The federal tax code is still a major source of anger and debate among Americans and a barrier to economic growth and opportunity. Other countries, like Estonia, have shown that taxes can be collected in a less stressful and more effective way and still bring in enough money.
Even though there have been many efforts to change it, the federal tax code is still a major source of frustration and debate among Americans and a barrier to economic growth and opportunity. After more than a century of tinkering and well-intentioned attempts to solve a wide range of social and economic problems, we have a confusing system of fines and handouts that no one likes but sometimes helps special interests and power brokers.
Even though each rule can be justified as helping one group or another, like an existing business or a group of taxpayers who have been paying taxes for a long time, the combination of complicated tax breaks and high income tax rates hurts newcomers and new sources of economic growth. Instead, it slows down the forces that make a healthy economy grow, making people less likely to work, save, and spend.
Compliance with the tax code is a huge hassle. It is believed that it takes 6.5 billion hours and costs about $313 billion per year, which is about 1.4% of GDP. Most of the burden is caused by difficult business taxes that take a lot of time and energy from entrepreneurs and small business owners, as well as huge tax departments at many large companies. The cost of tax planning, which is a big business on its own, is not included in the estimate. It also doesn't include the management costs and problems that have made the IRS so busy over the past few years. Last year, for example, only about 10% of the 73 million calls the IRS got from people asking for help were answered.
This doesn't have to happen. Other countries have shown that taxes can be collected in a way that is less annoying and works better. A great example is Estonia's tax system, which is so easy that most people can file their taxes online in about five minutes.
Estonia is also at the top of the Tax Foundation's annual list of the countries with the most competitive tax systems. This is because it doesn't tax company income twice by taxing both the entity and the shareholders. Even though the tax load is even and easy, Estonia's income tax system brings in a lot of money, which is similar to what other developed countries do. Americans might think it's impossible, but for the more than a million Estonians who have done well under this system for the past 22 years, it's a dream come true.
Based on what happened in Estonia and on ideas from our first study of possible reforms, we have come up with a simple plan for changing the U.S. tax code. The plan doesn't change the amount of money coming in or going out. It has two main parts that affect both personal and business income, as well as changes to how estates and capital gains are handled that cancel out our present death tax. Among the changes are:
A flat tax of 20 percent on individual income combined with a generous family allowance to protect low-income households. All other major credits, deductions, and preferences would be eliminated except the current-law Earned Income Tax Credit (EITC), a more stable Child Tax Credit (CTC), and tax-preferred savings accounts. A distributed profits tax of 20 percent in lieu of our current overly complex regime for taxing domestic and foreign profits earned by corporations and pass-through businesses. Elimination of taxes at death and simplified treatment of capital gains to remove the burden of unnecessary compliance and administrative costs.
By making the federal tax code easier to understand, the reform would cut compliance costs by a lot. This could save U.S. taxpayers more than $100 billion per year, with businesses saving more than $70 billion and individuals saving more than $30 billion in costs related to individual income and estate tax returns.
We think that, in the long run, the change would raise GDP by 2.3%, raise wages by 1.3%, and add 1.3 million full-time equivalent jobs.
A normal way to look at it is that the plan would improve average incomes after taxes by 0.3% in the long run. When the benefits of faster economic growth are added in, the average income after taxes would go up by 2.1% in the long run. Even though average incomes after taxes go up, in any measure that doesn't change the amount of money coming in, lowering taxes for one group of taxpayers means raising taxes for another group of taxpayers. Different parts of the plan could be changed to get different results in terms of sharing.
By raising GDP, the reform would lower the debt burden by 5.9 percentage points, as measured by the ratio of debt to GDP.
The reform's policies should be looked at as a whole. Just one change might not be a good idea on its own.
Background on Tax Reform
Tax reform has always been about reevaluating all of the rules that have built up over time, getting rid of the ones that don't work, and lowering the economic damage caused by high marginal tax rates. This is in line with the principles of good tax policy. Most experts on tax policy agree that taxes should be simple, clear, and steady over time. This makes them easy to understand, follow, and run.
Neutrality is another part of good tax policy. The tax code should usually treat taxpayers the same, with as few preferences as possible. This includes treating immediate consumption and delayed consumption through saving the same. A tax code that is based on these ideas will easily help the economy grow, which means more jobs, higher wages, more opportunities to move up, more innovation and progress, and a higher standard of living.
Our tax code is a long way from this. By taxing income, it makes it harder to save because it taxes both the money saved and the returns on savings that make up for the fact that you have to wait to spend it. The corporate income tax also applies to money saved and spent by a corporation. The estate tax is the last way that saving money is taxed. To make up for the fact that saving and investing aren't rewarded as much as they should be, lawmakers have created a patchwork of limited relief measures. These include widely used measures like 401(k) retirement accounts for individuals and bonus depreciation for businesses, as well as dozens of other more specialized and complicated carveouts that only help a few.
