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Yesterday, we presented data showing that the United States’ tax code is among the most progressive in the OECD when we compare Federal-level taxes, and an average value for state taxes. However, state income tax structures within the United States have just as much variation, in terms of progressivity, as OECD nations' income tax structures. We find that, using the same measure for the states as was used for the OECD, New York and California have tax codes more progressive than any OECD nation, even France or Portugal. Meanwhile, on the other end of the spectrum, 31 states have income taxes that would rank alongside the three least progressive income tax codes in the OECD. Five US states have income tax codes that are more progressive than the US federal tax code.Progressivity and Top Marginal Rates of State Income Taxes, 2014 State Rank Multiple of Average Earnings at which the Top State Income Tax Rate Applies Rank Difference Between Top Income Tax Rate and Marginal Rate on $25,000 of Taxable Income Top State Individual Income Tax Rate
District of Columbia
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
No Income Tax
* Income reflects May 2013 Bureau of Labor Statistics average earnings
* Tax rate and bracket information taken from here.
For a tax to be progressive, the average tax rate paid by an individual increases as their income increases. A flat tax, on the other hand, gives all taxpayers the same average tax rate regardless of income, while a regressive income tax would give taxpayers lower average tax rates as their incomes increase.
There are many ways to measure tax progressivity, especially when comparing effective rates. There is debate about what income measure should be used as a base, which deductions should be included in the comparison, and many other factors. At the state level, even very progressive tax systems can appear otherwise because of interactions with federal tax policies that redefine taxable income for states or allow deductions of state taxes, while state policies that allow federal taxes to be deducted also have major effects. Furthermore, many states offer a variety of credits and deductions that alter tax burdens, making the tax code more or less progressive.
Moreover, some states have a top rate that kicks in at a high threshold, but which isn’t very different from lower rates. Thus, a second way to measure tax progressivity is to measure the difference between top marginal tax rates, and some lower tax rate. The above table also shows the gap between the top marginal tax rate and the marginal tax rate on $25,000 of taxable income.
As can be seen, the list is similar, but not identical. Twenty-one states and the District of Columbia have progressive rate structures that rise after $25,000. California, New Jersey, and Vermont have the most progressive rate structures by a wide margin.
Policymakers may believe that more progressive rate structures will reduce inequality, however, there is relatively little evidence of this. In fact, states with more progressive tax codes have higher inequality, on average, than states with flat or no income taxes. Academic research by Raj Chetty and Emmanuel Saez (of Piketty and Saez fame) found that the progressivity of a state’s income tax had no significant correlation with upward mobility (though greater reliance on property taxes to fund local government apparently did increase economic mobility). Thus, policymakers may be adopting high tax rates that do real economic harm while doing little to encourage equality and upward mobility.
Read more on inequality here.
Read more on income taxes here.
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The Obama Administration announced this week that it would clamp down on corporate inversions by altering existing regulations dictating the treatment of foreign earnings and foreign controlled corporations.
These rule changes will seek to reduce the incentive for a company to invert by reducing its financial benefit.
These rule changes will undoubtedly reduce the incentive to invert. However, the rule changes are equivalent to giving a patient with pneumonia cough syrup: it treats the symptom, not the disease. The real problem of inversions is the uncompetitive nature of our tax code. Even more, a true reform that would move to a territorial system would make these rule changes unnecessary and would make inversions a non-issue.
What These Rule Changes Do
These rule changes have a few specific goals:
(1) Make it more difficult to invert
The first set of rule changes make it harder to invert in the first place. Under Section 7874, a U.S. corporation can invert (become a foreign corporation) when the foreign corporation owns at least 21 percent of the new combined foreign corporation. The rule change would disregard certain passive assets in this calculation. This means that it will be harder for a foreign company to reach the 21 percent threshold.
As part of this, Treasury will also make it harder for a corporation to meet the above threshold by preventing them from paying out large dividends in advance of an inversion to reduce its size. These dividend payments will be disregarded before applying the 21 percent ownership test.
(2) Prevent “Hopscotching” or transfers of property
The second change redefines certain transactions between an inverted firm and another foreign firm to be taxable under U.S. law.
Under current law, the United States taxes any foreign corporate income that is repatriated (brought back) to the United States as a dividend payment. For example, if a U.S. corporation earns $100 in a foreign country and then moves that money back to the United States, it triggers a U.S. tax liability. However, if that income remains outside of the United States and is reinvested in ongoing activities, tax is deferred.
