Testimony: The Costs and Complexity of the Federal Tax Code Demand Reform
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Note: The following is the testimony of Dr. William McBride,
Vice President of Federal Tax Policy & Stephen J. Entin Fellow in
Economics at the Tax Foundation, prepared for Senate Budget Committee hearing on April 18, 2023, titled, “A Rigged System: The Cost of Tax Dodging by the Wealthy and Big Corporations.”
The Size and Distribution of the Federal Tax Burden
Chairman Whitehouse, Ranking Member Grassley, and distinguished
members of the Senate Budget Committee, thank you for the opportunity to
provide testimony on the distribution of the federal tax burden. I am
William McBride, Vice President of Federal Tax Policy and Stephen J.
Entin Fellow in Economics at the Tax Foundation, where I focus on how we
can improve our federal tax code.
Today, my testimony will focus on four points. First, I will
describe the current federal tax system, showing that tax collections
are near an all-time high and the burden is highly progressive. Second, I
will describe how the tax code’s increasing complexity adds to this
burden, raising compliance costs for taxpayers and administrative costs
for the Internal Revenue Service (IRS).
Third, I will describe the economic costs of the tax code’s high
marginal income tax rates, which slow economic growth and reduce living
standards.
Finally, I will recommend ways to reform the federal tax code to
reduce complexity and improve economic incentives, grow the economy,
benefit low- and middle-income workers, and raise sufficient revenues at
or above current levels.
Federal Tax Collections are Near Record Highs
As a result of the economic recovery coming out of the pandemic and
surging inflation, federal tax collections hit an all-time high of $4.9
trillion in fiscal year (FY) 2022 that ended September 30, topping the
prior year’s record collections by $850 billion.[1]
As a share of gross domestic product (GDP), federal tax collections in
FY 2022 reached a multi-decade high of about 19.6 percent, up from 17.9
percent in the prior fiscal year and approaching the last peak of 20.0
percent set during the dot-com bubble in FY 2000.
Only two other years in U.S. history saw federal tax collections as a
share of GDP exceed the FY 2022 level, both during World War II: in
1943, federal tax collections reached 20.5 percent of GDP before falling
to 19.9 percent in 1944. FY 2022 tax collections exceeded the post-war
average of 17.2 percent of GDP by 2.4 percentage points.
In the most recent fiscal year, individual income tax collections
contributed the most to the surge in federal tax collections, growing 29
percent to $2.6 trillion in FY 2022 from $2.0 trillion in FY 2021. Payroll taxes
grew 13 percent to $1.5 trillion in FY 2022 from $1.3 trillion in FY
2021, while corporate taxes grew 14 percent to $425 billion from $372
billion, and other revenues grew 13 percent to $356 billion from $316
billion.
Individual income tax collections reached 10.5 percent of GDP in FY
2022, the highest level on record. That level substantially exceeded the
prior record of 9.9 percent of GDP set in FY 2000 as well as the World
War II-era record of 9.2 percent of GDP set in FY 1944.[2]
The surge in individual income tax revenue is partly attributable to
growth in capital gains revenue due to booming stock and housing markets
in 2021, itself a function of inflationary fiscal and monetary stimulus
during the pandemic.[3]
The Congressional Budget Office (CBO) estimates that capital gains
realizations and revenue roughly doubled during the pandemic years:
realizations grew to $2.0 trillion in 2021 and $1.7 trillion in 2022
from $881 billion in 2019 while revenues grew to $304 billion in FY 2021
and $378 billion in FY 2022 from $169 billion in FY 2019.[4]
Extreme economic volatility in recent years makes it difficult to
assess how tax collections have been impacted by the Tax Cuts and Jobs
Act (TCJA), which was enacted in 2017. Among other changes, the TCJA
reduced the corporate tax rate percent to 21 percent from 35 percent.
Corporate and other federal tax revenues were relatively low in 2018
through the first year of the pandemic but have since rebounded with the
economy and inflation. Average federal tax collections in the five
years since the TCJA’s enactment are about 17.3 percent of GDP—higher
than the 16.7 percent forecasted by the CBO following its passage,
higher than most years before the TCJA, and higher than the post-war
average of 17.2 percent.[5]
As the inflationary boom of 2021 has turned into a bust over the
course of the last year, and as the Federal Reserve continues to raise
interest rates to fight the inflation, growth in federal tax collections
is likely to slow in FY 2023. On a preliminary basis, the CBO reports
that federal tax collections in the first half of FY 2023 (October 2022
to March 2023) are down 3 percent from the same period in FY 2022, with
individual income tax revenue down 8 percent.[6]
However, based on current projections, federal tax collections as a
share of GDP will likely remain above the historical average in FY 2023.
Most of the Federal Tax Burden is Paid by High Earners
By any objective measure, the U.S. tax code is extremely progressive
and very redistributive. According to the latest IRS data for 2020, the
top 5 percent of taxpayers (about 7.9 million filers that earn more than
$220,521) paid in aggregate $1.1 trillion in income taxes, amounting to
62.7 percent of all income taxes paid that year.[7]
The top 1 percent of taxpayers (about 1.6 million filers who earn more
than $548,336) paid $723 billion in income taxes, or 42.3 percent of all
income taxes paid—a larger share than the bottom 95 percent of
taxpayers combined.
The share of federal income taxes paid by the top 1 percent is higher
than it has been in at least 20 years, according to IRS data.[8]
In 2001, the top 1 percent’s share of income taxes paid was 33.2
percent, then fluctuated with the business cycle and the ups and downs
of the housing and stock markets, before rising steadily to its current
high of 42.3 percent in 2020. The top 1 percent’s share of income taxes
could well go higher in 2021 and 2022 due to growth of capital gains
revenue, which is paid primarily by high earners.
