[Economic Report of the President (2009)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 5

Tax Policy

Economists agree that taxes affect people's incentives and
behavior. For example, allowing tax deductions for educational
expenses
makes it cheaper to go to college, which may encourage more people to
go to college. Taxes can also discourage people from engaging in
certain activities. Taxes on cigarettes, for example, make them more
expensive to purchase, which may discourage people from buying them.
Similarly, taxes on dividends (periodic distributions of a firm's
profits to stockholders) and capital gains (the growth in value of an
asset, such as corporate stock) decrease the return people receive
from investing their money, which might cause them to invest less.
When a higher tax rate is imposed on an activity, people have less
incentive to engage in that activity. To encourage people to work and
invest more, the tax rates on labor and investment income should be
reduced. Over the past 8 years, several policy changes have resulted
in lower tax rates for both individuals and businesses.
Individual income tax rates for all income levels are lower now than
they were in 2001. Also, specific incentives have been established to
reduce the adverse tax consequences of certain desirable activities,
from running a small business to buying an alternative-fuel vehicle.
Lower tax rates have increased the benefit to these activities; in
particular, lower tax rates on dividends and capital gains helped
business investment expand, thereby increasing the amount of capital
per worker which improves worker productivity. Tax relief has
contributed to the solid economic growth and job creation that
prevailed over most of the past several years.
However, important challenges remain. Foremost among these is the
fact that most of these tax reductions are scheduled to expire at the
end of 2010. Allowing them to expire would constitute one of the
largest tax increases in history and could have serious consequences
for the U.S. economy. Another challenge is to further reduce business
tax burdens and thereby encourage business investment in the United
States. The United States should continue to attract such investment in
today's global economy in order to develop better jobs for U.S. workers
and to continue improving our standard of living.
Of course, individuals and businesses would prefer not to be taxed at
all. Yet governments perform many functions desired by citizens--such
as building roads and bridges, maintaining law and order, and providing
for the national defense--and impose taxes to raise revenue for these
activities. While this chapter focuses on the economic effects of
taxes, it should be noted that this is only one side of the
Government's budget; a complete analysis of fiscal policy should
consider the economic effects of both the revenue and spending sides of
the budget.
The key points of this chapter are:
 Taxes alter individual and business incentives and have the
potential to distort their behavior. This Administration
consistently fought to reduce tax burdens on individuals and
businesses; tax rates are now much lower than they were just
8 years ago.
 Tax reductions over the past 8 years have improved
incentives to work, save, and invest.
 Globally, nations compete for businesses and the associated
jobs; the United States may need to reduce tax rates on
businesses to remain competitive in today's world.
 Future goals should include permanently extending the tax
relief of the past 8 years and reforming the Alternative
Minimum Tax (AMT).

Individual Income Tax Reform

Governments impose taxes to obtain the revenue needed to perform
their duties. The transfer of resources from individuals to the
government does not directly impose a burden on the overall economy
because the ability to purchase goods and services shifts from the
individual to the government--there is no net loss for the economy as a
whole. However, taxes can impose a considerable burden on the economy
for other reasons. Most significantly, taxes interfere with the
efficient allocation of resources by altering the rewards from working,
saving, and investing.
Resources are allocated efficiently when individuals and firms
allocate them to the activities for which they are best suited, thus
achieving the highest possible output for the economy. Without taxes,
individuals and firms can allocate resources in the most efficient
manner possible. With taxes, people receive lower benefits from taxed
activities and adjust their behavior accordingly. (In some cases, such
as when people engage in an activity that produces negative
consequences for others, imposing a tax can improve economic
efficiency; for example, high taxes on cigarettes can reduce the
damage caused by secondhand smoke.)
High tax rates on labor income can induce people to reduce the time
they spend working. This is particularly true for people with flexible
work weeks and in households with a second worker. High tax rates on
dividends and capital gains discourage people from investing and
reduce the funds available in financial markets. In turn, this reduces
business investment, which reduces the amount of capital available in
the economy. Less capital means less machinery and equipment for each
worker to use, making workers less productive and leading to
reductions in wages. The net result of these tax-caused changes is an
inefficient allocation of resources: output is lower than it would
have been in the absence of taxes. Economic research indicates that
the total economic burden imposed on the economy for each dollar of
income tax revenue collected actually exceeds 1 dollar, but estimates
of the exact burden vary widely.
A second problem arises when people engage in activities to avoid
paying taxes. The possibilities here include both legal activities,
such as using complicated tax shelters to prevent income from being
taxed, and illegal activities, such as not filing a tax return. While
the great majority of people pay the taxes they owe, the latest
Internal Revenue Service (IRS) estimate suggests that the gap between
the amount of tax people owed and the amount actually paid was
approximately $290 billion in 2001, or 13.7 percent of all taxes owed.
One consequence of people failing to pay their fair share of taxes is
that a higher tax rate must be imposed on those who do comply with tax
laws in order to collect the desired amount of revenue.

