- Key Facts
- High individual tax rates mean that individuals, families, and small businesses have lower income and less incentive to work, save, and invest.
- Contrary to popular misconception, the ultimate burden of corporate income taxes doesn't fall on corporations, but is instead borne by workers, shareholders and consumers.
- Most other developed world economies levy higher average tax rates than we do, but much of their tax burden comes from taxes on middle-class consumption (often in the form of VAT taxes that inflate the cost of goods and services).
- The 2017 tax reform improved the U.S. overall corporate tax rate competitiveness by incentivizing repatriation of overseas profits and lowering the overall corporate rate to incentivize investment in the U.S. The changes also reduced individual income tax rates overall through a combination of rate changes and increased amounts of income covered.
Taxes have played a significant role in U.S. history, dating back to the country’s inception. “Taxation without representation” was a primary driver in the original 13 colonies’ desire to gain independence from England. Grover Norquist writes in Foreign Policy that “Taxation in the colonies consisted of property taxes, poll taxes on men over 18, excise taxes, and forced labor contributions of a few days a month to build roads and assume other ‘public functions’ such as constable, assessor, or ‘hog reeve’ (an officer charged with the prevention or appraising of damages by stray swine,’ according to the Oxford English Dictionary).” Subsequent British taxes levied on the American colonies, such as the Stamp Act of 1765 and the Tea Act of 1773, fueled the colonists’ revolt against England (BBC).
Federal income tax in the United States was first enacted in 1913, after the 16th Amendment was ratified, “making it possible to enact a modern, nationwide income tax.”
After ratifying the 16th Amendment, Congress passed the Underwood-Tariff Act, also called the Revenue Act of 1913, which levied “a graduated income tax on U.S. residents.” As the izzit.org video below outlines, in 1913 “only the wealthiest Americans were required to pay income taxes” (see minute 2:45).
The chart below, from the Forbes article “A Brief History of the Individual and Corporate Income Tax,” illustrates how “the new income tax applied primarily to higher wage earners. The following table contains the marginal tax brackets in effect in 1913 and the equivalent amount in today’s dollars. For example, an individual earning $20,000 in 1913 would have been in the 1.0% marginal bracket. $20,000 in 1913 is equivalent to $480,697 today (based on an average annual rate of inflation of 3.17% over the 102-year period).”
Middle class Americans began paying income taxes in the 1930s. President Franklin Roosevelt “increased taxes, and, perhaps for the first time, reached into the middle class” to help fund the new government programs created under the New Deal to combat the economic crisis of the Great Depression. Since then, individual income tax has remained essential to our government’s revenue: “Since 1944, the individual income tax has consistently provided 40% to 50% of total federal revenue. Today the individual income tax is the largest income item in the federal budget.” (Forbes)
Taxes have always been controversial, including the right of the government to tax citizens in the first place. While Article I of the Constitution authorized Congress to levy taxes, the Founders limited Congress’ ability to impose direct taxes on citizens by requiring that taxes be apportioned among the states, meaning that tax levels in each state had to be tied to population. The 16th Amendment to the Constitution removed this restriction, thus enabling Congress to tax at will.
Individual taxes are levied upon individual taxpayers in the form of payroll and income taxes at the federal, state and sometimes local levels. U.S. individual income tax rates have varied considerably over the last century. This is especially true for the top income tax rate (also called the top marginal tax rate), which many economists consider having the largest impact on economic growth. The top rate has dropped considerably from 70% in the early 1960s to 28% in the late 1980s but has risen since then.
Meanwhile, the payroll tax (known on your pay statement as “FICA”) has overtaken the income tax as the federal tax that more Americans pay. This is due in part to payroll tax rate increases passed by Congress during the 1980s, and to measures that increased the progressivity of the income tax. Although the tax is technically divided between the employer and the employee (in the form of withholdings), the employee ultimately bears its total cost in the form of lower take-home pay. All working Americans pay payroll taxes; only about 53% of working people pay income tax.
High individual tax rates mean that individuals, families, and small businesses have less income and less incentive to work, save, and invest.
General Corporate Taxes
According to The Tax Foundation, the first corporate income taxes were imposed in 1909 at a rate of 1% on corporate in come of $5,000 or more.
