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Tax Reform America Can Afford T AX P OLICY P APER A UGUST 2014

Tax Reform America Can Afford




Justice Oliver Wendell Holmes once famously remarked, “Taxes are the price we pay for a civilized society.” Yet, by the same token, different taxes lead to different societies. Our current tax code is outdated, complex and unfair –– leading to slower growth, higher deficits, and greater manipulation by narrow interests. Comprehensive tax reform is long overdue.

The plan outlined below has four basic and bipartisan objectives:

1. Close tax loopholes to lower marginal rates while raising more revenue;

2. End tax preferences that primarily benefit the well-off and well-connected while broadening the tax base;

3. Reposition the corporate tax on a shareholder level to encourage investment while ensuring corporations pay their fair share;

4. Tax carbon pollution to decrease harmful emissions while reducing the regulatory reach of government.

In all, this plan will not just simplify an antiquated and complicated tax code, but it will also help grow the economy, reduce the deficit, and advance environmental sustainability.


1. An outdated tax code

The last time Congress passed a comprehensive tax reform bill was 1986, during President Reagan’s second term. The bill greatly simplified the tax code, removed unfair exemptions and tax breaks, and lowered rates. 1 Notably, the bill passed through a bipartisan effort, and both Democrats and Republicans had to accept significant compromises to ensure its passage. Democrats agreed to lower top rates dramatically, while Republicans agreed to raise the capital gains tax to the same rate as ordinary income. 2 President Reagan had to make a personal trip to Capitol Hill to convince fellow Republicans that an imperfect bill was better than no action at all. 3

Twenty-eight years later, the tax code is long overdue for another overhaul. Now more than 70,000 pages, the tax code has nearly tripled in length since 1986, with hundreds of changes piled on in each congressional session. 4 It is widely acknowledged that both parties want comprehensive tax reform, but recent efforts have stalled due to partisan conflict and entrenched special interests. 5

There are ample examples of provisions in our tax code that may have made sense at one point in time, but that most people would agree are now unreasonable. Credit unions have been exempt from income tax since 1916, when “they were often the sole source of financing for disadvantaged communities whose members had few assets,” even though most credit unions are now much less distinguishable from regular banks. 6 One provision even allows individuals to deduct much of the value of high-priced tickets to college sports games, under the heading of “charitable contribution” – a loophole that might already have been closed if the tax code were revised more frequently. 7


1 Birnbaum, Jeffrey H. The Washington Post. Oct. 22, 2006. “Taxing Lessons, 20 Years in the Making.”

2 Gutmann, Amy & Dennis Thompson. University of Pennsylvania. 2010. “The Mindsets of Political Compromise.”

3 Welna, David. NPR. Oct. 17, 2011. “Times Have Changed Since Reagan's 1986 Tax Reform.”

4 House Ways and Means Committee. 2014. “The Tax Reform Act of 2014.”

5 Milbank, Dana. The Washington Post. Feb. 28, 2014. “The Loneliness of a Tax Reformer.”

6 Matthews, Christopher. TIME. Feb. 27, 2013. “Should Credit Unions Have to Pay Income Tax?”

7 House Ways and Means Committee. 2014. “Tax Reform Act of 2014: Discussion Draft.”

These examples prove that the U.S. tax code is outdated and needs a fundamental, bipartisan overhaul – not just a series of occasional, limited fixes.

The federal tax code is also outdated in its ability to adequately fund the expenditures of today’s federal government, as well as the promises government has made in the future. Each of the last five times our country achieved a balanced budget, revenue has been around 19% of GDP –– the annual value of all the goods and services produced in our economy –– in comparison, in the last four years, tax revenues have averaged 15.4% of GDP. 8 Even more worrisome are the underfunded health and retirement benefits for the nearly 30 million Baby Boomers who will be entering retirement over the next 20 years, the cost of which is estimated to increase to 14.3% of GDP by 2039, compared to 9.7% of GDP today. 9

to 14.3% of GDP by 2039, compared to 9.7% of GDP today. 9 It is impractical

It is impractical and irresponsible to believe the federal government needs less or even the same amount of revenue in the future than it does today or did in the past. However, it matters greatly how government raises additional revenue. Politically, revenue increases should be paired with much larger spending reductions in order to gain the support of both parties. Economically, revenue should be increased by broadening the tax base (i.e. closing loopholes) rather than increasing any marginal tax rates on individuals or businesses, in order to prevent any harm to the economy. 10 This was the approach of the bipartisan Simpson-Bowles Commission in 2010, which achieved a revenue target of 20.6% and paired every dollar in revenue increases with three dollars in spending cuts or other savings. 11


8 Tax Policy Center. April 15, 2014. “Historical Source of Revenue as Share of GDP.”; Politifact. April 27, 2010. “Vern Buchanan says balanced budgets are rare in Washington.”