Lowering Tax Rates Stimulates Economic Growth

Taxing earned income reduces incentives to work because it reduces
the return from work. Similarly, taxing capital income (such as
interest, dividends, and capital gains) reduces the return from saving
and investing and therefore reduces the incentive to save and invest.
The changes in incentives, along with any associated behavioral changes
that result from changes in tax rates, are what economists mean when
they assert that taxes ``distort'' the normal operation of labor and
capital markets. When taxes are imposed on choices people make,
distortions tend to occur and markets operate at less than peak
efficiency. Because different types of taxes create different types
and sizes of distortions, one goal of tax policy should be to choose
tax rates that minimize the distortions and the accompanying
inefficiencies whenever possible.
Key determinants of the effect a tax system has on the economy are
the average tax rate--the fraction of income paid in taxes--and the
marginal tax rate--the amount of tax owed on an additional (that is,
marginal) dollar of income. A high average tax rate tends to
discourage people from engaging in an activity at all. For example, a
high average tax rate on labor income can reduce the total after-tax
return so much that it discourages people from working at all. In
contrast, a high marginal tax rate on labor income reduces an
individual's after-tax return from increased work effort and from
investing in additional education. The example in Box 5-1 examines
this particular issue in more detail. Because education levels
positively affect productivity, economic growth will generally be
higher when people acquire more education.
By reducing both average and marginal tax rates on labor and capital
income at almost every income level, the tax policies of the past 8
years reduced the distortionary effects of these taxes and thereby
improved the efficiency of the labor and capital markets and of the
U.S. economy as a whole.

----------------------------------------------------------------------
Box 5-1: Encouraging Human Capital Investment


High marginal tax rates can discourage people from pursuing
additional education and improving their skills to qualify for a
higher-paying job.  To see this, consider a high school teacher who is
choosing between continuing to work for about $50,000 per year (the
median salary for high school teachers in 2007), and getting additional
education so he can become a school principal and earn $80,000 per
year (the median salary for elementary and secondary education
administrators in 2007).  Although there may be other factors, suppose
this workerï¿½s main concern is his after-tax income.
Consider the impact of two different tax regimes: In the first regime,
assume the high school teacher would owe $5,000 per year in income tax
and the principal would owe $12,500 per year in income tax.  The
difference, $7,500, is the additional tax he would owe if he were to
acquire the skills needed to be a principal.  Comparing this amount to
the expected increase in income ($30,000), we see that the marginal
tax rate imposed on the additional income is 25 percent
($7,500/$30,000).  In the second regime, assume an alternate tax
system in which the high school teacher owes $3,000 per year in tax
and the principal owes $15,000 per year in tax.  Under this new
system, the tax impact of acquiring additional skills is $12,000.
Comparing this to the expected increase in income (still $30,000)
reveals that the marginal tax rate imposed on the additional income is
40 percent ($12,000/$30,000).
The larger marginal tax rate in the second regime means the worker
experiences a smaller increase in after-tax income; thus, his
incentive to acquire the skills necessary for the higher-paying job is
smaller in this regime and may cause him not to pursue additional
education.
As an aside, notice that if the worker chooses to stay a high school
teacher, he pays more in income tax in the first regime ($5,000) than
he would in the second ($3,000).  Part of the reason the first regime
has a lower marginal tax rate for additional education is that there
is a higher average tax rate on lower-earning individuals than in the
second regime.
-----------------------------------------------------------------------

Increased Work Incentives

A labor income tax decreases the incentive workers have to supply
labor to the market by reducing their take-home pay. Workers may
choose to work fewer hours, and some may even choose not to work at
all. These behavioral changes reduce the efficiency of the labor
market and of the economy as a whole. The tax relief of 2001 reduced
tax rates on labor income and thereby reduced the distortions and
efficiency losses created by taxing wages.
Economists have found that different people can be affected
differently by taxes. Some people exhibit very little change in labor
supply as tax rates vary, while others may enter or exit the workforce
entirely. Consider a married couple in which one person works at a
full-time job; call this person the primary breadwinner for the family
and assume he makes $50,000 per year and works a fixed 40-hour week.
The other person has the option of working at an hourly job and can
earn up to $10,000 per year, depending on how many hours she works;
call this person the secondary earner. When there is a change in tax
rates, the breadwinner will probably continue to work the same amount
of time because of the importance of his income to the family and his
fixed work hours. However, the work decisions for the secondary earner
are not as clear. Because married couples are taxed on their combined
income, any income earned by the secondary earner will be taxed at the
marginal tax rate facing the couple. Because an income tax lowers the
reward for working outside the home, it makes other activities (such
as leisure or raising a family) look relatively more attractive
compared to work. An increase in the marginal tax rate facing the
couple could reduce the return the secondary earner receives from
working by enough to cause her to choose not to work at all.
Alternatively, if a worker wants to earn a specific amount of income,
higher tax rates could cause her to increase work time.
In practice, economists find the labor supply of married men to be
relatively stable regardless of changes in tax rates. Research shows,
however, the labor supply of married women to be quite sensitive to
changes in tax rates, although this sensitivity has declined over the
last few decades as labor force participation by women aged 25-54
increased from about 50 percent in 1970 to over 75 percent in 2008.
The tax relief of the past 8 years reduced marginal tax rates at
almost every income level, reduced the distortions inherent in taxing
earned income, and thereby increased the rewards from working and
encouraged more people to work. In addition, tax relief that reduced
marriage penalties improved the incentives for secondary earners to
participate in the labor force.