In order to prevent possible circumvention of U.S. tax liability, the U.S. also deems payments for stocks or loans to the parent company as repatriated income. For example, a foreign subsidiary may purchase $100 of stock from the U.S. parent. $100 goes to the U.S. parent and the U.S. treats that as a taxable dividend.
When the U.S. parent inverts and becomes a foreign company, it no longer has to worry about the rule dictating loans and stock purchases because the income remains outside of the United States. It goes from one foreign country to another foreign country, never triggering U.S. tax liability.
This rule change will make these foreign-to-foreign transactions taxable as if they were dividends paid from a foreign corporation to a U.S. corporate parent.
(3) Prevent “de-controlling”
As stated, the income of foreign controlled corporations are taxable once it is paid to the parent corporation in the form of a dividend. However, if the corporation is not deemed “controlled” it is not liable as it is not considered part of a U.S. corporation.
When a corporation inverts and creates a foreign parent, it is possible for the U.S. corporation to transfer ownership of the foreign controlled corporation to the new foreign parent. At this point, the foreign corporation is no longer controlled and thus no longer liable for U.S. taxes on its income.
This rule change will prevent this. A transferred controlled foreign corporation would still be considered controlled by a U.S. corporation for tax purposes.
The Rule Changes do Not Address the Fundamental Problems with the Tax Code
None of the above rule changes address the underlying incentives to invert. The real problem is the U.S.’s worldwide corporate income tax system and its high corporate income tax rate.
As global operations become an increasingly important aspect of business, multinational corporations are under increasing pressure to lower their overall tax burden. There are two specific problems with the current U.S. corporate income tax that corporations are attempting to overcome through re-incorporation transactions:
The United States corporate income tax rate, 35 percent (39.1 percent combined with state rates) on corporate income, is relatively high by international standards. The U.S. corporate income tax rate is the highest rate among the 34 countries of the Organization for Economic Cooperation and Development (OECD). The fact that inversions have been accelerating reflects the fact that the U.S. is actually falling farther behind as time as gone on.
The second reason, is that the United States taxes domestic companies on their world-wide income, while most other countries tax their domestic companies only on domestically-earned income. This means that U.S. companies face a marginal tax rate of at least 35 percent on every dollar earned whether earned domestically or abroad, while their competitors do not.
Rule Changes are not Compatible with Fundamental Tax Reform
These rule changes not only fail to address the real issue with the U.S. tax code, they move our tax system in the wrong direction. Any fundamental tax reform that would improve the U.S. tax code would move to a territorial tax system. This system would exempt the foreign earnings of U.S. corporations from U.S. taxes. No longer would the Treasury need to concern itself with inversions, or when or how foreign earnings were brought back into the United States.
Read more about inversions here
The Nevada Supreme Court recently held that the 2004 Live Entertainment Tax (LET) does not constitute a violation of strip clubs’ rights to freedom of speech under the First Amendment. While the plaintiffs, comprising a group of Nevada strip clubs, claimed the excise tax was discriminatory in nature, the court – despite the numerous exemptions provided to other sub-industries in the live entertainment space – ruled it constitutional.
The LET is an excise tax levied on admissions, snacks, drinks, and merchandise in the live entertainment sector. The tax rate varies, however, depending on the size of the facility hosting the event. If the occupancy capacity of the facility hosting the event is less than 7500, the applicable tax rate is 10 percent, versus five percent if the capacity is greater than or equal to 7500. A strip club, thus, falls under the 10 percent tax rate (For more details on the LET and further background on the Nevada Supreme Court hearing of this case, see our previous blog post).
The LET has caused significant contention within the live entertainment sector, the key reason being the exempt status many sub-industries, like NASCAR racing, live ambient music, and even the Burning Man festival, enjoy. The initial intention of state legislators was to enact a clean, broad-based tax. However, with the many exemptions in place, it is not surprising that contention has arisen.
In the Nevada case, Deja Vu Showgirls of Las Vegas, LLC v. Nevada Dep't of Taxation, the plaintiffs argued the LET unconstitutional based on the following key points:Freedom of expression is subject to violation; A specific form of speech is explicitly being limited, meaning adult entertainment; Numerous exemptions granted to sub-industries in the live entertainment sector make the tax no longer broad-based, specifically targeting adult entertainment; The tax is content-based, requiring taxpayers to reveal in which form of speech they participate.
