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Dual- Rate Income Tax

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					        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.

				
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