The federal tax system is beset with problems: It does not raise sufficient revenue to finance government spending, it is complex, it creates outcomes that are unfair, and it retards economic efficiency. This chapter discusses several ways to improve taxes, including creating a value-added tax, increasing environmental taxes, reforming the corporate tax, treating low- and middle-income earners equitably and efficiently, and ensuring appropriate taxation of high-income households.
The following brief is part of Brookings Big Ideas for America–an institution-wide initiative in which Brookings scholars have identified the biggest issues facing the country and provide ideas for how to address them.
A good tax system raises the revenues needed to finance government spending in a manner that is as simple, equitable, and growth-friendly as possible. The United States does not have a good tax system. This chapter highlights five areas where tax policy could be improved: raising long-term revenue; increasing environmental taxes; reforming the corporate tax; treating low- and middle-income earners equitably and efficiently; and ensuring appropriate taxation of high-income households.
Raising Long-Term Revenue
Under current law projections, public debt as a share of the economy will rise from 77 percent currently—the highest level ever except for a few years around World War II—to about 129 percent by 2046.1 Revenues will rise slightly, but spending will rise much faster, due to increases in net interest, Social Security, and health programs. Under reasonable policy alternatives, the debt figures will rise even higher. High and growing levels of debt will crowd out future investment and stymie growth. They will also reduce fiscal flexibility, or the ability to respond to future recessions.
High and growing levels of debt will crowd out future investment and stymie growth. They will also reduce fiscal flexibility, or the ability to respond to future recessions.
Alan Auerbach of the University of California at Berkeley and William Gale estimate that in order to return the debt level to its 1957–2007 average of 36 percent of GDP by 2046 immediate and permanent (through 2046) spending cuts and/or tax increases equal to 4.2 percent of GDP will need to be implemented. Just to maintain the 2046 debt at its current share of GDP would require adjustments, starting in 2017, of 2.7 percent of GDP.2 It seems unlikely that changes of this magnitude could be managed on the spending side. Entitlements have proven difficult to reform, especially Social Security, as there is significant public and political backlash against cutting benefits. Moreover, any Social Security changes would likely be phased in slowly, and reasonable changes in the program would not affect the overall fiscal balance that much. In addition, discretionary spending has already been cut dramatically and is already slated to fall to historically low shares of GDP over the next 25 years. As a result, tax increases need to be part of a long-term fiscal solution.
One way to raise revenue is to broaden the tax base by reducing the number of specialized credits and deductions in the tax code.3 For example, under current law, a dollar’s worth of deduction reduces taxable income by a dollar and hence reduces the tax burden in proportion to the marginal tax rate. A high-income household saves 39.6 cents for a given dollar of deduction, whereas a low-income household saves only 10 cents or nothing at all. Setting the tax benefit of each dollar of itemized deductions to 15 cents would affect mostly high-income households and raise, on average, about 0.6 percent of GDP per year over a decade, or roughly a cumulative $1.4 trillion over the next 10 years. Current itemized deductions are expensive, regressive, and often ineffective in achieving their goals. The mortgage interest deduction, for example, does not seem to raise home ownership rates, yet it will cost the federal government around $70 billion in 2017. Limiting the benefits of the deductions for high-income households is a way of reducing the distortions created by the tax code, making taxes more progressive, and increasing revenue. Alternatively, the United States could cap the total amount of tax expenditures that an individual can claim.4
An alternative way to raise revenue is through the creation of a federal value-added tax (VAT), as a supplement to the current income tax system, rather than as a replacement.5 A VAT is essentially a flat-rate consumption tax with administrative advantages over a national retail sales tax. Although it would be new to the U.S., the VAT is in place in about 160 countries worldwide and in every OECD country other than the United States. Experience in these countries suggests that the VAT can raise substantial revenue, is administrable, and is minimally harmful to economic growth. Additionally, a properly designed VAT might help the states deal with their own fiscal issues. Although the VAT is regressive relative to current income, the regressivity can be offset in several ways, and we should care about the distributional impact of the overall tax and transfer system, not just specific taxes. The VAT is not readily transparent in many countries, but it would be easy to make the VAT completely transparent to businesses and households by reporting VAT payments on receipts, just like state sales taxes are reported today. While the VAT has led to an increase in revenues and government spending in some countries, higher revenues are precisely why the VAT is needed in the United States, and efforts to limit government spending should be part of an effort to enact a VAT. A new 10 percent VAT, applied to all consumption except for spending on education, Medicaid and Medicare, charitable organizations, and state and local government, could be paired with a cash payment of about $900 per adult and about $400 per child to offset the cost to low-income families (the equivalent of annually refunding each two-parent, two-child household the VAT owed on the first $26,000 of consumption).6 In all, this VAT could raise about a net 2 percent of GDP or about $390 billion in 2017, after allowing for the offsetting effect on other taxes.