However, the Nevada Supreme Court disagreed, stating that the tax does not inhibit freedom of expression; and, moreover, argued that the LET is broadly applicable, does not target the people who are actually exercising the right to freedom of expression (in this case, the stripper), and is not specifically directed toward adult entertainment.
This case is not the only legal process pertaining to taxation of strip clubs. A related ruling occurred in Texas, where a “pole tax,” a $5 per-patron admission fee at strip clubs, was at first deemed unconstitutional, but later revoked by the Texas Third Court of Appeals in May 2014.
Regardless of whether these state-levied taxes are unconstitutional, the key consideration is if this tax effectively raises revenues in a way that minimizes economic harm, given its relatively narrow base. Tax structures with a broad base and low rates are fundamental to a robust tax policy. A narrow tax base, on the contrary, can stir speculation with respect to the use of a tax as a political instrument to disfavor a specific group, as in the case of strip clubs in Nevada. This is as true of narrow tax privileges (like Nevada’s recent mega-deal with Tesla) as of narrow excise taxes. Ultimately, the purpose of the tax code is not to enable policymakers to pick favorites or make social policy, but to raise revenue with minimal economic distortions. On that test, regardless of its constitutionality, Nevada’s “stripper tax,” like many excise taxes, doesn’t perform very well.
Read more on Nevada here.
Read more on excise taxes here.
On the individual side, the Rubio and Lee tax reform plan includes two individual tax rates (at 15 percent and 35 percent), eliminates most deductions, and eliminate the marriage penalty. It also adds an additional $2,500 on top of the existing $1,000 child tax credit.
On the business side, the plan would lower the corporate tax rate, moves to full expensing, and shifts to a territorial tax system.
While our previous work finds that the economy would actually grow if we eliminated the child tax credit (this is due to high marginal tax rates from the phase out of the credit), the business-side tax provisions in the Rubio-Lee reform proposal contain the key components of a pro-growth tax code.
Cut the Corporate Tax Rate and Move to Full Expensing
Rubio and Lee propose a cut in the corporate tax rate and a move to full expensing.
Currently, the U.S. has the highest corporate tax rate in the developed world at 39.1 percent. This rate makes us highly uncompetitive internationally, but it also makes it expensive to invest at home.
Additionally, the current tax code requires businesses to write-off investments in capital (i.e. the tools we use to work, such as computers, tractors, manufacturing equipment, etc.) over multiple years, and even decades. Due to the time value of money and inflation, businesses are unable to fully account for the cost of these investment. This leads businesses to understate costs and overpay in taxes.
Full expensing fixes this issue by correctly defining business income. Under full expensing, businesses can claim 100 percent of business costs in the year in which the costs occur.
A lower corporate tax rate and a move to full expensing would grow the economy, increase wages, and create jobs.
Shift to Territorial
Currently, the U.S. is one of six developed countries with a worldwide system of taxation. This means that no matter where in the world a corporation earns income, it is subject to the U.S. high corporate tax rate once it brings that income back to the United States. This system places U.S. businesses at a competitive disadvantage with foreign businesses and is a major driver in the recent string of corporate inversions.
The Rubio-Lee plan would move to a territorial tax system:
“We will also propose that businesses only be taxed in the country where income is actually earned, rather than double-taxed when the money is brought back home. The way to reverse corporate inversions and bring capital in off the sidelines isn't to punish companies for obeying outmoded laws, but to change those laws to make America once again the best place in the world to pursue happiness and earn success.”
Growing the Economy
Each of the three key components of the business-side of Rubio and Lee’s tax reform plan—a lower rate, full expensing, and territorial taxation—are crucial pieces of a pro-growth tax code. If implemented, these provisions would boost investment, grow the economy, and lead to more jobs with higher wages.
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A defining characteristic of an individual income tax system is its degree of progressivity. The United States has a rather progressive income tax. This means that the average tax rate paid by an individual increases as their income increases. Contrast this with a flat income tax, which all taxpayers have the same average tax rate regardless of income or a regressive income tax, which taxpayers pay declining average tax rates as their income increases.
Most countries maintain progressivity in their individual income tax through marginal tax rate structures. These structures tax each subsequent bracket of taxable income at progressively higher rates. The United States’ income tax rates range from a low of 10 percent to a high of 39.6 percent. For example, a taxpayer with $40,000 of taxable income would be taxed on the first $9,075 at 10 percent, the next $27,000 at 15 percent, and the remaining $4,000 at 25 percent.
