Note: this is a shallow overview of a topic that we have not previously examined. For shallow overviews, we typically work for a fixed amount of time, rather than continuing until we answer all possible questions to the best of our abilities. Accordingly, this is not researched and vetted to the same level as our standard recommendations. If you have additional information on this cause that you feel we should consider, please feel free to get in touch. We use our shallow overviews to help determine how to prioritize further research.
In a nutshell
What is the problem?
The federal tax system in the U.S. is inefficient, overly complicated, unlikely to be able to cover rising federal expenditures in the long run, and may constrain economic growth.
What are possible interventions?
Fundamental income tax reforms, including shifting the tax base to consumption or broadening the income tax base by eliminating many tax expenditures, may increase rates of economic growth and help address long-run fiscal issues. Smaller adjustments to federal tax policy may also have substantial benefits. These reforms face several political obstacles, and we do not have a strong sense of how additional funding would be able to create policy change.
Who else is working on it?
Federal tax reform efforts attract significant attention from many think tanks and foundations, including the Tax Policy Center and the Peter G. Peterson Foundation, amongst others.
1. What is the problem?
Federal taxes in the U.S. are widely believed to be inefficient and overly complicated.1 Even taxpayers with simple tax situations spend considerable time and money filing income tax returns.2 Other individuals and businesses navigate a complex system of around 200 potentially applicable tax expenditures (e.g. deductions, exemptions, and credits).3 The system of tax expenditures makes federal taxes less progressive, narrows the overall base of taxable income, and reduces federal revenue, which may not be sustainable in the long run.4 Many specific tax expenditures reduce federal revenue without achieving any policy goals.5 More fundamentally, many scholars have argued that taxing income (rather than consumption) discourages savings and investment, which may negatively impact economic growth.6
2. What policy changes could be helpful?
We consider shifting the tax base from income to consumption or broadening the base of taxable income by eliminating many tax expenditures to be fundamental reforms of the federal tax system.7 We have seen arguments for the benefits of fundamental federal tax reforms:
- Consumption taxes, including value-added taxes (VATs), the “X tax,” and the personal expenditure tax (PET), are simpler and create greater incentives for savings and investment than income taxes, though there seems to be disagreement about the magnitude of the gains from switching from an income to a consumption tax base.8
- VATs require businesses to pay taxes on the difference between their sales and their purchases of inputs (i.e. the business is taxed on the value it adds to products or services). Each business that adds value to a product or service is taxed, which leads to increased retail prices for consumers.9 VATs are well-studied since they have been implemented in 160 countries, and have been discussed as a supplement to or partial replacement of U.S. income taxes.10 Since low-income households spend a greater proportion of their income than wealthy households, VATs are regressive unless they are offset by another program.11
- The X tax is a VAT modified to be more progressive. Businesses pay taxes on value added, but are able to exempt wages from their tax liability. Workers are also taxed at a progressive rate on their wages.12 The X tax is usually discussed as a replacement, rather than just a supplement, for the federal income tax system.13
- The PET is another alternative intended to replace the income tax system. Households are progressively taxed on their total annual expenses, but businesses are not directly taxed.14
- Base-broadening, rate-reducing tax reform would eliminate many tax expenditures while still using income as the tax base. Eliminating tax expenditures increases the overall proportion of income taxed, allowing for (some combination of) lower tax rates and higher federal revenues.15 Lower income tax rates may also incentivize savings and investment.16
Fundamental tax reform that caused greater rates of savings and investment could in turn lead to greater rates of economic growth.17 A dynamic simulation model by Altig et al. 2001 finds that replacing the federal income tax with a progressive consumption tax could increase rates of economic growth and add hundreds of billions of additional dollars each year to the national income while maintaining current progressivity.18 Other fundamental reforms modeled by Altig et al. 2001 would also increase growth rates, but would be quite regressive.19 However, we interpret these growth rate estimates with caution since the models that yield these results rely on relatively strong assumptions about the effects of tax incentives on saving and investment behavior, which may not turn out to be realistic.20 More generally, economists seem to disagree considerably about the magnitude of economic gains that tax reforms might yield.21
We have also seen arguments for the benefits of non-fundamental federal tax reforms:
- Simplifying tax filing: For most taxpayers, the IRS already has all the information it needs for tax filing.22 A “Simple Return” program, for which the IRS pre-files taxes for individuals with uncomplicated tax situations, could save individuals significant amounts of time and money. Goolsbee 2006 estimates that IRS pre-filing could collectively save up to 225 million hours of time and $2 billion a year paid in tax preparation fees.23
- Eliminating specific tax expenditures: Instead of focusing on the tax expenditure system as a whole (which also includes many social programs), reform efforts could target particularly inefficient or ineffective tax expenditures.24 The mortgage interest tax deduction, for example, may not actually promote home ownership as intended.25