Increased Saving and Investment Incentives

When individuals receive income, they can either spend it for current
consumption or save it to finance future consumption. Financial
intermediaries, such as banks and insurance companies, pool individual
savings to finance capital investments. For example, a bank may
combine the savings deposits of many individuals to make a loan to a
small business owner. The business owner plans to make a profit so she
can pay interest on her loan, which the bank uses to pay interest to
the depositors. Similarly, when people purchase stock in a company,
the company can use the funds to invest in new machinery and
equipment. These new assets generate income for the company that gets
returned to the investor in the form of dividends or capital gains.
These investments increase the amount of machinery and equipment used
by each worker, raising the productivity of workers; this helps to
increase workers' wages and, ultimately, increases the average
standard of living for Americans.
An important tax policy issue is the double taxation of income earned
from saving and investing. Taxing this income discourages individual
saving and investment, which reduces the funds available to finance
new businesses and for existing businesses to expand. Currently,
corporations first pay tax on their profit, then the after-tax profit
is either distributed to shareholders as dividends or reinvested in
the company by retaining it and allowing shareholders to benefit via
capital gains (that is, increased equity); either way, the shareholder
then pays taxes on the income he or she earns. As a result, income
from new capital investment by corporations, financed by individual
equity investment, is taxed twice--once by a tax on the
corporation's profit, and again by a tax on the dividends and
capital gains earned by the individual investor. This double taxation
of corporate income generates an effective tax rate on equity
investment that is greater than either the statutory corporate tax
rate or the individual income tax rate. Ultimately, such taxes lower
the capital-to-labor ratio, suppress wages, and harm long-run economic
growth. Box 5-2 gives an example of how double taxation can slow
economic growth.
The tax reductions of the past 8 years increased individual incentives
to save and invest. In 2001, the top marginal income tax rate was
reduced from 39.6 percent to 35 percent, thus reducing the tax on flow-
through businesses (businesses whose profits are not taxed directly;
instead, any profit they earn ``flows through'' the business to the
owners, who then pay individual income tax on it). Before 2003, capital
gains were taxed at a maximum of 20 percent, and dividends were taxed
as ordinary income (at a maximum rate of 38.6 percent in 2002). As part
of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA),
the maximum tax rate for long-term capital gains and dividends was
reduced to 15 percent. (The next section elaborates on the significance
of reducing tax rates on dividend income.)

-----------------------------------------------------------------------
Box 5-2: Double Taxation Slows Economic Growth

From an individual perspective, the act of saving reduces consumption
today so more can be consumed in the future. Similarly, when firms
invest they reduce present production so they can be more productive
and profitable in the future. Taxing capital income lowers the return
to saving and investment, which encourages current consumption and
discourages future consumption. For example, suppose a corporation is
considering selling additional stock to finance the construction of a
new plant. The corporation expects that the net return on this
investment (the return after subtracting depreciation) will be 10
percent. Suppose further that individuals will purchase the shares if
they receive a return of at least 6 percent. The investment is
socially beneficial because it generates a higher return (10 percent)
than the savers providing the funds require (6 percent).
When the new plant begins operating, the income it generates for the
firm is subject to the corporate income tax; currently, the corporate
income tax has a top marginal rate of 35 percent. Similarly,
individuals investing in the firm owe tax on the income they receive
from their investments; currently, the top marginal rate on dividends
and long-term capital gains is 15 percent.
Now consider an individual who invests $1,000 in the company's new
stock. The new plant generates $100 of net income on this investment.
The firm owes 35 percent in tax, leaving $65 of after-tax profit for
the firm. Suppose the firm immediately returns all of this money to
the investor as a dividend. The investor owes 15 percent in tax,
leaving about $55 for her to use. That is, after applying the two
taxes, the investor receives a return of only 5.5 percent on her
initial investment. Because this is less than her required return of 6
percent she will choose not to invest in this company's stock and the
new plant would not be built. In summary, taxing both corporate income
and individual capital income can produce an effective tax rate high
enough to alter saving and investment decisions enough to cause
socially beneficial projects to go unfunded.
-----------------------------------------------------------------------

Dividend Tax Relief

A major Administration accomplishment was reducing the tax rate
applied to corporate dividends. JGTRRA reclassified dividends so they
are taxed at the same rate as long-term capital gains, currently a
maximum of 15 percent. As Chart 5-1 shows, the change appears to have
been effective in expanding dividend payments: since 2003, real
dividend income has grown at an average of 11.1 percent per year,
while from 1983 until 2003, real dividend income grew at an average of
only 5.8 percent per year. (The 2004 spike in the chart reflects a
special one-time dividend paid by Microsoft Corporation.)



Reducing tax rates on corporate dividend payments directly reduces
the double taxation of corporate income. It also reduces the incentive
corporations have to use debt, rather than equity, to finance
purchases of new capital. The fact that corporations can deduct
interest payments from taxable income, but cannot deduct dividend
payments, makes it cheaper for firms to borrow (rather than issue
stock) to finance additional spending. Excessive borrowing increases
the chances of insolvency because the higher a firm's debt payments,
the greater the chance the firm's income will be insufficient to cover
these payments. Insofar as insolvency triggers bankruptcy, this
subjects equity holders and employees to additional costs and
uncertainty.
Changing the tax treatment of dividends also reduced the tax bias
against paying dividends compared to retaining earnings. Paying
dividends returns funds to stockholders, who can decide for themselves
how to use them, rather than having to leave the funds invested in a
particular company. Also, paying dividends is a way firms can provide
tangible evidence of their profitability. Clear signals about how
profitable different firms are help investors identify the most
efficient allocation of their resources. When the tax code penalizes
dividends relative to capital gains and penalizes equity financing
relative to debt financing, corporate financing decisions will be
inefficient.