The rate has fluctuated from 1% (1909-1915) to 52.8% at its highest, on income over $25,000 with a surtax of 26% in 1968-1969. (Tax Foundation) With the 2017 changes to tax legislation, the rate is now 21% for corporations. Many states also impose corporate taxes on businesses. Corporate income is generally subject to two levels of taxation, once when it is earned at the corporate level and again when income is distributed as a dividend to shareholders.
To avoid the double taxation of corporate income, many small business owners structure their businesses such that their profits are taxed at the individual rate. These “pass-through” businesses are incredibly popular -– there are roughly three and a half times the number of “pass-throughs” as traditional corporations and they account for over half of all business revenue — but this option is only available to closely-held business entities. All others are taxed at the corporate rate, which is graduated, similar to individual rates. (This two-minute Prager U video covers taxation on small businesses and pass-throughs.)
Throughout the many changes to tax rates since 1909, tax revenue as a percentage of the economy has remained surprisingly stable, usually accounting for between 18 and 20 percent of GDP.
High corporate tax rates inhibit business activity in the U.S., especially when they are higher than corporate tax rates in other developed countries. Foreign companies also might forgo establishing offices and/or operations in the U.S. for the same reasons.
Before the 2017 tax reforms, parent companies of many U.S. businesses chose to relocate to countries that offered a better business climate, including lower tax rates, through a process known as “inversion.” The U.S. Treasury Department cracked down on this controversial practice in April 2016 with new regulations. Some companies chose to relocate manufacturing facilities for both lower tax and labor, thereby impacting job creation. Companies also tended to keep income generated outside of the U.S. in offshore accounts to avoid higher U.S. tax rates. But with the 2017 tax legislation lowering the corporate rate to 21%, companies such as Apple have begun “repatriating” this income previously parked offshore, investing it in their U.S. operations or sharing outright with employees and investors.
Consumption taxes are levied when people consume a good or service. Consumption taxes are thought to encourage savings and investment, behaviors that drive economic growth. However, some argue that consumption taxes are regressive, i.e., unfairly burdensome to middle and lower income families than high earners.
Investopedia offers a helpful description of various consumption-based taxes, including basic sales taxes, luxury taxes and value-added taxes:
- “A consumption tax is a tax on the purchase of a good or service. Consumption taxes can take the form of sales taxes, tariffs, excise and other taxes on consumed goods and services. The term can also refer to a taxing system as a whole where people are taxed based on how much they consume rather than how much they add to the economy (income tax)….the consumption tax is not a new idea. It was used by the U.S. government for much of our history before being replaced with an income tax. The Bush administration backed a version of this in 2003, although the proposal was defeated. Ideally, a properly designed consumption tax system would reward savers and penalize spenders.”
- “A luxury tax is a tax placed on products or services that are deemed to be unnecessary or non-essential. This type of tax is an indirect tax in that the tax increases the price of the good or service and is only incurred by those who purchase or use the product.
The term has remained even though many of the products that are assessed with luxury taxes today are no longer seen as “luxuries” in the literal sense. Today’s definition leans more toward “sinful” items, such as tobacco, alcohol, jewelry and high-end automobiles. They are implemented as much in an attempt to change consumption patterns as to collect tax revenues.
Luxury taxes can also be called “excise taxes” or “sin taxes.” (investopedia.com).
- “A value-added tax (VAT) is a type of consumption tax that is placed on a product whenever value is added at a stage of production and at the point of retail sale. The amount of VAT that the user pays is on the cost of the product, less any of the costs of materials used in the product that have already been taxed.
More than 160 countries around the world use value-added taxation; it is most common in the European Union. But it is not without controversy. Advocates say it raises government revenues without punishing success or wealth, as income taxes do; it is also simpler and more standardized than a traditional sales tax, and there are fewer compliance issues. Critics charge that a VAT is essentially a regressive tax that places an increased economic strain on lower-income taxpayers, and also adds bureaucratic burdens for businesses.” (investopedia.com)
Facts to Know
Individuals and businesses are subject to taxes by local, state, and the federal government. This map illustrates the tax burdens levied by state and local governments. As you can see, the differences are substantial.
