This presentation reviews key considerations in tax reform – balancing revenues, growth, and tax equity. Charts describe the current tax system, its general framework, progressive structure, complexity, biases, and distorting features. It also explores who pays taxes, and how markets shift the tax burden.

1. The Economics of Tax Policy
and How to Think About Tax Reform
Tax Foundation University 2017, Part 1
Alan Cole and Stephen Entin
Tax Foundation
June 2, 2017

2. The Current Tax System

3. U.S. Federal Revenue as a Percentage
of GDP (1929-2015)

4. Composition of Federal Revenue
(1935-2020, Projected)

5. The Majority of Companies in the U.S. are Pass-
Through Businesses
Share of Private Business Establishments by Form, 2014
Source: Census County Business Patterns (2014) and Non-Employer Statistics (2014)

6. Pass-Through Businesses Now Earn More Income
Than C Corporations
Net Income (Less Deficit) of U.S. Businesses, by Form, Thousands of 2015 Dollars
Source: IRS, Statistics of Income, Integrated Business Data

7. Individual Income Tax
Key Elements and Structures
Kinds of Income less
Adjustments (certain expenses) =
AGI less
Deductions (itemized or standard) =
Taxable Income times array of
Marginal Tax Rates less
Credits (refundable or non-refundable) =
Tax which may be more or less
Progressive

8. Types of Income

9. Sources of Income

10. Above-the-line Deductions and
Adjusted Gross Income

11. Personal Exemption
• Reduces taxable income by $4,050 per person
claimed in 2017 (indexed).
• Phased out between AGIs of $261,500 and $384,000
for single filers;
• Between $313,800 and $436,300 for married
taxpayers; and
• Between $287,650 and $410,150 for heads of
household.
• Raises marginal tax rates roughly 1.1 percentage
point per exemption in phase-out range.

12. Standard Deduction Amounts, 2017
(indexed)
Single filers $ 6,350
Joint filers $12,700
Head of household $ 9,350
Percent of households claiming the standard
deduction in 2014: 68.5%

13. Itemized Deductions
• Mortgage Interest (on up to mortgage
balance of $1 million)
• State and Local Taxes Paid
• Charitable Contributions
• Misc. itemized business expenses (over 2% of
AGI) and medical expenses (over 10% of AGI)
• Raises marginal tax rates roughly 1.1 to 1.3
percentage points in phase-out range.

17. Qualified Capital Gains and Dividends
• Top U.S. marginal
rate of 23.8 percent
at federal level also
applies to “qualified
dividends” subject to
corporate tax.
• Lower rate designed
to partly mitigate
double taxation of
corporate earnings
compared to pass-
through earnings
taxed once.

18. Tax Credits
• Credits reduce tax burden, dollar for dollar. A
$500 tax credit reduces tax burden by $500.
• Some credits are “refundable,” which means
that they can create a negative tax burden.
• The two largest tax credits, both of which are
at least partially refundable, are the Earned
Income Tax Credit and the Child Tax Credit.

19. Income Tax Progressivity

20. Where Income Tax Revenues
Come From

21. Payroll Tax Structure
• Imposed equally on employers and employees.
• 6.2 percent for OASDI (up to $127,200 in 2017, indexed by
ave. wage growth – up from $118,500 in 2016 and 2015).
Combined rate 12.4 percent.
• 1.45 percent base rate for Medicare, no income cap.
Combined rate is 2.9 percent. (Add 0.9 percent surtax on
wages > $200,000 single or HoH, $250,000 joint, for a total
of 3.8 percent).
• Total combined base rate is 15.3 percent (or 19.1 percent
with add-on surtax).
• Larger than income tax burden for most taxpayers.
• Raises 2/3 of the revenue of the individual income tax.

22. Overall Tax Progressivity

23. Estate and Gift Taxes
• Lifetime estate and gift tax exemption of
$5.49 million (2017) (indexed).
• Rate of 40 percent
• 4th highest in the OECD; 15 of 34 countries
in the OECD have no estate or inheritance
tax.
• Gift tax exempt amount $14,000 per donor
per recipient. Excess counts against lifetime
exemption.

24. • Revenue minus expenses.
• Expenses include employee compensation and
business inputs.
• Interest paid is deductible, but dividends paid
are not.
• Capital expenditures are deductible on
depreciation schedules (except for modest
amounts of small business expensing).
• Graduated rates quickly reach 35%.
Corporate Income Tax Structure

25. Excise Taxes and Fees
• Gasoline
• Airport passenger taxes
• Guns and archery equipment
• Tobacco
• Alcohol
• Misc. (e.g. LUST, phone, waterways fees)

26. Reasons for Reform
The current tax system:
Distorts economic activity;
Depresses total income and employment;
Hides the cost of government;
Is complex, expensive to comply with, enforce;
Is subject to abuse by tax payers and IRS;
Is viewed as "unfair" (definitions vary).

