What is the problem with the American tax system? Taxpayers grumble about a variety of things, depending on their point of view. However, Pew Research Center polls repeatedly show that the majority of people are concerned that certain firms and rich individuals are not paying their fair amount. They feel that the tax system often causes low- and middle-income persons to pay a larger proportion of their income in taxes than higher-income individuals.
Despite these reservations, an IRS study released in November 2020 found that 94% of Americans feel it is “every American’s civic obligation to pay their fair share of taxes.” Although the majority of taxpayers are satisfied with the IRS’s performance, sentiments differ depending on age and education level. By 2021, taxpayer confidence and satisfaction with the IRS had decreased.
Some of the variation is due to political party connections. Republicans’ and Democrats’ perspectives have varied, with Democrats becoming more suspicious and Republicans becoming more optimistic, particularly after the 2017 individual and corporate tax cuts.
The newly passed Inflation Reduction Act (IRA) contains a new 15% alternative corporate minimum tax on company book earnings, which represents a substantial effort to combat tax evasion by some of the wealthiest firms. The IRA also provided the IRS with $80 billion in fresh funds over the next ten years to restore employee levels that had been substantially reduced for more than a decade, improve customer service, and strengthen enforcement.
However, the enactment of the IRA with the backing of all Congressional Democrats in the face of Republican opposition demonstrates the complexity of combatting tax evasion. Opponents of the IRS budget increase, for example, fear that it would promote greater and aggressive, even threatening, IRS audits of regular taxpayers. President Biden, on the other hand, has emphasized—and Treasury Secretary Janet Yellen has advised the IRS—that the law and its implementation should not raise taxes on families earning less than $400,000. The IRA originally included a statutory provision addressing protection for those with earnings less than $400,000, but it was removed after the Senate Parliamentarian declared that such a provision could not be established under the legislative Reconciliation process used to pass the IRA.
Although most taxpayers recognize that some form and level of taxation are required to fund the government, differing views on the appropriate size of government and its funding level, the optimal structure of a tax system, the system’s effective rates, and the impact on different groups and interests contribute to an extensive debate that would necessitate a tome to evaluate. Individuals and organizations will, predictably, try to utilize tax regulations to their advantage once they are in place. What matters is that we examine the uneven effect of those regulations, as well as who benefits and who does not.
As a result, this paper concentrates exclusively on the present U.S. income tax structure, emphasizing aspects and implications that create concerns for both taxpayers and politicians. (It does not address excise taxes, which apply to particular items and activities.)
- Taxpayers in the United States generally feel that all firms and people should pay their fair share of taxes, although many believe that some corporations and the rich pay too little.
- Low rates on investment gains and deductions to offset unrelated income are among the rules that enable higher-income persons to pay lower tax rates than middle- and lower-income taxpayers.
- Concerns about major firms paying little or no taxes prompted the establishment of a new 15% alternative corporate minimum tax on the book earnings of large corporations.
- Many rich people may use sophisticated tax planning to reduce or even eliminate estate and gift taxes.
Unfair Distribution of the Tax Burden
Most Americans believe that an income tax system that applies graded, higher rates to higher levels of income—commonly referred to as “progressive”—is fair. However, opponents today worry that the national tax burden is not appropriately graded based on income level among people and between individuals and enterprises, especially major multinational firms. News revelations about big firms not paying income taxes, as well as allegations that former President Trump paid very little income taxes for decades, eroded people’ trust in the system. The newly implemented alternative corporate minimum tax was created to combat tax evasion by wealthy firms.
Those people object to a system that often levies higher effective income tax rates on middle- and lower-income persons than on many with higher incomes and permits some higher-income taxpayers to escape paying completely. From this vantage point, a sizable proportion of US taxpayers believe the US tax system is unjust.
Some tax incentives are widely seen as reasonable, though not required. To arrive at an economically realistic computation of income, generally accepted allowances include the deduction of “ordinary and essential” company expenditures. Individuals also support the basic deduction, itemized deductions for medical expenditures, charitable donations, mortgage interest, certain losses, and refundable tax credits.
The provision in the tax law that exempts those with modest earnings from income tax (for 2022, below $10,275 for singles and $20,550 for married couples) is deemed reasonable and fair. Furthermore, exempting these individuals lowers administrative costs by avoiding the cost of processing a large number of tax returns that are unlikely to generate income.
Individual and corporate income taxes, payroll taxes, excise taxes, inheritance and gift taxes, and generation-skipping transfer taxes are all part of the Internal Revenue Code (IRC). However, much of the criticism has centered on the broad-based individual and corporate income taxes. There is understandably little passion for paying taxes. Nonetheless, issues about fairness, rather than the actual dollar amount of tax payments, presently create the majority of complaints—possibly a tacit acknowledgement of the tax law’s current rates, which are quite mild in comparison to significantly higher rates in the past.