The tax code has become a major way to redistribute wealth and give subsidies to almost all families, not just those with low incomes. This replaces economic growth and opportunity with political favors. There are more than 200 so-called "tax expenditures" in the tax code. These are credits, deductions, and other special rules that are expected to cost about $2 trillion each year (including lost income and payroll tax income and increased spending). More than 100 tax expenses have been made or changed in just the last three years.
Some tax expenditures are important parts of the tax code, but many are complicated and help certain businesses or types of households more than others. The Congressional Budget Office (CBO) says that about half of the total income tax benefits of spending go to high-income families. Getting rid of these kinds of rules would be one of the least harmful ways to make money.
The Tax Cuts and Jobs Acts (TCJA) of 2017 was the last major tax reform. It made important changes to the tax code, like lowering income tax rates and making it easier for businesses to write off expenses, while cutting back on some of the biggest tax breaks. But it kept a lot of the tax code's complexity and in some ways made it worse. Some businesses did worse because of things like the Section 199A pass-through business deduction and the Global Intangible Low Tax Income (GILTI) rule, which applies to foreign income.
Since the Tax Cuts and Jobs Act (TCJA), the ideas of subsidy, punishment, and micromanagement through the tax code have become more important. For example, last year's Inflation Reduction Act added another complicated minimum tax for large companies and a variety of subsidies for green energy. This created new uncertainties that will need a lot of help from the Treasury Department and will inevitably have unintended consequences related to tax planning and behavior that distorts the market.
A lot of the individual income tax code is also set to expire at the end of 2025 because of the Tax Cuts and Jobs Act (TCJA). Several business tax increases have already started, such as the phase-down of bonus depreciation, which makes now a good time to think about fundamental tax reform. The economy is getting worse, interest rates and inflation are high, and there are a lot of big financial problems ahead. All of these things make fundamental and growth-friendly tax change more important than ever.
Flat Tax of 20 Percent with a Generous Family Allowance
Following the Estonian model, the suggested change would create a much simpler income tax system for individuals, with a flat tax rate of 20% on all income except dividends, a standard deduction of $19,500 per filer, and a personal exemption of $5,000 per household member.
The flat rate applies to wages, salaries, capital gains, pensions and annuities, taxable Social Security benefits, taxable interest, rent and royalty net income, and taxable withdrawals from individual retirement accounts (IRAs). Dividends would not be taxed as income.
Most credits, deductions, and other preferences would be eliminated, including:
The itemized deduction for mortgage interest The itemized deduction for state and local taxes (SALT) paid The itemized deduction for charitable contributions The exclusion for capital gains tax on principal residences for gains up to $250,000 (single)/$500,000 (joint) Tax expenditures including the exclusion of capital gains tax for small corporate stock, the exemption on interest earned on municipal bonds, credits for green energy, the deduction for interest on student loans, the deduction for medical expenses, and credits for post-secondary education tuition
| Current Law | Reform Option | |
|---|---|---|
| Ordinary income tax schedule | Seven brackets in 2023: 10%, 12%, 22%, 24%, 32%, 35%, 37%. Seven brackets beginning in 2026: 10%, 15%, 25%, 28%, 33%, 35%, 39.6% | 20% on taxable income |
| Tax schedule for long-term capital gains | Three brackets: 0%, 15%, 20% | 20% on taxable income |
| Standard deduction | Standard deduction of $13,850 (single)/$27,700 (joint) in 2023 and indexed to inflation. Starting in 2026, standard deduction is reduced to $8,000 (single)/$16,000 (joint) and indexed to inflation | Permanent standard deduction of $19,500 (single)/$39,000 (joint) in 2023 and indexed to inflation |
| Personal exemption | Personal exemption of $0 until 2026; the exemption returns in 2026 and equals $5,800 in 2032 | Personal exemption of $5,000 starting in 2023, rising to $6,100 by 2032 with inflation |
| Child Tax Credit (CTC) | $2,000 CTC with a refundability limit of $1,600 in 2023, a 15% refundability phase-in, and a $2,500 earnings requirement. Phaseout begins at $200,000 (single)/$400,000 (joint). After 2025, the CTC returns to $1,000 with a $3,000 earnings requirement, and a phaseout starting at $75,000 (single)/$110,000 (joint) | Permanent $2,000 CTC with a $2,500 earnings requirement, both indexed to inflation, and full refundability. Phaseout begins at $50,000 (single)/$100,000 (joint), indexed to inflation. Phase-in and phaseout rates remain as under current law. |
| Earned Income Tax Credit (EITC) | Refundable tax credit accrued based on earned income and targeted at low-income workers | EITC is retained under current law parameters |
| Alternative Minimum Tax (AMT) | Second set of income tax rules subjecting some taxpayers to AMT tax liability at rates of 26 percent or 28 percent | The AMT is repealed |
| Net Investment Income Tax (NIIT) | 3.8 percent tax on certain passive investment income earned by those with modified adjusted gross income over $200,000 (single)/$250,000 (joint) | The NIIT is repealed |
| Tax-preferred savings accounts | Taxpayers may contribute to traditional accounts that provide a deduction for contributions and earnings are taxed upon distribution, or Roth-style accounts where contributions are taxed upfront and earnings are distributed tax-free | Tax-preferred savings accounts are retained under current law parameters |
Source: Internal Revenue Service (IRS), Tax Foundation research. |
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Under the new law, capital gains would be taxed the same way as other income, instead of on a different schedule as they are now. It would get rid of all exemptions for capital gains and interest, like the one for small company stock, and get rid of the Net Investment Income Tax (NIIT), which is an extra 3.8% tax on capital gains and other investment income over $250,000. With these changes, the tax code will be easier to understand and people won't be able to avoid, play games, get confused, or argue about the different tax rates for investment income.
