Experts across the political spectrum agree that the U.S. tax code is a huge mess and needs to be reformed as well as simplified. It is also generally accepted that lower tax rates will lead to faster economic growth.
As Congress turns its attention to tax reform, Senate Democrats have stated the basic principles which they would like to see included in any changes which are made:
Increase the wages of working families. This could be accomplished by lowering tax rates for all individuals across the board, paid for by eliminating (or at least shrinking) many of the personal deductions in the tax code. The approximately two thirds of all taxpayers who do not itemize deductions would then receive a tax cut, equivalent to a wage increase.
Promote domestic investment and improve middle class job growth. Lower tax rates will give businesses and entrepreneurs a bigger incentive to invest in business expansion and therefore grow the economy faster and create more new jobs.
Modernize our outdated business and international tax system. Our corporate tax rate at 35% is the highest in the developed world and, at the same time, produces below average revenue (see chart). Another reform would be to adopt business expensing (immediate tax write-off for new investment). Again, all such changes should be paid for by eliminating loopholes and shrinking deductions.
Any rewrite of the tax code must be deficit neutral. As important and valuable as tax reform is, it has to take into account our country’s most fundamental problem: our huge and rapidly growing national debt and therefore end up being deficit neutral overall.
Conclusion. The above principles, stated by the Senate Democrats, represent a sound approach to reforming the U.S. tax system. I hope that the Republicans are willing to recognize the validity of these proposals and include the Democrats in developing a bipartisan tax reform plan.
Responsible tax reform will be highly beneficial for the U.S. economy because:
Economic growth will be speeded up by lowering tax rates on businesses, thereby encouraging more investment.
National debt will shrink because faster growth will produce more tax revenue. But this only works if the revised tax plan is revenue neutral to begin with.
The Trump tax plan, described here and here, has the following features:
three tax brackets, reduced from seven. Simplification like this is a good idea.
double the standard deduction. This puts more money in the pockets of the average tax payer who does not itemize deductions and is therefore a good idea.
repeal of the alternative minimum tax. This only affects wealthy people and should be retained, if necessary, to make sure that overall reform does not increase the deficit.
lower capital gains tax. This will encourage more investment but should not be included unless the overall plan is revenue neutral.
repeal of inheritance tax. This tax feature should be retained until our annual budget deficits are eliminated, i.e. until we achieve balanced budgets on an annual basis.
preserving deductions for mortgage interest and charitable contributions. The mortgage interest deduction should be greatly reduced from its current level of $1 million per residence. Wealthy taxpayers don’t need that much help. Raising the standard deduction will already help middle income taxpayers.
cutting the corporate tax rate. This is an excellent idea as long as its revenue loss is made up elsewhere. It will encourage multinational corporations to bring their overseas profits back home for reinvestment in the U.S.
Conclusion. The Trump tax plan has some good features as well as some poor ones. Reducing tax rates is a good idea. But adding to annual deficits is a very bad idea. With some effort it is possible to reduce tax rates in a revenue neutral way.
Several large U.S. corporations have recently announced that they are planning to merge with foreign companies and move their corporate headquarters to a low tax country such as Ireland or Great Britain. The Obama Administration proposes to disallow such tax inversions by requiring that after such a merger at least 50% of the stock of the new company would have to be foreign owned. Such a regulatory fix is unlikely to solve a much more fundamental problem. The Tax Foundation has just published a new study, “Tax Reform in the UK Reversed the Tide of Corporate Tax Inversions,” describing a similar situation in Great Britain just a few years ago and what was done to reverse it. Basically GB took two actions:
Implementing a territorial tax system where profits are only taxed in the country where they are earned, and
Lowering the corporate tax rate from 28% in 2010 to 21% in 2014 and 20% in 2015. The GB rate had already been somewhat lower than the U.S. rate since the early nineteen-eighties.
