Income Tax Reform

Background

How to improve the tax code is the subject of much debate. Proponents of reform often call for increasing fairness and simplicity. But people define those concepts in different ways.

Policymakers focus on what types of income are taxed and at what rate. The broader the scope of the income taxed, the lower the tax rate needs to be to raise a given amount of money.

The tax system can be used to promote various social policy goals and provide subsidies based on certain circumstances. For example, policymakers need to decide whether to tax some people more than others based on factors such as marital status, presence of children, and homeownership. They must also look at who pays how much in taxes, including as a share of their total income.

Some options can inadvertently cause distortions in the decisions people make. For example, they may make choices primarily to minimize their tax burden. In addition, some tax provisions significantly increase the complexity of the system, making compliance more challenging.

The tax code is fraught with tensions and tradeoffs. Efforts to satisfy one principle of tax policy can violate another. The so-called marriage penalty offers a case in point. A married couple is generally treated as one tax unit. They must pay tax on their total combined taxable income. The marriage tax penalty exists when the couple’s tax liability is greater than the sum of what the two would pay were they not married and filed as individuals. It is impossible to eliminate the marriage tax penalties within the existing tax structure without violating other desirable features of the tax system, such as progressivityIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income..

Coordination among states is also an issue, particularly for people who work in one state but live in another. Uncoordinated tax systems can mean paying tax twice on the same income. In addition, state and localities may compete with one another in offering tax incentives for businesses. Such incentives are often ineffective at driving local job development while diminishing revenue.

INCOME TAX REFORM: Policy

INCOME TAX REFORM: Policy

Tax Reform

Tax reform should focus on raising sufficient revenue. It should make the tax system more equitable and efficient.

Reforms should

  • increase the system’s revenue-raising capacity, including broadening the tax base;
  • maintain ability to pay as the standard of tax equity;
  • result in a distribution of tax burdens that is no less progressiveIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income. than the current distribution under the individual and corporate income taxes;
  • avoid negative impacts on important social goals such as retirement savings and health insurance coverage;
  • reduce distortions in the tax code;
  • reduce the administrative record-keeping burden on American taxpayers;
  • be evidence-based with respect to economic development effects;
  • encourage American competitiveness and job creation; and
  • provide appropriate relief for people during the transition from one tax policy to another.

Marriage Penalities

Any further efforts to address marriage penaltiesA circumstance in which a married couple pays higher taxes when they file jointly than they would have if they could file as individuals. should be targeted to two-earner couples and structured to avoid increasing marriage bonuses.

Progressivity at the state level

States should increase the progressiveIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income. nature of their income tax systems. This can be done through such means as exempting from state tax rolls people with income below the povertyThe federal government defines “poverty” as income below specific thresholds. These thresholds are adjusted annually for inflation and vary according to family size and the age of the head of the family. line; adjusting personal exemptions, standard deductions, credits, tax rates, and brackets; and indexingTo make the value of something rise or fall according to changes in an indicator such as inflation. tax parameters for inflation.

Business taxes

Reforming business taxes, such as the corporate tax or a tax on the financial industry, should be considered in any effort to raise additional revenue.

Taxes paid to other states

States with income taxes should allow credits for taxes paid by their residents to other states so that no taxpayer is subject to double taxation.