A Proposal for a Dual-Rate Income Tax Testimony to the President’s Advisory Panel on Tax Reform Chris Edwards Director of Tax Policy, Cato Institute May 11, 2005 1. Proposed Dual-Rate Tax • A simpler income tax that treats Americans more equally and promotes economic growth. • Individual income tax rates of 15% and 27%. • Corporate income tax rate of 15%. • Cuts marginal tax rates on savings and investment, which moves toward a consumption-based system. • Takes steps toward the Hall-Rabushka flat tax. For dual-rate tax details, see Chris Edwards, “Options for Tax Reform, Cato Institute, February 2005, www.cato.org/fiscal/tax-policy.html. 2. Dual-Rate Tax: Individuals • Individual income tax rates of 15% and 27%. The top rate begins at $90,000 (singles) and $180,000 (married). This rate structure integrates with the federal payroll tax to create a roughly consistent marginal tax rate on earnings at all income levels. • Itemized deductions are eliminated, including the mortgage interest deduction and state/local tax deductions. • Middle income families would have their marginal tax rate fall from 25% or 28% to 15%. • The top individual rate on dividends, interest, and capital gains would be 15%. This structure builds around President Bush’s dividend and capital gains cuts of 2003. • Savings vehicles such as 401(k)s, IRAs, and HSAs would be retained. Indeed, Congress should consider liberalizing Roth IRAs and HSAs. • Revenue neutral in 2004 based on Tax Foundation static microsimulation model. 3. Marginal Income Tax Rates Single Taxpayer Taking the Standard Deduction 35% 30% Current law Marginal Tax Rate 25% 20% 15% Proposed dual-rate tax 10% 5% 0 20 40 60 80 100 120 140 160 T axable Income ($000s) 4. Combined Income and Payroll Tax Rates Marginal Tax Rate on Wages, Single Taxpayer 45% Current law 40% Marginal Tax Rate 35% 30% 25% 20% Proposed dual-rate tax 15% 0 20 40 60 80 100 120 140 160 T axable Income ($000s) 5. Dual-Rate Tax: Corporations • Corporate tax rate cut from 35% to 15%. • Equal treatment of interest and dividends. Both are taxed at 15% at individual level and 15% at corporate level. • Corporate tax base broadeners include deductions for interest, employee health care, and state and local taxes. • The corporate base should not be broadened with anti- investment provisions, as in 1986. • Dynamic feedback effects from a corporate rate cut would be large. A March Joint Tax Committee report showed that a corporate rate cut would give a much bigger boost to GDP growth than an individual tax cut. • The dual-rate tax structure could incorporate territorial treatment for international investments and capital expensing. 6. Dual-Rate Tax: Simplification • Nearly all individual deductions and credits eliminated. All taxpayers would take the standard deduction. • While that would be a huge simplification, the dual- rate tax retains an income tax structure and would not be as simple as a consumption-based tax such as Hall- Rabushka. • For corporations, the sharply reduced tax rate would greatly cut incentives for both legal tax avoidance and illegal tax evasion. The compliance costs of current tax rules on multinationals are enormous because the rules are complex and because firms are so responsive to the taxes. • Capital expensing and the territorial treatment of international investment would be simpler and more efficient. 7. Dual-Rate Tax: Fairness • The dual-rate tax would greatly increase “horizontal equity.” Americans with similar earnings would pay similar amounts of tax. • About 95% of households would pay tax at the 15% rate. • I support proportional taxation and the dual-rate tax takes a small step in that direction, but it is still very graduated or “progressive.” • For higher earners, tax rates are cut but itemized deductions that favor this group are eliminated. • For lower earners, the plan retains the earned income tax credit. • For all earners, the plan retains the current standard deduction, while expanding the personal exemption from $3,200 to $4,500. 8. Dual-Rate Tax: Economic Growth • The top marginal tax rates on dividends, interest, wages, and small business profits are cut. • Reduced marginal tax rates would increase productive activities and reduce “deadweight losses” of the tax system. Top Marginal Tax Rates 50% 44.8% Current law 45% Dual-Rate Tax 40.6% 40% 35.0% 35.0% 35% 27.8% 27.8% 29.7% 30% 27.0% 25% 20% 15% 10% Dividends Interest Wages Small business profits 8. Economic Growth, continued Top Marginal Tax Rates Current Law Dual-Rate Tax 1. Corporate income tax Dividends 35% 15% Interest 0 15% Wages 0 0 2. Individual income tax Dividends 15% 15% Interest 35% 15% Capital gains 15% 15% Wages 35% 27% Small business profits 35% 27% 3. Federal payroll tax Wages below $90,000 15.3% 15.3% Wages above $90,000 2.9% 2.9% Combined tax rates Dividends 44.8% 27.8% Interest 35.0% 27.8% Wages 40.6% 29.7% Small business profits 35.0% 27.0% Note: the employer half of the payroll tax is deductible against the corporate tax. 9. Global Tax Competition • The U.S. needs to respond to the global corporate tax revolution. KPMG data show that the average statutory corporate income tax rate in the 30-nation OECD has fallen from 38% in 1996 to 30% today (including national and subnational taxes). Average Top Corporate Tax Rate in the OECD 40% 38% 37.6% 36.8% Note: The U.S. federal plus 35.9% average state rate is 40% 36% 34.8% 34.0% 34% 32.8% 32% 31.4% 30.9% 30.0% 30% 28% 1996 1997 1998 1999 2000 2001 2002 2003 2004 10. Conclusions • Recent tax reforms (individual rate cuts, 15% dividend and capital gains rates, partial expensing) should be extended permanently. The dual-rate plan would build on these reforms. • The president’s call for a revenue-neutral reform necessitates trade-offs. The dual-rate plan eliminates most deductions and credits but cuts marginal tax rates on labor and capital. That would reduce tax complexity and increase fairness and growth. • International competitiveness is a much more important today than during the last big tax reform in 1986. Multinationals are increasingly responsive to taxes with regard to real investment and the movement of paper profits. A corporate tax rate cut would attract inflows of profits and investment to the United States, and is the single best reform that policymakers could pursue.