What's wrong with the American tax system? Depending on their perspectives, taxpayers complain about a wide range of features. However, recent studies reveal that a majority express a concern that the system is unfair. They believe that it often requires low- and middle-income individuals to pay the IRS a greater share of their income than is required from individuals with higher incomes.
Why that's important: Voluntary taxpayer compliance is essential to the functioning of the U.S. tax system and depends on its acceptance by taxpayers. And so far, most taxpayers comply—despite regular news stories highlighting flagrant examples of tax avoidance, legal and otherwise. An IRS survey published in March 2020 reports that 95% of Americans believe it's "every American's civic duty to pay their fair share of taxes." While people may complain about their taxes, researchers report that Americans are more likely to pay them than residents of most other countries.
All the same, Americans’ opinion of the fairness and effectiveness of the US tax system has declined markedly over recent years. Some of the change corresponds to party lines. Republicans’ and Democrats’ views have diverged, with Democrats increasingly skeptical and Republicans more positive, especially since the 2017 individual and corporate tax cuts.
Although most taxpayers recognize that some form and level of taxation is necessary to fund the government, differing views about the appropriate size of government and its funding level, the optimal structure of a tax system, the system’s effective rates, and its impact on different groups and interests contribute to an expansive debate that would require a tome to appraise. Accordingly, this article focuses primarily on the current U.S. income tax regime and emphasizes features and effects that raise issues for taxpayers and policymakers alike. (It does not discuss excise taxes, which apply more narrowly to specific products and activities.)
Once the rules are in place, individuals and corporations will, not surprisingly, do their best to use them to their advantage. What's important is to look at the disparate impact of those rules, as well as who benefits and who doesn't.
- Special tax rules often allow higher income individuals to pay lower effective rates than middle- and lower income taxpayers.
- Flat-rate tax credits, particularly refundable ones, provide the same level of benefit to all taxpayers regardless of income.
- Many corporations pay little or no tax.
- Alternative minimum taxes, never wholly effective, were weakened for individuals (and eliminated for corporations) by the 2017 law.
- Lower tax rates apply to capital gains and dividends than to wages, salaries, and self-employment income.
- Sophisticated tax planning enables many wealthy individuals to minimize—or even entirely escape—estate and gift taxes.
Unfair Distribution of the Tax Burden
Most U.S. taxpayers consider an income tax system that applies graduated, higher rates on higher levels of income—commonly characterized as “progressive”—to be fair. But, currently, many are concerned that the national tax burden is not sufficiently graduated according to income level among individuals and between individuals and businesses, particularly corporate businesses. News reports about major corporations paying no income taxes—and alleging that President Trump paid no more than minimal income taxes for decades—have undercut taxpayers’ confidence in the system.
Many object to a system that often imposes on middle- and lower-income individuals higher effective income tax rates than apply to many with higher incomes and that allows some higher-income taxpayers to avoid taxation entirely. Judged from this relative perspective, a large percentage of U.S. taxpayers considers the US tax system unfair.
Some tax breaks are broadly recognized as appropriate, even necessary. Generally approved allowances include the deduction of “ordinary and necessary” business expenses in order to arrive at an economically accurate calculation of income. Similarly, the standard deduction; itemized deductions for medical expenses, charitable contributions, mortgage interest and certain losses; and refundable tax credits for individuals, have broad support.
The tax code provision that imposes no income tax on individuals with very low incomes (for 2020, taxable income below $9,876 for single individuals and $19,751 for married couples ) is considered both realistic and fair. In addition, it saves administrative expense by eliminating the cost of processing many tax returns that are unlikely to produce revenue.
The Internal Revenue Code includes individual and corporate income taxes, payroll taxes, excise taxes, estate and gift tax, and generation-skipping transfer tax. However, criticism generally has focused on the broad-based individual and corporate income taxes. Understandably there is little enthusiasm for paying taxes; but, it is fairness and not the actual dollar amount of tax liabilities that currently generates most complaints, perhaps a tacit acknowledgement of the tax law’s current rates, which are relatively moderate compared to far higher rates in the past.
As budget deficits increased beginning in 2018 when major tax cuts reduced tax revenues—a trend intensified since the pandemic impaired the economy—concern grew not only about the fairness, but also the effectiveness and adequacy of the tax law and its administration.
Let's look at some of these issues in more detail.
Higher Benefits for Higher Tax Brackets
Although the US tax code increases marginal tax rates on taxable income as taxable income brackets rise—the structure of a progressive tax system—graduated rates and brackets aren't the only driving force. Progressivity is countered by:
- Exemptions and exclusions for certain types of income—for example, tax-exempt interest paid on state and local government bonds
- Special, lower rates for some income categories, such as capital gains and dividends
- Deductions for a wide range of expenditures, including some business expenses.