9 CBO. July 2014. “The 2014 Long-Term Budget Outlook.”

10 Mertens, Karel. National Bureau of Economic Research. June 2013. “Marginal Tax Rates and Income: New Time Series Evidence.”

11 The National Commission on Fiscal Responsibility and Reform. December 2010. “The Moment of Truth.”


A complex tax code

In a report it issued to Congress in 2012, the Internal Revenue Service (IRS) itself wrote, “The

most serious problem facing taxpayers — and the IRS — is the complexity of the Internal Revenue Code.” 12

Besides the astounding length of the federal tax code there are several other indicators of the tax code’s growing complexity. In 1975, Form 1040’s instruction manual was 39 pages long; by 2000 it was 117 pages long; and by 2013 it had nearly doubled to 206 pages. 13 One writer noted in 2012 that, “the number of special tax breaks for energy has soared from 11 in 1995 to 26 today, and each break has separate tax forms, instructions, regulations, and other paperwork.” 14

A complex tax code costs Americans time and money. According to IRS data, it takes 6.1 billion

hours each year for individuals and businesses to file their taxes, the equivalent of three million people working full time. 15 One study from George Mason University estimates that the complexity of tax compliance costs between $215 billion to $987 billion annually, in accounting costs and in foregone economic growth.

The complexity of the tax code also disproportionately affects less well-off Americans, who have neither the time nor the resources to exploit obscure tax code provisions. One government study found that almost half a million individuals overpaid their taxes because they did not itemize deductions – a time-consuming practice predominantly taken advantage of by wealthier Americans. 16 Almost 9 out of 10 Americans rely on assistance from paid professional tax preparers or tax software to file their taxes. 17 Finally, small businesses are also put at a disadvantage: the National Federation of Independent Business estimates that the cost of complying with the federal tax code is 67% higher for small businesses than larger businesses. 18

3. A broken corporate tax

At 35%, the U.S. federal corporate income tax rate is currently among the highest in the world. 19 Yet, federal corporate tax revenues as a percentage of GDP have steadily fallen over the past six decades, from a peak of 6% to less than 2%. 20 These two disparate facts testify to the extent to which the federal corporate income tax has become less effective at collecting revenue, while driving business investments and jobs away from the U.S.


12 National Taxpayer Advocate. Dec. 31, 2012. “2012 Annual Report to Congress.”

13 Keating, David. NTU. April 14, 2014. “A Taxing Trend: The Rise in Complexity, Forms, and Paperwork Burdens.”

14 Edwards, Chris. CATO. April 16, 2012. “The Tax-Code Mess.”

15 National Taxpayer Advocate. Dec. 31, 2012. “2012 Annual Report to Congress.”

16 GAO. April 2001. “Estimates of Taxpayers Who May Have Overpaid Federal Taxes by Not Itemizing.”

17 National Taxpayer Advocate. Dec. 31, 2012. “2012 Annual Report to Congress.”

18 NFIB. 2011. “NFIB Small Business Growth Agenda.”

19 Pomerleau, Kyle & Andrew Lundeen. Tax Foundation. Jan. 27, 2014. “The U.S. Has the Highest Corporate Income Tax Rate in the OECD.”

20 Tax Policy Center. May 17, 2013. “Corporate Income Tax as a Share of GDP, 1946-2009.”

Many corporations avoid paying taxes through accounting tricks, such as storing profits abroad: one study

Many corporations avoid paying taxes through accounting tricks, such as storing profits abroad:

one study concluded that more than $2.1 trillion in corporate profits sit overseas. 21 Apple, for example, only paid 8.2% of its worldwide profits in U.S. corporate income taxes, according to one estimate. 22 Recently, several corporations have taken a further step, by performing “tax inversions” – merging with smaller foreign companies for the purpose of relocating corporate headquarters abroad to avoid U.S. taxes. Overall, the Congressional Joint Committee on Taxation (JCT) estimates that the U.S. stands to lose almost $20 billion in tax revenue over the next decade because of these, and other methods of corporate tax evasion. 23

Yet, the most serious method by which corporations evade U.S. taxes is by moving, not just their headquarters, but also their operations, investments, and jobs overseas. While the average effective corporate tax rate is typically lower than the federal statutory rate of 35%, a 2011 analysis showed that the effective marginal rate on new investments was 34.6% - a rate higher than that of almost every other country. 24 It was in part due to America’s anti-competitive corporate tax from 2000 to 2010, during which U.S. multinational corporations cut 2.9 million jobs in the U.S. and added 2.4 million overseas. Because of this, the federal corporate tax may have ended up costing the U.S. economy even more than it was intended to cost corporations.


