What the Ideal Tax Code Looks Like
The following has been adapted from The Hidden Costs of Federal Tax Policy, published by the Mercatus Center at George Mason University. Download the book for free or buy a copy here.
Tax reform is a hot topic in Washington, D.C. But luckily, policymakers need not fly blind when it comes to defining the principles key to a successful revenue system.
The most basic goal of tax policy is to raise enough revenue to meet the government's spending requirements in the way that has the least impact on the economy. Academic research suggests that, to meet this goal, a successful system should be simple, equitable, permanent, and predictable.
The U.S. tax code does not live up to these standards. In fact, while most developed countries have lowered their corporate tax rates and restructured their tax systems to make them simpler, the United States appears to be taking the opposite approach. The current tax code distorts market decisions and hampers job creation, reducing both economic growth and tax revenue.
The statutory corporate tax rate in the United States is the highest in the industrial world — a factor that encourages businesses to move to lower-tax countries, taking jobs, money, and tax dollars with them. The costs of tax compliance in the U.S., meanwhile, may be nearly a trillion dollars annually, including accounting costs, economic losses, and lobbying expenditures.
Contributing to these costs, dozens of tax provisions set to expire every year are repeatedly extended in a seemingly endless cycle. This process is evidence of the tax code's complex and temporary nature — two faults that increase both uncertainty and costs for American people and businesses.
Clearly, the nation's economic and fiscal situation has increased the motivation — and the urgency — to reform the federal tax system, along with the federal government's other unsustainable institutions and practices. But what would an ideal tax code look like?
One thing policymakers should not do is raise tax rates. There is much research showing the negative consequences of raising tax rates on economic growth. Research by Christina Romer, former chair of President Obama's Council of Economic Advisers, and David Romer, an economist at the University of California–Berkeley, suggests that "a tax increase of 1 percent of GDP reduces output over the next three years by nearly 3 percent."
With tax cuts in mind, some have claimed that the Tax Reform Act of 1986 is model legislation for future reform. But despite the law's perceived success, it failed to fix the revenue system's large institutional problems, and the key reforms it did include were clawed back almost immediately. As a result, the tax code looks even worse today than it did before the reform.
Keeping the tax code as simple and as transparent as possible will reduce the incentives to reverse future tax reforms. This can be done by taxing a broad base at a single low rate, and by removing distortionary tax benefits that treat similar activities unequally.
In the individual tax code, for example, policymakers should work to reform the mortgage-interest deduction and marriage penalty. Consumer advocates view the mortgage-interest deduction as a benefit for lower- and middle- income taxpayers, but most of the benefits from the deduction go to high earners, and it encourages unnecessary levels of debt and borrowing.
Similarly, the marriage penalty creates unequal taxation among couples whose only differing characteristic is their marital status. The structure of joint income-tax filing creates a significant tax disincentive to marriage and raises the cost of working outside the home for married women. The negative effects of the marriage penalty are greatest for low-income households.
To regain competitiveness, the United States should also reduce its corporate tax rate to 25 percent at most, the average rate of other Organisation for Economic Co-operation and Development (OECD) countries — a move that will benefit everyone in the economy. U.S. corporate taxes have been shown to fall primarily on labor. This means that the taxes paid by U.S. corporations are mostly passed on to employees through lower wages and benefits.
The tax code's complexity is also evident in the rules applied to corporate capital investments. A reform called "full expensing" — under which businesses may deduct all their capital expenses from their taxable income immediately, instead of gradually over the life of the asset — would be another move toward a better tax system.
History has shown that tax reforms seldom last when special interests have substantial incentives to lobby Congress for tax breaks. Making the tax code as simple and as transparent as possible will help to ensure that future tax reforms aren't quickly reversed.
Jason J. Fichtner is a senior research fellow at the Mercatus Center at George Mason University. Jacob Feldman is an economist for the Bureau of Labor Statistics.