[Economic Report of the President (2006)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER  5

The U.S. Tax System in
International Perspective


All governments face two important decisions. They must choose the
scope and scale of public goods and services to provide for their
citizens, including national defense, public safety, education,
law enforcement, and social insurance. They must also decide how to
collect the funds to finance those public services, including what
things to tax and at what rate to tax them. These tax policy
decisions affect job creation, the allocation of resources,
economic efficiency, economic growth, and ultimately the living
standards of their citizens. In this chapter, we examine U.S.
choices in the context of the varied choices of other countries
around the world.
Recent calls for fundamental tax reform reflect long-standing
public frustration with the complexity of the U.S. system and
dissatisfaction with its economic effects. Last year's Economic
Report of the President outlined the need for tax reform and
evaluated several prototypes for reform. The President created a
bipartisan Advisory Panel on Federal Tax Reform that spent the
year evaluating the current tax system and recommended two
options for reform. This chapter provides a broader context for
evaluating these and other potential reforms.
This chapter makes three essential points:
 Every country makes fundamental choices about its tax
system: what level of overall tax burden to impose, what
to tax, and what tax rates to apply. These choices matter
because they have important economic consequences that
affect the living standards of their citizens.
 The United States has made different choices than other
countries: We have a relatively low tax burden, and we
finance more of that burden with a tax on personal income
instead of consumption.
 When viewed in an international perspective, the U.S.
system has been improved by some significant changes
but could benefit greatly from others, particularly those
focused on reforming the taxation of capital income.

Fundamental Choices in Tax Systems

The two fundamental questions that must be answered in designing a
tax system to raise revenue for government expenditures are what to
tax (the "base") and how much to tax it (the "rates"). Public
discussion of tax policy often also focuses on the distributional
consequences of these decisions, which are certainly important.
However, economists point out that the answers to these two
fundamental questions have equally important implications for the
economic decisions made by individuals and small and large
businesses, and thus for the overall performance of the economy.
In this section we discuss these tax policy choices and their
effects on economic decisions.

Designing a Tax System
Governments choose the size and scope of the public services they
wish to provide and the corresponding level of spending required. At
the same time, they choose how to finance that spending, through a
combination of taxation and borrowing. The use of borrowing
(deficits) to finance government spending has varied over time, and
the optimal level depends on many factors. For example, economists
have argued that it is reasonable to borrow to finance temporary
increases in spending (e.g., during times of war or to provide aid
after a disaster) or temporary declines in revenue (as in a
recession). In any case, the cost of government borrowing must
ultimately be financed by tax revenues, and so we focus here on
the tax system.
Every tax system is defined by two factors: the tax base and the
tax rate structure. The base defines what is subject to taxation
and the rate determines what portion is taken in tax. We begin by
considering two of the most common tax bases used: income and
consumption.
A tax system with a pure income tax base is designed to tax all of
the resources that increase a taxpayer's ability to consume,
regardless of what that taxpayer actually does consume. Taxable
income under this system includes all wage and salary income,
interest income, and dividends, and also can include increases in
wealth such as unrealized capital gains and noncash income such as
the implicit rental value of owner-occupied housing. In short, under
a pure income-based tax system, all income plus all increases in
wealth can be subject to taxation.
A consumption-based tax system, in contrast, taxes only the share
of income that is consumed, exempting the share that is saved.
Examples of consumption-based tax systems, such as a national retail
sales tax, a value-added tax, a consumption-based Flat Tax, or a
consumed-income tax, were presented in Chapter 3 of the 2005
Economic Report of the President, which addressed "Options for Tax
Reform."
The U.S. tax system is neither a pure income tax nor a pure
consumption tax, but rather a hybrid of the two. Although
nominally based on income, the U.S. system excludes significant
portions of the return to savings from the tax base (e.g.,
interest earned on assets held in a 401(k) employment-based
retirement plan or an Individual Retirement Account). The U.S.
system also excludes other forms of income from the tax base, two
key examples being the premiums paid by employers for employee
health insurance and the implicit rental value of owner-occupied
housing.
Another central aspect of designing a tax base is the treatment of
international activity, both of foreigners acting within U.S. borders
and of U.S. citizens and corporations conducting business abroad.
Currently, the United States applies its income tax, in principle,
on a worldwide basis, taxing all income earned by U.S. residents on
their economic activity in the United States and the rest of the
world, and allowing a limited credit for taxes paid to foreign
governments. Taxing on a worldwide basis means the U.S. applies its
tax to all economic activity in the country (regardless of the
nationality of ownership) and to all activity of U.S. residents and
U.S.-owned companies (regardless of the country in which that
activity occurs). The United States could, alternatively, tax on a
territorial basis, taxing all income earned within U.S. borders
regardless of the nationality of the person or corporations earning
the income, but not taxing income earned abroad. Territorial tax
treatment would exclude from the tax base all foreign earnings of
U.S. residents (both individuals and corporations). With
increasing competition among the United States and other countries
for economic activity, this choice also has important implications
for economic growth and efficiency.
In addition to choosing the tax base, the tax authorities must
also determine the tax rate structure. This choice has significant
effects on both the efficiency and the equity of the tax system.
Countries might choose one tax rate to apply to the entire tax base,
or a progressive schedule of tax rates, with higher rates applying
to those with greater resources. A key determinant of the effect of
the tax system on the efficiency of the economy is the tax rate that
is applied to the incremental use of resource-such as an additional
dollar of income or an additional dollar of consumption. This
marginal tax rate is important because it affects the taxpayers'
incentives, and thus their economic behavior, inducing them to make
decisions that are different from those they might have made in the
absence of the tax. These "distortions" of behavior (relative to
the no-tax benchmark) are the major channel through which the tax
system affects the efficiency of the economy.