The Macroeconomic Benefits of Lower Tax Rates

Over the past 8 years, tax relief has reduced distortions to labor
supply, saving, investment, and corporate governance. Making the tax
relief permanent can substantially improve economic efficiency and
increase economic activity. The Treasury Department estimates, for
example, that if the tax relief of 2001 and 2003 were made permanent
and were paid for by reductions in future government spending,
economic output would increase by 0.7 percent in the long run. The
benefits would be smaller or even negative, however, if the extension
of the tax relief results in additional government borrowing or future
tax increases rather than spending reductions. The Treasury Department
estimates, for example, that if the tax relief were made permanent but
the lost revenues were made up with other tax increases, economic
output would decline by 0.9 percent over the long run. The concern
about long-term financing for the tax relief is particularly important
because of the likelihood of rising spending pressures in the future,
as discussed in Chapter 6.

A Record of Tax Reform

One of the Administration's major tax policy objectives has been to
change tax laws so they better encourage activities that are
beneficial to the economy as a whole, such as work effort, saving and
investing, education, and the creation of new jobs. With regard to
individual income taxes, the Administration took steps each year to
reduce the burden imposed on the American taxpayer. Here are some of
the highlights of the actions taken:
 The Economic Growth and Tax Relief Reconciliation Act of
2001 was the most significant tax reduction since 1981. It
created a new low 10 percent tax bracket and phased in
reductions of the other existing marginal tax rates. It
reduced marriage penalties by increasing the standard
deduction and the lowest tax bracket threshold for married
taxpayers, increased the child tax credit, and made many
other tax preferences more generous. It also began phasing
out the estate tax.
 The Jobs and Growth Tax Relief Reconciliation Act of 2003
accelerated the phasing-in of many of the tax reductions
enacted in 2001. It also reduced capital gains tax rates and
applied the capital gains tax rates to dividends.
 The Working Families Tax Relief Act of 2004 and American
Jobs Creation Act of 2004 further accelerated the tax
reductions previously enacted, including increasing the
child tax credit to $1,000. These laws further reduced
marriage penalties by making the standard deduction for
joint returns twice the single standard deduction, and
expanding the 10 and 15 percent tax brackets for joint
returns to twice the size of the corresponding brackets for
single returns.
 The Pension Protection Act of 2006 made permanent a number
of pension-related provisions of previous tax bills, such as
higher dollar amounts for IRA contributions, higher dollar
limits on defined contribution plans, and catch-up
contributions for older workers.
 The Tax Increase Prevention Act (TIPA) of 2007 and the
Emergency Economic Stabilization Act of 2008 each extended
AMT relief. TIPA also increased the number of personal
credits that could be used to reduce AMT liability.
Each of the above measures was intended to promote long-term growth
and improve economic efficiency. Another significant measure was the
Economic Stimulus Act of 2008, which returned approximately $100
billion to consumers via tax rebates--up to $600 per taxpayer ($1,200
for couples filing jointly) and $300 for each dependent. Rebates were
phased out for taxpayers with over $75,000 in income (over $150,000
for couples filing jointly). On the business tax side, the Economic
Stimulus Act increased the dollar value of new equipment that could be
deducted in 2008 and provided an expanded depreciation allowance of 50
percent on certain business property put into service in 2008. The
primary purpose of these actions was to provide short-term, counter-
cyclical stimulus to the economy by encouraging short-run growth in
consumer spending and business investment. Tax rebates were chosen as
the best way to provide this short-term stimulus because of the speed
with which they put money into the hands of people most likely to
spend it. Similarly, the business tax incentives were designed to
encourage firms to accelerate purchases of capital equipment, making
such purchases in 2008 rather than waiting until 2009 or later.
Compared to the paths consumption and investment would have otherwise
followed, the rebates appear to have boosted real personal consumption
expenditures in the second quarter of 2008 and the accelerated
depreciation was expected to boost business investment throughout
2008.
In total, the tax relief enjoyed by taxpayers from 2001 to 2008 saved
Americans nearly $1.7 trillion in taxes. Chart 5-2 illustrates how
those benefits were distributed over these years. The value for 2008
includes over $100 billion from the Economic Stimulus Act of 2008.
Aside from stimulus, the amount of tax relief granted to individuals
declines after 2008 because of the expiration of temporary changes to
the AMT (discussed in detail later in this chapter) and declines
significantly in 2011 because most of the tax reductions are scheduled
to expire at the end of 2010.