Such adjustments—for simplicity, referred to collectively as "deductions" in the following discussion—can result in lower effective tax rates on the incomes of some very high-income individuals than apply to far lower incomes. These deductions sometimes enable taxpayers with extremely high levels of earnings and investment returns to avoid any tax liability.
Deductions vs. credits
Deductions that produce lower taxable incomes benefit taxpayers in a regressive, rather than progressive manner. The tax benefit for such items generally equals the amount of the reduction multiplied by the taxpayer’s marginal tax rate. Thus, if an individual taxpayer’s income falls into the top 37% tax bracket, each reduction of $100 from income that otherwise would be taxed at this rate will save the taxpayer $37. If the applicable rate is 24%, the savings for a $100 reduction in income would be only $24.
This allowance of greater tax savings for higher incomes contrasts with the savings from a tax credit. A 20% tax credit generally will save all taxpayers $20 in tax liability for each $100 expended, regardless of income level and tax bracket. However, if the amount of the credit exceeds the taxpayer’s tax liability, the taxpayer will not enjoy the full $20 savings unless the credit is refundable. Many tax credits are non-refundable.
Corporate tax avoidance
Currently the tax law generally applies a corporate income tax of 21%. However, many US corporations pay far lower effective rates or no tax at all because of substantial business write-offs, carrybacks and carryforwards of losses, aggressive tax planning and, if audited, tenacious and lengthy negotiating. Even as some challenge the existence of any corporate tax regime, others debate the appropriateness and level of corporate tax benefits, particularly those enjoyed by politically influential industries.
Alternative minimum tax limitations
Corporate and individual alternative minimum (AMT) rules were enacted to ensure that taxpayers with high income but substantial possible deductions and other tax breaks pay at least some taxes. To date, these rules have never fully accomplished that purpose, in large part because they have relied on tax law concepts and definitions rather than on economic or financial standards.
Then, the 2017 Tax Cuts and Jobs Act repealed the AMT for all C corporations. It also increased the exemption amount and exemption phaseout under the individual AMT, with the result that under present law fewer individual taxpayers are subject to the AMT than were covered by it prior to 2018
Preferential Rules for Investment Returns and Business Losses
Lower rates for investment returns and certain tax write-offs for businesses also are subjects of controversy.
Capital gains and dividends
Special low rates applicable to capital gains and dividends can enable taxpayers with significant investment returns to pay effective rates far below those applicable to ordinary income, such as salaries, wages or interest. Investor Warren Buffett, whose income is comprised largely of investment returns, famously acknowledged that the tax law should not allow him to pay a lower tax rate than his secretary.
Because these lower rates make the system less progressive and undercut perceptions of fairness, they provoke debate. Critics question the need for the rules and the size of the benefits. Proponents of these benefits, on the other hand, believe that they encourage desirable economic investment.
Certain business losses
Individuals who materially participate in a trade or business operated directly or in a pass-through entity—or who participate in a real estate business as a real estate professional—can use losses from such activities to offset earnings or investment income from other activities. The rules permitting current, carryback, and carryforward deductions for such losses by an active participant (or real estate professional, as applicable) permit eligible taxpayers to claim substantial write-offs that reduce or even eliminate their overall net taxable income.
Questions About Non-Income Taxes
In addition to income tax, the tax code imposes payroll and estate and gift taxes. Although generally less discussed than income taxes, some of these taxes present issues similar to those arising under the income tax.
Payroll taxes to fund Social Security benefits are imposed at the rate of 6.2% with respect to wages on each of the employer and employee—and 12.4% on net earnings of the self-employed—on up to $137,700 of such compensation for 2020 ($142,800 for 2021). In addition a Medicare tax of 1.45% applies to covered wages, with no wage cap. Because these taxes are imposed at flat rates regardless of income level, they are “regressive.” All wages are subject to these taxes; there is no exclusion or zero-rate level. Thus, for individuals with low incomes, these taxes are a substantial burden.
Some policymakers advocate imposing the Social Security tax at higher income levels, the way the Medicare tax already applies—or advocate extending it to unearned income. However, policy discussions tend to weigh the need to support trust funds against the risk that higher taxes on employers might adversely impact employment levels.
Estate and gift taxes
Estate and gift taxes apply to a small portion of the population and thus do not generate the breadth of interest or concern raised by income taxation. The doubling of the estate tax exemption to $11.58 million by the Tax Cuts and Jobs Act of 2017 significantly reduced its coverage.
Because many wealthy individuals and families engage in substantial tax-planning, the impact of the estate tax, currently 40% on assets in excess of the exemption amount, has been limited.
In addition to the current estate tax, the tax code imposes a generation-skipping transfer tax. This is a tax on transfers of assets valued in excess of the exemption level to beneficiaries more than one generation below the transferor.