When a larger standard deduction is combined with a personal exemption, it creates a big zero bracket that protects low-income households from the flat tax. Also, the reform would stabilize the CTC by setting a limit of $2,000 per child, which starts to go away for single filers at $50,000 and for couples at $100,000. With earned income over $2,500, the credit would keep coming in at a rate of 15%, and the full amount would be refunded. Going forward, the highest credit of $2,000 and the thresholds for when it starts and when it ends will be adjusted for inflation. With the CTC and the EITC still in place, most households making less than $50,000 will see a small or no tax rise.
Also, the change keeps tax-preferred savings accounts like 401(k)s and IRAs, which encourage people to save and protect many middle-income households from tax hikes.
A flat tax would be better than the current progressive income tax system, which has seven income tax bands and a lot of exclusions, exemptions, credits, and deductions. First, it makes the tax code a lot easier to understand. This cuts down on tax planning and evasion, as well as the costs of following the rules and running the government. At the moment, it takes U.S. taxpayers an average of 12 hours to follow the individual income tax rules, and doing so costs more than $75 billion per year. Based on what has happened in Estonia, where it only takes a few minutes to follow the rules, this reform would probably save U.S. taxpayers tens of billions of dollars every year in lower costs of following the rules.
Second, the reform lowers marginal income tax rates. Many middle-income taxpayers who are currently in the 22 and 24 percent brackets will see their rates go down a little, and many high-income taxpayers will see their rates go down by about half. This boosts economic growth by giving people more reasons to work, save, and spend. For example, the average federal marginal tax rate on wage income would go down from 23.2 percent to 19.9 percent because of the change.
The CBO found that by lowering marginal income tax rates, a flat tax would be much better for the economy than a progressive income tax. This is because a flat tax would lead to more economic output in the long run, especially for younger households, who would spend and work more over their lifetimes.
Distributed Profits Tax of 20 Percent
When it comes to business income, the change gives all domestic companies, both corporations and pass-through businesses, a tax on distributed profits like Estonia does. This system gets rid of the time-consuming process of figuring out taxable income after deductions, applying tax, and figuring out appropriate tax credits and other preferences. Instead, it puts a 20% tax on distributed profits, such as dividends and net share repurchases, at the entity level. So that people don't pay taxes twice, dividends received by individuals are not taxed as income.
By treating corporations and pass-through companies the same, this plan avoids the complexity of the current U.S. business tax system, which has different tax rules for C corporations, S corporations, partnerships, and sole proprietors.
| Current Law | Reform Option | |
|---|---|---|
| Taxes on C corporations and shareholder income | Corporations are subject to the 21% corporate income tax as well as the corporate alternative minimum tax (or book minimum tax) and stock buyback tax. Dividends received are subject to individual income tax. Owners of corporate equity are subject to capital gains tax upon realization | Corporate income tax is repealed, along with the book minimum tax and stock buyback tax, and replaced with a 20% entity-level tax on distributed profits. Dividends received are not subject to individual income tax. Owners of corporate equity are subject to capital gains tax upon realization. |
| Taxes on pass-through firms (partnerships, sole proprietorships, S corporations) and shareholder income | Profits are “passed through” to individual owners and subject to individual income tax at statutory rates of up to 37% through 2025 and 39.6% after that Through 2025, owners can deduct a portion of qualified business income. Owners of pass-through equity are subject to capital gains tax upon realization | Pass-through firms receive the same tax treatment as C corporations, i.e., they are subject to a 20% entity-level tax on distributed profits, and dividends received are not subject to individual income tax. Owners of pass-through equity are subject to capital gains tax upon realization |
| Fringe benefits | Some fringe benefits, such as employer-sponsored health insurance, are deductible at the firm level and excluded from individual income tax and payroll taxes | All fringe benefits are subject to the 20% entity-level distributed profits taxes and payroll taxes. Fringe benefits received are not subject to individual income tax |
| Taxes on foreign and cross-border income | Multinational corporations are subject to a complex set of rules and tax rates, including Subpart F, foreign tax credits, Global Intangible Low Tax Income (GILTI), Foreign-Derived Intangible Income (FDII), and Base Erosion and Anti-Abuse Tax (BEAT) | Foreign and cross-border income is exempt from tax, so long as it is subject to corporate tax in its foreign location |
Source: Internal Revenue Service (IRS), Tax Foundation research. |
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Payroll taxes and the 20% tax on distributed profits would apply to fringe benefits like health insurance given by a company. At the moment, firms can claim compensation in the form of fringe benefits, and individuals don't have to pay income or payroll taxes on them. This is the biggest tax break in the tax code. If fringe benefits were taxed (20% income tax plus payroll taxes), different types of pay would be treated the same. This would increase efficiency and prevent a major market distortion that favors employer-provided health insurance and third-party payers.
