In 2017, lawmakers passed the Tax Cuts and Jobs Act (TCJA), the most significant overhaul of US tax law since 1986. Among its many changes, the TCJA raised the standard deduction, limited several itemized deductions, eliminated the personal exemption, doubled the child tax credit, reduced the corporate income tax rate, temporarily allowed businesses to expense short-lived assets, and reformed the tax treatment of US multinational corporations’ foreign profits. While the 2017 law made substantial improvements to the tax code, major opportunities for additional reform remain. This chapter outlines a set of reforms to the individual and business tax systems that would create a broader, more neutral, and simpler tax base and encourage economic growth by reducing marginal tax rates on investment.
Key Points:
- The 2017 overhaul of the tax system made important improvements to the tax code, but businesses and individuals still face a relatively complex tax code that favors certain economic activities and unduly discourages work and capital accumulation.
- Additional reforms to the tax system can address these remaining challenges and promote growth, fiscal responsibility, and simplicity.
- By broadening the tax base and reducing tax rates, policymakers could improve the fairness of the tax code; reduce the tax penalty for work, saving, and investing; and make businesses more competitive on the international stage.
The individual income tax reforms we recommend would broaden the tax base by eliminating most itemized deductions and the exclusions for employer-provided benefits and municipal bond interest. We would also reduce marginal tax rates by replacing the current income tax schedule with four income tax brackets for wage income and just two tax rates for all types of capital income. In addition, our plan would repeal certain tax preferences (such as education tax credits) and modify others (such as the earned income tax credit and child tax credit).
Our business tax reform would replace the current tax treatment of businesses with a 15 percent cash flow tax on all businesses, regardless of their legal form of organization. The cash flow tax would be destination based, which would greatly simplify the tax treatment of foreign profits. Our plan would eliminate several non-neutral business tax expenditures. It would also enact a border-adjusted excise tax on carbon emissions.
Relative to current law, under which key TCJA provisions expire at the end of 2025, our proposal would reduce long-run revenue. However, our proposal is approximately revenue neutral relative to a baseline in which Congress extends the expiring TCJA provisions permanently. Crucially, the reform would reduce disincentives for investment and work and increase business competitiveness.
Guiding Principles for Tax Reform
Good tax policy is simple, pro-growth, and fiscally responsible. It provides neutral treatment of different economic activities and is perceived by citizens as fair. Unfortunately, the current tax code violates each of these principles.
Simplicity. A tax code should be easy for taxpayers to understand and comply with. The US tax code, which has fostered an industry of tax advisers and tax planners, is not simple. The Office of Information and Regulatory Affairs estimates that the cost of compliance is more than three billion hours of work annually.1
Pro-Growth. A pro-growth tax system requires low effective marginal tax rates. For individuals, low marginal rates not only minimize disincentives to work and save money but also reduce the incentive to misreport or underreport income.
For businesses, high marginal tax rates reduce the incentive to invest by increasing the required return on new projects.2 As presented in Table 4, we find that under current law, the tax burden on new investment is 8.4 percent, scheduled to rise to 16 percent in 2031. Including the individual income tax on business income (capital gains, dividends, and interest), the effective tax rate is 20.4 percent, scheduled to rise to 27.8 percent in 2031. Reducing the tax burden on investment can lead to a larger stock of productive capital and higher economic output.
Neutrality. A tax code should distort economic decision-making as little as possible. The individual income tax is inherently non-neutral between current and future consumption because it taxes savings, which finance future consumption. The individual income tax distorts many other decisions, including whether to enter or exit the labor market, how many hours to work, the type and quantity of investments to hold, where to live, whether to rent or own a residence, and what vehicle to drive.
Current business tax provisions violate neutrality along several dimensions. The tax burden on new investment, including both business-level and individual-level taxes, varies significantly by asset type. For example, equipment that benefits from 100 percent bonus depreciation faces much lower effective tax rates than do inventories, which businesses cannot deduct until sold. In addition, the income tax distorts the forms of financing used for investment, favoring debt financing over equity financing.