- Average vs. marginal tax rates: A person’s average tax rate is the percentage of his income that goes to the government; his marginal tax rate is the percentage of the next dollar he earns that goes to the government.
- Example: A woman making $100,000 in a progressive system (such as in the U.S.) that taxes the first $50,000 at 15 percent and everything above it at 25 percent will pay $20,000 in taxes. Her average tax rate is 20 percent and her marginal tax rate is 25 percent. If she’s considering working more hours to make more money, her marginal rate rises, so for every extra dollar she earns her average tax rate increases, thus she may not be motivated to work more. See this Prager U video.
- Tax breaks: The tax code includes exemptions, deductions, and credits that reduce taxation in certain instances. Which provisions of the U.S. tax code count as tax breaks is the subject of some dispute, but there is general agreement that among the largest breaks are the exclusion of employer-provided health care coverage from income and payroll taxes. The Obamacare Cadillac tax attempted to “remove a hidden subsidy for the most expensive employer-paid health insurance plans” by imposing a 40% excise tax on these plans. (CBS News) In January 2018, Congress voted to delay implementation of the Cadillac tax, along with several other Affordable Care Act medical taxes. Historically the tax code has included deductions for mortgage interest, state and local taxes paid, and charitable giving. This changed under the “Tax Cuts and Jobs Act” tax law that President Trump signed into law in December 2017. Mortgage deduction and state and local tax deductions are capped under the law, charitable deductions remained mostly unchanged, and the standard personal deduction was increased. (Investopedia)
- Consumption vs. income taxes: As mentioned above, while other developed countries rely heavily on consumption taxes, the U.S. leans more on income taxes. With an income tax, returns on investment (capital gains, dividends) are immediately taxed so investors realize lower returns on investment than under a consumption tax. And a lower return disincentivizes saving and investment, which are behaviors that drive economic growth.
- The U.S. system in comparative perspective: Most other developed-world economies levy higher overall average tax rates than we do. But much of their tax burden comes from the imposition of a consumption tax (often in the form of VAT taxes that inflate the cost of goods and services) on top of an income tax. By relying more heavily on VAT and other consumption taxes, these countries can maintain a lower income tax rate on both income from labor and capital (investment).
Theoretically, this system encourages people to defer consumption and invest and/or save their income. Though the overall tax system in these countries is more regressive than the U.S., meaning that middle class consumption represents a larger share of government revenue, these countries are sometimes viewed as more competitive for business investment because of lower corporate income tax rates (e.g., Ireland’s 12.5% top income tax rate).
As a result of this competition, corporate tax rates have fallen throughout the industrialized world, with the United States now joining with that trend. The 2017 Tax Reform legislation lowered the U.S. corporate income tax from the highest rate of any developed country to closer to the average rate imposed by developed countries.
Implications from 2017 Tax Reform
A rundown of how the new tax law will affect individuals and businesses is reproduced (edited for conciseness) below from Investopedia:
Income Tax Rate
The law retains the current structure of seven individual income tax brackets, but in most cases it lowers the rates: the top rate falls from 39.6% to 37%, while the 33% bracket falls to 32%, the 28% bracket to 24%, the 25% bracket to 22%, and the 15% bracket to 12%. The lowest bracket remains at 10%, and the 35% bracket is also unchanged. The income bands that the new rates apply to are lower, compared to 2018 brackets under current law, for the five highest brackets.
The law raises the standard deduction to $24,000 for married couples filing jointly in 2018 (from $13,000 under current law), to $12,000 for single filers (from $6,500), and to $18,000 for heads of household (from $9,550). These changes expire after 2025. The additional standard deduction, which the House bill would have repealed, will not be affected. Beginning in 2019, the inflation gauge used to index the standard deduction will change in a way that is likely to accelerate “bracket creep” (see below).
The law suspends the personal exemption, which is currently set at $4,150 in 2018, through 2025.
The law ends the individual mandate, a provision of the Affordable Care Act or “Obamacare” that provides tax penalties for individuals who do not obtain health insurance coverage, in 2019. While the mandate technically remains in place, the penalty falls to $0.
