Proposal for a “Dual‐​Rate Income Tax”

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I am delighted that President Bush has established an advisorypanel to study federal tax reform. The co-chairs of the panel,former senators Connie Mack of Florida and John Breaux ofLouisiana, are the ideal leaders to tackle the ambitious task ofoverhauling the tax code to create greater fairness, opportunity,and economic growth.

President Bush has already made progress on incremental taxreforms. Income tax rates have been reduced, dividend and capitalgains taxes have been cut, and the tax rules on retirement savingsvehicles have been liberalized.

However, the tax system remains terribly complex andinefficient. The number of pages of federal tax rules has increased48 percent in the past decade.1 The complex alternative minimum tax will hitabout 35 million households by the end of the decade if notrepealed. The high-rate U.S. corporate income tax is under growingpressure as global investment capital has become more mobile.

A number of tax reform plans would replace the income tax codewith a consumption-based tax system. These plans include theHall-Rabushka flat tax, a national retail sales tax, and asavings-exempt personal tax. There is no doubt that aconsumption-based system would spur faster economic growth becauseof its more favorable treatment of savings and investment. Also, asformer Princeton professor David Bradford stressed,consumption-based taxes are intrinsically simpler than incometaxes.2

I support replacement of the income tax with a consumption-basedsystem. But if policymakers do not want to make such a big reformjump all at once, the plan proposed here would be a big step towarda Hall-Rabushka flat tax. The "dual-rate income tax" is a goodmodel for reform within the bounds of the current taxstructure.

The dual-rate tax is a revenue-neutral option that would convertthe individual income tax to a system with two rates, 15 and 27percent. Most deductions and credits would be eliminated, butfamilies would enjoy reduced marginal tax rates. To promote growth,the maximum individual rate on dividends, interest, and capitalgains would be 15 percent. The corporate tax rate would be droppedto 15 percent. Such a reform would simplify the system, spurgrowth, and treat Americans more equally.

Details of the Dual-Rate Tax Plan
Under the plan, the individual income tax would be turned into atwo-rate tax that eliminated most deductions and credits.Individuals would be taxed at a low 15 percent rate on income up toabout $90,000 (singles) and $180,000 (married) and 27 percent abovethose thresholds. 3(Currently, there are six income tax rates ranging from 10 to 35percent). The vast majority of families - roughly 95 percent -would face a low 15 percent marginal income tax rate under thedual-rate plan. Under current law for 2005, singles with taxableincome above $29,700 and couples with taxable income above $59,400are in the 25 percent and higher tax brackets. The dual-rate planwould cut the marginal rate for most of those taxpayers to 15percent. See Figure 1.

Table 1

The 27 percent rate would kick in at the wage threshold at whichthe 12.4 percent payroll tax that funds Social Security cuts out.The effect would be to create a consistent marginal tax rate ofabout 29 percent on earnings of all middle- and higher-incomehouseholds, taking into account both the payroll and the incometax. That would be a big cut in the marginal rate for manymiddle-income families, who currently face a marginal rate of about38 to 41 percent.4 See Figure2. For example, single earners with wages between about $38,000 and$90,000 face a payroll tax rate of 15.3 percent and marginal incometax rates of 25 or 28 percent under current law.

Table 1

While marginal tax rates would fall under the dual-rate system,nearly all credits and deductions would be eliminated, such as themortgage interest deduction. By dropping marginal rates and endingspecial breaks, the dual-rate tax would create a high degree ofhorizontal equity.

The dual-rate tax plan would retain the current law standarddeduction, which is $5,000 for singles and $10,000 for marriedcouples in 2005. The plan would also include an increased personalexemption, which would partly offset the elimination of the childtax credit. The exemption would be increased from $3,200 undercurrent law in 2005 to $4,500. The plan would also retain the EITC,which reduces taxes for low-income workers.

The Dual-Rate Tax is Pro-Savings
The dual-rate tax would retain pro-savings features of the currenttax code, including 401(k)s, IRAs, and Health Savings Accounts.Indeed, further steps to simplify and liberalize personal savingscould be incorporated into the plan.5

In addition, a key goal of the dual-rate system is to reduce andequalize tax rates on income from savings. The maximum individualtax rate on dividends, interest, and capital gains would be 15percent. (Interest is currently taxed up to the maximum individualrate of 35 percent). To match that change, the corporate tax ratewould be cut to 15 percent and net interest deductions (interestreceipts less interest deductions) excluded from the taxbase.6 The result would bethat interest and dividends would be taxed at both the corporatelevel and the individual level at 15 percent, for a net combinedrate of 28 percent.7

Table 1 and Figure 3 show that the top combined marginal rateson wages, dividends, interest, and small business profits would bejust under 30 percent in the dual-rate plan, compared to 35 to 45percent under the current tax system.8 Wages would be taxed under the individual incometax and the existing payroll tax. Interest and dividends would betaxed under the individual and corporate income taxes.