High income taxpayers also pay the highest tax rates, according to
the IRS. The average income tax rate in 2020 was 13.6 percent. The top 5
percent of taxpayers paid a 22.4 percent average rate while the top 1
percent of taxpayers paid a 26.0 percent average rate—more than eight
times higher than the 3.1 percent average rate paid by the bottom half
of taxpayers. The top 0.001 percent, or the richest 1,575 tax returns
filed in 2020, paid nearly $71 billion in income taxes and had an average tax rate of 23.7 percent.
The average tax rate for the top 0.001 percent is slightly lower than
that of the top 1 percent because a larger share of the top 0.001
percent’s income is capital gains, which face a lower rate schedule. One
justification for the lower rate is that capital gains income is earned
in an environment where other taxes have already been applied. In
particular, shareholder taxes on capital gains and dividends essentially
apply on top of the corporate income tax of 21 percent. That is, the
same dollar of corporate income is first taxed by the corporate income
tax and then taxed again when distributed to shareholders in the form of
capital gains and dividends. Note that the shares and average tax rates
cited above do not reflect the additional burden of the corporate
income tax.[9]
Analysis from the CBO provides a more complete picture of the
distribution of the federal tax burden. When accounting for individual
income taxes—including the outlay portion of refundable tax
credits—corporate income taxes, payroll taxes, estate taxes, and excise
taxes, CBO finds that the federal tax system, as a whole, is
progressive. [10]
The latest data indicates that households in the highest income
quintile paid about 69 percent of all federal taxes in 2019, and the top
1 percent of households paid about 25 percent of all federal taxes.[11] In contrast, the bottom quintile of households paid about 0.1 percent of all federal taxes.
Like the IRS data on federal income taxes, the CBO analysis indicates
the share of all federal taxes paid by high earners has grown over
time. For example, the share of federal taxes paid by households in the
top 1 percent has approximately doubled to about 25 percent in 2019 from
roughly 12 percent in the early 1980s.
Furthermore, the CBO analysis indicates that average federal tax
rates increase substantially with income. For example, the top quintile
of households paid an average federal tax rate of 24.4 percent in 2019
and the top 1 percent of households paid an average federal tax rate of
30.0 percent. In contrast, the bottom quintile paid an average federal
tax rate of 0.5 percent, reflecting the fact that refundable tax credits for this group almost entirely offset payroll taxes and other federal taxes.
The CBO notes that within the top 1 percent’s average federal tax
rates are relatively flat at about 30 percent, as the effect of lower
capital gains tax rates are offset by higher average corporate tax
rates.[12] For example, the top 0.01 percent of households paid an average federal tax rate of 30.2 percent in 2019.
Over time, the average federal tax rate paid by the top 1 percent has
remained within a range of about 25 to 35 percent since 1979, and as of
2019 is about in the middle of that range and close to the average of
30.5 percent over the period 1979 to 2019. However, the average federal
tax rate for the bottom quintile has declined substantially, to nearly
zero in 2019 due to the introduction and expansion of refundable tax credits from a high of about 12 percent in 1984.
Data from the Joint Committee on Taxation (JCT)
confirms that average federal tax rates consistently rise with income.
When including all federal taxes, the bottom 50 percent of taxpayers
face an average federal tax rate of 6.3 percent, compared to an average
rate of 24.8 percent for the top 1 percent of taxpayers. The federal
income tax is the most progressive of the federal taxes, with corporate
income taxes and estate and gift taxes also adding to federal progressivity. The progressive tax sources more than offset payroll taxes and excise taxes
that apply higher average tax rates to lower income groups. The JCT
data also shows average federal taxes rise within the top 1 percent,
from an average tax rate of 22.6 percent for those in the 99th to 99.5th
percentiles of income to 32.9 percent for the top 0.01 percent of
earners, representing about 15,000 taxpayers in the United States.
Tax Code’s Complexity Adds to the Burden
By any measure, the federal tax code is extremely complex. Totaling
more than 6,000 pages and about 4 million words (plus about 15,000 pages
of associated tax law interpretations), no taxpayer can reasonably be
expected to fully comprehend it.[13]
The complexity derives in part from the basic challenge of defining and
taxing income, an endeavor the country embarked on more than 100 years
ago. Every Congress and administration since has revised and added to an
accumulating pile of deductions, credits, and special provisions. By
official measures, there are now more than 200 such special provisions
known as “tax expenditures,” costing about $2 trillion annually. In the
last three years alone more than 100 tax expenditures have been created
or amended.[14]
While some tax expenditures are important structural elements of the
tax code, many are complicated and disproportionately benefit specific
industries or types of households.[15] The CBO finds about half of the total income tax benefits of expenditures go to high-income households.[16]
The Inflation Reduction Act (IRA), enacted last year, adds several
complicated provisions to the tax code, including a book minimum tax, a
stock buyback tax, and more than 20 different tax subsidies for green
energy. All of these require extensive regulatory guidance which
continues to roll out even as much of the law took effect at the
beginning of this year.[17]
Taxpayers, too, have highlighted several remaining concerns and
ambiguities in the law (e.g., reporting requirements and applicable
financial statements for the book minimum tax, and domestic content
rules for the green energy tax credits).[18]
The uncertainty in the law also translates into uncertainty about the
budgetary costs and distributional impacts. For example, researchers
now estimate the budgetary cost of the IRA’s green energy credits and
subsidies will exceed $1 trillion over a decade, three times the
original cost estimated by the CBO and the JCT, with the benefits
accruing mainly to high earners.[19]
In the same month the IRA was enacted, Congress passed the CHIPS and
Science Act, which provides billions of dollars of targeted (and
complex) incentives and investment tax credits for semiconductor
manufacturing, along with a variety of eligibility and reporting
requirements.[20]
In 2022 (before the IRA or the CHIPS Act), Americans spent more than
6.5 billion hours trying to comply with the tax code, according to the
latest estimates from the White House Office of Information and
Regulatory Affairs (OIRA).[21]
Based on wage and benefit estimates for tax preparers and certified
public accountants, we estimate the hourly compliance costs of the tax
code equates to about $313 billion each year in lost productivity, or
1.4 percent of GDP.[22]
The compliance burden for individual taxpayers is nearly $74 billion
annually, while the burden on corporate entities of complying with just
their income tax returns is more than $60 billion. Much of the remaining
$179 billion of costs comes from complying with hundreds of other
business tax forms and regulations, such as those relating to
depreciation and amortization. Compliance with income tax returns for
estates and trusts costs $18 billion a year, approaching the amount of
tax revenue raised by the estate tax.
