Getting back to basics: The why of tax reform

Getting back to basics: The why of tax reform
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The U.S. tax code is littered with problems, and identifying them is the natural first step toward fixing the tax code. Unfortunately, finding a problem is almost always easier than proposing credible solutions for them.

As Congress debates tax reform, let’s start with the basics: Why does the tax code need reform, and who is hurt by a tax code that is out-of-date and makes U.S. firms less competitive with their overseas counterparts?

Asking for more simplicity in the U.S. tax code has started to sound like a cliché. Yet, simplicity can yield huge dividends in terms of tax revenues for the government as well as lower time and monetary costs for taxpayers.

In 2016, taxpayers spent more than 8.9 billion hours trying to meet their tax obligations, at an estimated cost of over $409 billion, approximately 12 percent of all federal tax revenues. This is time and money taken away from other productive activities that business owners and households could have engaged in.

According to the National Taxpayer Advocate’s report to Congress in 2012, 90 percent of tax filers pay a transaction fee to help file returns, either using commercial preparers or tax software. This is primarily due to the growth of the federal tax code from 400 pages in 1913 to over 74,000 pages in 2013.

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The tax code’s complexity is also a burden for the IRS. The IRS audits less than 1 percent of all returns, so the risk of being audited for under-payment or improper reporting is low on average.

 

To estimate the extent of non-compliance, the IRS publishes a “tax gap” study every few years. In the most recent tax gap study (for 2008-2010), the IRS estimates that actual taxes paid lag true tax liabilities by about 16 percent, resulting in an annual loss of $406 billion for the Treasury.

Under-reporting of income accounts for most of the tax gap, but taxpayers also under-pay their taxes or simply don’t file a tax return even though they should. In addition, the IRS has paid $132 billion over the last decade to people who were ineligible for EITC benefits.

Therefore, a good starting point for tax reform would be to move toward a simpler tax code, one that is easier for individuals and businesses to comply with and easier for the IRS to administer.

Of our different tax systems, the corporate income tax is in most desperate need of reform. The Congressional Budget Office in a recent report highlights how the U.S. has a corporate tax rate that is “among the highest in the world.”

While the numerous loopholes and credits allow many companies to avoid paying the top rate, the effective average and marginal rates are relatively high as well, with the U.S. among the top four countries with the highest rates.

These high rates hurt our economy by driving out investment. Research shows that companies are relatively more likely to invest in low-tax rather than high-tax countries. My own work with Kevin Hassett suggests that this loss in investment leads to lower worker productivity and lower wages for American workers.

In addition, the high U.S. tax rate creates powerful incentives for corporate profit-shifting and inversions, further heightened by the U.S. system of worldwide taxation of profits.

The corporate income tax applies to profits regardless of where they are earned worldwide, but only when that money is repatriated to the U.S. parent company. This creates incentives for businesses to keep profits offshore or to reincorporate in a foreign country that doesn’t tax their worldwide profits.

Despite the high rates, U.S. corporate tax revenue as a share of GDP is substantially lower than in other OECD economies.

While a cut in the corporate tax rate can have positive investment and economic growth impacts, it is important that such cuts be combined with some type of base broadening effort to avoid worsening our already unsustainable fiscal path.

This could involve limiting interest deductibility for companies, or taxing capital gains and dividends at higher rates. Proposals for a border adjustment, or a destination-based cash flow tax, also make sense.

In addition, limiting the mortgage interest deduction or the exclusion of employer contributions for medical expenditures, would help cut spending. Combined, such tax expenditures cost the U.S. over $1 trillion.

These might be justified if the benefits were largely going to lower-income households. But in fact, many of these expenditures benefit relatively well-off taxpayers more than lower-income households. So, cutting or limiting these makes good economic sense.

Finally, one little discussed area ripe for reform is the simplification of tax credit programs that target low-income households. The House Budget Committee report in 2012 highlighted how there are more than 92 programs designed to address poverty, and the U.S. spends more than $800 billion on these programs.

Yet, the eligibility rules vary across programs and differ considerably within the same program based on differences in marital status, income or asset levels and number of children in the household.

As a result, many people eligible for support through these programs don’t use them, while many who shouldn’t claim the money do. The EITC overpayment rate is estimated at 22 to 26 percent — a significant amount of money.

In addition, as households phase out of these programs, the “implicit tax rate”— the loss in income for every additional dollar earned — often exceeds 50 percent. This can create disincentives to work for low-income households, or at the very least, lead to an under-reporting of income.

The message is clear: Congress has a tough road ahead as it takes on the challenge of tax reform. But if we get back to the basics — the “why” of tax reform — and work toward a system that is simpler, fairer and more pro-growth, such efforts can yield enormous dividends in the long-run.

Mathur (@aparnamath) is a resident scholar in economic policy studies at the American Enterprise Institute.