Only a few OECD countries have a lower ratio of tax revenue to GDP than the United States, and the programme of medium-term tax cuts introduced last year will lower taxation even further. Nonetheless, there exist several areas where reforms are desirable: first, the income tax system is very complex; second, incentives to work, save and create new businesses may still be harmed; and third, the higher proportion of revenues that comes from taxes on income rather than on consumption may be inefficient in the long run.
At the moment, though, the 2001 tax cut, higher government spending and the slowdown in economic growth have reduced the scope for further tax cuts without raising tax cuts in other areas, placing the emphasis on the need for a balanced reform. Income tax, especially at the federal level, has become complex, with a large number of tax breaks. As the number of these tax breaks has risen, the government has tried to limit their cost by reducing their value to upper-middle income taxpayers. The result of this policy has been to multiply the number of possible tax rates for the same income: for middle income earners, there are typically between four and six effective marginal tax rates at the same income level, depending on precise individual circumstances.
Once individuals have determined their standard income tax bill, they have to calculate their tax bill a second time using the different rules of the Alternative Minimum Tax. Their tax payment is then based on the bigger of the two bills. This was originally designed to ensure that all people with very high incomes paid tax, but as its allowances have not been indexed to inflation, in contrast to those of the basic system, it now serves to limit tax deductions for middle income groups. The AMT should be ended, because as wages grow, more and more people are likely to be drawn into it in the coming years.
But it is in the area of corporate taxation where most simplification is required, as compliance is particularly expensive. In fact, costs are perhaps as high as half the yield of the tax due to the cost of the professionals needed to ensure compliance, to minimise payments and to apply the different rules of financial and tax accounting. Taxation creates economic distortions too, which policymakers must try to minimise. In the United States, joint taxation of married couples can be a disincentive to work for whichever partner is the second earner.
Assuming that the combined wage is high enough, the second earner will face a higher tax rate even if their individual wage is low – an incentive to stay home or work less hard. It is not just married couples that respond to taxes: higher income groups may be particularly responsive to changes in tax rates. Quite apart from boosting the value of work, lower rates would lessen the appeal of tax breaks. Such an effect might help to lessen the impact of reductions in marginal tax rates and cut the number of people involved in tax planning.
The tax system could also be reformed to attract even more low-skilled people into the labour force and reduce poverty. The tax system already gives a bonus to low earners. The limits for this bonus could usefully be increased in order that full-time workers earning the legal minimum wage became eligible for it.
Another key feature of the US tax system is that it depends more heavily than other countries on taxing income. Yet a consumption-based tax might boost saving, investment and, eventually, real incomes. While shifting to a full consumption-based tax is unlikely to happen because of the impact on income distribution, a second-best approach might be to lower corporate and capital gains tax rates, thus lowering the tax on saving and investment and moving the tax base towards consumption.
In addition, there are large variations in the taxation of capital income, depending on the financing instruments. Take the interplay of corporate and personal income tax. The system introduces a bias in favour of bond financing and discourages the payment of dividends. This is because profits are taxed twice: once as company profit and again as dividends to shareholders via personal income tax. The combined rate approaches 62% in higher tax states. But the combined rate is lower for retained earnings, if the shareholder realises a capital gain; it is lower still for interest payments that are taxed only once, when they reach the recipient.
Congress has begun reducing the deterrents to entrepreneurial activity by placing the majority of limited liability companies outside the corporate tax system, so avoiding double taxation of dividends and lessening biases towards debt financing. Further action is needed.
But it is also necessary to ensure that taxation does not discriminate against the investment that families and young people make in education and training – outlays that will boost further growth. The tax package introduced in 2001 did not, in the main, focus on taxing consumption or reducing complexity. Rather, it aimed to stimulate the economy and increase incentives by gradually lowering future income tax rates.
Yet such reforms would make the system more efficient. The current situation means that further tax cuts would have to be balanced by more tax increases elsewhere, even if some of the reforms we advocate could be financed by ending certain tax breaks. The introduction of value-added tax could offer a way to finance part of the cuts, but that would require co-operation with the states. In any case, the current system of state sales taxes would benefit from an overhaul. It would be a valuable step towards creating a more uniform tax base across the country.
OECD Economic Survey: United States, OECD, 2001.
©OECD Observer No 230, January 2002