2014 Taxable Income Brackets and Rates
$0 to $9,075
$9,076 to $36,900
$36,901 to $89,350
$89,351 to $186,350
$186,351 to $405,100
$405,101 to 406,750
States also have income taxes with varying degrees of progressivity and rates. On average, the top rate for a taxpayer in the United States tops out at about 46 percent.
The result is that as an individual’s income increases, so too does their average tax rate.
But how progressive is the U.S.’s tax code? One way to measure and compare the progressivity of income tax codes across countries is to express the level of income at which each country’s top tax bracket applies as a multiple of that country’s average income.
For example the United States’ top marginal income tax (state and federal combined) rate of 46 percent applies to a bracket of income over $406,751, or approximately 8.5 times the average income in the United States of $48,000. Very few people earn enough to face this top rate, creating a very narrow tax base. The higher the multiple, the more progressive and narrower the income tax base.
According to this measure, the United States has one of the more progressive income taxes in the OECD (8th of 34 OECD countries). Portugal has the most progressive income tax, with a top rate that applies at 16.2 times the average income, followed by France (15.1 times) and Chile (12.8 times).
Hungary has a flat tax, which means that the top rate (their only rate) applies at 0 times the average income, or on the first dollar. Estonia and Czech Republic have nearly flat income tax codes (top rates that apply at 0.2 and 0.4 times the average income in each country).
Progressivity and Top Marginal Rates of OECD Ordinary Income Taxes, 2013
Multiple of Average Income at which the Top Income Tax Rate Applies
Top Individual Income Tax Rate (National and Subnational)
One of the more interesting income tax codes is Sweden. Sweden is usually thought of as having a very progressive income tax that emphasizes redistribution. However, according to this measure, Sweden’s top rate is not narrowly targeted on a small group of high income earners. Rather, Sweden applies its high income tax rate to a large number of taxpayers. The top rate applies at 1.5 times the average income.
What would Sweden’s income tax system look like in the United States? The United States would have a top rate of about 56 percent (10 percentage points higher than it is currently). However, this top rate would apply at $84,365—a much lower level than our current top rate that applies at $406,751. This would be a significant base broadening for the income tax and a significant tax increase for many individuals.
Swedish Taxable Income Brackets and Rates (U.S. Dollars)
Municipal Rate Average
$0 to $58,912
$58,913 to $84,364
This is something to keep in mind when comparing tax revenue as a percent of GDP across countries: yes Sweden raises a lot more revenue than the United States (44.3 percent of GDP vs. 24.2 percent of GDP in 2012), but it does this with a significantly broader income tax base, not a significantly more progressive one.
Research in the field of economic development has widely recognized that entrepreneurship and new firm formation play an important role in promoting job creation and economic growth. According to a report released by Kauffman Foundation in 2011, nearly all net job creation in the United States occurred in firms less than five years old during the period of 1980-2005.
Using more recently available data from the Census Bureau Business Dynamics Statistics and Longitudinal Business Database which providing information on firm births, deaths, and employment size, it is confirmed that startups contribute significantly to both gross and net job creation.
While firms that are over 10 years old and have more than 500 hundred workers account for around 45 percent of all jobs in the private sector, they account for just under 40 percent of job creation and destruction. In huge contrast, business startups account for only 3 percent of total employment but almost 20 percent of gross job creation.
What Role Do Taxes Play in Entrepreneurial Activity?
Entrepreneurship involves risk taking. Before they decide which risk to take, entrepreneurs consider the tax cost between marginal tax rates for wage earnings, capital gains, and corporate income. The potential after tax return on their investment in time or money guides their decision. Is an entrepreneur going to keep his or her current wage job? Or invest in financial markets? Or start a business?
The current tax code influences this decision due to its non-neutral treatment of saving and investment. A pro-growth tax code eliminates any distortion of business decisions.
Complexity Deters Business Creation
The complexity of the tax code and the administrative burden of tax compliance deters entrepreneurs from engaging in innovative activities. Empirical research by Swedish scholars found that tax complexity has a negative effect on new firm formation across 118 countries.
In today’s world, international entrepreneurs have the opportunity to compare tax codes and rules across different countries and select the country with the more beneficial and friendly tax system to maximize their after-tax profits. If the United States—with a tax code ranked 32nd out of 34 OECD countries—hopes to compete for entrepreneurship, it will need to takes steps to simplify and reform its tax code.
A new bill from Representative Scott Peters of California would exempt some small businesses from quarterly tax payments. Currently, most businesses must send quarterly returns based on estimated tax to the IRS. This is a prudent piece of legislation that will reduce administrative costs and promote some growth, with virtually no downside.