Our estimate of compliance costs does not include the cost of tax
planning, which is a significant industry on its own. Nor does it
include the cost of uncertainty in the law for taxpayers, which makes
planning for taxes as well as investment and other economic activities
difficult and costly.
The majority of the compliance burden is from the complex taxing of
business income, which involves tracking and reporting multiple items of
income and expense to arrive at net taxable income and allowing offsets
from net income to account for past losses (in a typical year roughly
40 percent of companies are in a loss position).[23]
In addition, the U.S. tax code contains several business credits,
exclusions, and other special provisions that increase compliance costs.
Multinational corporations face a slew of complex provisions that
subject various types of foreign income and cross-border transactions to
tax, including Subpart F, Global Intangible Low-Taxed Income (GILTI),
Foreign-Derived Intangible Income (FDII), and Base Erosion and
Anti-Abuse Tax (BEAT).[24]
For individual filers, compliance costs generally increase
proportionally with income, such that most of the compliance burden is
borne by high earners.[25]
High earning individuals typically have multiple sources of income
beyond wages, including capital gains, dividends, rents, royalties, and pass-through business income from partnerships and S corporations (income from these business forms is subject to individual income tax rather than corporate income tax).
Another aspect of the tax code’s complexity is the administrative
costs and challenges for the IRS, an agency whose responsibilities have
grown well beyond simple revenue collection to include administration of
subsidies and benefits relating to children, health care, education,
housing, energy, the environment, economic stimulus, and more.[26]
Pursuant to its expanded role, in FY 2021 the IRS processed some 261
million returns and forms and received some 4.7 billion pieces of
information, detailing the composition and activities of nearly every
American household and business.[27]
In recent years, the IRS has found itself literally buried in
paperwork, resulting in processing delays, millions of returns
backlogged, and poor customer service.[28]
Last year, for instance, the IRS answered only about 13 percent of the
173 million phone calls it received from taxpayers asking for help;
those who got through waited an average of 29 minutes.[29] Clearly, administrative challenges at the IRS are also problematic for taxpayers.
A report from the Government Accountability Office (GAO) sheds light
on the challenges faced by the IRS and taxpayers as a result of the
increasing complexity of the code.[30] The report finds that the average number of hours the IRS spends per audit
has increased about 30 percent in recent years, to 6.5 hours in 2021
from 5.0 hours in 2010. The increase is concentrated in high-income
returns. Average hours per audit increased 209 percent for incomes of $5
million and above, to about 58 hours in 2021 from about 19 hours per
return in 2010. Average hours per audit increased 118 percent for
incomes between $500,000 and $5 million, to 34 hours from about 16, and
103 percent for incomes between $200,000 and $500,000, from about 10 to
21 hours. In contrast, audits for incomes below $200,000 took
considerably less time—about 2 hours on average for incomes below
$25,000, and 6 hours for incomes between $25,000 and $200,000, This
remained stable over this period.
The GAO report notes that IRS officials attribute the increase in
average audit hours to “greater complexity of higher-income audits and
increased case transfers due to auditor attrition.” The GAO report
mentions several legislative changes that have added to the IRS’s
responsibilities in recent years, including the Patient Protection and
Affordable Care Act, the Foreign Account Tax Compliance Act, the TCJA,
as well as some 496 million stimulus payments totaling $837 billion as
part of the CARES Act and other pandemic relief packages. (Note the GAO
report was published before enactment of the IRA or CHIPS Act.)
As a measure of the efficiency of audits, or the “bang for the buck,”
the GAO compared the recommended additional tax with hours spent on
audits. The GAO found that audits of the highest income returns—those
with income of $5 million or more—resulted in the highest amounts of
recommended additional tax per audit hour ($4,880 in 2021), followed by
audits of those claiming the EITC ($3,130) and those reporting less than
$25,000 of income ($2,120). In aggregate, the majority of the total
recommended additional tax came from audits of taxpayers with income
below $200,000. On average, roughly half of recommended additional
amounts are ultimately collected, however the collection rate for EITC
returns exceeds 70 percent since these audits are typically done prior
to issuing refunds.
Lastly, the GAO report documents that audit rates for individual
income tax returns have decreased for all income levels, dropping to
0.25 percent in 2019 from an average of 0.9 percent in 2010, which IRS
officials attribute mainly to reduced staffing as a result of reduced
funding. Audit rates decreased the most for high earners because,
according to IRS officials, these audits are generally more complex and
require more staff time to complete.
