Analysis: Alternative U.S. Tax Code
Introduction
For
some time now, there has been a growing discussion on whether the taxation base
we are currently using is the right one. Some people argue that the fact that
we are using income as the base of taxation makes the economy as a whole very
inefficient. Plenty of proposals have been put forth, all with different
specifications and details, aimed at making our tax system an effective and
equitable mean to provide our government with funds.
The
taxation system that we will be analyzing consists in changing the taxation
base from income to consumption while getting rid of the corporate income tax.
Plenty of European countries already have a taxation system in place which uses
consumption and not income as the base for federal taxation, and many analyses
have been made on whether eliminating corporate income tax is something that
will be generally beneficial or detrimental for a country’s economy.
The
specifics of the proposed tax code will be discussed further down and will be pinned
up against the current tax code so that at the end of our analysis, we will be
able to determine which system would work better for the general economy. It is
only reasonable that we analyze the current tax system first in order to
illustrate the changes that occur when applying the proposed tax code and the specifics
behind those changes.
Current Personal Income Tax
Economists,
politicians, and the general public within society all agree that the current
tax system is quite complicated and far from perfect. The personal income tax
is a big source of revenue for the government, it brings in additional funds
which are used to fund public goods and services which might be unlikely to be
supplied if not by the government. The current system is based on a set of
principles which guide the way legislators create tax policy, although in some cases
not every provision is consistent with these principles, and has some very
specific issues for which it has been nearly impossible to find solutions to.
The
main principles upon which our current personal income tax is based are: income
as the basis of taxation, progressivity, family as taxation unit, and an
annual, as opposed to a lifetime, income base. When bringing these principles
into action in a workable and comprehensive tax law, there have been several
identifiable issues which are worth noting. The three main issues with our
current tax law concern determining what should be considered “income,”
determining when some person has received such income, and deciding what
deductions, if any, should be granted to the taxpayers.
For
most taxpayers determining income is a straightforward process given that it
revolves only around their salary, however, this is not the case for
business-owning taxpayers. The current tax code recognizes that expenses an
individual incurs to make a living should be deducted from that person’s
taxable income. However, this presents an issue given that it gives individuals
who own a business the opportunity to claim business expenses and qualify for
tax deductions from things that should not be considered business expenses such
as traveling and dinners with “clients” which they, at times falsely, claim are
part of their business activities.
The
timing of when somebody has actually received some income can be tricky at
times as it is generally difficult to determine when income has effectively
been earned. There are many instances when taxpayers are given some money in
advance for a good or a service which is subject to be refunded if certain
conditions are not met. This creates an issue given that the present discounted
value of these kinds of tax liabilities is reduced when the tax is postponed,
hence the phrase that “a dollar today is worth more than a dollar tomorrow.”
Deductions
also present a great challenge for the current tax system. Policymakers are
constantly being challenged on the question of which deductions to allow and
which ones to modify or get rid of. These deductions are designed for two
purposes: to get closer to a more equitable tax system, and to encourage a
certain set of socially-desirable activities for which individuals would
otherwise not have incentives to do. Some deductions such as those for
charitable activities are controversial and widely criticized for benefiting
people in the higher income classes. Because deductions lead to different
individuals facing different rates, they tend to be distortionary and the bulk
of economists even argue that it would be preferable to utilize credits instead
of deductions.
Our
current system is very far from simple, it is the result of years of compromise
of competing, and sometimes conflicting, interests. Essentially, all of the
principles, assumptions, and implementation practices of the current system
have been put in doubt. People have pointed at different aspects of our current
tax code and suggested reforms. The proposed tax reform at hand targets the
underlying principle that our tax system ought to be income-based and suggests
that it might be better to have consumption be the base of it. The following
pages will include a discussion of the different aspects of the proposed system
and test it against the current system to assess whether one is better than the
other and where that superiority lies.
Current Corporate
Income Tax
The
current corporate income tax allows the government to tax incorporated
businesses, which are considered business entities with liabilities not
attached in any way to the investors of the corporation. This tax has,
throughout its history, been subject to plenty of criticism and controversy
with some claiming that corporations should be paying their “fair share” of
taxes just like individuals, and others arguing for tax deductions which would
allow corporations to run more efficiently. However, there is one thing that
most economists agree upon: the corporation does not bear the tax, people do.