Taxes Distort Economic Decisions
Virtually all forms of taxation distort economic decision making
because they change the cost of allocating resources to different
uses. Those distortions have a real economic cost that goes beyond
the burden of the tax being paid. The reduction in economic
efficiency generated by the changes in economic behavior that a tax
induces is called the excess burden of the tax. The excess burden
imposed by a tax increases dramatically as the marginal tax rate
increases. A standard demonstration in economics textbooks is that
excess burden is proportional to the square of the tax rate, so that
doubling the marginal tax rate roughly quadruples the excess burden
of the tax. This relationship between marginal tax rates and
economic efficiency is the reason that tax systems with broad bases
and low rates are generally considered the most efficient way to
raise revenue.
Of course, the tax rate specified in statute may not correspond
with what businesses and individuals actually pay in taxes because
of exemptions, deductions, and credits that reduce their tax burden.
The effective tax rate that people pay (and that drives their
behavior) may thus be lower than the statutory rate. Designing a tax
system involves choosing the statutory tax rates, defining the tax
base including any exemptions and deductions, and specifying tax
credits. The combination of those choices determines the effective
tax rate that people and firms pay, and that can alter their
behavior and cause distortions in the economy. In the next section
we discuss the distortions created by different tax systems.
Tax Systems and Economic Distortions
The complexities of modern tax systems can change many decisions
made by individuals and businesses alike. For example, individuals
choose how much they work, the forms of compensation they receive
(such as wages or health insurance), how much they save, and
whether they own or rent a home. Businesses must choose how many
workers to hire, where to locate workers and capital assets around
the world, the types of assets in which to invest, and the means of
financing these assets (e.g., debt, equity, or retained earnings).
Taxes can affect all of these decisions.
The choice between an income-based and a consumption-based tax
system affects the labor market decisions of workers, the savings
decisions of families, and the behavior of entrepreneurs. For
example, a worker facing a marginal tax rate of 40 percent on
income (who would thus take home only $6 for an additional
$10 earned) may decide to work less than someone who faces
a marginal tax rate of 20 percent (and would thus take home $8
for an additional $10 earned).
Relative to a consumption tax base, the use of an income tax base
increases the costs to individuals of saving for the future, as
detailed in Chapter 3 of the 2005 Economic Report of the President.
A tax system with the property of static efficiency does not distort
the choices that people make about how to allocate resources today
(for example, it does not affect their decision about whether to
consume apples or oranges). A system with the property of dynamic
efficiency does not distort the choice of how to allocate resources
between today and tomorrow (it does not affect the choice between
consuming apples today and consuming apples in the future).
Consumption-based taxes are more likely to be dynamically
efficient than income-based taxes. Someone earning a higher return
on a savings account can expect to consume more in the future for
each dollar saved, and is thus likely to save more. Taxing savings
(as is done in a pure income-based system) makes future consumption
relatively more costly, which leads people to save and invest less,
with adverse consequences for economic growth.
Further distortions are introduced into the U.S. economy by the
separate taxation of corporate income, rather than integration of
taxation of corporate and personal income. Corporate profits are
essentially taxed twice, first under the corporate income tax and
again under the personal income tax when corporate profits are paid
out as dividends. The result is a higher tax on income earned in the
corporate sector than that earned elsewhere in the economy. For
corporate income that is paid out as dividends, the combined tax
rate can be remarkably high: as much as 35 percent at the corporate
level and another 15 percent through the individual income tax,
considering Federal taxes alone. Including state tax rates and
accounting for deductibility, the Organization for Economic
Cooperation and Development (OECD) estimates the U.S. combined tax
rate can be as high as 50.8 percent. This double-taxation of
corporate income creates both static and dynamic inefficiencies.
It is also inconsistent with either a pure income tax base or a
pure consumption tax base.
The U.S. tax code also makes it costlier for firms to make some
kinds of investments than others, leading to additional distortions
of economic decision making. For example, investment financed from
prior earnings (equity) and investment financed from borrowing
(debt) are taxed differently, various assets are subject to
different depreciation rules, and dividend income received by
shareholders is taxed differently from capital gains. There are
also ways that U.S. firms can reduce their effective tax rate by
deferring their tax payments. Each of these differences affects the
choices that businesses make about where and how much to invest.
Finally, the U.S. application of a worldwide tax base affects firms'
decisions about where to locate and where to make investments.
Foreign-sourced income of U.S. companies is taxable, but the credits
taxpayers receive for foreign taxes paid are not applied uniformly.
There are limits to the amount of foreign tax credit a firm can
claim, which can create incentives for firms to change their
investment and business activity patterns across countries based on
international tax rates. Under this worldwide system, U.S. firms
operating in a foreign country may eventually be liable for not just
that host country's taxes, but also for U.S. taxes under some
circumstances. Competitors from countries taxing on a territorial
basis are not subject to this U.S. tax, and therefore may have a
competitive advantage, all else being equal.
More generally, the tax treatment of the foreign-source income of
U.S. multinationals under the current worldwide system is widely
thought to be one of the most complex aspects of U.S. taxation.
This complexity itself imposes a burden on these companies, causing
them to allocate substantial resources to tax planning and
compliance. With globalization and the increasing importance of
international capital flows, the distortions and complexity
generated by the current U.S. system are increasingly costly to the
U.S. economy.