Fiscal Responsibility. The tax code should generate sufficient revenues to enable the federal government to meet its financial obligations in an economically efficient manner. At present, the federal government is on a fiscally unsustainable path, as shown in Table 1 and discussed further in Chapter 3. The only truly sustainable fiscal strategy requires significant reductions to future entitlement spending, which is growing rapidly due to population aging and rising health care costs.
Table 1. Projected Federal Revenue and Outlays, Percentage of GDP
Even with entitlement spending restraint, however, we believe that the federal government will need revenue equal to the level it would receive under a baseline that assumes a permanent extension of the TCJA provisions slated to expire in 2025. Our proposal keeps revenue at that level.
Fairness. Tax fairness is a subjective concept, but a few simple principles should guide policymakers. First, the individual income tax code should be progressive, meaning that tax burdens as a share of income should rise as income rises. Second, the individual tax code should strive for horizontal equity; that is, taxpayers who are similarly situated should pay similar amounts of tax. Third, tax burdens should be visible to the people who bear them. The current business tax arbitrarily favors certain industries and legal forms of organization over others. Moreover, business taxes impose burdens on workers that those workers cannot easily observe.
Reforming the Individual Income Tax
Conservative tax reform proposals in the 1990s featured various types of consumption taxes. Most other developed countries have adopted a consumption tax known as a value-added tax. Although consumption taxes do offer an advantage in terms of efficiency, the transition from an income to a consumption tax in the US would pose political hurdles. Significant reforms to the individual income tax can maintain income as the primary base of the tax code and still improve efficiency.
Decades of tinkering have left the individual income tax code riddled with credits, deductions, and exclusions that narrow the tax base. Due to the narrower tax base, tax rates must be increased to maintain revenue. While the 2017 tax law achieved significant improvements, major opportunities for additional reform remain.
The proposed individual income tax reform plan features a simple, broad-based, low-rate structure that is transparent and stable, beginning with the repeal of many tax preferences that litter the tax code today and a reduction in statutory tax rates to encourage work and saving and reduce other distortions. The repeal of tax preferences would simplify the tax system and generally improve horizontal equity. The tax code would remain progressive—but likely less so than the tax code in 2022.
The goal is not to modify the tax code by giving everyone a tax cut and driving the federal debt higher. Some households would pay more tax, and others would pay less. While that approach may pose political challenges, it allows us to present a plan that promotes simplicity, growth, neutrality, and fairness while preserving fiscal responsibility.
Reduce Statutory Tax Rates. High marginal tax rates create incentives for taxpayers to alter their decisions, generally in unproductive ways. High marginal tax rates on labor income, for example, reduce the return to work and thereby discourage labor supply and economic output. The deadweight loss (or excess burden) associated with a tax, which measures the loss of economic efficiency, is proportional to the square of the tax rate.3 A tax rate increase from 10 percent to 12 percent, for example, causes only half the inefficiency of an increase from 20 percent to 22 percent. Our reform would reduce tax rates and simplify the tax treatment of ordinary and capital income.
Ordinary Income Tax Rates. There would be four ordinary income tax brackets for single filers: 10 percent ($0–$55,000 of taxable income), 20 percent ($55,001–$150,000), 30 percent ($150,001–$250,000), and 33 percent ($250,000 and above). The income ranges in which each tax rate applies for married taxpayers would be double the ranges listed for single tax filers.
Capital Gains, Interest, and Dividends. Under current law, the individual income tax system taxes long-term capital gains and qualified dividends at rates up to 20 percent and interest income and short-term capital gains at rates up to 37 percent. In both cases, the income is also subject to the 3.8 percent net investment income tax (NIIT), enacted as part of the Affordable Care Act.4
Our reform would repeal the NIIT. It would impose just two tax rates for all types of capital income (i.e., capital gains, interest, and dividends). The rate would be zero for taxpayers in the 10 and 20 percent income tax brackets and 20 percent for taxpayers in the 30 and 33 percent brackets. The top tax rate on interest income would be slashed to the lowest statutory rate since 1917. The overwhelming majority (97 percent) of taxpayers would not be subject to any tax on their dividends, capital gains, and interest income. The other 3 percent of taxpayers, who earn the majority of capital income, would be taxed at a low, flat rate.
