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) usually is the
standard that is used to make these comparisons, though other
single-rate, consumption-base tax systems would be similarly
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.
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
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
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.
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.
Mitchell is McKenna Senior Fellow in Political Economy at The