Simplifying the tax code—be careful what you wish for Behind the Numbers, October 2016

The call for simplifying the tax code has been getting louder, but do citizens and businesses really understand how it will impact their income and the current tax benefits they enjoy?

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Not long after the ink was dry on the landmark Tax Reform Act of 1986, many US citizens and businesses started crying out for further simplification and modernization of the tax code. Even today, many see it as increasingly outdated given the changing shape of the economy and the way in which major trading partners have reformed their tax codes. Increasingly, Members of Congress from both political parties have been working to turn these ideas into law. With such broad support, why has a meaningful solution to this problem stayed out of reach?

There are many reasons of course, including the often gridlock-inducing nature of twenty-first-century politics. However, one of the biggest substantive barriers to tax reform is the sheer number and variety of behaviors that the tax system has been designed to encourage or, in certain cases, to discourage. The tax code has helped support diverse activities such as home ownership, delivery of employer-provided health insurance, research and development, and clean energy production. Those receiving particular tax benefits generally view them as a “good” thing, not as a complication or an unfair deal. With individuals and businesses benefiting from specific provisions at such varying degrees, there is little agreement among taxpayers as to which tax benefits should be scrapped in return for increased simplicity and lower rates.

At the tax-rate level, the US tax system is fairly straightforward. Individuals pay progressively higher rates on their taxable income according to seven tax brackets, starting, in 2016, at a 10 percent rate for single filers on their first $9,275 of taxable income ($18,850 for married couples filing jointly or qualifying widow(er)) and rising to 39.6 percent on taxable income of more than $415,050 for single filers ($466,950 for married couples filing jointly or qualifying widow(er)).1 Individual filers not only include those who earn wages from employers but also those with earnings from non-incorporated businesses and partnerships. On the corporate side, there are also seven bands, moving progressively from 15 percent on the first $50,000 to 38 percent on taxable income above $15 million, before reverting to a flat tax of 35 percent for taxable income over $18.3 million.2

However, getting to the determination of how much tax a given individual, family, or business is required to pay is anything but straightforward. Businesses and individuals must first wade through a host of possible exclusions, exemptions, and deductions from gross income and then consider provisions that provide special credits, preferential rates of tax, or deferral of tax liability—items collectively termed tax expenditures in government budget-speak. In the most recent accounting by the Office of Management and Budget, there were 227 separate tax expenditures. Of these, 31 impact corporate filers only, with the vast majority impacting individual filings only or both individuals and businesses.

Table 1 lists the 35 most significant of the tax expenditures in terms of their projected revenue effects over the period 2016–25. Only 1 provision in the top 35 applies solely to corporate filers, while the rest apply either to individuals only or to both types of filers in varying proportions. For example, 96 percent of the revenue impact from the deductibility of charitable contributions (other than education and health) are attributable to individual filers, while only 36 percent of the revenue impact attributable to accelerated depreciation of machinery and equipment is due to individual filers reporting income from a pass-through business.

The 35 largest income tax expenditures by fiscal year

Although the goal of comprehensive tax reform has remained out of reach, it is also true that tax laws are not static. As a case in point, in table 1, the estimates of revenue impacts were calculated as of the laws in effect on July 1, 2015; therefore, the provisions of the Protecting Americans from Tax Hikes Act of 2015, which was signed into law on December 18, 2015, are excluded. This act includes many provisions that will raise the eventual costs of several tax expenditures, either by making the tax expenditure permanent, as is the case with the refundability of the child tax credit, the Earned Income Tax Credit marriage penalty relief, and the research and experimentation (R&E) tax credit, or by extending provisions such as the deduction for mortgage insurance premiums and the work opportunity tax credit further than the law as of July 2015.4

It is unquestionable that moving to a simpler tax code with lower marginal rates, for both individuals and businesses, will likely require policy makers to reduce or eliminate many of these tax expenditures.5 While the size of many of these expenditures is small relative to other types of government expenditures in some areas, in others, the elimination of these expenditures would represent a major shift in public policy. For example, the revenue lost from expensing of R&D and the R&E tax credit was only $9.4 billion in 2015, while direct federal outlays on research and development was $129.2 billion.6 In contrast, the 2015 annual outlays of the Department of Housing and Urban Development totaled $35.5 billion. In that same year the combination of tax expenditures related to housing (including exclusion of net imputed rental income, home mortgage deduction, capital gains exclusions, and deduction of state and local property taxes) was nearly seven times as much ($246.1 billion).7

Even if many individuals and businesses, in the abstract, understand and support the concept of financing lower marginal tax rates by curtailing or even repealing various tax expenditures, their reactions may be quite different when they learn that the regular tax benefit they have always used is now being seen as a “loophole” in need of closing. In that way, one might imagine many Americans coming to realize that they “only thought that they wanted tax reform.”