Simplifying the tax code would reduce IRS resources required to more
effectively administer it, including by reducing the time needed to
audit the currently complex returns of high earners. A simpler tax code
would also reduce taxpayer confusion so that there would be less need
for the IRS to produce volumes of guidance and respond to millions of
taxpayer calls for assistance. Less confusion on the part of taxpayers
would also boost compliance.[31]
As the IRS Taxpayer Advocate explains: “The most efficient way to
improve compliance is by encouraging and helping taxpayers to do the
right thing on the front end. That is much cheaper and more effective
than trying to audit our way out of the tax gap one taxpayer at a time
on the back end.”[32]
The Economic Cost of High Marginal Income Tax Rates
Decades of economic research amply demonstrates the steep cost of
high marginal income tax rates that arises from disincentives to work,
save, and invest.[33]
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, manifesting itself over the course of several years as a
drag on economic growth through less investment, less innovation, fewer
jobs, and lower wages.[34]
A study based on postwar tax reforms in the United States found that
reducing marginal tax rates on individual income for the top 1 percent
of earners leads to increases in real GDP and declines in unemployment,
with a 1 percentage point cut in the tax rate increasing real GDP by
0.78 percent by the third year after the tax change.[35]
Given the size of the U.S. economy today, that equates to about $204
billion in additional GDP for each 1 percentage point cut in the marginal tax rate
on individual income earned by the top 1 percent. The study shows the
benefits of the resulting economic growth would be felt throughout the
economy.
In looking at the experience of developed countries over the period
1971 to 2004, researchers at the Organisation of for Economic
Co-operation and Development (OECD) concluded that “a reduction in the
top marginal [individual] tax rate is found to raise productivity in
industries with potentially high rates of enterprise creation. Thus,
reducing top marginal tax rates may help to enhance economy-wide
productivity in OECD countries with a large share of such industries.”[36]
The CBO modeled three types of tax increases to fund a permanent
increase in government spending of 10 percent of GDP annually: a flat
labor tax, a flat income tax, and a progressive income tax. The CBO
found that a progressive income tax is the most economically damaging of
the three options, reducing GDP by 10 percent after 10 years, and
reducing lifetime consumption and hours worked, especially for younger
households.[37]
Corporate income taxes are generally more economically damaging than
individual income taxes, since they make investment opportunities less
profitable on an after-tax basis for corporations, reducing the
likelihood that marginal investments will be pursued. In most countries
including the U.S., business investment makes up the bulk of all private
sector investment; more uniquely in the U.S., about half of business
investment is done by corporations and the other half by pass-through
businesses subject to individual income taxes.
An OECD study examining data from 63 countries concluded that
corporate income taxes are the most economically damaging way to raise
revenue, followed by individual income taxes, consumption taxes, and
property taxes.[38]
A study on taxes in the United Kingdom found that taxes on consumption
are less economically damaging than taxes on corporate and individual
income.[39]
A study of U.S. tax changes since World War II found that a 1
percentage point cut in the average corporate tax rate raises real GDP
per capita by 0.6 percent after one year, a somewhat larger impact than a
similarly sized cut in individual income taxes.[40]
Based on U.S. state taxes, a study found that a 1 percentage point cut
in the corporate tax rate leads to a 0.2 percent increase in employment
and a 0.3 percent increase in wages.[41]
Furthermore, several studies demonstrate that the corporate tax is borne in part by workers.[42]
For instance, a study of corporate taxes in Germany found that workers
bear about half of the tax burden in the form of lower wages, with
low-skilled, young, and female employees disproportionately harmed.[43]
The corporate tax is also borne by owners of shares, including
retirees earning considerably less than $400,000. In the short run, the
JCT assumes owners of capital bear all of the corporate tax, yet that
includes more than 90 million tax filers earning less than $200,000. In
the long run, the JCT assumes workers bear a portion of the corporate
tax, such that the burden falls on more than 150 million tax filers
earning less than $200,000.[44]
Another factor to consider regarding the corporate tax in particular
is competitiveness with respect to our major trading partners, as
corporate investment is highly mobile internationally and will flow to
lower tax locations all else equal. The corporate tax rate reduction
from the TCJA brought the U.S. closer to the average among developed
countries accounting for federal and state level taxes, though it
remains slightly above average. The U.S. combined federal-state
corporate tax rate in 2022 was 25.8 percent, compared to 21.2 percent in
the average EU country and 23.6 percent in the average OECD country.[45]
Lastly, one of the most problematic and economically destructive
aspects of the U.S. tax code is the double taxation of corporate income
by the corporate income tax (and now also the book minimum tax) and
shareholder taxes on capital gains and dividends. Accounting for federal
and state corporate and individual incomes taxes, the top integrated
tax rate on corporate income distributed as dividends is about 47
percent in the U.S., compared to an OECD average of about 42 percent.[46]
Several OECD countries have integrated corporate and individual tax
codes to eliminate or reduce the negative effects of double taxation of
corporate income. In the U.S., after decades of double taxing corporate
income, a large share of business activity has migrated to pass-through
form, which has only one layer of income tax as owners report
pass-through profits on their individual income tax returns.[47]
For several years, the Tax Foundation has observed and analyzed tax
systems from around the world and evaluated them based on the principles
of sound tax policy.[48]
Most tax policy experts agree that 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, progress, and higher standards of living.
In our annual ranking of the most competitive tax systems, we found
for the ninth year in row that Estonia has the best tax code in the
OECD. [49]
This is in part because it has a fully integrated income tax system
that avoids double-taxing corporate income through taxes at both the
entity and shareholder levels. Instead of a complicated corporate income
tax and separate rules that apply to passthrough businesses, all
businesses are subject to a simple 20 percent tax on distributed profits
(including dividends and stock buybacks). At the individual level, a
simple flat tax of 20 percent applies to all individual income except
dividends, since they are already taxed by the distributed profits tax.