Most
corporate income is subject to a 21% statutory tax rate after being lowered
greatly from 35% by the Trump Administration through the Tax Cuts and Jobs Act
of 2017; this was the largest overhaul to the corporate income tax made in the
last 30 years. Just like with personal income tax, after tax liability is
calculated, a firm’s tax is reduced by tax credits which have throughout the
years allowed U.S. corporations, especially multinationals, to reduce their tax
burdens through complex tax-avoidance strategies.
One
thing to note is that the corporate income tax results in what people refer to
as “double taxation.” This occurs because income earned by corporations is first
subject to the corporate income tax, then this income may also be subject to an
additional layer of taxation at the individual level when dividends are paid or
when there are capital gains from the sale of shares. This can create an
incentive against the incorporation of businesses as many prefer establishing
limited liability corporations or partnerships to escape the burden of double
taxation. Another consequence of this is the fact that corporations tend to
prefer holding more retained earnings rather than paying dividends. This allows
for profits to go into increasing stock prices instead which can be more
attractive than paying dividends given that capital gains income can be timed
and is sometimes taxed at a lower rate than dividends.
The
fact that economic inefficiencies arise when taxes distort market choices is
undisputed. When businesses allocate their resources motivated by tax-induced
incentives, that generally indicates that resources might not be allocated in
the most efficient way. Therefore, the corporate income tax might lead to lower
economic efficiency to the extent that it leads to misallocation of capital
between corporate and noncorporate business entities. In fact, economist John
Shoven of Stanford University estimated the deadweight loss from the
corporation income tax in the intermediate run to be roughly 12% of the revenue
it generated. However, there are some deductions which attempt to address
instances where market failures exist. An example of this would be the tax
incentives for research and development which generate positive externalities and
usually tend to be underprovided by markets alone.
The
effective federal corporate tax rate has been declining sharply since 1986.
There is an ongoing debate on whether corporations, like individuals, should
pay taxes. While some argue they should be paying their “fair share,” others
argue against it given that the tax ultimately falls on people such as
employees, shareholders, or consumers and that it is a possibility that this
specific tax has no significant redistributive effect. Further on we will focus
on the analysis of a tax system with no corporate income tax, this given that
it is one of the facets of the proposed tax system to be analyzed in this
paper.
Changing the Base of Federal
Taxation from Income to Consumption
The
base for federal taxation has been widely discussed throughout the years, some
argue that consumption, not income, should be the base of federal taxation and
that is exactly the change we will be analyzing. The proposed taxation system
includes a change in the base of taxation from income to consumption which is
achieved by making forms of savings tax deductible. Since consumption is equal
to income minus savings, this change to the tax code will inherently change the
basis of taxation from income to consumption.
This
is a topic which has been widely discussed in the academic economic community
and there have been several research studies which estimate the economic impact
of such transition into consumption taxes. The estimates vary given the
different models and assumptions used, however, it is widely argued that
switching to a consumption tax would increase total economic output by 5% to
10% in the long run as compared with an income tax. This projected increase
occurs in a long period of time, often being 100 years, meaning that the change
in annual GDP growth would be quite small. Additionally, it should be noted
that any adjustments to make the switch less burdensome to groups that are
negatively affected will hinder the effectiveness of this change and would make
the growth even smaller.
One
of the biggest critiques of most consumption taxes is that they violate one of
the important principles upon which the current tax system is based:
progressiveness. This is the case given that wealthy individuals usually
consume a smaller fraction of their income than those with lower incomes and
also have more elastic demands for many of the products they consume. The proposed
change is no exception to this as it seems to be quite regressive in nature.