The code also imposes a gift tax, but provides a $15,000 annual exemption for gifts made to a single recipient. Generally, there is no actual gift tax due until the total amount of a transferor’s gifts in excess of the annual exemption level together exceed the lifetime exemption, which is currently $11.58 million.
The amount of the excess over the annual exemption level reduces both the lifetime gift tax exemption and the estate tax exemption on a dollar-for-dollar basis. Because of these high exemption levels, the applicability of the gift tax to average taxpayers is limited.
Are Tax Laws Enforced Fairly?
A basic question about any law asks: Are the law and its application fair and effective? Reports released by the Internal Revenue Service and analyses published by independent experts indicate that, for over a decade, the federal tax system has increasingly failed to meet these requirements
Taxpayers’ satisfaction and compliance with the tax system depend on their perception that the tax code imposes—and authorities collect—a level of tax revenue adequate to support the current government budget and investments for the future and that all taxpayers are paying their fair share.
For years, budgetary limitations on the IRS’ ability to address noncompliance have resulted in substantial shortfalls in tax revenue. Because of the IRS budget reductions and the resulting declines in headcount and enforcement, the difference between the tax revenue owed the government and the amount actually collected is mounting. Based on the IRS’ own 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, for 2020, and that between 2020 and 2029 the tax gap will rise to $7.6 trillion.
Unpaid individual income taxes represent the largest portion of the tax gap, approximately 70%. These reflect a noncompliance rate of almost 20%, with higher-income individuals responsible for the highest noncompliance levels.
Taxpayers who comply with tax laws are surely disquieted by reports that IRS budgets and enforcement activities have declined markedly since 2010. As its workforce has become smaller, the IRS' own statistics—as well as expert analyses and general media reports—have revealed that it is conducting fewer audits, with the most significant reductions occurring in audits of wealthy individuals, large corporations, and pass-through businesses and their owners.
Would some other tax system work better and be fairer? From time to time U.S, policymakers have evaluated alternative tax regimes as substitutes for or supplements to the US income tax.
A flat, single rate of tax on all income has had some adherents, who emphasize its simplicity and argue that it would be fairer to charge all taxpayers the same rate. However, to raise the level of revenue required for government operations, it would be necessary to adopt a rate so high that the burden on lower-income taxpayers has been judged economically and politically unrealistic.
Similarly, when a value-added tax (VAT) or consumption taxes on goods and services have been examined, the exemptions required to avoid overly burdening low-income taxpayers entail significant complexity. The need to devise rules to cover groups enjoying special benefits under the income tax system—not only specific industries but also the very significant charitable sector—would also be problematic.
Recently, a flat rate annual tax on wealth has been proposed by advocates generally motivated by growing economic inequality and greater concentration of wealth in a smaller percentage of the population, as well as the goal of increasing revenue. Although many, including economists and political scientists, have expressed concern about the concentration of wealth, the wealth tax proposal has not gained widespread support. This type of tax would entail significant complexity, particularly the difficult and burdensome task of valuing assets, such as works of art or private businesses, lacking a readily available, objective market value.
Even if such alternatives to the present system were deemed feasible, the transition from the present income tax laws to an alternative regime presents challenges so far judged prohibitive. The enactment of some supplementary tax regime—or the revision and expansion of the current excise tax and tariff rules to supplement the income tax—would avoid some complexities but nonetheless would increase administrative burdens for taxpayers and officials.
The Bottom Line
With the US budget deficit growing as a result of substantial tax cuts and the impact of the pandemic on the economy, two major needs are clear.
First, the effective rates of tax might be more progressive and taxpayers' perception of the law’s fairness enhanced if tax deductions were re-evaluated and any unnecessary, inappropriate, and excessive tax benefits—particularly special interest write-offs—were reduced or eliminated. Changes might include restoration of an improved corporate AMT and broader application of rules to prevent business losses from offsetting income from unrelated sources.
Also needed: better tax enforcement through restored and increased funding of the IRS. An expert review of data released by the Congressional Budget Office and the Treasury Department indicates that every $1 of additional investment in the IRS would yield $11 in increased tax collections and between 2020 and 2029 would raise $1.1 trillion in additional revenue over and above current projections.
Studies indicate that more and better auditing of high-income individual and large-corporation tax returns would substantially reduce the tax gap. With increased funding, for example, IRS auditors would be able to devote the time required to evaluate complex facts and circumstances to determine if business expense deductions were necessary and reasonable in amount. An 11-to-1 return on investment in more thorough and better targeted auditing and enforcement clearly justifies increasing the IRS budget.
Improvements in both these areas should pay the additional dividend of building taxpayer confidence in the tax system.