Ideas on U.S. Tax Reform

Policy Reports | Taxes

No. 377
Wednesday, December 09, 2015
by James P. Angelini and David G. Tuerck

In order to pursue meaningful tax reform, it is necessary to define income using either the consumption or the accretion to net worth (income) standard. Advocates of the consumption standard assert that by taxing consumption, the government achieves tax equity and removes a bias against saving the tax code would otherwise create.

Executive Summary

Arguably, saving is taxed only once under the consumption standard but twice under the accretion standard. However, advocates of the accretion standard say that the consumption tax is biased against low-income households because they consume a larger share of their income than do high-income households.

Corporate taxes present a separate problem in that they tax income twice — first, the corporate level and again at the individual level. Depending upon which standard is used, the government has a choice of three categories of reform to reduce the corporate tax with the intention of creating a more rational tax code:

  • Proposals that would retain, but reform, the corporate tax;
  • Proposals that would automatically eliminate the corporate tax; and
  • Proposals that eliminate any distinction between incorporated and unincorporated enterprises.

President Obama’s FY 2016 Budget proposal. The president’s budget proposal, unveiled in February 2015, included more tax incentives for lower income families, increased taxes on high-income taxpayers, and a reduction in the corporate tax rate — but only if some tax breaks for the oil, gas and coal industries were eliminated. The president’s budget also favors renewing the 100 percent capital gains exclusion for noncorporate taxpayers, making the research tax credit permanent and less complex, and expanding the credit for health insurance provided by small employers to their employees.

The Tax Reform Act of 2014. House Ways and Means Committee Chairman Dave Camp (R-Mich.) proposed the comprehensive Tax Reform Act of 2014. Under this act, the top corporate tax rate would be reduced to 25 percent, phased in over time, and carried interest would be taxed as ordinary income instead of as capital gains. Many corporate and business income tax breaks would be eliminated in order to broaden the tax base. For multinational corporations, Camp proposed a 95 percent exemption for dividends received by U.S. corporations from foreign subsidiaries. Subpart F rules would be changed to tax the intangible income (income arising from the sale of intangible property such as patents, trademarks and copyrights, or capital gains and dividends) of foreign subsidiaries when earned and to tax foreign intangible income at a 15 percent rate.

The most popular proposals are the following:

Proposals for Tax Integration. Since corporate dividends to shareholders are subject to double taxation,
options for integrating tax laws include a deduction for dividends and other distributions paid to shareholders up to the amount of the corporation’s “earnings and profits.”

The FairTax. This proposal would eliminate the corporate income tax and replace almost all federal taxes
with a national 23 percent retail sales tax and provide a “prebate” cash payment for each household.

Value Added Tax (VAT). The VAT tax base is similar to the FairTax base, except that there is no explicit cash payment or mandate to eliminate all other taxes as a condition for its implementation.

The Flat Tax. A flat tax is a (roughly) proportional, revenue-neutral tax on income that would require
eliminating many deductions and credits, and repealing the estate and gift taxes. According to one proposal,
all businesses and individuals would pay a standard 19 percent (declining to 17 percent later) on wages,
retirement distributions and unemployment benefits. The flat tax is by definition a tax on consumption.

The key to meaningful corporate tax reform lies in choosing which of these standards to adopt
and in deciding which standard — accretion or consumption — is to be followed. The answer lies in
educating the public to the fact that (1) corporate taxes, like all taxes on capital, reduce capital formation and, in the process, impose a burden on labor, and (2) the difficulty of achieving reform and of reducing compliance costs derives from an unwillingness to decide just what it is — “income,” as conventionally defined, or consumption — we want to tax.

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