It
is the case as individuals in higher income bracket tend to accumulate more
savings every year and given that under this system savings are deducted from
taxable income, they have a bigger advantage on that matter. This is also the
case with business expenses and investments as it is evident that individuals
with higher income are more likely to engage in these activities and would
therefore receive more deductions of these kinds.
|
Single |
Married
(Filling Jointly) |
Head
of Household |
|||
|
Amount
Range |
Rate |
Amount Range |
Rate |
Amount Range |
Rate |
|
$0 - $9,875 |
10% |
$0 - $19,750 |
10% |
$0 - $14,100 |
10% |
|
$9,876
- $40,125 |
12% |
$19,751 - $80,250 |
12% |
$14,101 - $53,700 |
12% |
|
$40,126 - $85,525 |
22% |
$80,251 - $171,050 |
22% |
$53,701 - $85,500 |
22% |
|
$85,526
- $163,300 |
24% |
$171,051 - $326,600 |
24% |
$85,501 - $163,300 |
24% |
|
$163,301 - $207,350 |
32% |
$326,601 - $414,700 |
32% |
$163,301 - $207,350 |
32% |
|
$207,351
- $518,400 |
35% |
$414,701 - $622,050 |
35% |
$207,351 - $518,400 |
35% |
|
$518,401+ |
37% |
$622,051+ |
37% |
$518,401+ |
37% |
Figure 1: 2020 Tax Rates
The
proposed tax system would have two brackets, the first $25,000 of taxable
income are to be taxed at a 25% rate and all taxable income above that will be
taxed at a 49% rate. However, the proposed system also includes a set of
standard deductions. These deductions will be of $15,000 if filing single,
$26,000 if filing jointly, and $6,000 per dependent. This change represents some
progressiveness as said deductions represent a very large percentage of
low-income individuals’ AGI which in some cases might even surpass 100%. On the
other hand, these deductions are of very little significance to people in the
higher income brackets as they represent only a small fraction of their AGI.
To
illustrate the changes, I have created a model (Figure 2) which predicts the
tax expenditures of the individuals filing single and with no dependents at
five different income levels. In the construction of such model, I am making
the assumption that whenever someone’s AGI is lower than the standard
deduction, they would not pay any taxes nor receive any money back. The model
was created using 2019 data from the Bureau of Labor Statistics on consumption
as a percentage of income assuming that the data represents a single individual
within the household for the sake of simplicity and illustration.
|
Income
Group |
Extremely
Low Earner/ Spender |
Bottom
20% |
Average
American |
Top
20% |
Extremely
High Earner/ Spender |
|
Total Income |
$9,000.00 |
$25,525.00 |
$73,572.60 |
$187,998.11 |
$1,000,000.00 |
|
Consumption (AGI) |
$9,000.00 |
$25,525.00 |
$53,708.00 |
$99,639.00 |
$300,000.00 |
|
Consumption as % of income |
100% |
100% |
73% |
53% |
30% |
|
Standard Deduction |
($15,000.00) |
($15,000.00) |
($15,000.00) |
($15,000.00) |
($15,000.00) |
|
Taxable AGI |
($6,000.00) |
$10,525.00 |
$38,708.00 |
$84,639.00 |
$285,000.00 |
|
Total Taxes Paid |
- |
$2,631.25 |
$12,966.92 |
$35,473.11 |
$133,650.00 |
|
Tax Expense % of Income |
- |
10% |
18% |
19% |
13% |
|
Previous Tax Rate |
10% |
12% |
22% |
32% |
37% |
|
Taxes Paid Under Current System |
$900.00 |
$3,063.00 |
$16,185.97 |
$60,159.40 |
$370,000.00 |
|
Difference ($) |
($900.00) |
($431.75) |
($3,219.05) |
($24,686.29) |
($236,350.00) |
|
Difference (%) |
-10% |
-2% |
-4% |
-13% |
-24% |
Figure 2: Tax
Expenditure Simulation Under New System
When
simulating the actual rates and taxes paid under the current changes there are
some things which must be noted. By analyzing the numbers, we can clearly see
that people across different income groups would all be paying less taxes than
under the current system. This essentially means that there is reason to
believe that the government would be raising less taxes under these provisions.
This would result in less money provided for public amenities, schools, and
healthcare among other things which are bound to disproportionately affect
lower income communities the most.
In
terms of equity shifts, the effects of this tax are quite interesting. First,
it is important to mention that people who have an AGI which is less than the
standard deduction they receive would not be paying any taxes under this
system. This change results in great benefits for those in the lowest income
classes. Then, as the income levels progress towards the lower middle-income
classes, we can see that the current system results in less difference for them
as someone in the bottom quintile would only be seeing a difference of
approximately 2% in their tax rate.