Lower Tax Burdens

As a result of the tax relief of the past 8 years, the average
Federal individual income tax rate declined to 20.4 percent in 2008.
Without tax relief, the average Federal tax rate would have been 24.2
percent. The top half of Table 5-1 shows the rates taxpayers at
different income levels face in 2008 as a result of the tax relief of
the past 8 years and the tax rates they would have faced if it were not
for this tax relief. Notice that taxpayers at all income levels
experienced a reduction in their average Federal tax rate for 2008. For
example, among people in the lowest income quintile, the average
Federal income tax rate would have been 5.2 percent without tax relief,
but with tax relief it was only 1.1 percent; while for people in the
highest income quintile, the average Federal income tax rate would have
been 29 percent without tax relief, and with tax relief it was only
25.4 percent.
The distribution of the burden of Federal individual income taxes is
shown in the bottom half of Table 5-1. Without tax relief, the lowest
quintile would have borne 0.8 percent of the Federal tax burden in
2008. With tax relief, the lowest quintile bore only 0.2 percent of
all Federal taxes. The highest income quintile was the only group to
see its share of Federal taxes increase in 2008, from 66.3 percent of
Federal taxes before tax relief to 68.9 percent after tax relief.



Pro-Growth Business Tax Reform

Throughout the past 8 years, the Administration has worked
consistently to lower the burden of taxes on businesses, with the
objectives of encouraging greater investment, job creation, and long-
term economic growth. To accomplish these goals, the Administration
has pursued two primary strategies: first, addressing enduring aspects
of the tax system that diminish returns on investment for both
individuals and businesses; and second, providing new tax incentives
for businesses to stimulate greater investment.

Reducing the Double Taxation of Corporate Income

As indicated earlier, one aspect of the current tax system that
diminishes returns on investment is the practice of double taxation of
corporate income, which reduces the return to saving and investing.
The Administration's 2003 tax relief reduced the magnitude of double
taxation by reducing the tax rate on both dividends and capital gains.
In addition, there have been amendments to the legal structure of
corporations that have helped reduce corporate tax burdens.
To understand these changes, it is first helpful to understand the
basic framework of corporate taxation. The tax treatment of business
income varies depending on the organizational structure of the firm.
There are two basic classifications of corporations for purposes of
taxation and regulation: (1) C corporations, the traditional large,
stock-issuing corporations; and (2) flow-through businesses, which
include S corporations, partnerships, and sole proprietorships. For tax
purposes, the main difference between these two groups is that flow-
through businesses are exempt from the corporate profits tax that is
imposed on C corporations. In flow-through businesses, profits are
distributed to owners and shareholders (flowing ``through'' the company
directly to their owners), who then pay income taxes on their gains.
(There are restrictions on both size and financial activities that
prevent most firms from qualifying to be S corporations.) This
arrangement allows flow-through business owners to avoid the double
taxation of corporate profits and to face lower effective tax rates
than do shareholders of C corporations. One goal of tax relief has been
to ``level the playing field'' by reducing the difference between the
tax rates applied to income generated by S corporations and C
corporations.
Two types of changes helped to reduce the burden of corporate taxes.
First, regulatory changes in 2004 and 2007 relaxed some of the
restrictions that limit which firms can be S corporations. In addition
to increasing the maximum allowable number of shareholders, new rules
were enacted to make it easier for a firm to elect to become, and to
remain, an S corporation. Second, each year from 2002 to 2005, and
again in 2008, allowances for depreciation deductions were extended or
expanded. As described below, these changes allow firms to take a
greater deduction from income when new capital equipment is purchased,
which effectively decreases the tax burden on income generated by that
equipment.

Accelerating Depreciation Allowances

A consistent goal of the Administration has been to provide tax
incentives for businesses to invest in new facilities and equipment.
One way this goal was promoted was by accelerating business
depreciation allowances. When physical assets (such as machinery and
equipment that can be used over and over when producing goods and
services) are used by businesses, their value declines (depreciates)
over time due to the wear and tear they experience. With this in mind,
businesses are allowed to deduct from their taxable income the dollar
amount of the depreciation of their assets. The more quickly a firm is
able to deduct, through depreciation, the cost of new investment, the
more attractive new investment becomes. Because different types of
assets have different useful lives and therefore depreciate at
different rates, the IRS established the Modified Accelerated Cost
Recovery System, which specifies the rates at which different types of
assets can be depreciated.
Accelerating depreciation rates improves investment incentives for
firms. As part of a temporary stimulus program, the Administration
succeeded in expanding businesses' first-year depreciation allowance
on qualified property by an additional 30 percent of its adjusted
basis in 2002, to encourage greater business investment in new
machinery and equipment in that year. In 2003, to provide additional
short-term stimulus, the first-year depreciation allowance was
expanded further, to 50 percent of the adjusted basis for qualified
property. This expanded depreciation allowance expired in 2004, but
was reintroduced--at 50 percent of the adjusted basis--as part of the
Economic Stimulus Act of 2008.

Increasing Small Business Expensing

In addition to accelerating business depreciation rates, the
Administration has supported pro-growth business tax policies by
increasing the amount of ``expensing'' small businesses can do for
their use of depreciable property. Distinct from the traditional
concept of ``business expensing,'' which refers to a business's
ability to deduct expenses incurred that are not associated with
acquiring or improving assets, Section 179 of the U.S. Internal
Revenue Code allows individuals and small businesses to deduct the
cost of property used to generate income, rather than having to
capitalize the benefits through the depreciation schedule discussed
above. The Administration expanded the capability of businesses to
expense the cost of property under Section 179; in 2003, the maximum
dollar amount that could be expensed under Section 179 was increased
to $100,000. In 2007 the limit was again increased, to $125,000, and
indexed for inflation for 2008 through 2010. Then, as part of the
Economic Stimulus Act of 2008, the limit was increased to $250,000 for
2008.