Table 2 compares the average marginal tax rate on wages, capital gains, interest, and dividend income in 2022 under current law and our reform. Marginal rates under our reform are lower in all cases, and the largest decline is for interest income.
Table 2. Average Effective Marginal Income Tax Rates by Form of Income, 2022
Repeal the Estate Tax. The estate tax, gift tax, and generation-skipping tax are additional taxes imposed on asset accumulation. The tax rate ranges from 18 to 40 percent, but the tax can be reduced by a credit for estates valued at less than $12.06 million ($24.12 million for married couples).5 Inherited assets also receive a step-up in basis for the capital gains tax. If a stock that was purchased for $100 is sold for $1,000 immediately before death, for example, the $900 capital gain would be taxed. If the same stock was inherited and sold by the heirs for $1,000, they would enjoy a new “stepped-up” basis of $1,000 and would not pay tax on the $900 capital gain.
Economists have found the current estate tax to have adverse economic effects by reducing savings and entrepreneurship.6 While the magnitude of these effects is not large, partly because the current estate tax applies to only a few taxpayers, this additional tax burden also creates complexity and raises relatively little tax revenue.
Our reform would repeal the estate and gift tax. It would also eliminate the step-up in basis at death, thereby broadening the tax base and reducing the lock-in effect whereby taxpayers are discouraged from selling long-held assets.
Broaden the Income Tax Base. Because the tax code is riddled with exemptions, exclusions, deductions, and credits, many economic activities face zero (or even negative) marginal tax rates, while other activities face relatively high marginal tax rates. This non-neutral treatment encourages taxpayers to pursue less productive activities to avoid taxes, reducing economic growth.
Itemized Deductions. Our plan would repeal the mortgage interest deduction. Combined with other reforms we propose, this would eliminate the tax disparity between renters and owners who are otherwise similarly situated. Likewise, our plan would eliminate the state and local tax deduction, which the TCJA capped at $10,000 through 2025.
Similarly, the tax deductibility of certain medical and dental expenses, investment interest expenses, and theft and casualty losses would be eliminated. Our plan would reform the charitable deduction, as discussed below. Deductibility of gambling losses and certain other currently allowable—but infrequently claimed—itemized deductions would be retained but converted to above-the-line deductions.
Employer-Provided Benefits. The exclusion for employer-provided health insurance is one of the largest tax expenditures and creates a strong incentive for employers to provide nonwage compensation over salaries and wages, a tax-induced distortion that has likely contributed to slower wage growth over time. Our plan would repeal the exemption, and the value of these benefits would be subject to both payroll tax and ordinary individual income tax. Employer arrangements whereby workers can receive certain other benefits, including transit and parking benefits, on a pretax basis would also be eliminated.
Education Tax Credits. In recognition of the importance of education, the tax code includes tax credits for education costs and a partial deduction for student loan interest. However, the empirical evidence indicates that these tax breaks do not increase the likelihood of a student attending college or the cost of the college they attend.7 Instead, the tax breaks simply transfer money from those who do not attend college to those who do. Our plan would repeal these ineffective tax breaks.
Municipal Bond Income. Our plan would eliminate the exclusion of interest payments from newly issued municipal bonds, restoring neutrality between state and local government financing and private financing. The exclusion would offer only a small tax advantage with interest income facing only a 20 percent top tax rate (down from 40.8 percent), and its repeal would promote simplicity and fairness.