27. 5,000
10,000
15,000
20,000
25,000
30,000
1980 1985 1990 1995 2000 2005 2010 2015 2020 2025
RealGDP(2009$)
Year
Actual
Trend
CBO Potential
CBO Projected
Projected Real Gross Domestic Product
Falls — And Stays — Below Its Trend
Data: Congressional Budget Office for Actual and Projected Real GDP. Trend Line computed by author
based on Real GDP growth over period 1960-2006.

28. A Sense of Urgency
LOST OUTPUT:
• We are about 17% below trend growth. We will not
recover without tax and regulatory reform.
• That’s losing the equivalent of 5 years’ total GDP.
• A full-blown tax reform could add 9%-10% to potential
output, and return labor force participation to normal.
RISKING RECESSION:
• The current expansion, as weak as it has been, is
getting old. Investment is faltering. We should not
engage in short run pump-priming, but permanent
reform for the long run would also help stave off short
run issues with growth.

29. The Tax Code is Over 10 Million Words Long
Number of Words in the Internal Revenue Code and Title 26 of the Code of Regulations
Source: Government Printing Office (2005, 2015); West Publishing Company (1955-2005).

30. OECD Revenues as a Percentage of
GDP (2012)

31. US Sources of Revenue Compared to
OECD Average

32. Source: OECD Tax Database, Table II.1
The U.S. Corporate Tax Rate is the Highest in the
Developed World
Top Statutory Corporate Tax Rate by OECD Country, 2014

33. Corporate Tax Rates Around the World Have
Declined, While the U.S. Has Stayed the Same
Source: Tax Foundation; Calculations based on data from the World Bank, OECD, KPMG, Deloitte, and PwC.

34. Impact of High U.S. Corporate Tax Rate
• High rate discourages capital formation in U.S.
• Taxes on capital are largely shifted to labor.
• If U.S. taxes on capital force capital abroad,
U.S. workers suffer, foreign workers gain.
• More likely, U.S. taxes on capital merely reduce
capital here; we lose, no one gains.
• High rate encourages shifting reported profit
abroad to lower-taxed jurisdictions.

35. Global Versus Territorial Taxation
Global: U.S. taxes firms on their domestic income
and the earnings of their foreign subsidiaries, then
gives a tax credit for foreign taxes paid. But the
foreign tax is deferred until the parent repatriates
the earnings (deferral of foreign source income).
Earnings of U.S. workers abroad above an exempt
amount get similar treatment but with no deferral.
Territorial: Almost all other countries tax business
activity or workers’ earnings within their borders,
and not the earnings of their businesses’ foreign
subsidiaries or wages earned abroad. This gives
foreign firms a competitive advantage vs. U.S.
firms trying to operate internationally.

36. Designing Tax Reform
• Selecting the type of tax (deciding on
rates, base, other features) with an eye toward
• Meeting revenue, growth, distribution
goals, facilitated by carefully
• Estimating outcomes via static and
dynamic analysis and scoring, to facilitate
• Navigating the Budget Process while
• Explaining it all to the public.

37. Tax Expenditures

38. Individual Tax Expenditures are about
Saving, Health, and Housing

39. Budget Rules
• Reconciliation vs. Normal Order
• Byrd rule impediments in the Senate
• Sunsetting vs. finding alternative
revenues beyond the budget window.
• Cutting spending.
• Redefining the window.

40. Knowing the Growth and Budget Outcomes
of Various Tax Provisions
Inside and Outside the Budget Window

41. The Triangle of Tax Reform
Tradeoffs

42. Different Tax Cuts Deliver Different “Bang for Your Buck” in Terms of
DYNAMIC REVENUES AND GDP
-$72 -$72 -$72 -$72 -$72-$72 -$56 -$48
$11
$106
$0
$68
$107
$368
$829
-$200
$0
$200
$400
$600
$800
$1,000
Static Revenue
Estimate
Dynamic Revenue
Estimate
Billions 2013 Dollars
Source: Tax Foundation TAG Model
New $1,000
Child Tax
Credit without
phase-out
Cut bottom
Federal PIT
rate from
10% to 3.5%
Cut top three
Federal PIT
rates to 29.2%
Cut corporate
tax rate from
35% to 24%
Move to
Full Expensing

43. Source: Tax Foundation Taxes and Growth Model (Oct. 2016)
Full Expensing Would Lead to Economic Growth
Static and Dynamic Revenue Estimates of Immediate Expensing of Capital Investment

45. Source: Tax Foundation Taxes and Growth Model (Oct. 2016)
A Corporate Rate Cut Would Lift GDP
Static and Dynamic Revenue Estimates of a 20% Corporate Tax Rate