Table 1

The dual-rate tax plan borrows from the "dual income tax"systems that have been implemented in a number of Europeancountries. Those systems feature a lower flat rate on individualcapital income (such as interest, dividends, and capital gains) andhigher, graduated rates on labor income. Austria, Denmark, Finland,Netherlands, Norway, and Sweden have implemented such reforms.Capital income is taxed at a lower flat rate in order to reduceeconomic distortions and to respond to rising global capitalmobility. If countries do not cut tax rates on capital income, taxcompetition will cause capital to flow abroad. For example, theNetherlands dropped its tax rate on dividends and capital gains to25 percent from 52 percent in 2001 in order to reduce taxevasion.

Table 1

Lower Rates Instead of Special Breaks
The dual-rate tax plan ends special breaks under the current taxsystem in favor of lower rates in order to create a more fair andefficient tax system. Consider the advantage of eliminating theitemized deduction for state and local income and property taxes.This deduction encourages state and local governments to raisetaxes because higher taxes are offset by the federal deduction. Thededuction mutes beneficial tax competition between jurisdictions.Also, before the recent change that allows a federal deduction forstate sales taxes, states were encouraged to favor income taxesover more pro-saving sales taxes.

Eliminating the deductibility of state and local taxes wasdiscussed before the Tax Reform Act of 1986. President RonaldReagan noted in June 1985: "Perhaps if the high-tax states didn'thave this federal crutch to prop up their big spending, they mighthave to cut taxes to stay competitive."9 Indeed, a study at the time by Harvard's MartinFeldstein and Gilbert Metcalf found that federal deductibility ledto modestly higher state spending.10The dual-rate tax system would eliminate thispro-spending distortion.

The changes to the individual income tax under the proposeddual-rate system are estimated to be roughly revenue neutral on astatic basis. Calculations were based on my analysis of IRS taxreturn data for 2002 and an estimate by the Tax Foundation for 2004using their individual tax microsimulation model.11

Cutting the Corporate Tax Rate
While the United States led the world with a corporate tax rate cutin 1986, today it has the second-highest corporate tax rate in the30-nation Organization for Economic Cooperation and Development.That creates a strong incentive for U.S. corporations to move theirreal investment and paper profits abroad. As much as $1 trillion indirect investment flows cross international borders each year, andresearch shows that these flows are increasingly sensitive tocorporate taxes.12Corporate tax reforms are urgently needed to tackle internationaltax competition head-on, and to attract these investment flows toour economy.

Table 1

The statutory U.S. corporate rate averages about 40 percent,including the 35 percent federal rate and the average state rate.By contrast, Figure 4 shows that the average rate in Asia, Europe,and Latin America is 30 percent or less. The average corporate taxrate in the OECD fell from 37.6 percent in 1996 to just 30.0percent in 2004.13 The U.S.needs to catch up to tax reforms occurring abroad to ensure thatAmerican businesses remain competitive in global markets.

Under the dual-rate plan, the corporate tax rate would be cutsharply from 35 to 15 percent. To retain revenue-neutrality, avariety of tax base broadeners and spending cuts would be needed. Afirst step would be to end the deduction for net interest in orderto create neutrality between corporate debt and equity.

The second step would be to end or limit the deduction foremployer-paid health insurance benefits. Employer-paid benefits forhealth insurance are currently tax-free, creating distortions inthe delivery of health care in the United States. An alternative tolimiting the employer deduction would be to limit the individualexclusion for employer-provided benefits. At the same time, HealthSavings Accounts could be expanded to shift the health care systemtoward individual coverage and control.14

Another corporate base broadener would be to eliminate thededuction for state and local taxes. That would create the benefitof increasing tax competition between the states. Without thefederal deduction, businesses would be more sensitive to statetaxes in their location decisions, thus providing a usefulconstraint on state and local fiscal policy.

The combination of these corporate tax changes (net interest,the health care deduction, and state and local taxes) would expandthe corporate tax base by about 70 percent and offset more thanhalf of the revenue loss from the rate cut.15 To get the corporate rate all the way down to15 percent and retain revenue neutrality, corporate subsidies onthe spending side of the federal budget could be cut.16

Also note that cutting the corporate tax rate would createmacroeconomic feedback effects that would offset a substantialshare of the revenue loss. Global investment flows would pour intothe United States to take advantage of the 15 percent corporaterate, which would have the effect of boosting federal revenues.

The proposed corporate tax changes borrow from both theHall-Rabushka flat tax and the "comprehensive business income tax"proposed in a 1992 Treasury study.17Both proposals would equalize the treatment ofinterest and dividends by excluding interest from the business taxbase. Also, the flat tax would broaden the tax base by ending thededuction for employer-paid health benefits. The flat tax wouldalso end the business deduction for federal payroll taxes. Thedual-rate tax retains deductibility of federal payroll taxes butends the deduction of state and local taxes to encourage interstatetax competition.

