In order to balance our budget and reduce the amount of debt the government takes on each year, we must match the level of government revenues with the level of spending. Currently, the government spends approximately $3.5 trillion a year, which is far more than the approximately $2.1 trillion it collects in taxes. This imbalance between spending and tax revenues is expected to continue, and even grow, over the next several decades. By 2040, revenues will only cover half of total spending.
We can reduce our spending, increase our revenues, or a combination of the two. The more we reduce our spending by making the kinds of changes described earlier, the less we will need to raise taxes. On the other hand, the more we raise taxes, the less we would need to cut spending.
The government generates revenues mostly through taxes placed on the income of individuals and corporations. In addition, the code allows for many forms of “deductions” and “tax credits,” often called “tax expenditures” because they give a benefit and are therefore similar to spending. Tax expenditures cause the government to give up about $1 trillion per year in revenue. These and other special provisions also add complexity to the process of filing taxes.
Additionally, our high corporate tax rate puts U.S. companies at a disadvantage in the global marketplace, but raises less corporate tax revenue than most economically developed nations. Taxpayers also use the conflicting rules on capital gains taxes to their advantage, further lowering government revenue.
Our tax system is complicated and does not raise sufficient revenues to finance the nation’s spending. There are many ways to increase revenue. There are also changes that we can make to improve how our overall tax system works.
Allow the Bush tax cuts to expire for some or all individual taxpayers
The Economic Growth and Tax Relief Reconciliation Act of 2001 and the Job Growth and Tax Relief Reconciliation Act of 2003 (commonly known as the Bush tax cuts) were enacted during a time when the government had a budget surplus, and the surpluses were projected to continue for the foreseeable future. The Bush tax cuts are scheduled to expire at the end of 2010.Extending all of the tax cuts will be very costly; the lost revenue would add $3.7 trillion to the deficit over the next 10 years, according to the Tax Policy Center. Policy makers must decide on a course of action on the Bush tax cuts. They could allow the tax cuts to expire for all taxpayers; allow the tax cuts to expire just for high-income taxpayers (individuals earning more than $200,000 and households earning more than $250,000); or extend the tax cuts for everyone. They could also extend some or all of the tax cuts for a limited time period instead of making the cuts permanent.
Eliminate or scale back tax expenditures
Our tax code does more than raise revenues. It also reflects efforts to influence private economic decisions through favorable tax provisions. As a result, it contains hundreds of “tax expenditures ” in the form of deductions, credits, exemptions, and exclusions. These expenditures make the process of filing taxes more difficult, amount to $1 trillion in lost revenues for the government each year, and provide the greatest share of their benefits to higher income taxpayers. Some economists argue that the expenditures have obsolete or undesirable social effects. Eliminating selected deductions and exclusions, or “broadening the tax base,” would allow the government to raise more revenue.
The five largest tax expenditures alone amount to an estimated $573 billion of lost revenue annually, which is more than the government spends on Medicare each year. Changes to these and other tax provisions, including two of the most widely used and most costly—adjusting the tax treatment of employer-sponsored health insurance, and capping or converting the home mortgage interest deduction—would help raise the amount of federal revenues collected.
Find new sources of revenue
Some policy experts have proposed looking for new sources of revenue other than income taxes. Many policy experts believe that taxes on spending, or consumption, are preferable to taxes on income. This is because taxes on income might discourage people from working, while taxes on spending encourage people to save more because a tax on spending would make consumer products more expensive. Increased saving would in turn reduce our reliance on foreign lenders because American would have more funds to lend to the Treasury. Two common suggestions for new taxes include a consumption tax and a carbon or other form of energy tax.
Simplify the tax system
Administering the tax system would be easier if the system itself was simpler. By harmonizing the tax rules regarding retirement savings, capital gains, and family and education credits, the government could reduce the amount of complexity taxpayers face while also helping to avoid errors, improve compliance, and raise revenues.
Encourage better compliance with the tax laws
The IRS estimates that the "tax gap"—the difference between taxes owed and what the government actually collects—was about 16 to 20 percent of revenues in recent years according to the Tax Policy Center. The government could do more to encourage voluntary compliance by making the tax system simpler and fairer (so people feel that everyone is paying their fair share), and increasing enforcement. The government should also consider providing the IRS with more resources for enforcement and monitoring.
Reform the corporate tax system
Relative to other countries, the U.S. has a high corporate tax rate. The high tax rate makes our corporations less competitive because it raises their operating costs. Although we have the second highest statutory corporate income tax rate among other Organization for Economic Co-operation and Development (OECD) countries, whose economies are comparable to our own, U.S. revenue for corporate taxes is the fourth lowest in the OECD as a share of the economy (gross domestic product—GDP). This is partly due to the fact that many U.S. corporations move their operations overseas to avoid our relatively high corporate tax rate. Other corporations create special non-corporate businesses (such as S-corporations) that allow them to avoid taxation on some of their income.
The corporate tax system also includes many special deductions and credits that benefit specific business activities. For example, corporations are allowed a special deduction for income produced domestically, and receive special tax treatment for employee stock ownership plans. Some tax economists argue that many of these provisions distort economic activity, and increase complexity and the cost of accounting. These provisions also reduce the effective tax rate that most corporations pay. Reforms to reduce marginal tax rates for corporations and broaden the corporate tax base could result in more efficiently raised revenues, easier administration, and reductions in the cost of compliance.
PGPF TAX PRIMER
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The Debate Over Expiring Tax Cuts: What About the Deficit?, Tax Policy Center
Options to Fix the AMT, Tax Policy Center
Effects of Imposing a VAT to Replace Payroll Taxes or Corporate Taxes, Tax Policy Center
Is a VAT in Our Future?, Tax Policy Center
The Automatic 401(k): A Simple Way to Strengthen Retirement Saving, Tax Policy Center
How Does the Tax Exclusion for Employer-Sponsored Health Insurance Work? Tax Policy Center
Should There Be a VAT in America’s Future?, Brookings Institution