Increasing Environmental taxes
Economists have long recommended specific taxes on fossil-fuel energy sources as a way to address global warming. The basic rationale for a carbon tax is that it makes good economic sense: unlike most taxes, carbon taxation can correct a market failure—namely, that people and businesses do not pay the full cost of emitting carbon—and make the economy more efficient.7 It could also serve to raise revenue as an alternative to the taxes described above.
Although a carbon tax would be a new policy for the federal government, the tax has been implemented in several other countries. On average, a reasonably designed U.S. carbon tax alone could raise gross revenue by about 0.7 percent of GDP each year from 2016 to 2025 (around $160 billion per year).8 Carbon taxes are a good idea even if we did not need to increase revenues, because they can contribute to a cleaner, healthier environment by providing price signals to those who pollute. They have foreign policy benefits as well, as they plausibly reduce U.S. demand for oil and dependence on oil-producing nations. The permanent change in price signals from enacting a carbon tax would stimulate new private sector research and innovation to develop new ways of harnessing renewable energy and energy-saving technologies. The implementation of a carbon tax also offers opportunities to reform and simplify other climate-related policies that affect the transportation sector. The regressivity of a carbon tax could be offset in a number of ways, including refundable income or payroll tax credits.
Reforming corporate taxation
In the standard textbook setup, the earnings of equity holders are taxed twice: once under the corporate tax when they are earned, and then again under the individual income tax when they are paid to shareholders as dividends or capital gains. This summary both overstates and misstates the real problem. First, no corporate income is fully taxed under the individual income tax, since dividends and capital gains are taxed at preferential rates and capital gains are only taxed when the asset is sold. Second, a significant share of dividends and capital gains accrues to nontaxable entities—nonprofits or pensions—thus reducing the tax burden further. Third, a large share of corporate profits is never taxed at the corporate level in the first place. Aggressive corporate tax avoidance, including shifting funds out of the country through transfer pricing or other mechanisms, is an important factor in corporations reducing their tax burden.
The United States has the highest top corporate rate in the world at 35 percent. For many businesses, the tax distorts choices in favor of the noncorporate sector over the corporate sector. For other businesses, the corporate tax burden is offset by tax preferences. In the corporate sector, the tax favors debt over equity and retained earnings over dividends. As a result of numerous loopholes, aggressive corporate tax avoidance, and the large share of U.S. businesses that takes the form of non–C-corporation activity (which is in itself a form of corporate tax avoidance), U.S. corporate tax revenues as a share of GDP are only average compared to other countries, despite the high tax rate. In recent years, for example, corporate profits have equaled 12 percent of GDP, but corporate tax revenues have hovered around 2 percent of GDP.
Hence, the problem is not just that some forms of corporate income face two levels of tax; it is also that some forms face no tax. As a result, the main goal of corporate tax reform should be to tax all corporate income once and only once, at the full income tax rate. Given all of the flaws in the corporate tax, it should not be surprising that there are several approaches to reform that could help. None is without problems; each would address different aspects of the system.
Given all of the flaws in the corporate tax, it should not be surprising there are several approaches to reform that could help.
One option would be to replace some or all of the corporate income tax with a tax on shareholder wealth accumulation, as proposed by Eric Toder and Alan Viard. Under this approach, there would be no corporate tax. Instead, “American shareholders of publically-traded companies would be taxed on both dividends and capital gains at ordinary income tax rates, and capital gains would be taxed upon accrual,” rather than realization.9
Alternatively, the U.S. corporate income tax could be converted into a corporate cash-flow tax. This idea, proposed by both the House Republicans10 and Alan Auerbach,11 would essentially be a VAT with a wage deduction. It would encourage new investment by replacing deductions with immediate expensing for physical investment. The tax would be applied on a destination basis, which essentially limits the focus of the tax to transactions occurring exclusively on domestic soil and thus avoids all international transfer pricing issues.
