April 14, 2004

April 14, 2004 | WebMemo on Taxes

A Tax Code Report Card

About 140 million taxpayers will send tax returns to Uncle Sam this year, in a painful exercise involving 8 billion pages of paper that will help transfer about $1.8 trillion from the productive sector of the economy to government. Recent legislation has resulted in lower tax liabilities, which certainly is a welcome change for many taxpayers. An equally interesting question, however, is whether these tax policy changes have led to a better tax code.

 

Not all tax cuts are created equal. Some tax cuts, specifically "supply-side" reductions in tax rates on work, saving, investment, and entrepreneurship, can yield large benefits to the economy. Properly designed, they even can simplify today's Byzantine tax system. But it is also is possible to cut taxes in ways that lead to a more complicated tax system while simultaneously doing nothing to improve the economy's performance.

 

To judge the desirability of tax policy changes, there must be a yardstick - a benchmark, so to speak, of an ideal tax system. This theoretical ideal would have a low tax rate, and it would tax income only one time. Such a system would not impose a second layer of tax on income earned in other nations, and taxpayers would find it easy to understand. The flat tax (specifically the Hall/Rabushka system[1]) usually is the standard that is used to make these comparisons, though other single-rate, consumption-base tax systems would be similarly useful.

 

Based on these criteria, the tax changes enacted in 2001 and 2003 move the code in the right direction. But the improvements are only modest. Much more needs to be done.

 

What Changed

  • Tax Burden - Modest improvement
    After reaching a near-record level of 20.9 percent of gross domestic product (GDP) in 2000, the overall tax burden has declined. Indeed, it is now less than 17 percent of GDP, the lowest level since 1959. But this exaggerates the degree of improvement since tax collections are still being affected by the recent economic downturn, especially the drop in capital gains tax receipts. The Congressional Budget Office projects that revenues will soon rebound to about 18.1 percent of GDP, which is exactly what tax revenues averaged between 1950 and 2000. And if the 2001 and 2003 tax cuts are allowed to expire, the tax code will revert to the system that was in place when Bill Clinton left office--completely erasing the small improvements of the past few years.
  • Tax Rates - Modest improvement
    Marginal tax rates have been slightly reduced for all taxpayers. This is a laudable development since the marginal tax rate (the tax paid on additional increments of income) determines the degree to which the system discourages productive economic behavior. Most importantly, the top tax rate on personal income has dropped from 39.6 percent to 35 percent, a reform that should encourage entrepreneurs and investors to create more wealth for the American economy. It is worth noting, however, that the top tax rate was only 28 percent when Ronald Reagan left office. Moreover, tax rates for all taxpayers will revert to their Clinton-era levels if the 2001 and 2003 tax cuts are not made permanent.
  • Double-taxation - Significant improvement
    One of worst features of the tax code is the way that some types of income are subject to several layers of tax. Income that is saved and invested receives the worst treatment. Thanks to the capital gains tax, corporate income tax, personal income tax, and death tax, it is possible for a single dollar of income to be taxed four times. This is a perverse policy since every economic theory-even Marxism-agrees that capital formation is the key to long-run growth and higher living standards. The good news is that the Bush tax cuts significantly reduced double taxation. In addition to minor reductions in the tax rates on personal income, the capital gains tax has been reduced from 20 percent to 15 percent, and the top tax rate on dividends has been lowered from 39.6 percent to 15 percent. Last but not least, the death tax is abolished beginning in 2010. The bad news is that all these tax cuts will expire at the end of 2008 (dividends and capital gains) and 2010 (income tax rates and death tax repeal).
  • International Competitiveness - Modest improvement
    The United States has a substantial advantage over many other developed nations. The aggregate tax burden in America (including state and local taxes) is about 27 percent of GDP. This compares quite favorably to the tax burden in European Union nations, where taxes consume about 42 percent of national economic output. The 2001 and 2003 tax cuts improved U.S. competitiveness, but it is important to realize that the United States lags in certain areas. The United States, for instance, imposes the second-highest corporate tax rate of any developed nation. America even has higher corporate tax rates than socialist welfare states like France and Sweden. The 35 percent corporate income tax rate (40 percent including the average of state corporate tax rates) puts U.S.-based companies in an unenviable position-especially since this high tax rate applies to income earned in other nations. This is why some companies have re-chartered in (or inverted to) jurisdictions like the Cayman Islands and Bermuda that have better tax law. While the Bush tax cuts have improved overall U.S. competitiveness - which is why our economy is doing better and creating more jobs than Europe - the corporate tax system is a glaring exception.
  • Simplicity - Modest deterioration
    Cutting tax rates and reducing double-taxation are both important, but supply-side tax cuts do not necessarily make the tax code simpler or easier to understand. The reductions in personal income tax rates, for instance, do not change the complexity of the IRS 1040 tax form. The lower tax rates for dividends and capital gains are another example. These policies will improve economic performance, but they do not alter the amount of paperwork required to compute annual tax liabilities. But this is not the end of the story. Some of the tax policy changes in recent years actually made the tax system more convoluted. Special tax credits, deductions, exemptions, and preferences have been added to the system, making a bad system even worse. And it appears that the situation will deteriorate even further based on the degree of social engineering and back-door industrial policy provisions in the energy bill and FSC replacement legislation.
  • Civil liberties - Modest deterioration
    The IRS budget has grown substantially, and the agency has been given carte blanche to be more aggressive. This is unfortunate. The IRS already has enormous powers, and taxpayers are denied basic constitutional protections such as the presumption of innocence. Moreover, the potential for abuse grows every time the tax code becomes more complicated, meaning that taxpayers may face a "perfect storm" of a more hard line IRS enforcing an even more complex tax code. But things could be worse. Some politicians want to give the IRS mind-reading powers, or at least that is the only possible interpretation of proposals to enact an "economic substance" doctrine - a scheme that would give the IRS the power to persecute taxpayers if the agency decides that taxpayers made decisions in order to lower their tax liabilities.

America may not tax as much as some other nations, but it is hardly a ringing endorsement to say our tax system is not as burdensome as France's. Tax rates are still excessive, and the level of complexity is intolerably high. The 2001 and 2003 tax bills are a step in the right direction, but many miles remain on the journey to a simple and fair system like the flat tax.

 

Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.



[1] See Hall and Rabushka's The Flat Tax.

 

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy