Editor’s note: This is the second of two installments excerpting The Republican Revolution 10 Years Later: Smaller Government or Business as Usual? to be published this month by the Cato Institute. The February installment examined the good aspects of GOP tax policy. This month’s excerpt analyzes the bad.
Aside from the temporary capital expensing provisions enacted in 2002 and 2003, U.S. federal corporate taxes have not been substantially cut since 1981. (The American Jobs Creation Act of 2004, which modestly cuts corporate taxes, was passed as this article was going to print.)
While many Americans seem to believe corporations are big winners under Republican governments, the GOP has not cut corporate taxes appreciably during the current administration. That is unfortunate, because the U.S. corporate income tax desperately needs to be cut and simplified to adjust to the realities of the increasingly competitive global economy.
U.S. policymakers have been asleep at the switch while nearly every other industrial country has cut its corporate tax rate in recent years. The combined federal and average state corporate tax rate is 40 percent, 10 percentage points higher than the average among our 30 major trading partners.
Figure 1 shows that the average corporate tax rate in the 30-member Organization for Economic Cooperation and Development plunged from 37.6 percent in 1996 to 30 percent in 2004.
America’s high corporate tax rate creates many problems for the economy. It causes U.S. companies to lose out in global markets to foreign businesses that face lower tax burdens. It also causes the American economy to lose investment dollars to countries with more inviting tax climates.
The high corporate tax rate also has encouraged companies such as Enron to structure elaborate transactions to avoid corporate taxes. Other U.S. firms have reincorporated abroad in low-tax countries to avoid uncompetitive U.S. tax rules on foreign investment.
To reduce such tax avoidance, U.S. policymakers have proposed and enacted several pieces of anti-shelter legislation in recent years, but those minor fixes just make the tax code more complex and more uncompetitive.
A more fundamental response to global tax competition is needed. The U.S. corporate tax rate should be cut sharply, and policymakers should consider replacing the corporate income tax with a consumption-based cashflow tax. [Editor’s note: A cashflow tax is a form of expenditure or consumption tax. It allows tax deductibility for all business expenditures at time of payment and makes dividend and interest payments non-taxable in the hands of the recipient. Allowing immediate deductibility means businesses are taxed on their cashflow, hence the term cashflow tax.]
Individual Rates Too High
Today’s top individual income tax rate of 35 percent is higher than the 28 percent rate achieved in the late 1980s. President George W. Bush’s tax cuts have not fully reversed the tax rate increases of George H.W. Bush in 1990 and Bill Clinton in 1993. The top tax rate is economically very important because of the concentration of small businesses, entrepreneurs, and investors in that rate bracket.
Also, the income affected by the top tax rate is the most mobile of all income–as the rate increases, reported income tends to disappear.
A related problem is that the overall income tax code is too progressive, too steeply graduated. For example, the average federal income tax rate (income tax liability divided by adjusted gross income) for those earning more than $200,000 was 26 percent in 2002. The average tax rate of households earning between $50,000 and $100,000 was 11 percent.
Thus, the income tax is very vertically unequal. To increase fairness and equality, and to spur economic growth, the top statutory tax rates should be substantially reduced.
Tax Complexity Has Increased
Tax complexity has increased substantially during the past decade. Figure 2 shows the total number of pages in the tax code, regulations, and related Internal Revenue Service (IRS) rules increased almost 50 percent between 1995 and 2004. Table 1 provides a variety of other indicators showing tax complexity has increased under the Republican Congress.
Tax forms and IRS instruction books are longer, there are more tax forms, Americans are spending more money for tax preparation services, and the number of narrow tax breaks, or loopholes, has increased.
Despite occasional calls for simplification by members of Congress from both parties, when it comes to writing tax legislation, members usually support provisions that increase complexity.
Addicted to Narrow Provisions
Members of Congress seem addicted to narrow tax credits, special deductions, and complex income limitations. For example, the Taxpayer Relief Act of 1997 contained 11 narrow education tax breaks for such items as student loan interest, a tuition tax credit, and an education IRA. Each item has complex requirements related to income, eligibility, and administration.
In 2001 the congressional Joint Committee on Taxation issued a 1,300-page report, requested by Congress, on simplifying the tax system. Despite the report’s many useful recommendations, including eliminating the individual and corporate alternative minimum taxes, Congress ignored it.
Complexity continues to get worse each year. The alternative minimum tax (AMT) problem, for example, is expected to explode as the number of individuals paying that complex add-on tax increases from 3.7 million in 2004 to 30 million by 2010.
Deficit Creates Tax Threat
While Bush and Congress have passed some important tax cuts in recent years, they have allowed federal spending and the resulting budget deficits to increase dramatically. Taxpayers face a big threat because future congresses and presidents may use the deficit as an excuse to raise taxes, as Clinton did in 1993.
Federal outlays rose 29 percent under Bush between fiscal 2001 and fiscal 2005. That big-spending policy was remarkably irresponsible and short-sighted–both economically and politically–because the resulting deficits will create political pressure to let the 2001 and 2003 tax cuts expire, which would wipe out Bush’s primary fiscal achievements.
Fundamental Reform Shunned
The biggest Republican tax policy failure of the past decade has been the inability to move ahead with fundamental tax reform, despite high-level support in Congress.