Energy. The current tax system provides scores of tax credits and other tax preferences related to various forms of energy production, mostly clean or renewable energy such as wind, solar, and geothermal—but other forms as well. The Joint Committee on Taxation estimates that under current law, clean energy–related tax expenditures will exceed $60 billion between 2020 and 2024.8 Even in the confines of clean energy, current policy defies the principles of neutrality by favoring some technologies over others. Moreover, the temporary nature of many clean energy policies creates uncertainty and provides windfall gains to certain taxpayers.9
Reform Tax Benefits for Workers and Families. Current tax law includes myriad policies intended to adjust tax liabilities based on income and household size and encourage work for low-income earners. The TCJA of 2017 made significant but temporary changes to a number of these policies, including an increase in the standard deduction coupled with the elimination of the personal exemption and an increase in the child tax credit. The earned income tax credit (EITC) would further encourage work if expanded, while the child tax credit has grown so large that it creates significant and undue fiscal reliance on nonparent taxpayers.
Standard Deduction. Current law allows a standard deduction in 2022 of $12,950 for single filers and $25,900 for married couples filing jointly.10 With the elimination of most itemized deductions, the standard deduction can be replaced with a flat, nonrefundable tax credit of $1,500 for single filers and $3,000 for married joint filers. This reform would be revenue neutral, but it would be simpler to understand and more progressive than current law. For example, the credit would be worth more than the standard deduction for a taxpayer in the 10 or 12 percent marginal tax rate bracket, but it would be worth less than the standard deduction for a taxpayer in the 30 or 33 percent tax bracket.
EITC. The EITC is a tax credit designed to reward and encourage work among low-income individuals, particularly those with children.11 In addition, the current EITC has been shown to efficiently reduce poverty and induce a host of related beneficial effects.12
Table 3. Current-Law and Reform EITC Parameters
As shown in Table 3, the maximum EITC would increase by $500 for workers with one child, $1,000 for workers with two children, and $1,500 for workers with three or more children. For example, the maximum EITC in 2022 for a worker with two qualifying children would be $7,164, instead of the current $6,164. The EITC would also be doubled for childless workers, from $560 to $1,120.
Child Tax Credit. Since its establishment in 1997, the child tax credit has ballooned from a $500 per child benefit worth roughly $16 billion per year to a policy costing the federal government over $220 billion in 2021.13 Far from providing a targeted benefit to low-income households with children and encouraging work, the child tax credit expansion in 2021 pushed the tax system toward one that increasingly relies on childless households to finance government. The 2021 child tax credit expansion (temporary for one year) also removed the work incentive for low-income households that had been a core component of the policy since its creation.
The revised credit would be $1,500 per child. The $1,500 value is $500 more generous than the pre-TCJA law’s $1,000 credit but $500 less generous than TCJA’s $2,000 credit (which is scheduled to expire at the end of 2025). The credit would be refundable in cash for taxpayers who do not owe income tax, up to a limit of 15 percent of the taxpayer’s labor income. Under current law, the phase in of the refundable credit begins after $2,500 of earned income. Eliminating the income threshold increases the maximum value of the credit by up to $375 for lower-income households.
Alternative reforms to these policies are made by AEI’s Angela Rachidi, Matt Weidinger, and Scott Winship in Chapter 8, where they propose consolidating the current EITC, child tax credit, and head-of-household filing status into a “working family credit” that is generally more generous than the policy reforms outlined above.
Reform the Tax Benefit for Charitable Giving. Under current law, a deduction for charitable donations is available to taxpayers who itemize their deductions but not those who claim the standard deduction. A consequence of the TCJA’s large increase in the standard deduction is that fewer taxpayers itemize their deductions and can receive a deduction for charitable giving.
To broaden the availability of the charitable deduction, our plan would allow an above-the-line deduction available to all taxpayers, not just those who itemize under current law, to the extent that the annual total exceeds $500 for single filers ($1,000 for married couples filing jointly). Such a reform would result in a modest net increase in charitable giving relative to pre-TCJA law.14 Chapter 14 by AEI’s Howard Husock delves further into the justification for an above-the-line deduction.