Tax Credits for Research and Development

Finally, a number of tax credits have been extended to businesses to
encourage the types of research and development investment that have
benefits for the public. Economists use the term ``public goods'' to
describe things that could easily be used by more and more people with
little or no additional production cost. From a social perspective,
private companies generally make insufficient investments in public
goods, such as scientific research to develop new technologies for
health care or to expand utilization of renewable energy resources.
This ``underinvestment'' occurs because companies pursue investment
projects based on the potential value to themselves and generally do
not consider the full benefit to society that could result from the
investment.
For example, suppose a company was considering investing in research
to develop a vaccine against diabetes. Once developed, the company
would sell the drug at a price set high enough to recover its research
costs and to generate some profit. Ultimately, the company would
evaluate the merits of the investment based on the profit it expected
to receive from selling the vaccine relative to the profit it could
earn on other possible investments. Unfortunately, the price the firm
would need to charge could exceed what some people who would benefit
from the drug can afford to pay. As a result, some people who could
benefit from the vaccine will not get it, and the company will
underestimate the full value of this research investment. That is, the
research will have a public value that is greater than its private
value to the company. Put another way, for goods with large social
benefits, private markets tend to offer smaller returns than are
needed to result in efficient levels of investment.
Tax credits can be used to ``fill the gap,'' by providing the company
with an additional incentive that will encourage it to undertake this
publicly beneficial investment. In the area of alternative energy, the
Administration successfully extended existing research and development
tax credits and expanded upon them in 2005 and 2006, providing an
additional 20 percent credit for qualified energy research and
increasing the percentage of research and development expenses that
qualify for the credit. In 2005 and 2006, private industry research
and development grew notably. Annual research and development spending
by private industry grew by only 2.9 percent per year over the 20
years from 1985 through 2004. Subsequently, private industry research
and development grew at an average rate of 5.1 percent per year in
2005 and 2006.

International Competitiveness

Today's global economy enjoys more economic interconnectedness than
ever before. Efficiency improvements in information, communication,
and transportation technologies have increased the ability of
international firms to compete with U.S. firms in domestic and
international markets. Associated improvements in the international
mobility of capital mean that modern companies have a high degree of
international flexibility regarding the location of new facilities.
Thus, companies that want to open new facilities can compare
investment opportunities across the globe to find locations with the
highest after-tax return. As a result, a country's corporate tax
policy, including its statutory tax rates, can have a significant
impact on both job creation and the competitiveness of businesses
within that country. There is ample evidence that companies include
tax considerations when determining where to locate new facilities, a
fact that has led to a sense of competition between countries as they
try to attract companies by reducing their respective corporate tax
rates.
To illustrate the trend toward lower corporate tax rates, Chart 5-3
shows the statutory corporate tax rate for the United States and the
average (weighted by gross domestic product (GDP)) statutory corporate
tax rate for non-U.S. members of the Organization for Economic Co-
operation and Development (OECD) since 1981. (State and local rates
are combined with the Federal statutory rates where appropriate.)
During the early 1980s, the United States had a statutory corporate
tax rate of nearly 50 percent, which was higher than the OECD average.
Significant tax reform in 1986 reduced the United States's combined
(Federal and State) rate to about 39 percent, a level it has roughly
maintained since then. While this change reduced the
U.S. tax rate to well below that of most other OECD countries in the
late 1980s, other countries soon began reducing their corporate tax
rates as well. By 2008, the non-U.S. OECD average corporate tax rate
had fallen to about 30 percent, and the non-U.S. median corporate tax
rate stood at 27.5 percent. Table 5-2 gives statutory tax rates for
most OECD countries; the United States currently has the second
highest statutory corporate tax rate of any industrialized country,
less than 1 percentage point below Japan's.
That said, the United States offers companies a more generous
depreciation allowance than do most other countries--only Italy and
Greece offer greater allowances (see Table 5-2). When considered
together, the high statutory tax rate in the United States is somewhat
mitigated by its generous depreciation allowance. However, as shown in
the last column of Table 5-2, the United States still has the fourth
highest effective marginal tax rate on equity-financed projects, which
can dampen the competitiveness of U.S. businesses and can dissuade
firms from locating new facilities--and the associated jobs--here in
the United States.

Future Challenges

The tax policy changes of the past 8 years have considerably reduced
the burden on taxpayers and improved the efficiency of U.S. income tax
laws. However, there is more work to be done. In addition to making
these changes a permanent part of the tax code, the AMT needs to be
reformed or even eliminated, and the tax code should be greatly
simplified because complying with its incredible complexity consumes
resources that could be put to better use elsewhere.

Making Tax Relief Permanent

Failing to extend the tax relief enacted over the past 8 years would
amount to one of the largest tax increases in history. Individuals at
all income levels, from low-income Earned Income Tax Credit recipients
to high-income taxpayers, would be negatively affected. The total
increase would average nearly 1.9 percent of GDP per year over the
next 10 years and would increase the tax burden on the economy to well
above the average over the past 40 years of 18.3 percent of GDP.
Taxing business income reduces the incentive people have to invest in
businesses. Tax relief has encouraged greater business investment over
the last several years. Going back to the high tax rates of the 1990s
could reduce business investment, which could in turn reduce workers'
wages and economic growth. In an international context, higher
corporate tax rates would make locating new businesses in the United
States less attractive, and would further depress jobs and growth.