21 Drawbaugh, Kevin & Patrick Temple-West. Reuters. April 8, 2014. “Untaxed U.S. corporate profits held overseas top $2.1 trillion: study.”

22 Fleischer, Victor. The New York Times. June 4, 2013. “Calculating Apple’s True U.S. Tax Rate.”

23 Montgomery, Lori. The Washington Post. Aug. 6, 2014. “U.S. policymakers gird for rash of corporate expatriations.”

24 Chen, Duanjie & Jack Mintz. CATO. Feb. 2011. “New Estimates of Effective Corporate Tax Rates on Business Investment.”

4. An unfair tax code

The federal tax code contains over two hundred deductions, exemptions, exclusions, and credits. 25 Some of these so-called “tax expenditures” – such as the Earned Income Tax Credit – are designed to serve a broad swath of society, pursue worthwhile societal goals, and enjoy widespread support. However, many are just the opposite: targeting narrow interest groups or the wealthy and adding billions of dollars to the national debt each year.

Several major features of the tax code disproportionately benefit well off Americans. For example, income from capital gains and dividends is taxed at a lower rate than ordinary income, costing the government $85 billion in 2013 and benefitting virtually none besides the wealthiest Americans (the top 5% of earners gain about half of the benefit from this preferential tax treatment). 26 The mortgage interest deduction, while vital to encouraging homeownership, costs the government $70 billion and “benefits higher-income households much more than other households,” according to the Congressional Budget Office. 27 For 73 years, owners of luxury yachts, for example, have sometimes been able to claim their boats as a second home under the mortgage interest tax deduction. 28

second home under the mortgage interest tax deduction. 2 8 On the whole, in 2013, over

On the whole, in 2013, over 50% of the $900 billion government spent on the top ten tax expenditures benefited those in the top fifth of the income spectrum while only 13% benefited those in the middle fifth –– exacerbating growing inequality in our country. 29

Tax loopholes are not just unfair; they also hurt the federal budget and the economy. According to the Tax Policy Center, tax expenditures cost the federal government almost $1.3 trillion in lost revenue in 2012 – around double the size of the U.S. defense budget. 30 Tax loopholes create perverse incentives, causing individuals and businesses to make inefficient economic decisions and slowing economic growth. Finally, each tax expenditure forces the government to maintain or raise overall marginal rates to make up for lost revenue.


25 Sides, John. The Monkey Fact. Feb. 16, 2012. “The Facts about Tax Progressivity.”

26 CBO. May 2013. “The Distribution of Major Tax Expenditures in the Individual Income Tax System.”

27 Ibid.

28 Kessenides, Dimitra. Bloomberg Businessweek. Jan. 30, 2014. “Ending Tax Breaks for Yachts.”

29 CBO. May 2013. “The Distribution of Major Tax Expenditures in the Individual Income Tax System.”

30 Marron, Donald B. Tax Policy Center. 2012. “How Large Are Tax Expenditures? A 2012 Update.”


1. Close Tax Loopholes and Simplify the Tax Code

Tax reform must begin with getting rid of the many unnecessary provisions that contribute to its complexity, benefit narrow constituencies, and cost the government money. These loopholes –– also known as “tax expenditures” because they are government spending in disguise –– are popular for politicians to attack in general, but difficult for them to actually eliminate.

That’s because attempting to remove any single provision of the tax code is usually an uphill battle: the benefits of any given tax provision are usually concentrated among a small group of supporters willing to advocate incessantly for it, while the costs are diffused to millions of Americans with little incentive to oppose just one of many unfair and detrimental tax measures. Thus, any approach to tax reform that proposes to eliminate tax loopholes one by one is likely politically infeasible.

Instead, Congress should adopt a “Zero Plan” approach, in which all individual and corporate tax expenditures would be eliminated from the tax code, except for those that lawmakers specifically vote to add back in. 31 That way, politicians are forced to defend why the public’s money should be used to finance any particular special provision.

Any tax expenditure that remains in the tax code should meet several tests: it should be fair and simple, interfere minimally with the free market, and further broad societal goals. And, moving forward, any additional tax expenditures should have to be paid for through higher marginal tax rates or cuts to other spending.

Congress should implement the Zero Plan and keep the following tax preferences:

The Earned Income Tax Credit & Child Tax Credit

Tax credits for education and retirement savings

The deduction for charitable contributions

The deduction for mortgage interest, only on primary residences

Closing tax loopholes would save a significant portion of the total $1.3 trillion government spends on tax expenditures each year. It is difficult to estimate the exact amount that would be saved, given uncertainty about how individual behavior would respond to different tax incentives. Regardless, a portion of these savings should be dedicated to reducing the federal deficit in at least a 3:1 cuts-to-revenues approach, and the remainder should be used to lower marginal tax rates for all individuals. Under the Simpson-Bowles deficit reduction plan, for instance, marginal income tax rates were reduced to three brackets of 12%, 22%, and 27% as a result of eliminating tax expenditures. 32

In general, eliminating tax expenditures will go a long way towards simplifying the tax code. Ideally, compliance with the federal tax code for most people should only take a few minutes and be able to be completed on a single sheet of paper.


