Income Tax Reform

Background

For years the issue of fundamental tax reform has been on the minds of policymakers, experts, and the public. This has been spurred by:

  • the complexity of the existing income tax code,
  • inadequate revenue raised by the existing system and the resulting budget deficit,
  • projected increased demands on the federal fiscal system,
  • growing concern about the individual alternative minimum tax,
  • a belief that the US savings rate is low because of the tax code,
  • concern for the international competitiveness of the economy’s export sector, and
  • public dissatisfaction with the existing tax system.

Although most of the debate over the federal tax system has revolved around simplifying the income tax and making it more economically neutral, other types of taxes have been proposed as the basis for structural reforms.

Structural reform of the income tax—some proposals would reform the current income tax (both individual and corporate) by eliminating many tax expenditures to broaden the revenue base, while reducing marginal rates or equalizing the treatment of different types of income. This was the approach taken in the 1986 tax reform legislation. Fundamental tax reform proposals that emerged from the National Commission on Fiscal Responsibility and Reform and other policy groups in 2010 also largely adopt this approach.

Corporate income taxes—in recent years a number of notable proposals focused on corporate tax reform. Corporate taxation is a very complex subject with a large number of narrow provisions, yet several key motivating factors underpinned many proposals: making US businesses more competitive in the global marketplace, eliminating incentives to move jobs overseas, and making sure corporations pay their fair share in taxes. The key elements of the proposals included reducing the top marginal corporate tax rate, modifying the treatment of foreign-source income, and limiting some of the most widespread tax avoidance opportunities.

Integration of the individual and corporate income taxes—some reform proposals would integrate individual and corporate income taxes. This integration would help reduce difference in the tax treatment of various kinds of income and eliminate tax avoidance opportunities that such difference presents.

Consumption taxes—some proposals rely on the introduction of a consumption tax, described in greater detail below, to supplement or replace existing revenue sources. Transitioning to a consumption tax may pose a number of challenges; among them is the potential pitfall of taxing accumulated wealth that has already been taxed under the income tax. This may put an additional burden on seniors, who disproportionately own assets accumulated during their working years. (For more, see this chapter’s section Consumption Taxes.)

Greenhouse and other environmental taxes—these taxes put an economic price on such things as emission of greenhouse gases or other kinds of pollution. Currently, these detrimental activities do not result in a directly related economic cost. Proponents of these taxes argue that imposing the cost would reduce undesirable activities and help address environmental challenges. Opponents are concerned about the effects on the competitiveness of the U.S. businesses and the burden on low-income individuals.

Fundamental tax reform should be evaluated against the principles listed at the beginning of this chapter and described more fully below.

Revenue adequacy—collecting sufficient revenue is the primary reason for any tax system’s existence. At the rates currently proposed, most consumption tax reform plans would collect less revenue than the current system does. In the current fiscal environment this may severely jeopardize government’s ability to perform its functions, including the most basic ones.

Equity—any new tax structure should preserve the progressive nature of the federal tax system. Consumption taxes, which are the centerpiece of many reform proposals, are generally regressive; low-income people are burdened disproportionately because they consume a larger share of their income than higher-income people do. To some extent this disproportionate burden can be alleviated by providing lump-sum rebates or exempting necessities. The progressive nature of the overall tax and transfer system also depends on how tax revenue is spent. For example, dedicating revenues from a regressive tax to services for lower-income people might make the overall federal fiscal system more progressive.

Intergenerational equity is another concern regarding all consumption taxes. Subjecting spending from savings to a new tax on consumption would tax older adults twice, once when income was earned during their work years and a second time during retirement, as they spend down their savings to buy goods and services.

Economic neutrality—typically taxes create some inefficiencies by distorting economic choices and thus people’s behavior in the market. One major goal of most tax reform proposals is to reduce these distortions and encourage stronger economic growth. Proponents of consumption taxes note that income taxes encourage consumption over saving. Integrating the individual and corporate income taxes would reduce distortions that influence how businesses are organized and how income is transferred from corporations to shareholders. By eliminating certain tax deductions and other preferences, fundamental restructuring of the current income tax would also improve the neutrality and efficiency of the tax system.

Social and other policy goals—the current income tax code attempts to encourage the fulfillment of certain socially desirable goals, such as health insurance coverage, retirement savings, labor-force participation by low-wage workers, and home ownership, among others. The degree to which these provisions help society to achieve these goals, however, is subject to debate and should be considered against the additional complexity and costs they create. A major reform, such as introduction of a consumption tax, could decrease some of these incentives and increase others.

Administrative efficiency—the degree of administrative complexity depends greatly on the form of the tax. Advocates of flat-rate consumption taxes claim that such schemes are administratively simpler than the income tax, but in practice consumption taxes have had their own administrative complexities and costs, comparable to other revenue sources.

Income Tax Reform: Policy

Tax Reform

Tax reform should focus on raising sufficient revenue and making the income tax more equitable and efficient. Reforms should:

  • increase the system’s capacity for raising adequate revenue, including through tax base broadening;
  • maintain ability to pay as the standard of tax equity—tax reform should result in a distribution of tax burdens that is no less progressive than the current-law distribution of burdens 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 transition relief.

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