Capital gains are taxed as ordinary income at 20 percent. Rather than a
complicated estate tax like ours that taxes accumulated savings at
death, bequeathed assets are simply taxed as capital gains when sold by
the heir with deductible basis determined only by costs incurred by the
heir.[50]
Simplicity and neutrality are the hallmarks of the Estonian income tax system.[51]
Taxes are so simple in Estonia that they can typically be filed in five
minutes, and the cost of compliance for businesses is among the lowest
of any country.[52]
Estonia’s tax system is also very pro-growth, increasing small business
entrepreneurship, investment, labor productivity and thereby wages.[53] Estonia’s income tax system does all of this while generating substantial revenue comparable to other developed countries.[54]
We recently analyzed the effect of a revenue-neutral reform of the
U.S. tax code along the lines of the Estonian income tax system, keeping
only certain features of the current code that benefit low-income
households (such as the EITC and Child Tax Credit) and support saving
(such as 401ks).[55]
By greatly simplifying the federal tax code, these reforms 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 tax returns.
In addition to compliance cost savings, our modeling of the reform’s
impacts on the U.S. economy indicates it would increase GDP by 2.3
percent in the long run, amounting to about $400 billion in additional
annual output by 2032 and $1 trillion in the long run (both in 2023
dollars). These changes would increase the long-run capital stock by 3
percent, amounting to $2.1 trillion in 2023 dollars. Additionally, we
estimate it would add 1.3 million full-time equivalent jobs and raise
wages by 1.3 percent. By increasing GDP, we would reduce the debt burden
as measured by the debt-to-GDP ratio by 5.9 percentage points over the
long run.
Distributionally, we find the reform would increase after-tax income
overall by 2.1 percent in the long-run, accounting for improved
economic growth, with a larger boost of 2.7 percent for the bottom
quintile of earners and 3.0 percent for the second quintile.
More generally, the U.S. could learn from the experience of other
countries in the OECD, which rely more heavily on consumption taxes than
the U.S. does.[56]
Value added taxes (VATs) are a major source of revenue in virtually
every developed country except the U.S., and as the literature cited
above indicates, VATs and other taxes on consumption are among the least
economically harmful ways to raise revenue.[57]
OECD countries have also tended to abandon more complicated means of
taxing high earners such as wealth taxes due to their administrative and
economic challenges.[58]
Rather than high capital gains taxes, or any attempt to tax unrealized
capital gains, most OECD countries have lower capital gains tax rates
than the U.S., and tax capital income overall at lower average tax
rates.[59]
Consumption taxes can be designed to progressively tax the
consumption of higher earners without the administrative complexity and
compliance costs of our current progressive income tax system. For
example, by splitting the VAT base in two, businesses would pay taxes on
their cash flow (sales less purchases and compensation paid), while
households would pay taxes on compensation received. Applying a
progressive rate schedule at the household level, with the top rate
matching the rate on business cash flow, is a relatively simple way to
achieve progressivity within a consumption tax.[60]
Under a more standard value-added tax, the most efficient way to
increase progressivity would be to offer targeted relief to lower- and
middle-income households.[61]
Conclusion
We as a country have built a federal tax system that is inherently
complex, costly, and controversial, one that is centered on taxing both
individual and business income at progressive tax rates and littered
with various preferences. To the extent it is comprehensible at all,
taxpayers do not perceive it as fair. The IRS has real challenges
administering such a complicated tax system, but boosting the IRS budget
will not fix the underlying problem that caused Americans to call the
agency 173 million times last year asking for help.
As top priority, lawmakers should simplify the tax code so that
taxpayers can understand the laws and the IRS can administer them with
minimum cost and frustration. As the IRS’s National Taxpayer Advocate
states in their most recent report to Congress, “Simplifying the Code is
the most important step Congress can take to reduce taxpayer compliance
burdens. Simplification is essential to the integrity of the U.S. tax
system and will enhance voluntary compliance.”[62] We have outlined reforms that would reduce taxpayer compliance burdens by at least $100 billion per year.
Second, lawmakers should reduce the economic drag caused by the tax
code, particularly as economic growth is expected to slow this year and
most economists are forecasting a recession.[63]
The tax code is one of the most effective levers available to lawmakers
to address this economic slowdown, but it should not be done through
preferences that are targeted and complicated but instead by broadly
improving incentives to work, save, and invest through lower marginal
tax rates on individual and corporate income.
We have shown that revenue-neutral tax reform can greatly improve
economic growth, increasing GDP by 2.3 percent in the long run, adding
1.3 million jobs, and raising wages by 1.3 percent such that after-tax
incomes for the bottom 40 percent of earners increase by nearly 3
percent on average. Additionally, the experience of other countries
shows that taxing consumption as opposed to income raises substantial
revenue in a more economically efficient way. To address distributional
concerns, lawmakers can design consumption taxes
to progressively tax the consumption of higher earners without the
administrative complexity and compliance costs of our current
progressive income tax system.
[1] William McBride, “Inflation is Surging, So Are Federal Tax Collections,” Tax Foundation, Oct. 13, 2022, https://taxfoundation.org/federal-tax-collections-inflation-surging/; Congressional Budget Office, Budget and Economic Data, https://www.cbo.gov/data/budget-economic-data.
[2] Office of Management and Budget, Historical Tables, Table 2.3-Receipts by Source as Percentages of GDP: 1934-2028, https://www.whitehouse.gov/omb/budget/historical-tables/;
A similar measure from the Bureau of Economic Analysis (BEA) indicates
federal and state individual income taxes as a share of personal income
reached an all-time high of 14.7 percent in calendar year 2022. See BEA,
National Income and Product Accounts, Table 2.1 Personal Income and Its
Disposition, https://www.bea.gov/itable/national-gdp-and-personal-income.
