greatly distorted the health care market by creating a third-party payer system that makes employers and insurance companies—not employees or patients—the true “customers” of health care. Patients do not act as true consumers because they pay only a fraction of the cost and actually have the incentive to over-consume health care. While most economists see the only solution to this government-created problem is to eliminate the exclusion, capping the exclusion may be a short-term step in the right direction. However, the Panel’s recommended cap levels are so high, and indexed to 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. , that most health plans are likely to be unaffected in either the near term or long term. Thus, the proposal may have little effect on controlling third-party health expenses.
Home mortgage incentive
Both plans would replace the interest deduction with a 15 percent credit limited to Federal Housing Administration allowances, which would vary by home location. The panel’s recommendation to limit the home mortgage interest deduction is a step in the right direction, but does not go far enough to limit the distortions it causes. Current law allows those tax filers that itemize on their federal tax return to deduct their home mortgage interest payments, up to home mortgages of $1 million.
Under this new proposal, we would still have a system where government is heavily subsidizing the housing sector. The new “home mortgage incentive” would continue to distort investment decisions toward housing and away from other productive uses like factories and equipment. Also, while one goal of tax reform is to make the tax code less complex, the reform proposal fails on this issue with regards to the home mortgage incentives because taxpayers would now be forced to look up their county and find the appropriate FHA allowance in addition to having to perform more calculations. Overall, the change in policy is a marginal improvement for economic efficiency, but a setback for tax simplicity.
Plan A would provide a zero tax on dividends paid by corporations from “domestic income” and a 75 percent exclusion for capital gains. Plan B would tax capital income at a rate of 15 percent. The level of economic welfare a society enjoys is a function of the amount of capital and labor supplied to businesses in it. Critics have charged that because it taxes the rewards to saving—interest income—the existing federal 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. system discourages saving. This, they argue, shrinks the pool of funds available for investment in plant and equipment, lessening productivity and wage growth.
A pure consumption tax would eliminate this problem by only taxing income which is consumed, not that which is saved. Plan A moves the tax system closer to this ideal by not taxing dividends paid by corporations from domestic income. It would also lower effective 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. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. rates but create a disparity between the tax rates on capital gains and dividends. This would create an incentive for taxpayers to value capital gains over dividends. Meanwhile, Plan B would tax all capital income at a uniform rate of 15 percent. While both of these plans generally represent an improvement in the taxation of capital income relative to the current system, further improvement could be achieved by further reducing, or eliminating, the taxation of this type of income.
The fallacy of transition costs
When tax reform picks up steam, taxpayers with transition problems focus more on their short-term problems than on tax reform’s long-term promise of a more prosperous economy. That can mean getting bogged down in endess details and political squabbling because, as the saying goes, “The devil’s in the details.” If sufficient plans for transition are not part of the reform legislation, those details will translate into retroactively higher taxes for some taxpayers.
However, it is not impossible to design fair transition rules, and the earlier that tax reformers make their transition plans public, the more likely they are to be believed. In the absence of an explicit transition regime, taxpayers who can see a retroactive tax increase coming will not appreciate the vaguer promise of tax reform’s benefits such as tax relief or higher wages from faster economic growth. These dubious taxpayers would include such politically powerful groups as mortgage-paying homeowners and manufacturers with remaining depreciable assets. Comprehensive transition would prevent retroactive tax hikes in these cases, and it would also prevent retroactive tax cuts. If capital income is taxed less after reform, which is the case in most reform plans, then capital income from pre-reform savings would be taxed at the old rates.
These are legitimate worries but ones that can be legitimately addressed with good transition rules. Many complaints alleging insoluble transition problems are in fact just the voice of tax reform opponents who cannot argue the merits of tax reform and therefore choose to make it seem impractical by raising exaggerated or invented transition problems.