Reforming Business Taxation
Our business tax reform plan focuses on addressing the remaining problems with business taxation after the TCJA. This plan would eliminate the tax burden on new investment and reduce distortions across different types of investment, forms of financing, and legal forms of organization. It would also improve the tax treatment of US multinationals by reducing incentives to shift profits out of the United States while maintaining competitiveness.
Reduce the Corporate Income Tax Rate to 15 Percent. In today’s economy, goods and services may be produced across multiple jurisdictions using labor and many types of capital. This supply-chain complexity presents a challenge for the corporate income tax. Corporate income tax systems are generally based on where production takes place. If a company has a factory in Germany, for example, Germany generally has the right to tax those profits. For large multinational corporations with production spanning multiple jurisdictions, “sourcing” taxable income can be complex. Companies can claim deductions and realize revenue in different countries, enabling them to book net income in countries where tax rates are lower.
The incentive for corporations to shift profits is primarily from the difference in statutory tax rates between countries. Under current law, the US statutory corporate tax rate of 25.8 percent (21 percent federal tax rate plus 4.8 percent average state and local tax rate) is near the average among Organisation for Economic Co-operation and Development (OECD) member nations (weighted by gross domestic product, or GDP) of 26 percent (Figure 1).15 It is slightly higher than the OECD median corporate tax rate of 25 percent and is the 12th highest rate among the 35 OECD member nations. It is also near the average of all countries.16
Figure 1. Statutory Corporate Income Tax Rates, OECD Countries, 2022
This reform would reduce the corporate income tax rate to 15 percent. Combined with state and local corporate income tax rates, the weighted average statutory tax rate in the United States would stand at roughly 21 percent. This would be 4 percentage points below the OECD average and lower than the rates in Canada, France, Germany, and Japan.
Convert the Corporate Income Tax into a Cash Flow Tax. Under current law, the tax treatment of business investment varies by type of asset and how the investment is financed. Fixed assets such as equipment, structures, and intellectual property (IP) are deducted over time, according to depreciation schedules. Short-lived investments qualify for “100 percent bonus depreciation” and can be expensed or immediately deducted. That provision, however, is scheduled to phase out between 2023 and 2026. In contrast, inventories are only deducted when sold. In addition, the costs of debt financing (interest expense) are deductible, subject to limitations, while the costs of equity financing (dividends) are not deductible.17
Our reform would replace the depreciation system with expensing all capital investments. Businesses, regardless of size and legal form of organization, would fully deduct the cost of new investments in the year in which the asset (regardless of type or value) is placed into service. Inventory accounting methods—first-in, first-out accounting; last-in, first-out accounting; and average cost—would similarly be replaced with expensing. Land would also be expensed. Special expensing provisions, such as Section 179 expensing for small businesses, would become unnecessary.
In addition, the reform would eliminate the deduction for net interest expense. Businesses would no longer be able to deduct net interest expense, matching the tax treatment of dividends.
Replacing the corporate income tax with a cash flow tax would reduce distortions in business tax in three ways. First, a cash flow tax would not penalize new investment at the entity level. For an investment that earns just enough to break even in present value, the tax value of the upfront deduction (15 percent times the value of the investment) is exactly equal to the expected tax on the returns (15 percent times the discounted present value of future cash flows). As a result, the marginal effective tax rate would be zero for all types of investment, except certain types of IP, which would enjoy a negative marginal effective tax rate due to the research and development credit (Table 4).
Table 4. Impact of Reform on Marginal Effective Tax Rates on New Investment
Second, the cash flow tax would be neutral across different types of investment. As mentioned previously, the tax burden at the entity level would be zero across all assets except IP.
Finally, the cash flow tax would eliminate the debt-equity bias at the entity level. On average, both debt-financed and equity-financed investment would face an average marginal effective tax rate of –1.6 percent. The total tax burden on debt and equity, including the individual income tax, on holders of these securities would largely be equalized. Debt-financed investment would face a total effective tax rate of 12.9 percent, compared to 14.4 percent for equity-financed investment. A small bias would remain because holders of debt have lower incomes on average than holders of equity. As a result, interest income faces a slightly lower average marginal tax rate than do capital gains and dividends.