[3] William McBride, “Inflation is Surging, So Are Federal Tax Collections,” Tax Foundation, Oct. 13, 2022, https://taxfoundation.org/federal-tax-collections-inflation-surging/.
[4] Congressional Budget Office, “The Budget and Economic Outlook: 2023 to 2033,” February 15, 2023, https://www.cbo.gov/publication/58848; CBO, Budget and Economic Data, Revenue Projections, by Category, https://www.cbo.gov/data/budget-economic-data#7
[5] Congressional Budget Office, Budget and Economic Data, https://www.cbo.gov/data/budget-economic-data.
[6] Congressional Budget Office, “Monthly Budget Review: March 2023,” April 10, 2023, https://www.cbo.gov/publication/58995.
[7] Internal Revenue Service, Statistics of Income,
“Number of Returns, Shares of AGI and Total Income Tax, AGI Floor on
Percentiles in Current and Constant Dollars, and Average Tax Rates,”
Table 1, and “Number of Returns, Shares of AGI and Total Income Tax, and
Average Tax Rates,” Table 2, https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-rates-and-tax-shares; Erica York, “Summary of the Latest Federal Income Tax Data, 2023 Update,” Tax Foundation, Jan. 26, 2023, https://taxfoundation.org/publications/latest-federal-income-tax-data/.
[8] Erica York, “Summary of the Latest Federal Income Tax Data, 2023 Update,” Tax Foundation, Jan. 26, 2023, https://taxfoundation.org/publications/latest-federal-income-tax-data/.
[9]
The IRS statistics on shares and average tax rates also do not include
the outlay portion of refundable tax credits, such as the Earned Income
Tax Credit (EITC) and the Child Tax Credit (CTC),
which if included would reduce further the average tax rates paid by
low-income filers and increase the share of federal income taxes paid by
high-income filers.
[10] Congressional Budget Office, “The Distribution of Household Income 2019,” Nov. 15, 2022, https://www.cbo.gov/system/files/2022-11/58353-HouseholdIncome.pdf; Garrett Watson, “CBO Analysis Finds Income Growth and Progressive Tax Code in 2019,” Tax Foundation, Jan. 10, 2023, https://taxfoundation.org/us-income-growth-progressive-tax-code/.
[11]
In CBO’s analysis, the top 1 percent income group represents about 1.2
million households. Income thresholds defining each income group vary by
household size. For example, a one person household in the top 1
percent of income earns more than $447,200 in 2019 while a four person
household in the top 1 percent earns more than $894,400.
[12]
In CBO’s analysis, 75 percent of corporate income taxes are allocated
to owners of capital in proportion to their income from interest,
dividends, rents, and adjusted capital gains, and 25 percent to workers
in proportion to their labor income.
[13] Demian Brady, “Tax Complexity 2021: Compliance Burdens Ease for Third Year Since Tax Reform,” NTU, April 15, 2021, https://www.ntu.org/foundation/detail/tax-complexity-2021-compliance-burdens-ease-for-third-year-since-tax-reform.
[14] 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.
[15] 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/.
[16] Congressional Budget Office, “Distribution of Major Expenditures in 2019,” October 2021, https://www.cbo.gov/system/files/2021-10/57413-TaxExpenditures.pdf.
[17]
Alex Durante, Cody Kallen, Huaqun Li, William McBride, and Garrett
Watson, “Details & Analysis of the Inflation Reduction Act Tax
Provisions,” Tax Foundation, Aug. 12, 2022, https://taxfoundation.org/inflation-reduction-act/;
Cody Kallen, William McBride, and Garrett Watson, “Minimum Book Tax:
Flawed Revenue Source, Penalizes Pro-Growth Cost Recovery,” Tax
Foundation, Aug. 5, 2022, https://taxfoundation.org/inflation-reduction-act-accelerated-depreciation/;
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/; Alex Muresianu, “Breaking Down the Inflation Reduction Act’s Green Energy Tax Credits,” Tax Foundation, Sept. 14, 2022, https://taxfoundation.org/inflation-reduction-act-green-energy-tax-credits/; Internal Revenue Service, “Latest Updates on the Inflation Reduction Act of 2022”, https://www.irs.gov/inflation-reduction-act-of-2022.
[18] Chandra Wallace, “Corporate AMT Comment Letters Rich in Detail – And Disagreement,” Tax Notes, Mar. 22, 2023, https://www.taxnotes.com/tax-notes-today-federal/corporate-alternative-minimum-tax/corporate-amt-comment-letters-rich-detail-and-disagreement/2023/03/22/7g804; Yuka Hayashi and Richard Rubin, ”New EV Rules Mean Fewer Models Eligible for Tax Credit,” Wall Street Journal, Mar. 31, 2023, https://www.wsj.com/articles/new-ev-rules-mean-fewer-models-eligible-for-tax-credit-98b6b63c?st=ks82qvy8bxihh8h&reflink=desktopwebshare_permalink.