- Limits on the use of tax expenditures: Reforms might also raise federal revenues by regulating the use of tax expenditures in upper tax brackets, or by placing a cap on the total permissible value of tax expenditures as relative to income.26
Carbon taxes and land value taxes are also mentioned in discussions of optimal tax policy, but we have not investigated them thoroughly for this overview.27
3. Prospects for reform
Federal tax reform faces several political obstacles:
- Our impression is that politicians are reluctant to support fundamental tax reform. Although some tax reforms could create widely-distributed long-term benefits, groups that would suffer losses would likely oppose the reforms,28 and the potential for widely-distributed benefits may be illusory.29
- Any fundamental reforms are likely to alienate powerful stakeholders on either the left or the right. The addition of VATs to the income tax system is often opposed both by those who want to limit government spending and those who are worried about the tax’s regressiveness.30 Similarly, an X tax may have difficulty gaining political support both because it would appear that wealthy citizens who primarily make their income from investments rather than wages would only be lightly taxed and because it would actually impose large one-time losses on those existing wealth-holders.31 A PET may also have difficulty gaining public support because no taxes are levied on businesses, and because individuals would be taxed on borrowed money.32
- Anti-tax groups have expressed opposition to reforms simplifying tax filing.33
On the other hand, projected increases in federal spending are expected to eventually require some type of revenue-increasing tax reform.34 In the near future, reforms that place a cap or limit on the use of tax expenditures seem more politically feasible than eliminating tax expenditures.35
All things considered, we’re pessimistic about the prospects of any fundamental federal tax reforms in the near future.36 Some of the smaller reforms discussed above may be considerably more tractable.37
4. Who already works on this?
Federal tax reform efforts attract significant attention from a wide variety of players, and we have not attempted to develop a full sense of the landscape.
Much of our assessment above has been informed by work from the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, which is a leading voice in tax policy discussions.38 Several major foundations, including the Bill and Melinda Gates Foundation, the John D. and Catherine T. MacArthur Foundation, the Ford Foundation, and the Rockefeller Foundation, support the Tax Policy Center.39
Our understanding is that many foundations tend to support tax reforms relevant to social programs, but not fundamental tax reform.40 A potential exception would be the Peter G. Peterson Foundation, which disbursed around $8.6 million in grants in the fiscal year 2013-2014, and is devoted to addressing long-term challenges to the federal budget.41 Amongst other things, it has promoted reducing the number of tax expenditures and simplifying the federal tax system as a response to projected long-term budget deficits.42
Many other advocacy and interest groups participate in tax policy discussions.
5. What could a new funder support?
Funders interested in this area could support a variety of research and advocacy activities aimed at promoting reforms.43
We briefly explored the possibility that technical capacity to translate high-level reforms into detailed technical proposals or legislative text was a gap in the field, but the experts we talked to did not think this was the case.44 We have not otherwise investigated the expected impact of additional funding for different avenues of support.
6. Questions for further investigation
Our research in this area has been relatively limited, and many important questions remain unanswered by our investigation.
Further research on this cause might address:
- How likely would further funding for fundamental tax reform research and advocacy be to accelerate reforms?
- How likely is it for advocacy efforts in favor of simplifying tax filing or other non-fundamental reforms to overcome political opposition? Are there fairly tractable short-term opportunities to advance such reforms?
- To what degree do the efficiency-improving justifications for fundamental tax reform apply to more modest reform efforts (e.g. reforming the mortgage interest deduction)?
- What are the distributional consequences of various tax reform proposals?
7. Our process
We decided to investigate this area due to our strong impression that the complexity of the U.S. tax code creates significant compliance costs, and due to our weak impression that alternative tax systems could positively impact economic growth.
Our investigation consisted of conversations with tax policy experts and some limited desk research. Public notes are available from our conversations with:
- Alan D. Viard,45 Resident Scholar, American Enterprise Institute
- Bill Gale,46 Senior Fellow, Economic Studies Program, Brookings Institution; Co-Director, Urban-Brookings Tax Policy Center
- Daniel Shaviro,47 Wayne Perry Professor of Taxation, New York University School of Law
- David Kamin,48 Assistant Professor of Law, New York University
- Richard England,49 Visiting Fellow, Lincoln Institute of Land Policy; Professor of Economics and Natural Resources, University of New Hampshire
|Altig et al. 2001||Source|
|Brown and Gale 2012||Source|
|Nguyen et al. 2012||Source|
|Our non-verbatim summary of a conversation with Alan D. Viard on March 25, 2014||Source|
|Our non-verbatim summary of a conversation with Bill Gale on March 28, 2014||Source|
|Our non-verbatim summary of a conversation with Daniel Shaviro on July 17, 2014||Source|
|Our non-verbatim summary of a conversation with David Kamin on August 1, 2014||Source|
|Our non-verbatim summary of a conversation with Richard England on March 27, 2014||Source|
|Peterson Foundation 990 2013-2014||Source|
|Peterson Foundation Revenues and Taxes 2010||Source|
|Tax Policy Center Funders 2015||Source|
|World Bank GNI 2015||Source|