U.S. Tax Policy in International Perspective

In this section we examine the choices the United States has made
about the size of the national tax burden, the forms of taxation
to employ, and the tax rates applied. We compare these choices to
those made by other countries and show that the United States has a
relatively low overall tax burden, and its choices about which tax
sources to rely upon differ substantially. Recent reforms in other
countries are highlighted.

International Comparison of Overall Tax Burdens
A common measure of the overall tax burden is the ratio of total
taxes paid to all levels of government to the gross domestic
product (GDP). This share represents the fraction of the total
output of the economy that is taken in taxes in any given year, or
the average tax rate. This measure of overall tax burden is
particularly useful for international comparisons. First, it is
unaffected by international differences in national versus
subnational government responsibilities. Second, it adjusts for
differences in the overall size of the countries'economies.
Among countries in the OECD, the United States has a relatively
low total tax burden (including Federal, state, and local taxes).
Total taxes in the United States at all levels of government
amounted to 26.4 percent of GDP in 2002, substantially lower than
the OECD average of 36.3 percent. This share is also below the
European Union (EU) average of 40.6 percent.
Chart 5-1 uses OECD data from 2002 to illustrate the average tax
rates (total taxes as a share of GDP) for the 15 largest countries
of the OECD.  Only Mexico, Korea, and Japan had total tax burdens
smaller than that of the United States in 2002. OECD countries such
as Sweden and Denmark, on the other hand, had tax burdens that were
as much as 20 percentage points of GDP higher than that of the
United States.
The United States faces a significant fiscal challenge in keeping
the overall tax burden low in the future. Growth in Federal
entitlement spending if not checked, threatens to require
substantial increases in taxes, significantly altering the tax
choices the United States has made in the past. Box 5-1 provides
an overview of this fiscal challenge and its implications for tax
policy.