Expand Net Operating Loss Deductions. Under current law, businesses that earn profits face immediate taxation. However, businesses that lose money do not receive an immediate refund. Instead, they are required to carry forward losses to future years and deduct them against the income earned in those years.
In addition, losses face a general limitation of 80 percent of taxable income. The delay in the ability to realize losses reduces their value. This tax treatment creates a bias against risky investments that may lose money for several years before breaking even.18 Further, companies that do not currently have taxable income may lose out on investment incentives because they must wait to get the benefits of their expensing deductions for new investments.
Our proposal corrects those problems. Our plan eliminates the limitation on net operating losses of 80 percent of taxable income. Net operating losses would continue to carry forward indefinitely, but unlike under current law, losses that are carried forward would earn interest at the 10-year Treasury bond rate. For example, if a business generates a $100 loss in the current year and carries it over to deduct it the following year, the business would receive a $103 deduction, assuming the interest rate is 3 percent.
Tax All Businesses the Same. In the United States, there are two major business forms: traditional C corporations and pass-through businesses. Pass-through businesses include sole proprietorships, partnerships, limited liability companies, and S corporations. About 95 percent of all businesses are pass-through businesses, and these businesses report about 60 percent of all business income in the United States.19
Pass-through businesses do not face an entity-level tax. The owners pay tax at their current ordinary rates, between 10 and 37 percent, but they receive a special 20 percent deduction (called Section 199A) on some types of business income. Owners also often pay 3.8 percent additional tax on their pass-through business profits, either from the Self-Employment Contribution Act tax of 2.9 percent plus the 0.9 percent Medicare surtax or from the 3.8 percent NIIT.20
In contrast, traditional C corporations face the entity-level 21 percent corporate income tax. After-tax corporate profits are then taxed as dividends, if distributed to shareholders, or as a capital gain, if the profits are retained and the shareholder sells their stock. Long-term capital gains and dividends are taxed at rates between 0 and 23.8 percent (20 percent top income tax on long-term capital gains and qualified dividends plus the 3.8 percent NIIT).
Under current policy, a business owner who faces the top statutory individual income tax rate could experience a tax increase if they decided to incorporate and become a C corporation. As a sole proprietor, this taxpayer faces a tax rate of 32.7 percent when considering Section 199A, self-employment tax, and the Medicare surtax (Table 5).21 However, as a C corporation, this business owner would face a tax burden as high as 39.8 percent.22 The C corporation could lower its tax burden if it retained some of its profits rather than paying them out as dividends and the owner did not sell the stock, thereby avoiding any current individual income tax burden.
Table 5. Overall Top Statutory Tax Rate, Sole Proprietor vs. C Corporation, Current Law (2022)
Under this reform, all businesses would be subject to the same tax regime, no matter their form of organization. They would face the 15 percent entity-level tax plus individual income tax on distributed profits. For pass-through businesses, profits earned would immediately face an entity-level tax of 15 percent. Profits distributed to owners as a dividend would be taxed as dividend income. Any profits retained and reinvested in the business would not face additional taxation until distributed or unless that owner sells their stake and realizes a capital gain. Our plan would also eliminate Section 199A. Businesses would face an all-in statutory tax rate of 32 percent, regardless of legal form of organization.23
On net, this proposal would reduce the overall tax burden on pass-through businesses relative to current law. In 2026, the top individual income tax rate on pass-through business income will rise from 29.6 percent (37 percent top statutory rate reduced by the 199A deduction) to 40.8 percent (39.6 percent plus the impact of a special provision called the Pease limitation).24 In addition, pass-through businesses could defer the second layer of tax by retaining profits, an option they do not have under current law.
Lawmakers may also want to consider anti-avoidance measures for closely held businesses. Because retained earnings would not immediately face tax and because labor income would face higher tax rates (including payroll taxes) than business income, owners who participate in day-to-day business operations would have an incentive to label their income as profits rather than as labor. To prevent business owners from mislabeling income, lawmakers could create rules that require business owners to split their income into capital and labor portions, based on the amount of capital invested in the business.
Although it is not part of this proposal, lawmakers could consider integrating the entity-level tax and the individual income tax, similar to the proposal by Eric Toder and AEI’s Alan D. Viard, as a way to eliminate double taxation of business profits.25 Under such a proposal, interest, dividends, and capital gains would be taxed as ordinary income. However, business owners, shareholders, and bondholders would receive a credit for entity-level taxes already paid. Under integration, business income would ultimately face the individual income tax rate.
Make Business Taxes Destination Based. The TCJA introduced a new international tax system meant to reduce the incentives to charter corporations abroad and shift profits to low-tax jurisdictions. The law created an exemption for dividends paid to US parent corporations from foreign-controlled foreign corporations, effectively eliminating the residual US tax on foreign profits of US multinationals. At the same time, it introduced a new minimum tax regime targeting highly mobile income. This regime includes two new income categories: global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII). Together, these provisions tax the returns to IP products used to serve foreign markets at a minimum tax rate of between 10.5 and 13.125 percent.26
In addition, the TCJA introduced the base erosion and anti-abuse tax (BEAT). This minimum tax requires large multinational corporations to pay a top-up tax if their BEAT liability exceeds their corporate tax liability. BEAT is a 10.5 percent tax on an alternative broader tax base with only a limited number of deductions. This minimum tax is designed to reduce the incentive for both US and foreign-based multinational corporations to shift profits out of the United States.
Although the TCJA provisions attempt to strike a delicate balance between protecting the US tax base and maintaining the competitiveness of US multinationals operating in foreign countries, they are not without flaws. GILTI and FDII somewhat arbitrarily define the returns to IP. Additionally, GILTI’s foreign tax credit rules can result in taxpayers with foreign effective tax rates above the GILTI rate paying residual US tax, and BEAT is complex and creates several arbitrary tax cliffs for taxpayers.27
A cash flow tax, such as we propose, can be either destination based or origin based. Under a destination-based cash flow tax, businesses are denied deductions for all purchases of foreign goods and services (imports), and revenues from foreign sales (exports) are excluded from taxable income. For example, if a business imports goods from the United Kingdom for sale in the United States, the cost of those goods would not be deductible against taxable income. If a business exports goods from the United States for sale in the United Kingdom, the gross revenue from those sales would not be part of taxable income.
There are several significant advantages of a destination-based cash flow tax. First, cross-country transactions are effectively ignored, which eliminates the ability to shift profits through transfer pricing.28 Second, it eliminates the incentive to locate high-return investments in low-tax jurisdictions.29 Third, it eliminates the need for all current-law anti-profit-shifting provisions (e.g., GILTI, FDII, BEAT, and Subpart F).
Under an origin-based cash flow tax, imports and exports would be treated as they are under current law (imports deductible and export income taxable). An origin-based cash flow tax would be a less disruptive change from current law, but the current-law opportunities for multinational corporations to shift profits out of the United States would persist. To be sure, those incentives would be reduced due to a much lower statutory tax rate (15 percent) and the elimination of the interest deduction.
We propose that the tax be destination based. However, if lawmakers opt for an origin-based cash flow tax, they should consider a simplified minimum tax on foreign cash flow to reduce profit-shifting incentives.
The OECD is working toward a global deal on the taxation of multinational corporations. The deal includes a “Pillar Two” proposal to enact a 15 percent minimum tax on the foreign profits of multinational corporations. It is not yet clear whether all countries will enact and enforce the minimum tax. Lawmakers may need to consider how the OECD proposal would interact with any potential US reform.
Tax Carbon Emissions. While repealing poorly designed clean energy tax subsidies would broaden the tax base and remove distortions in the tax code, it would also remove all tax policies geared toward addressing costs that will arise from climate change. This reform would replace the costly and inefficient clean energy policies with an excise tax on CO2 emissions. Economists across the political spectrum have long agreed that a carbon tax efficiently and effectively reduces carbon emissions.30
The tax would be set at $20 per metric ton and increase 5 percent per year, similar to a proposal outlined by the Congressional Budget Office.31 The tax would be imposed on the upstream businesses that refine petroleum, extract coal, and process natural gas.
The tax would be border adjusted, applying to imports based on their carbon content but exempting exports. Including a border adjustment mechanism is crucial for the continued competitiveness of US businesses, including their ability to compete in foreign markets and avoid any unfair advantage to imports of carbon-intensive goods. A border adjustment for imports and exports of fossil fuels would be straightforward. Border adjusting other energy-intensive products, such as steel and aluminum, would pose challenges, but researchers have offered multiple strategies for addressing these.32
A carbon tax would most efficiently encourage utilities, manufacturers, commercial building operators, and households to reduce emissions as they seek to (lawfully) avoid this tax. While reducing emissions and encouraging innovation into new and cost-effective forms of energy and energy efficiency, a carbon tax would also raise revenue to offset some of the costs of other reforms outlined above.
Broaden and Simplify the Business Tax Base. In addition to the major proposals, our reform would simplify the corporate tax base by eliminating business tax expenditures that subsidize specific economic activities. This includes the exemption for credit union income, tax credits for green energy investment and production, the tax credit for marginal wells, and the capital gains exclusion of small corporation stock. All accelerated depreciation provisions would be superseded by the expensing provided for all investments under the cash flow tax.
Revenue Impact
Repealing the exclusion for employer-provided benefits and repealing most itemized deductions would significantly broaden the income tax base. Repealing education tax preferences and green energy tax preferences would also raise revenues. Our plan would use the increased revenue to lower marginal tax rates on ordinary and capital income while reforming the tax treatment of charitable giving and repealing the estate and gift tax. The reform’s expansion of the EITC is offset relative to current policy by the reform to the child tax credit.
The baseline for expected revenue increases after 2025 with the scheduled expiration of the TCJA. The individual tax reforms would yield a modest increase in revenues in the 2023–25 period of roughly 0.3 percent of GDP. Relative to the long-run post-2025 revenue baseline, they would reduce revenues by 0.4 percent of GDP annually. Repealing the estate and gift tax and the step-up in basis would reduce revenues by roughly 0.1 percent of GDP annually.
The business tax reforms, including the price on carbon emissions, would increase federal revenues by 0.3 percent of GDP against a current-law baseline each year. Reducing the corporate income tax rate to 15 percent would reduce federal revenue by 0.2 percent. However, converting the corporate tax to a cash flow tax would have a negligible impact on revenue. This is primarily because the loss of revenue from expensing would be offset by eliminating the deduction for net interest expense. Replacing the current tax provisions affecting foreign profits with a border adjustment would raise revenue by 0.3 percent of GDP. Expanding net operating losses and treating all businesses the same would each reduce federal revenue by 0.1 percent of GDP, and the carbon tax would raise an additional 0.3 percent of GDP.
Taken together, the individual and business tax reforms would reduce revenues by approximately 0.2 percentage points as a share of GDP beyond 2025, relative to current law (Table 6). However, they would be roughly revenue neutral relative to a baseline that extends the expiring TCJA provisions.
Table 6. Revenue Impact of Proposed Reforms, 2031
Conclusion
The TCJA improved the tax code, but the opportunity for additional reforms remains. Our tax reform proposal further improves the tax code by reducing marginal tax rates for individuals and businesses and broadening the tax base. Our proposal would not only make the tax code simpler and fairer but also reduce economic distortions and encourage economic growth. The proposal would reduce federal revenue relative to current law but raise about the same amount of revenue as making the TCJA permanent. Taken together, these reforms will contribute to higher standards of living for future generations and make the US a more globally competitive place to do business.
Acknowledgments
The authors wish to thank Grant M. Seiter for excellent research assistance and Alan D. Viard for valuable comments and suggestions.