Concerns emerged not just about the fairness but also about the efficacy and appropriateness of the tax system and its administration as budget deficits worsened, starting in 2018 when large tax cuts lowered tax revenues—a trend exacerbated since the COVID-19 epidemic harmed the economy.
Let’s look at some of these issues in more detail.
Higher Benefits for Higher Tax Brackets
Although the United States tax law raises marginal tax rates on taxable income as taxable income brackets climb (the structure of a progressive tax system), graduated rates and brackets aren’t the main driving factor. Progressivity is thwarted by:
- Exemptions and exclusions for certain categories of income, such as tax-free interest on state and local government bonds
- Some income categories, such as capital gains and dividends, have special, reduced rates.
- Deductions for a broad variety of costs, including some significant business expense allowances
Such changes, referred to collectively as “deductions” in the future for convenience, might result in lower effective tax rates on the earnings of certain extremely high-income persons than on considerably lower incomes. These deductions may occasionally help taxpayers with extraordinarily high incomes and investment returns avoid paying taxes.
Deductions vs. credits
Deductions that result in reduced taxable income benefit taxpayers regressively rather than progressively. In most cases, the tax advantage for such products is equal to the amount of the decrease multiplied by the taxpayer’s marginal tax rate. Thus, if an individual taxpayer’s income is in the highest 37% tax band, each $100 decrease in income that would otherwise be taxed at this rate saves the taxpayer $37. If the appropriate rate is 24%, a $100 decrease in income would result in a savings of just $24.
This provision for larger tax savings for higher-income individuals contrasts with the savings from a tax credit. A 20% tax credit saves all taxpayers $20 in tax obligation for every $100 spent, regardless of income level or tax category. However, unless the credit is refundable, if the amount of the credit exceeds the person’s tax bill, the taxpayer will not get the whole $20 savings. Many tax deductions are non-refundable.
Corporate tax avoidance
Currently, the tax code imposes a 21% corporate income tax. Many U.S. firms, on the other hand, pay considerably lower effective rates—or no tax at all—due to significant business write-offs, loss carrybacks and carryforwards, sophisticated tax planning, and, if audited, persistent and prolonged bargaining. While some question the existence of any corporation tax structure, others question the appropriateness and quantity of corporate tax advantages, especially those obtained by politically powerful sectors.
Alternative minimum tax limitations
Corporate and individual alternative minimum tax (AMT) laws have been implemented throughout the years to guarantee that taxpayers with high income but significant deductions and other tax benefits pay at least some taxes. The AMT was then removed for all C companies by the Tax Cuts and Jobs Act of 2017. It also enhanced the exemption level and exemption phaseout under the individual AMT, resulting in fewer individual taxpayers being subject to the AMT now than before 2018.
The minimum tax requirements were never totally effective in guaranteeing that all taxpayers were taxed. These legislation mostly failed because they were based on tax law principles and definitions of income rather than economic or financial norms. Recognizing the limits of previous regulations, the newly approved alternative corporate minimum tax of 15% applies to the “book” revenue that firms declare on their financial income statements for tax years starting after December 31, 2022.
If a corporation’s minimum tax obligation exceeds its normal corporate income tax due, it is liable to this “alternative” minimum tax rather than the standard 21% corporate income tax. However, the new law’s applicability is restricted since it only applies to firms with three-year annual average financial statement earnings of more than $1 billion.
Preferential Rules for Investment Returns and Business Losses
Lower rates for investment returns and some corporation tax write-offs are other contentious issues.
Capital gains and dividends
Capital gains and dividends have special low rates that allow taxpayers with strong investment returns to pay effective rates much below those applicable to regular income, such as salaries, wages, or interest. Warren Buffett, whose income is mostly made of investment profits, famously said that the tax code should not enable him to pay a lower tax rate than his receptionist.
These lower rates spark criticism because they make the system less progressive and weaken ideas of fairness. Critics dispute the need of the restrictions as well as the magnitude of the advantages. However, supporters of these advantages feel that they stimulate good economic investment.
The contentious carried interest law, which favors some investment professionals, notably managers of private equity and hedge funds, exemplifies the difficulties of resolving fairness problems. It permits them to pay just a 20% gains tax plus a 3.8% investment tax on their gains, at a total rate that is lower than regular income taxes, which may reach 37%. Attempts to repeal this unique treatment in the IRA were unsuccessful, with the exception that the holding time for carried interest advantages was increased from three to five years.
Certain business losses
Individuals who significantly participate in a trade or business conducted directly or via a pass-through organization, or who engage in a real estate business as a real estate professional, may utilize losses from such operations to offset profits or investment income from other activities. The regulations allowing active participants (e.g., real estate professionals) to claim current, carryback, and carryforward deductions for such losses allow qualifying taxpayers to claim significant write-offs that decrease or even eliminate their entire net taxable income.