Family Credits and Deductions
The law temporarily raises the child tax credit to $2,000, with the first $1,400 refundable, and creates a non-refundable $500 credit for non-child dependents. The child credit can only be claimed if the taxpayer provides the child’s Social Security number. (This requirement does not apply to the $500 credit.) Qualifying children must be younger than 17. The child credit begins to phase out when adjusted gross income exceeds $400,000 (for married couples filing jointly, not indexed to inflation). Under current law, phaseout begins at $110,000. These changes expire in 2025.
Head of Household
Trump’s revised campaign plan, released in 2016, would have scrapped the head of household filing status, potentially raising taxes on 5.8 million single-parent households, according to an estimate by the Tax Policy Center (TPC). The law leaves the head of household filing status in place.
Mortgage Interest Deduction
The law limits the application of the mortgage interest deduction for married couples filing jointly to $750,000 worth of debt, down from $1,000,000 under current law. Mortgages taken out before Dec. 15 are still subject to the current cap. The change expires after 2025.
State and Local Tax Deduction (SALT)
The law caps the deduction for state and local taxes at $10,000 through 2025. The SALT deduction disproportionately benefits high earners, who are more likely to itemize, and taxpayers in high-tax states (e.g., California and New York), many of which are “Democratic states.” A number of Republican members of Congress representing high-tax states opposed attempts to eliminate the deduction altogether, as the Senate bill would have done.
Other Itemized Deductions
The law leaves the charitable contributions deduction intact, with minor alterations (if a donation is made in exchange for seats at college athletic events, it cannot be deducted, for example). The student loan interest deduction is not affected (see “Student Loans and Tuition” below). Medical expenses in excess of 7.5% of adjusted gross income are deductible for all taxpayers – not just those aged 65 or older – in 2017 and 2018; the threshold then reverts to 10%, as under current law.
The law does, however, suspend a number of miscellaneous itemized deductions through 2025, including the deductions for moving expenses, except for active duty military personnel; home office expenses; laboratory breakage fees; licensing and regulatory fees; union dues; professional society dues; business bad debts; work clothes that are not suitable for everyday use; and many others. Alimony payments will not longer be deductible after 2019; this change is permanent.
See full Investopedia article for details on Alternative Minimum tax, Retirement Plans and HSAs, estate tax, and student loans and tuition.
Corporate Tax Rate
The law creates a single corporate tax rate of 21%, beginning in 2018, and repeals the corporate alternative minimum tax. Unlike tax breaks for individuals, these provisions do not expire. Combined with state and local taxes, the statutory rate under the new law will be 26.5%, according to the Tax Foundation. That puts the U.S. just below the weighted average for EU countries (26.9%).
U.S. companies’ effective tax rate – defined as the tax paid on investments earning the market rate of return after taxes – was 18.6% in 2012, according to the Congressional Budget Office (CBO); that was the fourth-highest rate in the G20.
Supporters of cutting the corporate tax rate argue that it will reduce incentives for corporate inversions, in which companies shift their tax base to low- or no-tax jurisdictions, often through mergers with foreign firms.
The law allows full expensing of short-lived capital investments — rather than requiring them to be depreciated over time – for five years, but phases the change out by 20 percentage points per year thereafter. The section 179 deduction cap doubles to $1 million, and phase-out begins after $2.5 million of equipment spending, up from $2 million.
Owners of pass-through businesses – which include sole proprietorships, partnerships and S-corporations – currently pay taxes on their firms’ earnings at the individual income tax rates, the highest of which is 37%, down from 39.6%.
The law creates a 20% deduction for pass-through business income. Certain industries, including health, law and financial services, are excluded from the preferential rate, unless taxable income is below $157,500 (for single filers). To discourage high earners from recharacterizing regular wages as pass-through income, the deduction is capped at 50% of wage income or 25% of wage income plus 2.5% of the cost of qualifying property.
The net interest deduction, which currently has no cap, will initially be limited to 30% of earnings before interest, taxes, depreciation and amortization (“Ebitda”). After four years, it will be capped at 30% of earnings before interest and taxes (“Ebit”).
Businesses with up to $25 million in average annual gross receipts over the preceding three years will be eligible to use cash accounting, up from $5 million under current law.
Net Operating Losses
The law scraps net operating loss carrybacks and caps carryforwards at 90% of taxable income, falling to 80% after 2022.