Consider this statement by Bob Dole and Newt Gingrich in the foreword to the 1996 report of the National Commission on Tax Reform and Economic Growth:
“The current tax system is indefensible. It is overly complex, burdensome, and severely limits economic opportunity for all Americans. We made clear on the very first day of the 104th Congress that our top priority would be to change the status quo and to bring fundamental change to America. And we agreed that there is no status quo that needs more fundamental changing than our tax system.”
Within months of coming to power in 1995, Republicans began holding congressional hearings on fundamental tax reform, and many members introduced tax reform legislation. Most plans proposed replacing the individual and corporate income taxes with a simpler and more efficient consumption-based system.
Despite that top-level call for change, Dick Armey’s leadership, the efforts of leading think tanks, and the enthusiasm of many citizens for reform, legislation to overhaul the tax system was not moved through the House or the Senate.
Flat Taxes Proposed
One leading reform idea was the consumption-based flat tax introduced by Dick Armey in June 1994, modeled on a 1981 plan by Hoover Institution economists Robert Hall and Alvin Rabushka.
Following Armey’s lead, Steve Forbes campaigned for president in 1996 with a flat tax as the centerpiece of his platform. Tax reform was so popular even moderates, such as Sen. Arlen Specter (R-PA), and liberals, such as Richard Gephardt (D-MO), offered their own flat-tax plans. (Specter’s was a derivation of Hall-Rabushka; Gephardt’s was a not-very-flat income tax).
A competing reform idea is replacement of the income tax with a national retail sales tax. Sen. Richard Lugar (R-IN) introduced his retail sales tax plan in April 1995. He was followed by Ways and Means Chair Bill Archer, who said he wanted to “rip the income tax out by its roots” and replace it with a sales tax.
Another reform idea is the pro-savings “USA Tax”‘ proposal, currently championed by Rep. Phil English (R-PA). Many articles and books during the 1990s examined the economic growth and simplification advantages of consumption-based taxation, including early studies by the Cato Institute.
Opposition Too Powerful
Despite all the support for fundamental tax reform inside and outside the Beltway, it has not happened yet. Why not? There are several reasons:
- Splits among tax reformers. Nearly all the major tax reform plans of recent years, including the flat tax, retail sales tax, and USA Tax proposal, have been economically similar in that they all rely on a savings-exempt or consumption-based structure. However, key design features, such as the point of collection and treatment of imports and exports, have been sufficiently different to prevent agreement on a common plan.
- Big business has not come on board. Corporations spend millions of dollars lobbying to gain narrow tax breaks and defend against narrow tax increases. Most companies put little effort into supporting fundamental tax reform. Also, the last major tax “reform” bill–the Tax Reform Act of 1986–imposed a substantial tax increase on corporations. Businesses are justifiably concerned that “reform” means an increase for them.
Nonetheless, corporations should consider that the past decade of lobbying for narrow provisions has earned them little: The corporate tax is more punitive than ever. The corporate tax legislation passed in 2004 contains only limited reforms and does not solve major problems.
- Social engineering undercuts reform. A good deal of the GOP’s tax policy focus during the past decade has been on narrow, social policy tax breaks. That focus has diverted energy from fundamental tax reform, and it has made reform more difficult to achieve because narrow breaks create new constituencies against reform. For example, families with children may now be against any simple and neutral tax reform plan if it takes away the recently enacted $1,000 child tax credit.
- Fewer Americans are paying income tax. Since the 1980s, Congress has steadily reduced the constituency for tax reform by taking millions of moderate-income Americans off the tax rolls. Expansion of the earned income tax credit in 1990 and 1993, the child tax credit, the new 10 percent tax bracket, and other provisions have had the effect of zeroing out income tax liability for millions of families.
By 2003, 60 million of the 150 million U.S. households (39 percent) did not pay a dime of federal income tax. That has created a large group with a strong interest against any tax reform that asks them to pay even a simple, low-rate tax.
- Democrats’ opposition to reform. In the 1980s, tax reform was a bipartisan concern, with prominent Democrats and liberal think tanks offering reform proposals. Democrats introduced versions of the Hall-Rabushka flat-tax plan in Congress in early 1982, and in 1985 the Brookings Institution’s Henry Aaron and Harvey Galper proposed a comprehensive consumption-based tax plan.
But since becoming the minority party in the 1990s, the Democrats have focused their energy on throwing darts at Republican reform plans, while offering no reform alternatives of their own. For tax reform to move ahead, it may be necessary for some forward-thinking Democrats to get on board the tax reform movement.
Reform Returning to Agenda
Despite these hurdles, one can bet serious tax reform will come back onto the agenda in Washington. The past decade of tax debates has shown tax cuts and major tax reform ideas are popular with the general public. Tax cutting continues to be important to the electoral success of the Republican Congress.
Dynamics in the tax system will also raise the profile of reform. Tax complexity continues to spiral upward, and the AMT will soon be hitting 30 million American households. Those dynamics may spur a tax revolt and demands for a major tax system overhaul.
Also, the federal corporate income tax is headed for a train wreck as other countries continue to cut their statutory rates and investment capital becomes ever-more globally mobile.
The tax reform ingredient that is missing right now is a new generation of Republican leaders to build on the efforts of Bill Archer, Dick Armey, and other would-be reformers of the 1990s.
Chris Edwards ([email protected]) is director of tax policy at the Cato Institute, Washington, DC.