These lower tax rates have had many positive consequences for the
economy. Lower taxes for individuals increased people's disposable
income, allowing them to save more and spend more. Lower taxes for
businesses increased business incentives to invest in new capital
assets, which will improve worker productivity and wages and increase
their international competitiveness. Letting tax relief expire will
remove many of the gains made in each of these areas.

Fixing the Alternative Minimum Tax

The first minimum tax was enacted in 1969 in response to a Treasury
Department report that a number of high-income taxpayers had no
Federal income tax liability in 1966. The Alternative Minimum Tax,
which is a parallel tax system with its own set of exemptions,
deductions, and tax rates, was intended to ensure that high-income
taxpayers pay their fair share of taxes. A major difference between
the regular income tax laws and the AMT is that several significant
deductions allowed under the regular income tax--such as personal
exemptions, State and local income taxes, and business expenses--are
not allowed under the AMT.
Technically, all taxpayers are required to compute their tax liability
under both the regular income tax laws and the AMT and then pay the
larger tax amount. Having to compute one's tax liability twice
increases both compliance costs and the complexity of the tax code. In
practice, the large income exemption available under the AMT means
low-income taxpayers hardly ever owe more under the AMT. For many
years, middle-income taxpayers were similarly unaffected by the AMT.
However, the major problem with the AMT is that, unlike the regular
tax exemptions and bracket thresholds, the AMT values are not indexed
for inflation. This means that, as people's incomes naturally rise,
even if only with inflation, an increasing number of middle-income
taxpayers find themselves having a greater tax liability under the AMT
than they do under the regular tax code. To counteract this problem,
the exemption has been permanently increased several times, most
recently in 1993, to $45,000 for joint returns and to $33,750 for
singles. Above the exemption amount, the AMT tax rate is 26 percent on
the first $175,000 of taxable income and 28 percent thereafter.
(Adjusting for inflation, the $45,000 exemption in 1993 is worth more
than $66,000 in 2008 dollars.)
In its first year of operation, the minimum tax affected only 19,000
taxpayers and raised about $122 million, meaning this tax caused these
taxpayers to owe $122 million more in tax than they owed under the
regular tax laws. In 2007, the AMT affected over 4 million taxpayers
and raised roughly $26 billion in revenue (about 1 percent of all
Federal revenue). Under current law, these numbers are projected to
increase to over 29 million taxpayers and over $100 billion in revenue
in 2009.
Chart 5-4 shows the number of taxpayers who are forecast to be
affected by the AMT under different future policies. Under current
law--with the AMT parameters returning to their 1993 levels after 2008
and tax relief expiring at the end of 2010--the number of AMT-affected
taxpayers will rise sharply in 2009, ultimately reaching nearly 44
million taxpayers in 2018. In 2008, Congress enacted an AMT ``patch,''
which adjusted the AMT parameters for 1 year to $69,950 for joint
returns and $46,200 for singles (Congress has enacted short-term
changes to the AMT parameters several times since 2001). If this patch
is permanently extended and tax relief is allowed to expire at the end
of 2010, the number of AMT-affected taxpayers would rise to 8 million
in 2018. Alternately, if tax relief is extended (the ``policy
baseline'' lines in Chart 5-4) the number of AMT-affected taxpayers
will grow to 56 million in 2018 if the AMT parameters are allowed to
return to their 1993 levels or to 21 million taxpayers if the AMT
patch is permanently extended.
Taxpayers with many dependents or significant business deductions and
those in high-tax States are more likely to be subject to the AMT.
Three reductions to taxable income allowed under regular tax laws but
not under the AMT are personal exemptions, miscellaneous business
deductions, and State and local taxes. Taxpayers claiming more
dependents may be accustomed to



seeing a large reduction in taxable income because of the personal
exemption allowed for each dependent, but no corresponding reduction is
available under the AMT. Similarly, miscellaneous business deductions,
allowable under the regular tax laws when they exceed 2 percent of
adjusted gross income (AGI), are not deductible under the AMT.
Taxpayers in a State with relatively high income taxes or relatively
high property taxes receive a relatively large deduction under the
regular tax laws but receive no relief for this expense under the AMT.
The result of these items not being deductible under the AMT is that
people with these deductions are more likely to be subject to the AMT
than are people without these deductions. Among otherwise similar
people, taxpayers with these deductions generally still pay less in
Federal income tax than do people without these deductions, but the
existence of the AMT reduces the tax benefit these deductions provide
and means these people will have the extra work of filling out the
additional form(s) required for the AMT.
Prior to 1998, most personal credits (such as the education tax
credits and the child and dependent care credit) could not be used to
reduce tax liability owed under the AMT. In fact, even if a taxpayer
did not owe additional tax under the AMT, he or she would be
prohibited from using the full amount of a credit if it would reduce
his or her tax liability below the level determined under the AMT.
This reduction in credit usefulness was yet another way people could
be ``hit'' by the AMT.