International Comparison of Tax Bases and
Rate Structures

Beyond different choices about the scope and size of government,
the OECD countries have also made different choices about the tax
systems used to raise funds. Almost all of the OECD countries use
some mix of personal income, corporate income, payroll, sales, and
other taxes (e.g., estate and excise taxes), but they differ
significantly in their degree of reliance on each. Chart 5-1
illustrates the composition of each country's tax revenue sources:
personal income taxes, taxes on goods and services (consumption
taxes), social security taxes, corporate income taxes, and other
taxes.
The United States relies more heavily on personal income taxation
than other OECD countries do. Indeed, in 2002 the United States
collected 37.7 percent of its total taxes through the personal income
tax compared to an OECD average of 26.0 percent.  Given this
difference, one might then ask how other countries finance their
spending. The primary alternative tax base is consumption. OECD
countries collected an average of 31.9 percent of total revenues from
taxes on goods and services, mainly through value-added taxes (VATs).
A VAT is a tax applied to the gross receipts earned by sellers of
products, but sellers receive a tax credit for taxes paid on the
inputs they use, so the tax effectively applies only to the value
that they themselves added in the

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Box 5-1: Fiscal Challenges Ahead
U.S. Federal tax revenues and Federal expenditures have remained
fairly stable as a share of national output (GDP) over the past four
decades. Despite this overall stability, substantial changes have
occurred in the composition of both revenues and expenditures.
These expenditure trends in particular foreshadow a major fiscal
challenge facing the United States.
Total Federal revenues have averaged 18.2 percent of GDP since the
1960s, with only modest variation around that average, although the
composition of revenues has shifted toward payroll taxes and away
from excise and corporate income taxes. As discussed in this chapter,
the income tax base and rates have changed many times during this
period, but the overall contribution of income taxes to total revenues
has been fairly stable.
Total Federal outlays since the 1960s have also remained close to the
long-run average of about 20.4 percent of GDP, despite many changes
in the economy and the mix of government programs that have occurred
since 1962. This stability masks important underlying trends, however,
in the composition of expenditures. The share of GDP and of the
government's budget allocated to spending on Medicare, Medicaid, and
Social Security has risen steadily, while the share devoted to defense
has fallen. If the growth of spending on these programs goes
unchecked, there will soon be a major break in the generally stable
fiscal situation that the United States has enjoyed for most of the
postwar period.
The cost to the Federal government of these three entitlement programs
is expected to rise from 8.0 percent of GDP today to about 15.6 percent
of GDP in 2045. In 2005, all other spending programs of the Federal
government, excluding interest payments on the national debt,
amounted to 9.0 percent of GDP. With this growth, and other programs
remaining constant as a share of GDP, in 2045 the Federal budget
excluding interest on the debt will consume 24.6 percent of the
GDP, compared to 17.0 percent today, with continuing increases
beyond that date. Adding back interest on the national debt could
make the share of GDP absorbed by the Federal budget even larger.
The implications of these trends are grave. If the major entitlement
programs grow as forecast, future generations will be forced to
choose between massive tax increases, near-elimination of all
government programs outside of entitlements (including defense and
essential services), or some combination.
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making of the product. Only 17.6 percent of U.S. tax revenues came
from taxes on goods and services in 2002, primarily through state
and local sales and excise taxes. Recall, however, that the
personal income tax is actually a hybrid income-consumption tax, so
that some of the taxes collected through the U.S. income tax system,
and those of other countries, might be thought of as taxes on
consumption.
The United States has also made different choices about the
marginal tax rate structure to impose on its tax base. Chart 5-2
shows the top marginal personal income and corporate income tax
rates in various OECD countries, including the 15 largest OECD
economies and Ireland. The black bars illustrate the personal rate
and the gray bars illustrate the corporate rate. The chart shows the
OECD's "all-in" definition of the top rate, which includes taxes
collected by all levels of government and the employee portion of
the social security tax. The top marginal personal income tax rate
of 43 percent in the United States is comparable to that of several
of the OECD countries such as the United Kingdom (41 percent), and
slightly lower than those in France (47 percent) and Japan (48
percent), which matches the OECD average (48 percent), and
significantly below the rates in Germany and the Scandinavian
countries (all 55 percent or higher). At the same time, the
United States has a combined (Federal and state) marginal
corporate income tax rate of 39 percent, well above the OECD
average of 30 percent, and second highest to that of Japan.
Chart 5-2 illustrates several important points. First, while the
U.S. top individual income tax rate is comparable to those of
other OECD countries, its top corporate rate is relatively high.
Second, except for Mexico, each country's top personal rate is
higher than its top corporate rate. Third, there is no clear
correlation between the top personal and corporate tax rates.
Ireland, for example, has a moderately high personal rate but a
very low corporate rate, while Germany has high rates in both cases.
The United States has also chosen to tax on a worldwide basis, as
discussed above, unlike some other countries. In 2003, 13 of 30 OECD
countries taxed on a worldwide basis, including Japan, Korea, Mexico,
and the United Kingdom. The majority of OECD countries (17 countries
in 2003) tax on a territorial basis, including Canada, France,
Germany, Ireland, Netherlands, Spain, and Sweden.
Finally, the United States has made different choices about the
integration of personal and corporate income tax structures. The
United States uses a classical system, which taxes corporate and
personal income separately, based on the status of corporations as
separate legal entities. This results in the double taxation of
income earned in the corporate sector. Other countries using this
system include Ireland, Sweden, and Switzerland. Alternatives to the
classical system provide some form of dividend tax relief, thereby
avoiding