These two changes in the corporate tax code have had a dramatic effect. First of all, the number of corporations in GB has been increasing steadily. By 2017 GB is likely to overtake the U.S. in total number of corporations. Secondly, GB actually raises more corporate tax revenue than the U.S. and has been doing so for some years. It should be clear from this discussion that the U.S. should significantly lower its corporate tax rate. The biggest problem in doing this is public opinion. The organization Wallet Hub has just published its “2014 Tax Fairness Survey” which shows that only 10% of the population believes that taxes should be higher on wages than on investment income, whereas 33% thinks the reverse. An equal tax rate on both is preferred by 57% of respondents. This will make it politically difficult, for example, for the U.S. to match GB’s 20% maximum rate on corporations since even middle class U.S. taxpayers pay a tax rate of 25% or higher. However it might be possible to abolish the corporate tax altogether if dividends and capital gains were then taxed at the same rate as wage income.
The most important thing, however, is to significantly lower the corporate tax rate, one way or the other, in order to incentivize U.S. multinational corporations to keep more of their business and profits in the U.S.
Several large U.S. corporations have recently announced that they are planning to move their headquarters to a low tax company such as Ireland or Great Britain, in order to reduce the high corporate taxes which they now have to pay. Many observers agree that the best way to address this problem is to lower the corporate tax rate down to an internationally competitive rate of about 20% to 25%. Such a rate cut would be paid for by closing the loopholes and deductions which many corporations now enjoy. The Business Insider reporter, Danny Vinik, makes a very good argument for going further and completely eliminating the corporate income tax for the following reasons:
Corporate taxes don’t collect that much revenue. As shown above the revenue from this tax has dropped to about 2% of GDP which is about $300 billion at the present time. This is roughly 10% of total annual federal tax revenue.
Tax capital gains and dividends at the same rate as earned income. This would make up for the lost revenue and is justified because there would no longer be double taxation of corporate earnings.
The corporate tax is not progressive. It is now paid for by both workers (with lower wages) and shareholders. Eliminating this tax (and replacing it with higher taxes on dividends and capital gains) makes the tax more progressive.
Corporations waste huge amounts of money trying to reduce their tax bill. What they now spend on tax lawyers and lobbyists could be put to more productive use.
The current system disadvantages new businesses. It’s the old firms which have collected all the deductions. New firms start out paying the full 35% rate which puts them at a large competitive disadvantage.
It will make our financial system safer. Since debt payments are tax deductible and equity financing is not, debt financing is currently incentivized. The elimination of the corporate tax would end this preference of debt over equity.
Taking this action would not only have all of these benefits, it would make the U.S. the most desirable place in the world to locate a business. We would experience a huge economic boom, creating millions of new jobs. It would end our present economic funk and put us back on a rapid growth trajectory. What are we waiting for!
The Yale Tax Law Professor, Michael Graetz, has proposed a new tax system “100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States” which would do wonders towards straightening out the huge fiscal and economic problems now facing our country. How do we rev up the national economy in order to put more people back to work and, at the same time, raise the revenue needed to operate the government in the 21st century without mountains of debt? Mr. Graetz’s basic idea is to tax consumption rather than relying totally on an income tax. Under his plan both savings and investments will be taxed at a lower rate which will encourage more of both. The Plan has these features:
A broad based Value Added Tax of about 14% is enacted on goods and services. The U.S. is the only advanced economy without a VAT.
Families earning less than $100,000 are exempted from the income tax. For incomes between $100,000 and $250,000, the tax rate would be 15%. For income over $250,000, the rate would be 25%.
The corporate income tax rate is lowered to 15%.
The Earned Income Tax Credit (EITC) is used to provide relief from the VAT burden to low-income families by using payroll tax offsets.
The plan is designed to be revenue neutral as verified by the Tax Policy Center.
This plan has many advantages including:
Taxing consumption and lowering the corporate tax rate to 15% from its current level of 35% would dramatically encourage investment in the U.S. thereby stimulating the economy and creating both new jobs and higher wages for American workers.
It would eliminate more than 100 million of the 140 million U.S. tax returns.
With many fewer Americans paying income taxes there would be far less temptation for Congress to use income tax exclusions, deductions and credits to try to address social and economic problems.
The plan retains all of the progressive features of our current tax system whereby higher income earners pay higher tax rates.
The point of describing the Graetz Plan in some detail is not to suggest that it is the best way to implement tax reform but rather that here, at least, is one attractive way to do it. The purpose is to move the discussion forward. We badly need to make changes along these lines!