AMT Reform Ideas

The most obvious way to deal with the AMT would be to abolish it
entirely, although this would require the Federal Government to forgo
over $1.7 trillion in revenue over the next 10 years (assuming tax
relief is extended through at least 2018). Short of that, there are
several incremental approaches that could be used. One alternative
would be for Congress to enact permanent inflation indexing of the AMT
income exemption and other parameters. The recent experiences when 1-
year increases in the AMT exemptions were enacted make clear that a
permanent solution is needed. Other ways to reduce the impact of the
AMT on the middle class include allowing deductions for personal
exemptions and State and local taxes. Prohibiting taxpayers from using
their personal exemptions under the AMT means the AMT treats large
families differently than the regular tax code does, and effectively
makes it more expensive for people to raise a family.

Simplifying the Tax Code

Finally, it remains difficult to overstate the complexity of the U.S.
Internal Revenue Code: at standard print sizes, it would fill
thousands of pages, with more added nearly every year. Deductions,
exemptions, phase-outs, credits, and the AMT add complexity to the tax
code that makes it challenging for ordinary people to determine their
tax liability. See Box 5-3 for a fuller discussion of these issues.

-----------------------------------------------------------------------
BOX 5-3: Tax Code Complexity

The U.S. individual income tax system is extremely difficult to
understand and, as a result, imposes a substantial burden on taxpayers
in the form of time and money spent complying with its various rules.
There are dozens of tax credits and deductions, many of which target
specific social goals.  As the number of credits and deductions has
grown over the years, the number of overlapping provisions has also
increased, which often creates complicated interactions among
provisions. Further, eligibility can vary across similar tax
preferences due to idiosyncratic definitions and complicated phase-out
provisions intended to limit tax benefits to lower-income taxpayers.
For example:
 The tax code currently contains a dozen special tax
preferences relating to educational expenses.  Three commonly
utilized preferences--the Hope credit, the Lifetime Learning
credit, and the tuition deduction--help families meet the
costs of post-secondary education, but each provision varies
in terms of eligibility and benefits.  Also, the use of one
tax provision may affect a student's ability to use one of the
other provisions and can even affect a student's eligibility
for subsidized student loans or Pell Grants.
 Phase-out provisions reduce the benefit of certain tax
preferences (such as personal exemptions and the tuition
deduction) for high-income taxpayers.  Similarly, the maximum
allowable amount of itemized deductions can be reduced for
taxpayers with an AGI above $159,950 (in 2008).  These
provisions require additional calculations for taxpayers and
also effectively increase their marginal tax rate. In 2008, an
estimated 13 percent of taxpayers who itemized deductions will
have their allowable itemized deductions reduced.
 When the parents of a qualifying child file separate tax
returns, the tax code contains a number of special rules to
determine which parent can claim the child as a dependent.
These rules depend on the marital status and adjusted gross
income of the parents as well as on the amount of time the
child lives with each parent.
 To prevent parents from shifting investment income to their
children, the unearned income of dependent filers is taxed at
the parents' marginal tax rate.  However, to limit this
provision to higher-income families, this applies only to a
child's unearned income in excess of a certain limit ($1,800
in 2008).
 As discussed in the text, the AMT, which requires taxpayers to
calculate their tax liability a second time using a different
set of tax rules and rates, affects a growing number of
taxpayers.
-----------------------------------------------------------------------

Complying with these complex laws costs taxpayers time and money. It
takes time to read and understand the laws, to collect the relevant
data and keep records, and to fill in the forms themselves (or to have
someone else do it). In fact, the tax laws are so complex that an
entire industry of lawyers and accountants exists to help people
comply with the laws and even to find ways to avoid paying the taxes
they owe. The resources used in this industry are unavailable for use
to produce other goods and services. In effect, other than for tax-
related purposes, there are no consumable goods or services produced
by these resources--one could argue that the economy is wasting these
resources. Several studies have examined the social cost of the
complexity of our tax code. A Government summary of these studies
concludes that the annual cost of complying with the tax laws averages
at least 1 percent of GDP (about $140 billion in 2008) and may be even
higher. Tax reform that substantially simplified the tax code would
free up these resources for more beneficial uses.

Conclusion

Taxes distort incentives to work, save, and invest. By lowering
individual income tax rates at all income levels over the past 8
years, the Administration has substantially reduced these distortions
and increased incentives to work, save, and invest. Lower Federal tax
rates on capital gains and dividend income, along with the temporary
increases in depreciation allowances, increased business incentives to
purchase new capital equipment and reduced the double taxation of
corporate income. Each of these changes improves the efficiency of the
tax structure, enhances economic growth, and improves our standard of
living over the long run. However, most of these tax reductions are
scheduled to expire at the end of 2010, which would eliminate many of
the gains made over the past 8 years. Allowing these tax reductions to
expire will increase taxes for all income groups, with the lower- and
middle-income groups experiencing the largest percentage increases.
Despite the improvements of the past 8 years, there remains much to be
done to make the tax code as efficient as possible. In the
international arena, the relatively low U.S. corporate tax rates of
the late 1980s were left unchanged while most other developed
countries dramatically reduced rates. As a result, U.S. corporate tax
rates are now among the highest in the developed world. This handicap
is partly offset by other tax provisions, such as generous
depreciation allowances. But the resulting tax burden still places
U.S. companies at a competitive disadvantage relative to companies in
lower-tax jurisdictions, and it reduces our ability to attract capital
in an environment where capital is highly mobile across international
borders. In addition, two long-standing problems needing attention are
the Alternative Minimum Tax and the complexity of the U.S. income tax
laws. Without its annual ``patch,'' the AMT would affect more than 20
million more taxpayers each year.