The bill makes no change to actual tax owed. Instead, it just exempts small businesses from reporting to the IRS on a quarterly basis. Estimated tax for businesses is similar to what withholding does for workers; tax is paid in installments throughout the year rather than all at once on April 15. This works out well for taxpayers who have smooth, predictable cash flows, like mature businesses or salaried workers.
New businesses do not have that kind of certainty. They will have unforeseen expenses, or unexpected bulk orders, or other surprise events that change their taxable income considerably. It is unreasonable to base policy on asking people to predict the unpredictable.
Furthermore, detailed and complex accounting requirements are most wasteful when applied to small businesses. The costs of completing forms do not scale linearly with the size of a business; instead, the burden of complexity is much tougher for smaller firms to bear.
A good principle in tax policy – as well as policy in general – is to let the little things go. This principle has taken form in a legal maxim, de minimis non curat lex, Latin for “the law does not concern itself with trifles.” Currently, any business expected to owe at least $1,000 in tax for the year must file quarterly. $1,000 is a trifling amount to the IRS, one that need not be split into installment payments.
The Peters bill would allow very new businesses, or businesses with less than $1 million in total revenues, to file their taxes only once yearly – an arrangement that seems more reasonable.
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The Tax Foundation’s International Tax Competitiveness Index ranks the United States tax code 32nd out of 34 OECD countries. An obvious question to ask, then, is why the U.S. remains so wealthy, and so successful at creating new businesses.
A report from Harvard Business School – a survey on U.S. competitiveness – helps answer this question. The HBS alumni, like Tax Foundation, evaluated the U.S. tax code as very uncompetitive. However, on several other dimensions, like higher education and innovation, the U.S. excelled:
In other words, the U.S. is indeed a wealthy and competitive country. But it is wealthy and competitive despite its tax code, not because of it.
Taxes certainly do matter: France, Portugal, Italy, and Spain - the least tax-competitive countries in Europe in our Index, have struggled a great deal to emerge from the recession; France and Italy have recorded two consecutive years of negative GDP growth, Portugal has recorded three, and Spain has had six. In contrast, Estonia, Switzerland and Sweden – the top three European nations – have consistently recorded positive GDP growth every year since the end of the recession.
But taxes are not the only thing that matter. The American economy has fared much better than the economies of other countries with poor tax competitiveness. That is where the other, more positive elements of the Harvard Business School report become more important. The U.S. has flexible labor markets, and it reliably leads the world in technology, higher education, and innovation.
Simply put, while assessments of the U.S. tax code – both at Tax Foundation and elsewhere – are bleak, there is much to be optimistic about in America. We are a smart nation in need of a smarter tax code.
Representative Chris Van Hollen (D-MD) has introduced a bill called the “CEO-Employee Pay Fairness Act.” This bill would prevent a corporation from deducting the cost of compensating CEOs if the corporation did not raise the wages of all employees that earned less than $115,000 by a specific formula based on inflation and productivity growth.
In his press release, he argues that the current tax code subsidizes CEO pay by “allow[ing] corporation[s] to deduct unlimited amounts of “performance-based” pay for executives regardless of whether their employees’ wages increase.”
This is a mischaracterization of a tax deduction and how the current tax code works. In fact, the current tax code limits the deduction for executive compensation, rather than subsidizes it.
The corporate income tax is a tax on corporate profits. The 39.1 percent corporate tax rate should apply to a corporation’s revenues, minus its costs. A large part of these costs to a corporation is its labor compensation for both typical workers and executives. For example, if a company has sales of $100, but spends $50 in labor compensation, the company’s profits are $50. The tax is applied to that.
A subsidy in this case would be a deduction that is larger than the actual cost of labor compensation. This would drive down taxable income and taxes paid, while the company’s true pre-tax profits would remain the same. Current law is not a subsidy.
In fact, current law goes in the opposite direction. Congress has previously limited the amount of compensation company can deduct for CEOs. Section 162(m) disallows any deduction for executive compensation that surpasses $1 million. The only exception is for performance-based pay: a company can deduct stock options that exceed the $1 million threshold.
What this means is that companies that pay executives more than $1 million in non-performance-based pay actually overstate their taxable income and pay taxes on more than their true pre-tax profits.
Representative Van Hollen’s bill would further limit the deduction by applying it to performance-based pay, pushing current law further from being a subsidy and even further from being neutral.
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