[19]
John Bistline, Neil Mehrotra, and Catherine Wolfram, “Economic
Implications of the Climate Provisions of the Inflation Reduction Act,”
Brookings Papers on Economic Activity, March 2023, https://www.brookings.edu/wp-content/uploads/2023/03/BPEA_Spring2023_Bistline-et-al_unembargoedUpdated.pdf; Jason Furman, “Comment on “Economic Implications of the Climate Provisions of the Inflation Reduction Act,”” Mar. 30, 2023, https://www.brookings.edu/wp-content/uploads/2023/02/2b_20230330-BPEA-climate-furman-comment.pdf; Christine McDaniel, “The Cost of Battery Production Tax Credits Provided in the IRA,” Forbes, Feb. 1, 2023, https://www.forbes.com/sites/christinemcdaniel/2023/02/01/the-cost-of-battery-production-tax-credits-provided-in-the-ira/?sh=362fc62279ef; Christine McDaniel, “The Costs of Wind Production Tax Credits Provided in the IRA,” Forbes, Mar. 8, 2023, https://www.forbes.com/sites/christinemcdaniel/2023/03/08/the-costs-of-wind-production-tax-credits-provided-in-the-ira/?sh=7cd6f4295ff7; Goldman Sachs, “Carbonomics: The Third American Energy Revolution,” Mar. 22, 2023.
[20] Erica York, “Careful What You Wish For: CHIPS Subsidies Require “Excess Profits” Sharing,” Tax Foundation, Mar. 2, 2023, https://taxfoundation.org/biden-semiconductor-chips-act-subsidies/.
[21] White House Office of Information and Regulatory Affairs, Information Collection Review, https://www.reginfo.gov/public/do/PRAMain.
[22] Scott Hodge, “The Tax Compliance Costs of IRS Regulations,” Tax Foundation, Aug. 23, 2022, https://taxfoundation.org/tax-compliance-costs-irs-regulations/.
[23]
Arthur P. Hall, “House Way & Means Committee Testimony: Compliance
Costs of Alternative Tax Systems II,” Tax Foundation, March 1996, https://files.taxfoundation.org/legacy/docs/8926e37c5827f958604933276fcb4864.pdf?_gl=1*1bocc81*_ga*MjkzNjU2MTcuMTY4MDg2NjcyOA..*_ga_FP7KWDV08V*MTY4MTI5MzY4Ni40LjEuMTY4MTI5MzczNy45LjAuMA.
[24]
Kyle Pomerleau, “A Hybrid Approach: The Treatment of Foreign Profits
under the Tax Cuts and Jobs Act,” Tax Foundation, May 3, 2018, https://taxfoundation.org/treatment-foreign-profits-tax-cuts-jobs-act/.
[25]
Daniel Berger, Eric Toder, Victoria Bryant, John Guyton, and Patrick
Langetieg, “Estimating the Effects of Tax Reform on Compliance Burdens,”
Urban Institute, May 19, 2018, https://www.urban.org/research/publication/estimating-effects-tax-reform-compliance-burdens.
[26]
Alex Muresianu and Garrett Watson, “Chaotic IRS Filing Season Shows the
Perils of Running Social Policy Through the Tax Code,” Tax Foundation,
Apr. 18, 2022, https://taxfoundation.org/irs-filing-season-2022/.
[27] Internal Revenue Service, Data Book 2021, May 2022, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book; Joseph Bishop-Henchman, “Transforming the Internal Revenue Service,” Cato Institute, Apr. 11, 2023, https://www.cato.org/policy-analysis/transforming-internal-revenue-service/.
[28] 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/; Joseph Bishop-Henchman, “Transforming the Internal Revenue Service,” Cato Institute, Apr. 11, 2023, https://www.cato.org/policy-analysis/transforming-internal-revenue-service/.
[29] 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/.
[30]
Government Accountability Office, “Tax Compliance: Trends of IRS Audit
Rates and Results for Individual Taxpayers by Income,” May 17, 2022, https://www.gao.gov/products/gao-22-104960.
[31] Garrett Watson, “Closing the Tax Gap and Improving the Tax Code Are Complementary Goals,” Tax Foundation, November 21, 2019, https://taxfoundation.org/closing-tax-gap-improving-tax-code/.
[32]
Erin Collins, “NTA Blog: IRS Strategic Operating Plan Has Potential to
Transform Tax Administration,” National Taxpayer Advocate Blog, April 6,
2023, https://www.taxpayeradvocate.irs.gov/news/nta-blog-irs-strategic-operating-plan-has-potential-to-transform-tax-administration/.
[33] N. Gregory Mankiw, Matthew Weinzierl, and Danny Yagan, “Optimal Taxation in Theory and Practice,” Journal of Economic Perspectives 2009, volume 23(4), https://eml.berkeley.edu/~yagan/OptimalTaxation.pdf; 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/.
[34] 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;
[35] Karel Mertens and José Luis Montiel Olea, “Marginal Tax Rates and Income: New Time Series Evidence,” The Quarterly Journal of Economics 133:4 (November 2018), https://academic.oup.com/qje/article-abstract/133/4/1803/4880451?redirectedFrom=fulltext.
[36]
Åsa Johansson, Christopher Heady, Jens Arnold, Bert Brys, Cyrille
Schwellnus, & Laura Vartia, “Taxation and Economic Growth.”
[37]
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/.
[38]
Åsa Johansson, Christopher Heady, Jens Matthias Arnold, Bert Brys, and
Laura Vartia, “Taxation and Economic Growth,” Organisation for Economic
Co-Operation and Development Working Paper No. 620, July 3, 2008, https://www.oecd-ilibrary.org/economics/taxation-and-economic-growth_241216205486.
[39] Ahn D. M. Nguyen, Luisanna Onnis, and Raffaelle Rossi, “The Macroeconomic Effects of Income and Consumption Tax Changes,” American Economic Journal: Economic Policy 13:2 (May 2021), https://www.aeaweb.org/articles?id=10.1257/pol.20170241&&from=f.
