Dr. Mike Walden
It was a hot, humid day in 1985. President Reagan was appearing at Reynolds Coliseum. I was in the audience. The arena was not yet air-conditioned. Despite huge fans that had been brought from Ft. Bragg, everyone was sweating. As the President stepped to the podium he mentioned the warmth in the building and promptly removed his suit coat. As if on cue, all the dignitaries on the stage also removed their coats!
The purpose of President Reagan’s visit was to promote his tax proposals being considered by Congress. Now, a little over thirty years later, another president – President Trump – is asking Congress to again make some big changes to the federal income tax code.
Changing the tax code always creates discussion and debate. It’s easy to understand why. The U.S. income tax is the largest generator of public revenues in the world – for example, collecting $3.2 trillion in 2015. It’s also complex. One organization estimated the federal tax code and associated regulations total 10 million words! Also, many industries are at least partially dependent on the deductions and credits embedded in the income tax code.
So, to help you follow the upcoming debate about federal income taxes, let me present three key categories of disagreement I hear every time tax changes come up. Then I’ll let you decide what arguments make the most sense for inclusion in any new tax package.
What – or Who – Should Be Taxed? There are many possible answers to this question, but today the big debate is between businesses and individuals. Should businesses be given special tax breaks because they create jobs and payrolls in the economy? Or, should there be a level playing field between businesses and individuals?
The question usually comes down to how big companies – specifically corporations – are taxed. There is support to significantly reduce the federal tax rate on corporations for two reasons. First, the U.S. rate is high compared to foreign tax rates on corporations, which some say puts U.S. corporations at a disadvantage. Also, some of the earnings of corporations flow back to shareholders, who would then pay an individual tax – meaning corporate earnings are double-taxed.
Opponents reply that when the deductions and credits allowed for corporations are recognized, the U.S. “effective” corporate tax rate is much lower. Also, some research suggests that double-taxation of corporate earnings is relatively small since the majority of those earnings are today paid to non-taxable accounts, such as retirement plans.
Should Tax Rates Rise with Income? This is the debate between a “progressive” tax system and a “flat” tax system. With a progressive tax system, an individual’s taxable income is divided into ranges – or brackets – and each range is taxed at a different rate. Importantly, as a taxpayer moves up the income ranges, the applied tax rate rises. In a flat system, there are no ranges – all taxable income is taxed at the same rate.
Two notions support a progressive tax system. First is the belief that higher income individuals can afford to pay more taxes, one reason being that they benefit more from the services (like national defense and security) provided by government. The second is that the value of additional dollars are worth less to a higher income individual – therefore to equalize the commitment of taxpayers, higher income individuals must pay taxes at a higher rate.
Of course, not all agree. Critics question the arbitrary cutoffs for the tax ranges, and also worry the boost in the tax rate corresponding to more income may discourage additional work. Critics also question the psychological differences in the value of a dollar to individuals with different income, and also challenge the claim that higher income households benefit more from government. Their conclusion therefore is that one rate for all taxable income makes the most sense.
Should the Tax Code Promote Certain Kinds of Spending? There’s an argument that certain kinds of individual spending not only benefits the person doing the spending, but also benefits society at large. Some research suggests homeowners take more interest in their community than renters. Private giving to charities may reduce the need for public support. Personal spending on health care might make an individual a more productive worker and thus increase the total output of the economy.
For these reasons a large segment of the income tax code is devoted to motivating certain kinds of spending through tax deductions (the spending reduces the individual’s taxable income) and tax credits (the spending directly reduces taxes owed).
As you might expect, there is a countering viewpoint on using the tax code to back specified personal spending. Opponents say their use complicates the tax code and reduces revenues. Some find the research supporting the deductions and credits dubious. Critics also argue tax deductions and credits can be easily “gamed” by special interests and often benefit higher-income taxpayers more.
Get ready for an upcoming bruising battle over altering federal income taxes. And if the battle comes this summer – as it did in 1985 – get ready for a sweaty debate. But hopefully – with my information – you’ll be able to decide on the outline of your favorite plan!
Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.