The plan needs rules to keep people from abusing it, but compared to the current law, it doesn't have too many requirements for administration or compliance. Under current U.S. law, all of the international rules that deal with foreign income, such as the very complicated Subpart F and GILTI regimes, would not be needed. Instead, the system would be based on a simple 20 percent tax on the distributed profits of domestic firms. Distributions from foreign firms to U.S. companies would not be taxed any further if the foreign distributions were already taxed enough in their home countries.
The proposal also takes a simple method to the global minimum tax that the OECD and about 140 countries are negotiating for large multinational companies. Companies could avoid a top-up tax from the minimum tax rules if their profit distributions are high enough to meet the 15% minimum tax compared to the model rules' meaning of income. This is like what will happen to Estonian businesses when the minimum tax rules are put into place.
Under current law, U.S. companies must keep more than one set of books in order to meet the needs of their stakeholders and pay the right taxes. Most of the time, shareholders and investors use regular book accounting to figure out how well a company is doing financially. Tax accounting is used to make sure that the taxes on company income and income from businesses that don't have to file taxes are paid. As part of the Inflation Reduction Act, which went into effect last year, there is also a new book minimum tax that large businesses must pay. This tax requires an alternative book accounting. As more countries start to use the global minimum tax, big businesses will have to follow yet another set of rules, which will require yet another way to keep their books.
One goal of the change is to make it easier to follow the rules by cutting down on the number of different sets of books that need to be kept. With the distributed profits tax, the cost and controversy of tax accounting for company and pass-through business income taxes are mostly gone. They have been replaced by simple accounting for distributed profits, which is already done as part of regular book accounting. The only other accounting that needs to be done is for the global minimum tax rules that may be used in different countries. These rules are mostly based on regular book accounting principles as well. Lastly, it's important to note that regular book accounting is also enough to meet the needs of tax officials when it comes to audits, like figuring out if the reported income and assets are real.
The administrative and compliance costs of the Estonian business tax system are among the lowest in the developed world. This is especially helpful for entrepreneurs, startups, and small businesses that could not otherwise afford the high compliance costs of the current system, which are estimated to be more than $150 billion per year. With the change, business compliance costs would go down by a lot, but it's hard to say how much. The cost of filling out difficult depreciation and amortization forms, which is estimated to be $24 billion, and the cost of filling out forms for the deduction for qualified business income, which is estimated to be $18 billion, would go away. A lot of the costs of filing forms 1120 and other business income tax returns, which are estimated to be more than $60 billion, would also go away. This means that the change would likely save businesses more than $70 billion a year in compliance costs. By making it easier for businesses to pay their taxes, entrepreneurs and business leaders can put their money and time toward more useful activities and grow their businesses.
Both empirical and theoretical study shows that the Estonian business tax reform has helped the economy in ways other than saving money on compliance costs. The way the distributed profits tax is set up, with no tax on earnings that are kept, gives entrepreneurs and businesses a strong and general reason to grow and spend. The reward is especially helpful for startups and small businesses that don't have a lot of credit or cash on hand because they use their own earnings to pay for themselves.
One study found that, compared to a corporate income tax that brings in the same amount of tax revenue, the distributed profits tax makes companies 7 percent more valuable overall. This is because the design is better. Another study found that Estonia's distributed profits tax encourages companies to keep a bigger share of their earnings, pay down their debt, and spend more. As a result, the country's long-term capital stock goes up by 10% and its output goes up by 4%. The Tax Foundation's worldwide list of the most competitive tax systems in the developed world puts Estonia at the top of the list. This is because Estonia's business tax system is simple and geared toward growth.
Researchers found that the reform, which replaced a corporate income tax similar to ours with a distributed profits tax, significantly increased retained earnings and liquidity while reducing the use of debt, especially among smaller companies with limited liquidity. This change has made companies more resilient during economic downturns. These studies also show that the change led to more investment and more work being done per hour.