Under the dual-rate system, the corporate tax could be moved allthe way to a Hall-Rabushka cash-flow business tax with four furthersteps. First, depreciation would be replaced by capital expensing.Second, accrual accounting would be replaced by cash accounting.Third, the "worldwide" tax system would be replaced by a"territorial" system that taxes firms on their domestic profitsonly. Territorial taxes are used by most industrial countries todaybecause they are simpler and they allow firms to better compete inforeign markets.18 Fourth,the tax would be extended from corporations to all types ofbusinesses.

Conclusion

The president's call for tax reform creates both risks andopportunities for taxpayers and the economy. The risk stems fromsome policymakers who may view tax reform as an opportunity toincrease revenues to fund entitlement programs and reduce thebudget deficit. The president is right to reject that approach.There is no need for higher taxes when there are hundreds ofinefficient federal programs that could be eliminated to savemoney.19

However, to support rising entitlement costs the economy needspro-saving and pro-growth policies more than ever. The financialstrains that will be caused by the retirement of the baby boomergeneration will be easier to handle if the nation has a moreefficient tax system. Tax reforms can help to increase personalsaving to allow people to be better prepared for their futurehealth care and retirement needs. And tax reforms can increaseinvestment and productivity, enabling U.S. businesses to bettertackle rising competition in global markets. The dual-rate tax planwould take a big step toward the simple, neutral, and pro-growthtax system that the United States needs to prosper in the comingdecades.

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1. Page count of the CCH Inc.Standard Federal Tax Reporter.

2. See Chris Edwards, "SimplifyingFederal Taxes: The Advantages of Consumption-Based Taxation," CatoInstitute Policy Analysis no. 416, October 17, 2001.

3. More precisely, the plan's taxrates would be applied to taxable income, which would be adjustedgross income (as under current law) less the standard deduction andan expanded personal exemption. In 2005 the standard deduction is$5,000 for single and $10,000 for married filers, and the expandedpersonal exemption would be $4,500. Thus, the 27 percent bracketwould begin at about $80,000 of taxable income for singles andabout $160,000 of taxable income for married couples. (Dividends,interest, and capital gains would taxed at a maximum of 15percent).

4. Calculations include the effect ofthe employer-paid payroll tax being deductible against thecorporate income tax.

5. The administration has proposedadding lifetime savings accounts and simplifying the rules oncurrent retirement plans. For a description, see U.S. Treasury,"General Explanation of the Administration's FY2005 RevenueProposals," February 2004,www.treas.gov/offices/tax-policy/library/bluebk04.pdf.

6. Looking at IRS data for allnonfinancial C corporations for 2000 and 2001, the interestdeduction is typically about $60 billion larger than interestincome. Special rules would be required for the financial servicesindustry. For corporate data, see IRS, Statistics of IncomeDivision, Corporate Income Tax Returns 2001 (Washington:Government Printing Office, undated), Table 12.

7. Calculated as 15 +(1-0.15)*15.

8. For this proposal, I have assumedthat the corporate income tax would be paid by C corporations, asunder current law. Small businesses would continue to pay tax underthe individual system. However, in the long run the tax code shouldbe reformed to equalize the tax treatment of all businesses.

9. Ronald Reagan, Remarks during aWhite House Briefing on Tax Reform, June 7, 1985,www.reagan.utexas.edu/resource/speeches/1985/60785b.htm.

10. Martin Feldstein and GilbertMetcalf, "The Effect of Federal Tax Deductibility on State andLocal Taxes and Spending," NBER Working Paper no. 1791, January1986.

11. The Tax Foundation's IndividualTax Simulation Model is based on the IRS, Statistics of Income,public use data file.

12. Chris Edwards and Veronique deRugy, "International Tax Competition: A 21st-Century Restraint onGovernment," Cato Institute Policy Analysis no. 431, April 12,2002.

13. KPMG, "Corporate Tax RatesSurvey," January 2004.

14. See Michael Cannon, "CombiningTax Reform and Health Care Reform with Large HSAs," Cato InstituteTax & Budget Bulletin no. 23, May, 2005.

15. Based on my calculations ofaggregate IRS data for all nonfinancial C corporations in 2000 and2001. The exclusion of interest income and deductions would expandthe corporate tax base by about 10 percent; ending the healthinsurance deduction would expand the base by about 30 percent; andending deductions for state and local taxes would expand the baseby about 30 percent. Special rules would be needed for thefinancial services industry under such a tax plan. For corporatedata, see IRS, Statistics of Income Division, Table 12.

16. Business subsidies, or"corporate welfare" on the spending side of the federal budgettotals about $90 billion annually. See Chris Edwards and TadDeHaven, "Corporate Welfare Update," Cato Institute Tax &Budget Bulletin no. 7, May 2002.

17. U.S. Department of Treasury,Integration of the Individual and Corporate Tax Systems(Washington: Government Printing Office, January 1992).

18. For a discussion ofinternational tax systems used in other countries, see PeterMerrill, PricewaterhouseCoopers, Testimony before the House BudgetCommittee on the "Competitiveness of the U.S. Tax Code," July 22,2004.

19. Chris Edwards, "Downsizing theFederal Government," Cato Institute Policy Analysis no. 515, June2, 2004.