or reducing double taxation. Under the imputation system,
shareholders are given a personal income tax credit for tax paid
by the corporation on that portion of its profit. Countries using
imputation systems (wholly or partially) include Australia,
New Zealand, Norway, Canada, and the United Kingdom.  Another
alternative is the dividend exclusion method, under which a
portion of dividends paid to individuals is excluded from tax at
the individual level. Countries using this method include Germany,
France, Finland, and Italy. A final method that can be used to avoid
double taxation of dividend income is to apply a two-rate system.
Under this approach, distributed corporate profits (paid out in
dividends) and undistributed profits are taxed at two different
rates with undistributed profits taxed at a higher rate. The extent
to which this approach eliminates the double taxation of dividend
income depends on the rates chosen.


Recent International Tax Reforms
We begin by reviewing several common trends in recent tax reforms
that have been adopted by a diverse set of nations. We then examine
the implications of these reforms for international tax competition
and for reform of the U.S. system.

International Tax Reform Trends

According to the OECD, most countries making changes in their tax
systems since 1999 have lowered personal and corporate income tax
rates. Those rate reductions were often financed, at least in part,
by base broadening. Within this overall pattern of lower personal
and corporate income tax rates, there are four discernible trends.
One clear trend among OECD countries is reducing the taxation of
wage and salary income. These taxes have been reduced through both
rate reductions and increases in taxable income thresholds. The
OECD average "all in" tax rate for a full-time production worker
fell from 25.6 percent in 2000 to 24.8 percent in 2003. The
corresponding marginal tax rate fell from 35.4 percent to 34.3
percent. Among G-8 countries since the year 2000, France, Germany,
Japan, Russia, and the United States have all lowered personal
income tax rates that apply to wage and salary income. Changes in
the tax brackets and rate structures generally made these tax
systems less progressive, although accompanying changes in
exemptions, deductions, and credits complicate the distributional
picture.
A second trend is reducing the tax rates applied to corporate
income. The OECD average corporate income tax rate fell from 33.6
percent in 2000 to 30.8 percent in 2003. As in the case of wage and
salary taxation, these rate reductions have typically been
accompanied by base-broadening measures. Since 1999, the G-8
countries of France, Germany, Italy, and Japan all reduced their
corporate tax rates.
A third trend is reducing the taxation of capital income
(especially capital gains and dividends) under the personal income
tax. Top marginal tax rates on dividend income (corporate plus
personal) fell over the period 2000-2003 among OECD countries from
50.1 percent to 46.4 percent. Reforms in Italy, Japan, and the
United States, in particular, all reduced the personal income tax
rates applied to interest, dividends, or capital gains. Six of the
G-8 countries have also altered their tax systems to better
coordinate their personal and corporate income taxes. Several
countries of the EU, including France, Germany, and Italy, applied
partial dividend exclusions, and Russia lowered its dividend tax
rate.
A fourth trend is the increasing popularity of flat rate income
tax schedules. Since the mid-1990s, eight Eastern European
countries, including Russia, have adopted income taxes with flat
rate structures. The personal tax rates among these eight reform
countries range from a low of 12 percent in Georgia to a high of
33 percent in Lithuania, and average 20.6 percent. On the corporate
income side, the tax rates range from a low of 10 percent in Serbia
to a high of 24 percent in both Estonia and Russia, and average