Questions About Non-Income Taxes
Aside from income tax, the tax legislation levies payroll taxes, as well as inheritance and gift taxes. Although less addressed than income taxes, several of these levies raise difficulties comparable to those raised by income taxes.
Payroll taxes to finance Social Security benefits are levied at a rate of 6.2% on wages paid by both the employer and the employee, and 12.4% on self-employment earnings up to $147,000 in 2022. Furthermore, the Medicare tax of 1.45% applies to covered earnings with no wage ceiling (the tax is 2.9% for self-employed individuals).
These taxes are “regressive” since they are levied at flat rates regardless of income level. These taxes apply to all earnings; there are no exemptions or zero-rate levels. As a result, these taxes represent a significant burden for persons with modest earnings.
Some officials favor implementing the Social Security tax at higher income levels, as the Medicare tax currently does, or expanding it to unearned income. However, policy debates often evaluate the necessity to sustain trust funds against the danger that greater taxes on companies may harm employment levels.
Estate and gift taxes
Estate and gift taxes affect a tiny percentage of the population and hence do not elicit the same level of attention or concern as income taxation. In 2022, the estate tax exemption is $12.06 million. Because many rich people and families engage in extensive tax preparation, the estate tax, which is now 40% on assets in excess of the exemption threshold, has had a minimal effect.
A generation-skipping transfer tax, in addition to the present estate tax, is imposed under the tax law. This is a tax on the transfer of assets worth more than the exemption threshold to recipients who are more than one generation behind the transferor.
The law also includes a gift tax, although there is a $16,000 yearly exemption for donations made to a single recipient. In general, no gift tax is required until the cumulative value of a transferor’s donations in excess of the yearly exemption level exceeds the lifetime exemption, which is $12.06 million in 2022.
The excess beyond the yearly exemption threshold decreases the lifetime gift tax exemption as well as the estate tax exemption on a dollar-for-dollar basis. Because of these high exemption limits, the gift tax’s application to typical taxpayers is restricted.
Are Tax Laws Enforced Fairly?
A basic concern regarding every legislation is whether the law and how it is applied are fair and effective. According to Internal Revenue Service reports and studies published by independent experts, the federal tax system has been progressively failing to satisfy these standards for more than a decade.
Taxpayers’ contentment and compliance with the tax system are dependent on their belief that the tax law imposes—and authorities collect—a sufficient amount of tax income to finance the current government budget and future investments, and that all taxpayers are paying their fair part. Most low- and middle-income individuals’ e-filed tax returns, whose wages and investment income are submitted to the IRS on information forms, are essentially audited each year when their returns are matched to information forms. Many of these taxpayers believe that affluent persons may minimize, or even prevent, their tax burden by using debatable deductions and exclusions to balance revenue from their enterprises and investing activities.
For years, fiscal constraints on the Internal Collection Service’s capacity to combat noncompliance have resulted in significant tax revenue shortages. Because of IRS budget cuts and related decreases in personnel and enforcement, audit rates for all individual returns at all income levels dropped between 2010 and 2019. The gap between the amount owing to the government and the amount collected has grown dramatically.
Furthermore, the audit rate for all taxpayers declined between 2010 and 2019, albeit audit rates for lower-income groups were lower than those for higher-income taxpayers. During those years, the number of audits for returns with $5 to $10 million in income decreased by 81%, while audits for returns with more than $10 million in income decreased by 66%. During the same time period, the number of returns submitted by each category climbed by 92% and 84%, respectively.
Based on the IRS’ calculation that it failed to collect $380 billion due in all tax categories between 2011 and 2013, it has been estimated that the IRS will fail to collect more than $630 billion (i.e., 15% of taxes due) in 2020—and that the tax gap will grow to $7.6 trillion between 2020 and 2029 unless IRS resources are increased. Unpaid individual income taxes account for the majority of the tax gap, accounting for around 70% of the total. These figures represent an almost 20% noncompliance rate, with higher-income persons being accountable for the greatest levels of noncompliance.
Taxpayers who followed the law found news that the IRS’s funding and enforcement actions had decreased significantly after 2010 unsettling. The IRS’ figures, as well as expert evaluations and general media reports, indicated that it is performing fewer audits as its staff has shrunk, with the most dramatic cutbacks happening in audits of rich people, major organizations, and pass-through firms and their owners. An expert examination of data given by the Congressional Budget Office and the Treasury Department indicated that every $1 invested in the IRS would result in an extra $11 in tax revenues.
With a rising tax deficit and mounting complaints about justice, the Biden administration sought, and Congress authorized, an extra $80 billion for the IRS in the IRA. The CBO previously predicted that increasing IRS spending would result in a net revenue gain of $204 billion, which has now been revised to $124 billion from 2022 to 2031.
