The federal tax code is a mess from any economic perspective. It is not efficient, fair, or clear. A complete set of suggestions to improve the tax system would take hundreds of pages, as did the excellent 2005 Report of the President’s Advisory Panel on Federal Tax Reform. My discussion will concentrate on a few of the needed changes that would help stimulate a more efficient and faster growing American economy.
A major priority is to eliminate taxes on savings and investments. One reason is that they involve double taxation since personal and corporate incomes are first taxed, and then the returns on the savings and investment out of these incomes are taxed again later on. A second even more important problem with taxes on savings and investments is that in the long run they are shifted to labor because these taxes lower after-tax returns, and thereby discourage investments. A lower rate of investment slows down capital accumulation, which leads to a lower ratio of capital to labor. Wages are lower and pretax returns to capital are higher when the capital/labor ratio is lower.
Moreover, the present system taxes different forms of saving and different types of investment goods at different rates. This distorts the allocation of investments among investment categories. For example, depreciation tax rules allow durable capital to be depreciated more slowly than less durable capital, which lowers the relative tax rate on more durable capital. Similarly, savings that enter tax-free IRA or Roth accounts are taxed less heavily than other forms of savings.
One way completely to eliminate taxation of investments is to allow all investments to be written off immediately as expenses instead of being depreciated over time. Taxing only earnings would eliminate double taxation of savings.
Expensing investments and taxing earnings moves the income tax code a long way in the direction of a tax on consumption rather than on incomes. The basic efficiency advantage of consumption taxes is that they do not distort the decision to consume now rather than consume later since the returns on savings and investments are not taxed. By contrast, income taxes do distort this decision since they tax the incomes earned on savings as well as the incomes that led to the savings.
Whether ones moves to a consumption tax or not, taxes should be simpler and flatter because that would reduce the large cost of tax compliance, and encourage greater investment and work effort. A reasonable proposal that would maintain progressivity yet have a much flatter tax structure would be to have only two or three tax rates, such as 20%, 25%, and 30%. The 20% rate would apply to incomes below a certain threshold, 25% would be the rate on incomes above this lower threshold until an upper income threshold, and 30% would be the tax rate on all incomes above the higher threshold. The tax rate on low labor market earnings would be even less than 20% if the earned income tax credit on low earnings were retained. This credit encourages poorer individuals to enter the labor force rather than staying out to become eligible for various welfare benefits, such as food stamps, unemployment compensation, and housing subsidies.
The income tax base should be widened both because that would be more efficient, and because a wider base would also help maintain tax revenue as rates are flattened, and taxes on savings and investments are removed. For starters, the deductibility of mortgage interest should be eliminated because that artificially encourages investments in home ownership relative to investments in other forms of capital. This deduction also favors higher income families since they are more likely to itemize deductions, and they have higher marginal tax rates. If it were too difficult politically to eliminate this deduction, a big improvement would be to allow a tax credit to all homeowners equal to a fraction of their mortgage interest payments. There would be an upper bound to the amount of interest payments that could qualify for the tax credit.
The exclusion of interest on state and local bonds from income taxes should be abolished because that artificially encourages spending by these governments relative to spending by households and businesses. Since higher income individuals hold the vast majority of state and local bonds, this tax exemption also favors higher income persons in an undesirable way.
The tax on business cash flow (net of investment outlays) should be aligned with the proposed flatter personal income tax structure by lowering corporate and partnership tax rates to the proposed maximum tax rate on personal income, say 30%. Doing this, and taxing business cash flow net of investment deductions, would integrate the business tax into an overall consumption tax.
I discussed the most needed reforms, although other reforms are also desirable-many are considered in the report mentioned above on federal tax reform. Unfortunately, major reforms do not have much chance of enactment in the present political climate, but they are longer run goals that should appeal to both Democrats and Republicans.