Estonia's tax system is one reason why its economy is one of the most lively and full of entrepreneurs in Europe. For example, Estonia is first in Europe when it comes to the number of startups per person, the amount of venture capital funding per person, and the amount of capital investment per person. Since the financial crisis in 2009, Estonia has come back strong as a center of innovation and startups in Europe. Venture capital spent in early-stage startups has grown from $4 million in 2009 to almost $1 billion in 2021.
In those 12 years, Estonia's real GDP per person has grown by 53%, compared to 19% in the U.S. and an average of 17% across the OECD. Since the tax change in 2000, Estonia's GDP per person has grown by 119 percent, compared to 27 percent in the U.S. and 26 percent on average in the OECD.
Elimination of Taxes at Death
Under U.S. law as it stands, the estate tax doesn't bring in much money, discourages investment in capital, and slows down economic growth. It adds one more tax to saving and investing, which already have to pay a lot of taxes. It also has a lot of compliance and administrative costs linked to the valuation of estates, and it leads to a lot of tax planning (since the tax code gives many ways to avoid paying). Research has shown that the costs of complying with the estate tax, which are currently expected to be $18 billion per year, are close to and often more than the amount of tax money collected.
As you might guess, Estonia has a much easier option. Estonia doesn't have a death tax or an estate tax. Instead, the person who inherits an asset has to pay a capital gains tax when the asset is sold and a gain is made. When an asset is inherited, it gets a "zero basis." This means that there is no need to keep track of the original basis (the original cost of the buy) from the person who died or any of the paperwork that goes with it. In other words, when someone inherits an asset, it is treated like any other asset, and the reimbursement basis is based on how much it cost the person to get it.
Think about a $1 million home that you inherited. The person who got the inheritance wouldn't have to pay taxes on it. Instead, they would only have to do so when they sold the land. At that time, the person who got the property would have to pay taxes on the full value of the property minus any costs that could be deducted, such as costs for making changes to the property after the inheritance.
| Current Law | Reform Option | |
|---|---|---|
| Estate tax | Tax rate on net estate value up to 40% for assets over $12.92 million in 2023. Exemption value is scheduled to fall to about $6 million in 2026, indexed to inflation thereafter | Estate tax is repealed |
| Gift tax | Tax rate on gifts up to 40% for gifts worth over $17,000 in 2023 | Gift tax is repealed |
| Step-up in basis | Asset cost basis is adjusted to fair market value for the inheritor | Asset cost basis is set at zero for the inheritor |
Source: Internal Revenue Service (IRS), Tax Foundation research. |
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By eliminating the incentive under current law to pass assets on to heirs along with a “stepped-up” basis, this reform encourages the realization of capital gains within one’s lifetime, thus boosting tax revenue from capital gains. That is, the reform effectively removes the need for tax planning around death. It also eliminates the administrative challenge and controversy around valuing assets at death, where disputes with tax authorities can take a decade or more to resolve. Much, if not all, of the $18 billion of compliance costs associated with the current law estate tax would be eliminated under this reform.
Replacing the estate tax with a zero-basis transfer of capital gains at death certainly has downsides. For the most part, the downsides relate to the problems of taxing capital gains in general, namely that it punishes saving and entrepreneurship, a problem made worse by inflation, and encourages tax-driven decisions regarding realizations. That is why it is important to keep the tax rate as low as possible and broaden the base to maintain sufficient tax revenue.
The estate tax as currently structured takes the opposite approach, with a narrow base and a top tax rate of 40 percent (compared to 20 percent on capital gains under the proposal). As such, the estate tax is relatively more economically damaging and entails more avoidance, tax planning, complexity, and compliance and administrative costs per dollar of revenue raised.
Likewise, alternatives such as capital gains treatment with carryover of basis or stepped-up basis would entail substantially more compliance and administrative costs. Overall, the proposed reform is recommended due to its simplicity, low compliance and administrative costs, and reduced economic harm relative to current law.
Economic Effects
We estimate that implementing the reform outlined above in the U.S. would increase GDP by 2.3 percent in the long run, amounting to about $400 billion in additional annual output by 2032 and $1 trillion in the long run (both in 2023 dollars). The reform would increase the long-run capital stock by 3 percent, amounting to $2.1 trillion in 2023 dollars. Additionally, we estimate the reform would add 1.3 million full-time equivalent (FTE) jobs and raise wages by 1.3 percent.
Two major changes drive the economic results: the replacement of the current progressive income tax structure with a flat 20 percent tax on individual income, which raises GDP by 1.3 percent and adds 1.2 million FTE jobs, and the replacement of current business income taxes with a 20 percent distributed profits tax, which raises GDP by 1.7 percent and adds 412,000 FTE jobs.