31 The Joint Committee on Taxation’s definition of “tax expenditure” is one simple criterion for which provisions of the tax code would be eliminated if no action were taken to preserve them.

32 Tax Policy Center. 2010. “The Bowles-Simpson “Chairmen’s Mark” Deficit Reduction Plan.”


Reposition the Corporate Tax

Congress should reposition the corporate tax as a revenue-neutral tax on corporate profits at the shareholder level.

This idea, contained within the Common Sense Tax proposed by economist Laurence Kotlikoff, stems from a simple accounting identity: that all net profits earned by corporations ultimately end up in the hands of shareholders. 33 Further, directly taxing corporations does not mean corporate entities themselves are actually paying the tax; indeed, many simply pass the tax on in the form of lower wages to employees or higher prices to consumers.

Where the current corporate tax system incentivizes corporations to shield their profits from taxation by keeping them overseas or moving their entire operations abroad, the Common Sense Corporate Tax would ensure corporate profits are taxed as they accrue by taxing the people who own the corporation –– the shareholders. In this system, people who hold shares of C-corporations above a defined income threshold would pay taxes in much the same way as those who own proprietorships, partnerships or S-corporations.

Repositioning the corporate tax as part of comprehensive tax reform would cause significant economic growth from business and industry and help stop U.S. companies from moving overseas. A large-scale computer simulation run by the Tax Analysis Center showed that reforming the corporate tax in this way would result in increases in American investment, output, and real wages. 34

It is not always the case that the interests of the U.S. government, corporations, and individual

Americans align, yet repositioning the corporate tax is an opportunity to reduce the federal deficit,

spur economic growth, keep jobs in the United States, and ensure that the profits made by corporations are taxed in full.

3. Realign Tax Priorities

When used in a targeted, appropriate and effective way, the tax code can help promote important societal goals such as business investment, support for the working poor, home ownership, higher education, and retirement security. The tax code should also reflect what should be one of government’s highest priorities: addressing the threat of global climate change. 35

Congress should enact a carbon tax that is:

Phased-in –– $20/ton in the first year and gradually increasing thereafter

Revenue-neutral –– every dollar raised is offset by lowering taxes elsewhere

Border-adjustable –– applied to certain foreign imports, rebated from exports

A revenue-neutral and border-adjustable carbon tax is the best way for government to take action

on this environmental issue because it would decrease pollution, reduce the size of government,

and incentivize other countries to price carbon similarly.

First, a modest carbon tax could achieve significant reductions in harmful emissions. A 2013 CBO study showed that a tax of $20 per metric ton of carbon dioxide and other greenhouse gases could


33 For more information on the Common Sense Tax, see:

34 Kotlikoff, Laurence J. The New York Times. Jan. 5, 2014. “Abolish the Corporate Income Tax.”

35 IPCC. 2013. “Climate Change 2013: The Physical Science Basis.” Working Group Contribution to the Fifth Assessment Report of the IPCC.

reduce total emissions by 8% over a decade. 36 The tax would encourage the development and utilization of cleaner and renewable fuels.

Second, the carbon tax can replace many inefficient and economically harmful government subsidies and regulations that are designed to address climate change. And since the carbon-tax would be revenue neutral, it would result in lowering pollution –– not growing government.

Third, the carbon tax could be implemented to be border-adjustable – applied to foreign imports from countries where such a tax does not exist and removed from American exports. Other countries would have an incentive to mirror America’s actions (to collect revenue that would otherwise be collected by our country), addressing the collective problems faced by other proposals to promote environmental sustainability.

Even for those who remain skeptical of the threat of climate change itself, there is reason to support the carbon tax: every dollar raised through the taxation of pollution (something we should want less of) would be used to lower taxation on working, saving, and investing (something we should want more of) –– to the tune of $1.2 trillion over a decade. 37 The carbon tax would protect individuals and families from higher priced goods or services (such as gasoline) through a lower income or payroll tax; and special rebates should be designed to protect the lowest-income Americans.

If government must raise revenue, then it should do so in the least harmful way possible. The carbon tax can help correct a market failure and simultaneously foster a more efficient economy – – not to mention advance our moral responsibility to be good stewards of our environment. Perhaps this is why the carbon tax has been called “the tax favored by most economists.” 38


36 CBO. May 2013. “Effects of a Carbon Tax on the Economy and the Environment,”

37 Ibid.

38 Gale, William G. The Brookings Institution. March 12, 2013. “The Tax Favored by Most Economists.”