A major change in the treatment of foreign source income should also be considered. In a pure worldwide system, all income from around the world is taxable, and all costs are deductible. In a pure territorial system, income earned outside the country is not taxable, and costs incurred outside the country are not deductible. A key issue, of course, is how income and expenses are allocated to each country because firms go to great lengths to move income to low-tax countries and deductions to high-tax countries. Most advanced countries lean toward a territorial system. The United States, by contrast, leans toward a worldwide system, but there is an important exception—taxes on actively earned foreign income are deferred until the income is repatriated to the United States. Currently, U.S. firms have more than $2 trillion in actively earned funds overseas that have not been repatriated and therefore go untaxed. This income is often described as being “trapped” outside the United States.12 This characterization is only partially correct, though. The money may actually be in a bank in the United States and funding investment in the United States. However, the funds cannot be used to pay dividends to shareholders or to buy back firm shares until the funds are “repatriated” to the corporation, a legal procedure that generates a tax liability.
Senior Research Analyst (Former) - Urban-Brookings Tax Policy Center
There are two general proposals to deal with the issue of funds sitting “abroad.” One is to move to a worldwide system without deferral.13 The other is to move toward a territorial system.14 As noted, a big issue with territorial systems is that they increase the incentives that already exist to shift income into low-tax countries and deductions/costs into high-tax countries. The implementation of a territorial system would need to be accompanied by very stringent rules about income and cost-shifting. There has been a desire on the part of some lawmakers to have a one-time repatriation tax holiday, perhaps to finance infrastructure.15 This would be a mistake, and would simply encourage firms to shift more funds overseas in an effort to gain a future tax advantage.16
Revising treatment of low- and middle-income earners
Under a progressive income tax, the highest statutory marginal tax rates are placed on the highest-income households. Under our current system, however, low- and middle-income earners often face very high effective marginal tax rates. These earners are in income ranges where increased earnings cause phaseouts of tax subsidies and benefit programs. The net effect of earning more—including higher wages, higher income tax payments, and lower program benefits—can impose quite significant effective tax rates on such households. This situation is unfair to those families, is inefficient, and discourages actions that would enhance social and economic mobility.
For example, Melissa Kearney and Lesley Turner note that a secondary earner in a married household typically pays a higher effective tax rate on the margin than the primary earner. This issue arises because the two incomes are combined to form one tax unit, even though the secondary earner often has a lower individual income than the primary earner (and would have a lower marginal tax rate if filing as a single person). This is particularly problematic for low- and middle-income households because it discourages additional work to support their family, which could result in extra income that may reduce their benefits or even render the family ineligible for programs such as food assistance or the Earned Income Tax Credit (EITC). On both fairness and economic grounds, Kearney and Turner propose a 20 percent secondary-earner tax deduction until a cap is reached. This deduction would improve the incentive to work, provide more economic security to working low- and middle-income families, and mitigate the secondary-earner penalty. On net, the authors estimate that their proposal would cost the federal government $8.2 billion per year.17
Of course, another option to mitigate the tax burden faced by low- and middle-income earners is to expand eligibility for the EITC or transform the Child and Dependent Care Credit (CDCC) to a refundable benefit.18 Both of these programs are already executed through the tax code in an effort to aid low- and middle-income families, and changes to the programs could expand economic opportunity or increase the degree of fairness in the system. Specifically, EITC benefits could be raised for families with fewer than two children, especially for childless workers. This improves the incentives for work in these households, and it can lead to better economic outcomes for the associated families. By converting the CDCC to a refundable credit, low-income families would be able to reap greater benefits from the program and retain more disposable income. Additionally, it would incentivize the use of higher-quality child care. To make these options revenue neutral and prevent them from exacerbating the long-term revenue issues described above, the income eligibility caps for these programs could be lowered or other provisions could be removed.
Taxing the Rich
There are three reasons to increase the tax burden on high-income households. First, their income has increased dramatically over the past several decades, yet their tax payments have not kept pace. Second, if the fiscal reforms described above are implemented, the main benefit will be economic growth, but such growth in the past several decades has accrued largely to high-income households, who should thus be expected to pay for it. Third, despite much rhetoric to the contrary, reasonable variations in taxes on high-income households do not appear to have any negative discernible impact on growth.19
There are many ways to boost revenue collected from high-income households. The most prominent examples would include higher taxes on capital gains and dividends, restrictions on tax expenditures, higher income tax rates, or a tighter estate tax. Taxing carried interest as ordinary income also makes sense in principle, but is difficult to implement without creating new forms of avoidance and, as a result, would raise very little revenue.
The U.S. tax system is far from ideal, and there are several areas for improvement. Reforming the system so that it pays for government spending, treats taxpayers fairly, and improves incentives for productive activity can alleviate many issues and only be a plus from an economic standpoint.