The law eliminates a special deduction found in section 199 that was designed to reduce the income tax rate of domestic manufacturers.
The law enacts a deemed repatriation of overseas profits at a rate of 15.5% for cash and equivalents and 8% for reinvested earnings. Goldman Sachs estimates that U.S. companies hold $3.1 trillion of overseas profits. As of Sept. 30 Apple Inc. (AAPL) alone holds $252.3 billion in tax-deferred foreign earnings, 94% of its total cash and marketable securities.
The law introduces a territorial tax system which is designed to penalize the shifting of profits to countries with lower or no taxes.
The law also alters the treatment of intangible property that is held abroad which often refers to intellectual property such as patents, trademarks and copyrights (Nike Inc. (NKE), for example, houses its Swoosh trademark in an untaxed Dutch subsidiary).
(The above section was adapted from Investopedia.com.)
As exciting and potentially beneficial tax reform is, it only stays in place when legislators want it to. Tax rates tend to change when leadership and their corresponding priorities and governing principles change. A challenge for businesses and individuals is planning tomorrow’s business endeavors, not knowing if today’s laws will stay in place. It is a constant pendulum that bears consideration when it comes to electing leaders.
What Role Should Government Play?
The purpose of taxation should be to raise the revenue necessary to meet the government’s spending requirements while not distorting economic decision-making or discouraging saving and investment.
During times of slow economic growth, it is particularly important to examine if the tax code reduces economic activity and whether fundamental reform is needed. The looming debt crisis also makes spending restraint an urgent priority, since without that restraint it will be impossible to keep the tax burden on our economy from growing much heavier. Likewise, tax policy that spurs economic growth will in theory increase revenue for the government from generating more corporate and individual income that can be taxed, as well as more taxable economic activity for consumption-based taxes.
Principles of Reform
Simple. The complexity of the tax system makes it difficult and costly to comply with and encourages tax avoidance. A simpler and more transparent tax code promotes compliance and increased revenues.
Efficient. The tax code impedes economic growth by distorting market decisions in areas such as work, saving, investment and job creation. An efficient tax system provides sufficient revenue to fund the government’s essential services with minimal distortion of market behavior.
Equitable. Americans of all income levels and personal situations believe the tax code is unfair. This perception is largely fueled by the code’s “loopholes”—or provisions intended to benefit or penalize select individuals and groups. “Tax fairness” should reduce or eliminate provisions that favor one group or economic activity over another, especially among equal-income earners.
Predictable. Tax certainty inspires economic growth and investment and also enhances competitiveness. An environment conducive to growth requires a tax code that provides both near- and long-term predictability.
Videos on Taxes
These educational videos from Izzit.org and PragerU explain some of the history of tax collection, how taxes work in the U.S., the differences between progressive and flat taxes, etc. These are also great resources to share and watch with your kids.
Thought Leaders on Taxes
- Americans for Tax Reform is best known as the progenitor and enforcer of the Taxpayer Protection Pledge. All candidates for state and federal offices are encouraged to sign the pledge to their constituents that states they will oppose any increases in marginal tax rates on individuals or corporations, and oppose any overall increase in taxes. It originates with President Reagan, who used the pledge as part of his effort to enact the landmark 1986 Tax Reform Act. According to their most recent estimate, the pledge is currently binding on 219 members of the House of Representatives (a majority), 39 members of the Senate, and more than 1,100 state officeholders.
- The Tax Foundation is a research group dedicated to fundamental reform of the U.S. tax code, to restoring our international competitiveness, and to promoting pro-growth tax policies in the states. They stand out for their ability to do economic modeling that predicts the budget and economic impact of legislative proposals (often called “scoring”) and you will often see them cited in the press for producing useful economic data related to tax proposals.
- The Mercatus Center at George Mason University has top-notch scholars who promote free-market policies with an eye towards economic growth and limited government.
Questions for Discussion
- What is the most important goal of tax reform: raising growth, lowering the overall tax burden, simplifying the code, or making taxes more fair?
- What is your opinion of the 2017 tax reform?
- What is more important – how the tax code treats businesses or individuals?
- Does the Taxpayer Protection Pledge make sense?
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