However,
the biggest beneficiaries from this change, as the model shows, would be the
people in the highest income classes. As Figure 2 illustrates, people in the
top 20% would be paying around 13% less in taxes. This number goes up as income
grows with extremely high earners and spenders paying around 24% less than what
they currently pay under the current tax system. The evident explanation to
this is that as income grows, consumption as a percentage of income decreases.
Low-income individuals are less able to save and more often than not they end
up spending 100% of their income on basic necessities. On the other hand, it is
very rare for someone to spend $1 million a year on non-business expenditures,
meaning that high earners save more and are greatly rewarded for this natural
occurrence under this system.
Individual
behavior is also likely to change in response to the changes in taxation. Given
that savings and investment are to be deducted from taxable income, these
behaviors are said to be incentivized and are expected to increase. Individuals
under this system will choose to save and invest large portions of their income
whenever possible in order for their taxes to be lower. This is beneficial
given that with people’s savings accounts increasing, individuals will have
more liquidity and will be less affected in periods of economic downturns. They
would also be incentivized to invest their money which will increase the pool
of capital that businesses have and will allow them to grow, leading to
increased job creation. However, as previously stated, low earners would find
it very difficult to benefit from this as they usually spend 100% of their
income.
Changing
the taxation base constitutes a big change which is likely to have a big impact
on society. As we have discussed, there is evidence to believe that the change will
provide the government with fewer funds than under the current system. Then, taxing
consumption can also be seen as either progressive or regressive when looked
from different perspectives. It can be seen as progressive as standard
deductions represent a bigger portion of low-income individuals’ AGI and in
some instances lead them to be tax exempt. However, I believe this is
outweighed by the overall regressiveness of the measure as it is clear that
high-income individuals would be the main beneficiaries of this change,
acquiring benefits far greater than those in the lower and middle classes
resulting in increased inequalities. Individual behaviors and attitudes towards
investing and saving are also likely to change with this particular tax and
that is very likely to bring about positive change and economic stimulation.
All these changes have to be measured and balanced out in order to assess
whether making this switch would be in general better or worse for society.
Eliminating the
Corporate Income Tax
As
previously stated, corporate income tax is controversial given that it has
provisions for which it is very difficult to assess who carries the burden of
the tax. However, economists agree that it is people, not corporations who bear
the burden of this tax; it is the people working, owning shares, or consuming
the products or services of the company who are ultimately affected. The
corporate income tax has been declining for the last 30 years or so and has
reached a new low with the Trump Administration tax cut, however, the proposed
tax system would not only reduce it but rather eliminate it completely.
Eliminating
the corporate tax is an idea that, although popular, has raised very
comprehensive and realistic equity concerns given that the income tax
contributes to the overall progressivity of the tax system. Statistics from the
Congressional Budget Office estimated that in 2010 the average corporate income
tax paid by those in the top 1% of the income distribution was 6.9% while those
in the bottom quintile of the income distribution paid an average tax of only 0.7%.
Further, it is estimated that households in the top income quintile paid 78.8%
of all corporate income taxes while those in the bottom quintile paid merely 1.7%
of all corporate income taxes while earning 5.1% of all the pretax income.
These
statistics allow us to see how, through a corporate income tax, the tax system
is actually filtering down funds from the top earners in the economy into the
lower earners. What makes a corporate income tax appealing is its
progressivity, the fact that it places most of the burden on high income people
and provides the lower income earners with modest benefits. All of this means
that just like the switch from an income to a consumption tax base in the personal
income tax, eliminating the corporate tax would increase the inequities in
American society given that it is a device through which we have distributed benefits
progressively and successfully.
In
terms of efficiency, as we know, introducing taxes into an otherwise free an
unregulated market inevitably creates some inefficiencies. The corporate tax
system is believed to reduce economic efficiency in the sense that it generates
a misallocation of capital in the business sector between corporate and
noncorporate firms. Economists have argued that intense distortions occur given
that in some markets, there is production going on both in the corporate sector
as well as in the unincorporated sector so as the tax increases the cost of
production in the incorporated sector, production begins shifting to the
unincorporated sector which generates a deadweight loss that is frequently in
excess of 100% of the revenue generated. Additionally, as previously stated, the
corporate income tax also creates a distortion by double taxing corporate
income.