For context, we estimated the TCJA would increase GDP by 1.7 percent in the long run and add 339,000 jobs, indicating the proposed reform would have a substantially larger positive impact on the economy.
| Provision | Change in GDP | Change in Capital Stock | Change in Wages | Change in Full-time Equivalent Jobs |
|---|---|---|---|---|
| Repeal the Alternative Minimum Tax (AMT) | -0.1% | Less than +0.05% | Less than +0.05% | -115,000 |
| Exempt dividends from individual income tax | +0.2% | +0.3% | +0.1% | +41,000 |
| Replace individual income tax with a flat 20% tax on ordinary income | +1.3% | +1.6% | +0.2% | +1.2 million |
| Expand the standard deduction from $13,850 to $19,500 (double for joint filers) starting in 2023 and eliminate Head of Household filing status | +0.1% | -0.4% | -0.2% | +328,000 |
| Reinstate the personal exemption at $5,000 starting in 2023, indexed for inflation | Less than +0.05% | Less than +0.05% | Less than +0.05% | +26,000 |
| Tax capital gains at a flat 20% rate and set zero basis for inherited assets | -0.1% | -0.2% | -0.1% | -32,000 |
| Eliminate most individual tax expenditures* | -0.6% | -1.4% | -0.3% | -239,000 |
| Repeal the Net Investment Income Tax (NIIT) | +0.1% | +0.1% | Less than +0.05% | +10,000 |
| Repeal estate tax and gift taxes | +0.1% | +0.3% | +0.1% | +23,000 |
| Reform the Child Tax Credit (CTC) and repeal the Child and Dependent Care Tax Credit (CDCTC) | Less than -0.05% | Less than -0.05% | Less than -0.05% | -24,000 |
| Repeal the corporate income tax and replace it with a 20% entity-level tax on distributed corporate profits. Tax pass-through firms as C corporations through the 20% entity-level tax on distributed profits | +1.7% | +3.1% | +1.3% | +412,000 |
| Subject employer-sponsored health insurance and fringe benefits to 20% entity-level tax on distributed profits and subject benefits to payroll tax | -0.3% | -0.4% | Less than -0.05% | -364,000 |
| Impact of budget deficit reduction | 0% | 0% | 0% | 0 |
| Total Economic Effect | +2.3% | +3.0% | +1.3% | +1.3 million |
Revenue Effects
Compared to the baseline, we think the change would bring in $334 billion more in federal tax revenue from 2023 to 2032. This is the 10-year budget window. The plan brings in about $606 billion in the first three years, when the baseline reflects the TCJA individual provisions. After 2025, when the TCJA provisions are no longer in effect, the baseline represents higher tax collections. At the end of the budget window, in 2032, the plan is expected to lose about $40 billion.
We predict that the plan will bring in $173 billion over the budget window, when economic growth caused by the reform is taken into account. The reason for the decrease compared to traditional analysis is that the base-widening tax hikes had less of an effect on the economy in the first few years, so they brought in less money. But by 2032, the plan will start to bring in more money because the economy will be bigger and income and payroll taxes will be higher.
| Provision (Billions of Dollars) | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2023-2032 |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Individual Provisions | |||||||||||
| Replace current law individual income tax schedule with a flat 20% ordinary income tax | $352.7 | $348.8 | $349.6 | $36.9 | $39.5 | $40.6 | $42.7 | $44.8 | $46.1 | $48.3 | $1,350.0 |
| Repeal the Alternative Minimum Tax (AMT) | -$19.5 | -$19.2 | -$19.1 | -$55.6 | -$59.5 | -$61.3 | -$63.5 | -$65.9 | -$68.7 | -$71.3 | -$503.6 |
| Tax capital gains at a flat 20% rate and exempt dividends from individual income tax | -$170.1 | -$169.6 | -$170.6 | -$48.0 | -$51.9 | -$53.7 | -$55.8 | -$58.1 | -$60.5 | -$63.0 | -$901.3 |
| Expand the standard deduction from $13,850 to $19,500 (double for joint filers) starting in 2023 and eliminate Head of Household filing status | -$212.7 | -$203.6 | -$202.9 | -$410.5 | -$438.4 | -$450.2 | -$468.3 | -$484.8 | -$502.7 | -$524.0 | -$3,898.1 |
| Reinstate the personal exemption at $5,000 per filer and dependent starting in 2023, indexed for inflation | -$332.9 | -$330.2 | -$332.1 | -$17.5 | -$19.2 | -$17.4 | -$19.0 | -$20.7 | -$19.3 | -$21.1 | -$1,129.4 |