17.9 percent. Countries adopting these flat income tax structures
tend to also apply value-added taxes at relatively high rates,
typically 18%.
Evidence on International Tax Competition
Evaluating the U.S. tax system in relation to other national tax
systems is particularly important in a world where nations compete
for business and mobile capital (including physical, financial,
and human capital) by making their tax systems more attractive. A
recent review of evidence on international tax competition suggests
a systematic change in the pattern of tax rate setting. From 1982
to 1999, there was a substantial increase in international capital
mobility, reflected in the amount of foreign direct investment
(purchase of buildings, machinery, and equipment) and other
measures of the flow of international capital.  At the same time,
statutory corporate tax rates (tax rates established in the law)
declined all around the world and corporate tax bases were
broadened, resulting in little change in effective average rates.
An exception to that general rule is that effective tax rates for
foreign subsidiaries of U.S. firms located in small countries fell
sharply between 1992 and 2000.
While the United States reduced its top combined corporate tax rate
from 50 percent in 1982 to 39 percent in 2005, as measured by the
Institute for Fiscal Studies, other countries have made even more
significant reductions. The United States now has the second
highest combined corporate income tax rate among OECD countries,
behind only Japan. With international tax rates falling overall,
and a convergence between rates applied by large and small countries,
the United States risks becoming less competitive in attracting
capital. As capital becomes more mobile, it is increasingly easy
for companies to move their productive activities, including
physical capital, export/import operations, research and
development activities, and other forms of knowledge creation,
around the world in response to tax incentives. (Chapter 7, The
History and Future of International Trade, discusses the role of
global engagement in firm performance.) In the current environment
of international tax competition, the United States will be
increasingly challenged as the destination of choice for
internationally mobile capital and jobs.


U.S. Tax Reforms: Past, Present, and Future
Reform of the U.S. tax system can play a critical role in
improving economic efficiency and the competitiveness of U.S. firms
In this section, we examine past tax-reform efforts in the United
States, starting with the Tax Reform Act of 1986 (TRA86), and
project potential future reforms. We focus in particular on reform
of the U.S. tax base and on the taxation of savings or the return
to savings, such as interest, dividends, and capital gains.

Twenty Years of Tax Reform
The U.S tax code has many provisions that give preferential
treatment to certain types of income. In some instances, these
preferences may improve efficiency, such as incentives to increase
retirement saving or investment in new equipment that offset
distortions introduced by the income tax system. In other cases,
tax preferences intentionally distort economic decisions in order
to promote certain kinds of economic activity, such as the
introduction of tax credits that subsidize advanced education,
labor market participation, research and experimentation, or the
employment of disadvantaged workers. These provisions narrow the
tax base and result in higher marginal tax rates for at least
some taxpayers. They also add complexity to the tax code. The
President's Advisory Panel on Federal Tax Reform illustrated the
trade-off between tax rates and the tax base in the current U.S.
tax system. Their calculations suggest that with a broader tax
base, tax rates in all tax brackets could be reduced by about a
third. Multiple changes to the tax base in the last two decades
reflect this tension.