Would a different tax system be more efficient and equitable? Alternative tax systems have been studied as alternatives or complements to the US income tax on a number of occasions by US politicians.
Some supporters of a flat, single tax rate on all income stress its simplicity and believe that charging all taxpayers the same rate would be more equitable. However, in order to boost the amount of revenue needed for government operations, a rate so high that the burden on lower-income taxpayers is deemed economically and politically impossible would be required.
Flat-rate tax credits, especially refundable ones, benefit all taxpayers equally, regardless of income.
Similarly, when a value-added tax (VAT) or consumption tax on goods and services is studied, the exclusions necessary to prevent overburdening low-income people are rather complicated. The necessity to develop regulations to include organizations that get special advantages under the income tax system—not only certain companies, but also the extremely important charity sector—would be troublesome.
Recently, supporters for a flat rate yearly wealth tax have advocated it, citing rising economic inequality and higher concentration of wealth in a smaller fraction of the population, as well as the need to raise money. Despite the fact that many people, including economists and political scientists, have voiced worry about wealth concentration, the wealth tax concept has not achieved universal support. This form of tax would be very complicated, especially given the difficult and time-consuming job of evaluating assets without a publicly accessible, objective market value, such as pieces of art or private enterprises.
Even if such alternatives to the current system were considered practicable, the transfer from current income tax legislation to an alternative regime entails problems that have so far been deemed insurmountable. The implementation of a supplemental tax system, or the reform and extension of existing excise tax and tariff laws to complement the income tax, would avoid certain complications while increasing administrative demands on taxpayers and authorities.
Why are U.S. taxpayers critical of the of the tax system?
Many taxpayers believe that the tax system is unjust. They object to the fact that it allows many high-income persons to pay the government a lesser proportion of their income than is required of lower-income taxpayers. Many people are disturbed by reports in the press that some large, well-known firms have paid little or no tax for years.
Are these taxpayer criticisms of the tax system accurate?
The majority of the issues raised by taxpayers are legitimate. Experts have investigated and verified that the Internal Revenue Code offers deductions and other tax advantages that often result in lower-income persons paying higher effective tax rates than higher-income taxpayers.
IRS officials, academic studies, and press stories have all corroborated that certain extremely lucrative U.S. firms have claimed high profits but little taxable income and hence minimal tax obligations. The newly approved Inflation Reduction Act of 2022 (IRA) includes a new 15% alternative corporate minimum tax to combat corporate tax evasion, at least by large firms, by utilizing financial, “book” revenue as the tax base rather than taxable income.
Will the new IRS funding help ordinary taxpayers or just increase taxes and audits?
Individual taxpayers with low and moderate incomes are anticipated to see administrative improvements in customer service and tax-return administration over the next several years. Much of the increased investment is earmarked for strengthening contacts with people and replacing outmoded computer systems used in return processing. The IRS should improve its response time to phone calls. It should also process returns more quickly, which will assist those anticipating a tax refund.
Because both the Treasury Secretary and the President have authorized the IRS not to raise taxes or audit rates on taxpayers with incomes under $400,000, typical people should not face higher taxes or increased audit risk as a result of the larger IRS budget. However, critiques of substantive elements of the Internal Revenue System, such as low rates on gains and certain investment income, will remain untouched until the tax code is amended in the future.
The Bottom Line
Americans commonly express dissatisfaction with the structure of the Internal Revenue Code, the administration of the tax system, and the fairness with which it operates. Recent legislation, which includes a new 15% alternative corporate minimum tax and an increase in IRS spending of $80 billion to enhance customer service, modernize technology, strengthen enforcement, and close the gap between taxes owing and collections, is designed to address some of these problems. However, the legislation’s failure to raise capital gains and income tax rates for the rich, as well as the ordinary 21% corporation rate, and to remove too favorable company deductions, has spurred criticism that more changes are required.
Several major areas remain unaddressed.
- First, tax rates may be more progressive, and corporate tax changes may apply to a broader variety of business organizations.
- Taxpayers’ perceptions of the law’s fairness may be improved if tax deductions were re-evaluated and any superfluous, inappropriate, or excessive tax advantages were decreased or removed, especially special interest write-offs.
- Rules to prohibit corporate losses from being offset by revenue from unrelated sources might be applied more extensively.
Effective use of the increased IRS money might boost taxpayer trust. According to studies, greater and better audits of high-net-worth person and large-corporation tax filings would significantly lower the tax gap. With more funds, IRS auditors should be able to dedicate the time necessary to evaluating the complicated facts and circumstances given in tax returns submitted by businesses and rich people.
Changes to the tax code, on the other hand, need Congressional and presidential action. To improve the performance and public impression of the tax system, both substantive tax legislation reforms and administrative improvements are required.
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