| Make permanent the $2,000 TCJA Child Tax Credit with a $2,500 earnings requirement, full refundability, and a phaseout of $50,000 (single)/ $100,000 (joint). Index the CTC earnings requirement, phaseout amounts, and credit amount to inflation. Repeal the Child and Dependent Care Tax Credit (CDCTC). | $42.9 | $39.7 | $38.4 | -$57.8 | -$62.4 | -$65.7 | -$69.3 | -$73.3 | -$77.3 | -$81.4 | -$366.2 |
| Repeal the Net Investment Income Tax (NIIT) | -$56.5 | -$55.3 | -$54.7 | -$54.4 | -$57.8 | -$58.9 | -$61.6 | -$64.5 | -$67.6 | -$70.8 | -$601.9 |
| Eliminate most individual and business tax expenditures* | $227.2 | $229.3 | $233.2 | $244.7 | $265.5 | $275.3 | $287.3 | $300.9 | $314.0 | $328.1 | $2,705.4 |
| Business Provisions | |||||||||||
| Repeal the corporate income tax and replace it with a 20% entity-level tax on distributed corporate profits. Tax pass-through firms as C corporations through the 20% entity-level tax on distributed profits | -$37.5 | -$19.1 | -$6.1 | -$57.2 | -$60.5 | -$46.2 | -$39.8 | -$35.8 | -$32.2 | -$29.9 | -$364.1 |
| Subject employer-sponsored health insurance to 20% entity-level tax on distributed profits and subject benefits to payroll tax | $372.6 | $365.8 | $363.6 | $359.5 | $382.0 | $389.6 | $401.2 | $413.4 | $426.5 | $439.9 | $3,914.0 |
| Subject all fringe benefits to the 20% entity-level tax on distributed profits and payroll taxes | $26.1 | $26.6 | $27.6 | $31.9 | $34.6 | $35.8 | $37.0 | $38.3 | $39.6 | $41.1 | $338.6 |
| Estate Tax, Gift Tax, and Step-up in Basis Provisions | |||||||||||
| Repeal estate tax and gift taxes | -$20.0 | -$21.0 | -$22.0 | -$23.0 | -$34.0 | -$38.0 | -$41.0 | -$44.0 | -$48.0 | -$51.0 | -$342.0 |
| Set zero basis for inherited assets | $11.7 | $12.0 | $12.2 | $12.5 | $12.4 | $13.4 | $13.6 | $14.2 | $14.8 | $15.6 | $132.3 |
| Total Conventional Revenue | $184.2 | $204.2 | $217.2 | -$38.3 | -$50.0 | -$36.6 | -$36.5 | -$35.5 | -$35.3 | -$39.6 | $333.8 |
| Total Dynamic Revenue | $90.8 | $121.2 | $143.8 | -$52.4 | -$56.2 | -$33.5 | -$23.8 | -$14.0 | -$3.9 | $0.9 | $173.0 |
Source: Tax Foundation General Equilibrium Model, February 2023. *Note: “Eliminate most individual tax expenditures” includes the repeal of the state and local tax deduction (SALT), the charitable contribution deduction, the mortgage interest deduction, the exclusion for capital gains on principal residences, and the exemption for municipal bond interest. Also includes smaller items like the deduction or interest on student loans, credits for post-secondary education tuition, renewable energy tax credits, the exclusion for credit union income and the exclusion of capital gains tax for small corporate stock. |
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The expanded standard deduction and the personal exemption reduce revenue by $3.9 trillion and $1.1 trillion over 10 years, providing large tax cuts for individuals. The repeal of the Net Investment Income Tax (NIIT) and the Alternative Minimum Tax (AMT) also reduce revenue by about $1.1 trillion.
Tax collections from C corporations and pass-through firms would fall by about $364 billion over 10 years, a result that includes an offsetting effect of higher capital gains revenue due to higher retained earnings increasing the value of firms.
Eliminating most individual tax expenditures, taxing employer-sponsored health insurance and fringe benefits, and moving to a 20 percent flat tax on ordinary income raise a combined $8.3 trillion in the budget window, largely offsetting the reductions in revenue.
The plan would slightly increase the debt-to-GDP ratio by 2063 from 249.6 percent to 251.4 percent on a conventional basis, costing about $2 trillion over the next 40 years after interest costs.
On a dynamic basis, a larger economy and the resulting net revenue increase would reduce the debt-to-GDP ratio from 249.6 percent to 243.7 percent in 2063, a difference of 5.9 percentage points.
Distributional Effects
Normally, the change would raise the average income after taxes by about 0.3% over the long term. The bottom quintile's after-tax income would go up by 0.7%, and the second quintile's would go up by 1.1%. This is partly because the standard deduction, personal exemption, and lifetime Child Tax Credit were all raised.
The reform's "base broadeners" would cause people in the middle and high middle quintiles to have less money after taxes. The after-tax income of the top 1 percent of earners would go up by 15.9 percent.