The Effect of Recent Reforms on the Tax Base
We have ample evidence from the last two decades that tax policy
is always evolving. The last comprehensive U.S. tax reform was the
Tax Reform Act of 1986. That reform was revenue-neutral, broadening
income tax bases and lowering marginal tax rates dramatically. TRA86
actually built on reductions in marginal tax rates that began in
1981 when the top rate was reduced from 70 percent to 50 percent.
Under the base-broadening provisions of TRA86, marginal tax rates
were reduced further, with the top rate cut to 28 percent. Rates
applied to different types of income were also made more uniform.
For example, one study estimated that effective capital tax rates
(taking into account depreciation schedules and other tax
provisions that differ across types of capital) prior to TRA86
ranged from a 45.6 percent tax on income from industrial buildings
to a 3.3 percent subsidy of income from general industrial
machinery. After TRA86 those effective tax rates converged to 37
percent and 38 percent, respectively. Leveling the playing field
in this way reduces the distortions to investment across various
forms of capital. While TRA86 made effective tax rates more
similar across types of capital income, it also raised the
overall cost of capital, which likely discouraged investment and
reduced dynamic efficiency.
Since TRA86, there have been more than 100 different acts of
Congress making nearly 15,000 changes to the tax code. These
changes have altered both the individual and the corporate tax
bases. Some changes have narrowed the tax base (such as the 1997
repeal of the Alternative Minimum Tax for small business and the
2001 increase in the standard deduction for joint filers), while
others have broadened it (such as the 1990 and 1993 limits on
itemized deductions and the 1993 expansion of the taxability of
Social Security benefits). Other reforms have changed the tax rates
applied to this base, such as the rate reductions enacted in 2001
and accelerated in 2003. The introduction and expansion of numerous
tax credits, such as the Child, HOPE, Lifetime Learning, Welfare to
Work, and Renewal Communities credits, have narrowed the base and
introduced disparities in tax rates applied to different types of
income.
Disparities in effective marginal tax rates on capital are once
again quite large, varying with the method by which capital is
financed and by the type of asset. A recent study finds that the
effective tax rate on corporations ranges between a tax of 36.1
percent on equity-financed activity to a subsidy of 6.4 percent
of debt-financed activity. Furthermore, that study finds that the
effective marginal tax rate varies from a high of 36.9 percent to
a low of 9.2 percent, depending on the asset type. The current
piecemeal tax system is thus both complex and inefficient. In the
following section, we examine potential reforms to address these
issues.


Potential Reforms to the Tax System
The increasingly globalized business environment in which U.S.
investors and firms operate makes the design of an efficient and
competitive tax system particularly crucial. Two central issues in
the current tax reform debate are the choice of tax base along the
income-consumption spectrum and the coordination of personal and
corporate tax rates. Recent U.S. tax reforms have lowered the tax
rates on capital income. Comprehensive reform could uniformly lower
the level of capital income taxation, and could thus reduce the
distortions of the current tax system and support greater potential
economic growth.

Comprehensive Business Taxation
One shortcoming of the U.S. tax system, discussed above, is the
double taxation of corporate income, which subjects capital income
to a high effective rate. Since 2003, the United States has taken
steps to reduce this problem by applying a substantially lower
(15 percent) individual tax rate to dividend and capital gains
income, thereby implicitly applying a two-rate system. The
President has recommended making permanent these lower tax rates
on capital.  Over the years, several comprehensive reforms to
integrate corporate and personal income taxes have been proposed.
The Treasury Department developed a proposal for a Comprehensive
Business Income Tax (CBIT) in the 1990s. The proposed system was
designed to give equal tax treatment to corporate debt and equity,
tax corporate and noncorporate businesses alike, and reduce the tax
distortions between retained and distributed earnings. The CBIT
still provides a relevant prototype for integration within the
context of an income tax system. Alternatives have also been
proposed that move away from reliance on an income tax by
implementing a cash-flow business tax (see Box 5-2, for example).