- For current law projections, see Congressional Budget Office, “The 2016 Long-Term Budget Outlook” (Washington: 2016). For current policy assumptions, see Alan J. Auerbach and William G. Gale, “Once more unto the breach: The deteriorating fiscal outlook” (Washington: Brookings, 2016).
- Authors’ calculation based on current policy assumptions and starting the adjustments in 2017.
- William G. Gale, “Why Higher Taxes Will Have to be Part of the Medium- and Long-Term Fiscal Solution,” Tax Vox (blog), Tax Policy Center, January 23, 2012, http://taxvox.taxpolicycenter.org/2012/01/23/why-higher-taxes-will-have-to-be-part-of-the-medium-and-long-term-fiscal-solution/.
- For further analysis of tax expenditure reform options, see Daniel Baneman et al., “Options to Limit the Benefit of Tax Expenditures for High-Income Households” (Washington: The Tax Policy Center, 2011).
- Yale University law professor Michael Graetz also has proposed a VAT, but he would use the revenues gained to cut the income tax substantially—raising the exemption to about $100,000 and taxing income above that level at a flat 25 percent—and to halve the corporate tax rate. See: Michael J. Graetz, “100 Million Unnecessary Returns: A Fresh Start for the U.S. Tax System,” Yale Law Journal 112 (2004): 263–313.
- For more discussion, see: William G. Gale and Benjamin H. Harris, “Proposal 10: Creating an American Value-Added Tax” (Washington: The Hamilton Project, 2013); Eric Toder and Joseph Rosenberg, “Effects of Imposing a Value-Added Tax to Replace Payroll Taxes or Corporate Taxes” (Washington: The Tax Policy Center, 2010).
- William G. Gale, “The Tax Favored by Most Economists,” Brookings, March 12, 2013, www.brookings.edu/research/opinions/2013/03/12-taxing-carbon-gale.
- Donald Marron, Eric Toder, and Lydia Austin, “Taxing Carbon: What, Why, and How,” Tax Policy Center, June 24, 2015, www.taxpolicycenter.org/publications/taxing-carbon-what-why-and-how.
- Eric Toder and Alan Viard, “A Proposal to Reform the Taxation of Corporate Income” (Washington, D.C.: Tax Policy Center, 2016)
- “A Better Way: Our Vision for a Confident America,” Tax Reform Task Force, Speaker of the U.S. House of Representatives, June 24, 2016, https://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf
- Alan J. Auerbach, “A Modern Corporate Tax” (Hamilton Project, Brookings, 2010) www.americanprogress.org/wp-content/uploads/issues/2010/12/pdf/auerbachpaper.pdf.
- “Companies Invest ‘Trapped’ Untaxed Foreign Profits in U.S.,” Bloomberg, December 15, 2011, www.bloomberg.com/news/articles/2011-12-14/companies-hold-46-of-untaxed-foreign-profits-in-u-s-assets-1-.
- Office of Management and Budget, Fiscal Year 2016 Budget of the U.S. Government (Washington, D.C.: U.S. Government Printing Office, 2015) www.whitehouse.gov/sites/default/files/omb/budget/fy2016/assets/budget.pdf
- H.R. 1, Tax Reform Act of 2014, December 2014, www.congress.gov/bill/113th-congress/house-bill/1.
- See the July 2015 “Bipartisan Framework for International Tax Reform” on Senator Robert Portman’s website at www.portman.senate.gov/public/index.cfm/files/serve?File_id=146abc53-1763-4a0a-93ee-3d4eecf2a61c.
- William G. Gale and Benjamin Harris, “Don’t Fall for Corporate Repatriation,” Brookings, June 27, 2011, www.brookings.edu/opinions/dont-fall-for-corporate-repatriation/.
- Melissa S. Kearney and Lesley J. Turner, “Giving Secondary Earners a Tax Break: A Proposal to Help Low- and Middle-Income Families,” Discussion Paper 2013-07 (Hamilton Project, Brookings, 2013) www.hamiltonproject.org/files/downloads_and_links/THP_Kearney_DiscPaper_Final.pdf.
- Hilary Hoynes, “Building on the Success of the Earned Income Tax Credit” (Brookings, Brookings, June 19, 2014); and James P. Ziliak, “Supporting Low-Income Workers through Refundable Child-Care Credits” (Brookings, 2014).
- William G. Gale and Andrew A. Samwick, “Effects of Income Tax Changes on Economic Growth” (Brookings, 2016).