On a long-term, dynamic basis, the larger economy increases after-tax incomes compared to the traditional analysis, leading to an average after-tax income rise of 2.1%. The income of the bottom quintile goes up by 2.7%, while the income of the second quintile goes up by 3%. Compared to what most people think, the middle and high middle quintiles have less of a drop in their incomes after taxes.
Even though average incomes go up after taxes, tax cuts for one group of taxpayers have to be paid for by tax hikes for another group of taxpayers for any change to be revenue neutral. Changing different parts could lead to different distributional effects.
| Income Group | Conventional, Long-Run | Dynamic, Long-Run |
|---|---|---|
| 0% to 20% | 0.7% | 2.7% |
| 20% to 40% | 1.1% | 3.0% |
| 40% to 60% | -2.7% | -1.0% |
| 60% to 80% | -4.5% | -2.7% |
| 80% to 90% | -4.2% | -2.3% |
| 90% to 95% | -3.5% | -1.5% |
| 95% to 99% | 2.1% | 4.3% |
| 99% to 100% | 15.9% | 18.2% |
| Total | 0.3% | 2.1% |
Source: Tax Foundation General Equilibrium Model, February 2023. |
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Modeling Notes
The modeling results are compared to a baseline set by the law before the Inflation Reduction Act went into effect in 2023. The Inflation Reduction Act includes a new book minimum tax, a tax on stock buybacks, and benefits for green energy. As we saw in our earlier study of the bill, rolling back these policies would have more effects on the economy, the budget, and how the tax burden is shared.
We used data from the National Income and Product Accounts (NIPA) on company and pass-through business profits to figure out the tax base. This helped us figure out how the 20% distributed profits tax would affect tax revenue. One important assumption is about how much of their income businesses will keep after the new entity-level tax. Based on past averages from NIPA, we assume that, under the current law, companies get to keep 50% of their profits. Estimates of the effects of Estonia's distributed profits tax, which replaced a corporate income tax similar to ours, show that kept earnings went up by about 11 percentage points as a result of the change. The change was bigger for small businesses. We assume that after the change, the share of profits that U.S. companies keep will go up by 10 percentage points, from 50% to 60%. This means that the distributed profits tax will bring in less money.
But as firms keep more of their earnings, their value goes up. This means that capital gains and tax income from capital gains also go up. The real tax rate on capital gains is much lower than 20% because it takes into account things like deferral and the amount of assets owned by foreigners and in tax-free accounts. The effect of delay is lessened by getting rid of the step-up in basis.
We used the tax expenditure estimates from the Treasury Department, the HI benefit amounts from the Bureau of Economic Analysis, and the distributional analysis from the Congressional Budget Office to figure out how getting rid of the exclusion for employer-sponsored health insurance (HI) would affect tax revenue and how people would pay for health care. Then, we calculated the HI benefit as a percentage of salaries and added it as an extra source of income to our models of individual income items and the taxes that apply to them during the budget window. We also included it in our economic and distributional analyses. We assume that, as a result of the change, firms will move away from health insurance and other perks and toward cash compensation, so that by the 10th year, all compensation will be in cash.
Other than HI, other fringe benefits aren't very big, so our figures only take into account the income tax exclusion under current law.
We figure out how the business rules will affect the economy by changing the way the service price of capital is calculated for the business sector. In Estonia, business gains are not taxed until they are given out. There is no extra tax that shareholders have to pay on profits. Capital gains from selling shares are treated the same way as other income. Interest payments are not taken into account (there is no deduction or tax), but interest income is treated as regular income for the person who owns the bond.
The service price of capital is the weighted average of two types of financing: debt and stock. Then, the equity is split again, with 60% of the earnings being kept and 40% being given to the owners.
The real discount rate of the company is used to figure out the price of the service. The company's discount rate is equal to the expected after-tax rate of return, r, plus any taxes that the company or its owners have to pay. For profits that are shared: r/(1-t_w), where t_w is the tax on profits that are shared. For retained earnings: r/(1-t_cg), where t_cg is the effective capital gains tax rate, adjusted for deferral and the share of assets owned by foreigners and in tax-free accounts. For debt: r/(1-t_i), where t_i is the effective tax rate on interest income, adjusted for assets owned by foreigners. Then, the price of the simulated service is worked out in the same way as our current model, but with a new discount rate and a new net present value of depreciation allowed because there is no income tax.
In the change, all businesses are treated the same. So, the price of the service is the same for both businesses that are corporations and those that are not.
We haven't tried to model how the reform will change how companies act when it comes to moving income or economic activity across borders. It's possible that a lot of multinational companies would like the reform, which would lead to a lot of onshoring or reshoring of operations and profits from other countries over time. But because this effect of a spread profits tax hasn't been studied in the real world, we didn't count it in the results.
The authors would like to thank Kyle Pomerleau, Stephen J. Entin, and Gary Robbins for their contributions.