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Box 5-2: Simple, Fair, and Pro-Growth: Proposals to Fix America's
Tax System

Recommendations of the President's Advisory Panel on
Federal Tax Reform

The President's Advisory Panel on Federal Tax Reform was charged
with evaluating the current Federal tax system and developing
alternatives that achieved improvements in simplicity, fairness,
and growth potential. They were asked to make at least one
recommendation based on the current income tax system, to make
their recommendations revenue-neutral, and to preserve incentives
for charitable giving and home ownership. In addition, the panel
chose to design their recommendations to preserve the current
distribution of tax burden. Their 2005 report recommends two
alternatives to the present income tax system: a Simplified
Income Tax (SIT) and a Growth and Investment Tax (GIT). The SIT
plan is a simplified version of the current income tax system. The
GIT plan moves to a modified consumption tax that retains some
income tax elements.
These two proposals have several features in common. They both have
fewer tax brackets and lower top marginal tax rates for individuals
and families than the current system. Both plans would repeal the
Alternative Minimum Tax (AMT) for families and corporations. Both
simplify the tax treatment of savings and lower the tax burden on
productivity-enhancing investments by businesses. Either plan would
be substantially simpler than the present tax system, and both plans
maintain the present distribution of tax burden across income groups.
The two plans diverge primarily in their taxation of business and
capital income, using different bases for business taxation. The
SIT plan retains a simplified income tax applied to corporations,
while the GIT plan would apply a cash-flow tax to all businesses (not
just corporations). While they both lower the effective tax rate on
capital income, they use different approaches to do so. The SIT plan
excludes dividends paid to individuals from the individual income tax
base and excludes 75 percent of corporate capital gains from U.S.
companies, while the GIT plan applies a uniform 15 percent tax to
interest, dividends, and capital gains at the individual level. The
SIT plan adopts a simple accelerated depreciation method for
investments, while the GIT plan would permit full expensing of
investment. The plans also tax foreign income differently. The SIT
plan taxes income on a territorial basis (with foreign-sourced income
untaxed), while the GIT cash-flow tax is destination-based (with
exports untaxed).
Either of these two recommendations represents a significant step
forward in making the U.S. tax system simpler, fairer, and
growth-enhancing, but each would involve substantial transition
costs. They deserve serious consideration and more comprehensive analysis.
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The President's Tax Reform Panel
The broader goals of any comprehensive tax reform should be the
creation of a system that is simple, is fair, and promotes
economic growth. The President's Tax Reform Panel sought to design
revenue-neutral and distribution-neutral plans to achieve these
goals. The panel proposed two prototypes for reform: a Simplified
Income Tax (SIT) and a Growth and Investment Tax (GIT), summarized
in Box 5-2. Both of these proposals fundamentally alter the tax
bases for individuals and businesses as well as the treatment of
capital income. Either of these reforms would represent a large
change and involve important transition issues. While each plan
embodies features that are attractive from the point of view of
efficiency, fairness, and simplicity, comprehensive review of
these plans and policy debate is needed before making such
substantial changes to the tax system.


Conclusion

Every government faces choices about how to design its tax system
in order to finance the services it provides for its citizens.
Because virtually all forms of taxation distort economic decision
making, each country faces the challenge of designing a tax system
that raises needed revenue and achieves distributional and other
goals while distorting economic decisions as little as possible. By
taking into account the effects of tax rules on the economic
behavior of individuals and firms, governments can provide a tax
environment that fosters the most-efficient allocation of resources
and the best economic performance possible.
The United States has chosen to impose an overall tax burden that
is low relative to most other industrial countries and to rely most
heavily on the personal income tax. Governments of other advanced
economies rely less on personal income taxation and more on
consumption taxes, such as value-added taxes, in order to finance a
larger public sector. Given the U.S. reliance on the personal
income tax, we face the continuing challenge of keeping the income
tax base broad and the rates low in order to keep the economic
burden of taxation as small as possible.
Global tax reforms have changed the tax landscape substantially
in recent years. Other advanced economies have generally reduced
taxes on wage and salary income, reduced taxes on capital income
under the personal income tax (in particular, capital gains and
dividends), and reduced taxes on corporate income. While our
personal income tax rates are comparable to those of other
countries, our corporate tax rate is now the second highest among
OECD countries. These international differences could endanger the
ability of the U.S. economy to attract capital in a world where
capital is increasingly mobile. Any reform of the U.S. tax system
should aim to improve the performance of the U.S. economy and to
spread the burden of financing government spending simply and fairly.