[40] Karel Mertens and Morten O. Ravn, “The Dynamic Effects of Personal and Corporate Income Tax Changes in the Unites States,” American Economic Review 103:4 (June 2013), https://www.aeaweb.org/articles?id=10.1257/aer.103.4.1212.
[41]
Alexander Ljungqvist and Michael Smolyansky, “To Cut or Not to Cut? On
the Impact of Corporate Taxes on Employment and Income,” National Bureau
of Economic Research Working Paper No. 20753 (October 2018), https://www.nber.org/system/files/working_papers/w20753/w20753.pdf.
[42] Stephen J. Entin, “Labor Bears Much of the Cost of the Corporate Tax,” Tax Foundation, Oct. 24, 2017, https://www.taxfoundation.org/labor-bears-corporate-tax/; and Alex Durante, “Who Bears the Burden of Corporate Taxation? A Review of Recent Evidence,” June 10, 2021, https://www.taxfoundation.org/who-bears-burden-corporate-tax/.
[43] Clemens Fuest, Andreas Peichl, and Sebastian Siegloch, “Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany,” American Economic Review 108:2 (February 2018): 393–418, https://www.doi.org/10.1257/aer.20130570.
[44] Joint Committee on Taxation, “Revenue Estimates and Distributional Analyses,” Aug. 3, 2021, https://www.finance.senate.gov/imo/media/doc/jct_analysis_on_corporate_tax_increase.pdf.
[45] Cristina Enache, “Corporate Tax Rates around the World, 2022,” Tax Foundation, December 13, 2022, https://taxfoundation.org/corporate-tax-rates-by-country-2022/.
[46] OECD, Tax Database Table II.4. Overall Statutory Tax Rates on Dividend Income, https://www.oecd.org/tax/tax-policy/tax-database/; Elke Asen, “Double Taxation of Corporate Income in the United States and the OECD,” Tax Foundation, January 13, 2021, https://taxfoundation.org/double-taxation-of-corporate-income/.
[47] Scott Eastman, “Corporate and Pass-through Business Income and Returns Since 1980,” Apr. 23, 2019, https://www.taxfoundation.org/pass-through-business-income-since-1980/
[48] TaxEDU, “Principles of Sound Tax Policy,” Tax Foundation, https://taxfoundation.org/principles/.
[49] Daniel Bunn and Lisa Hogreve, “International Tax Competitiveness Index, 2022,” Tax Foundation, Oct. 17, 2022, https://taxfoundation.org/2022-international-tax-competitiveness-index/.
[50] William McBride, “Biden’s New Tax Proposals are Complicated and Rife with Double Taxation,” Tax Foundation, Mar. 13, 2023, https://taxfoundation.org/biden-tax-fairness/.
[51]
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, Oct. 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/.
[52] 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/;
William McBride, Garrett Watson, Erica York, “Taxing Distributed
Profits Makes Business Taxation Simple and Efficient,” Tax Foundation,
Mar. 1, 2023, https://taxfoundation.org/distributed-profits-tax-us-businesses/.
[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;
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;
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;
Eduardo Davila and Benjamin Hebert, “Optimal Corporate Taxation under
Financial Frictions,” NBER Working Paper No. 25520, October 2021,
https://www.nber.org/papers/w25520.
[54]
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
[55]
William McBride, Huaqun Li, Garrett Watson, Alex Durante, Erica York,
and Alex Muresianu, “Details and Analysis of a Tax Reform Plan for
Growth and Opportunity,” Tax Foundation, February 14, 2023,
https://taxfoundation.org/growth-opportunity-us-tax-reform-plan/
[56]Daniel
Bunn and Cecilia Perez Weigel, “Sources of Government Revenue in the
OECD,” Tax Foundation, Feb. 23, 2023,
https://taxfoundation.org/oecd-tax-revenue-by-country-2023/.
[57] William McBride, “What Is the Evidence on Taxes and Growth,” Tax Foundation, Dec. 18, 2012, https://www.taxfoundation.org/what-evidence-taxes-and-growth/.
[58]
Daniel Bunn, “What the U.S. Can Learn from the Adoption (and Repeal) of
Wealth Taxes in the OECD,” Tax Foundation, Jan. 18, 2022, https://taxfoundation.org/wealth-taxes-in-the-oecd/.
[59]
Daniel Bunn and Elke Asen, “Savings and Investment: The Tax Treatment
of Stock and Retirement Accounts in the OECD,” Tax Foundation, May 26,
2021, https://taxfoundation.org/savings-and-investment-oecd/#Capital; Jacob Lundberg and Johannes Nathell, “Taxing Capital—An International Comparison,” Tax Foundation, May 11, 2021, https://taxfoundation.org/tax-burden-on-capital-income/.
[60] This design is known as the “X Tax,” developed by the late economist David Bradford. See Robert Carroll and Alan D. Viard, Progressive Consumption Taxation: The X Tax, (Washington, D.C: The Rowman & Littlefield Publishing Group, 2012).
[61]
See Rita de la Feria and Michael Walpole, “The Impact of Public
Perceptions on General Consumption Taxes,” British Tax Review 67:5 (Dec.
4, 2020), 637-669, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3723750
for a discussion on how other approaches, such as exemptions or reduced
rates can, counterintuitively, increase regressivity by providing more
benefits to higher-income households.
[62] Internatal 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/.
[63] See for instance: National Association of Business Economics, “Outlook Survey,” February 2023, https://nabe.com/NABE/Surveys/Outlook_Surveys/February_2023_Outlook_Survey_Summary.aspx; The Conference Board, “Probablity of US Recession Remains Elevated,” April 12, 2023, https://www.conference-board.org/research/economy-strategy-finance-charts/CoW-Recession-Probability.