However,
some of the exemptions, credits, and deductions in the current tax system are
attempts to address certain instances in which markets left alone are failing
to maximize economic efficiency. This is the case, for example, with the
incentives that the tax system provides for research and development. These
activities generally lead to technological innovation which is associated with
positive externalities that benefit society as a whole. It is suggested by
economic theory that such activities that generate positive externalities are
usually underprovided in an economy, therefore, by providing incentives that
promote these activities, the tax system is actually aiding in making the
economy more efficient.
However,
generally speaking, getting rid of the corporate income tax would make the
economy more efficient given that the inefficiencies caused by the tax far
outweigh the benefits that credits, exemptions, and deductions generate in
terms of efficiency. With the current system completely eliminating the
corporate income tax, we can expect the economy as a whole to work in a way that
is more efficient than how it currently is operated.
An
additional issue with the current tax code is the fact that it is extremely complex,
and this complexity leads to increased compliance costs given that complex tax
systems, such as the one in place right now, require taxpayers to devote more
time and economic resources to tax preparation. These compliance efforts and
spending generate inefficiencies given that the resources devoted to tax
preparation are not available to be employed someplace else on the economy.
This also leads to certain taxpaying corporations finding themselves in a
competitive disadvantage given that those with limited resources may not be
able to claim as many tax benefits as those that have more resources available
to be dedicated to maximizing their tax benefits and deductions. Therefore,
from this perspective, eliminating it would lead to increased efficiency and a
slight positive improvement towards equity through the elimination of these
complexities which generate additional costs for corporations.
Complete
elimination of the corporate income tax has been widely discussed and advocated
by certain groups in the economy, but what exactly would happen if we got rid
of the corporate income tax in the United States? Given that this is a mean
through which we have been able to successfully distribute resources equitably
in the past, eliminating this tax would lead to the further expansion of
inequities within our society. However, this tax also causes our economic
system as a whole to be a lot less efficient. By allowing production to flow
from the corporate to the unincorporated sector and increasing compliance
costs, the tax creates distortions in the economy which can lead to great
deadweight losses in certain markets, undoubtedly hindering economic efficiency.
Eliminating the tax addresses these inefficiencies and makes the economy more
efficient in general terms.
Conclusions
The
proposed federal income tax system had two major new provisions: changing the
base of taxation from income to consumption in the personal income tax and
eliminating the corporate income tax. These new provisions would fundamentally
change the taxation system as we currently know it and would come with big
unknowns for which we will only be certain once they are implemented and
results are readily available to be evaluated. They provide major changes in
equity by being progressive in some aspects and regressive in others, and in
efficiency by eliminating distortions and bringing freedom to the markets to
follow their natural course. These provisions can be evaluated in radically
different ways under the Utilitarian and Rawlsian perspectives.
By
looking at this situation through a Utilitarian lens, we would only be
concerned with whether the overall benefits outweigh the overall costs. In
other terms, efficiency. As we have agreed upon, the changes proposed to the
tax system bring about a more efficient economic system. These are provisions
that eliminate distortions in the corporate sector and bring about greater
economic profits through a more efficient allocation of goods. However, the
system generates certain inequities for which one would have to assess the
loses and gains in utility that these shifts generate. This is impossible to do
given that we would have to get utility functions from every single person in
society to assess if overall utility is increased or decreased by these
changes. Therefore, it is fair to conclude that a utilitarian would be in favor
of the proposed changes given that by making the economy more efficient, the
changes provide a positive overall economic benefit in terms of economic
profits and expansion.
If
we were to evaluate the changes made to the current tax system from a Rawlsian
perspective, we would be most concerned with the changes that the proposed tax
system would bring about for the individuals who are worst-off in society, in
this case they are the ones in the lower income brackets. Given that the
proposed changes to the base of taxation and the elimination of corporate
income taxes perpetuate inequalities in society and would leave people in the
lower and middle income brackets worse off with respect to those with higher
income, this proposal would not make any sense to be implemented from a
Rawlsian perspective.
Being
a firm believer in the argument that a society is only worth as much as its
weakest member, I would be inclined towards a Rawlsian perspective in believing
that the proposed tax system would be detrimental for our society and worse
than the status quo, which is represented by the current tax system. One of the
biggest contemporary issues is that of inequalities within our society so the
idea of having a tax system which further perpetuates that issue instead of
working to counter it makes no sense in the contemporary socioeconomic
environment of the United States.
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