America’s federal tax system has grown from a simple system of collecting revenue to fund the government into a massive behemoth intended to also direct the behavior of businesses and individuals. Simplifying the tax code and adjusting tax rates will enhance job creation and make the American economy more competitive.

 

COMPLEXITY AND COMPLIANCE BURDENS 

Through tax deductions, tax credits and various other rules, the tax code has become a massively complex instrument of social and economic policy. As a result, the U.S. tax system imposes an incredible compliance burden and distorts economic decisions. According to the National Taxpayer Advocate Service, the U.S. federal tax code is now more than 3.8 million words long. In 2008 alone, Americans spent more than 6.1 billion hours complying with the U.S. tax code, the equivalent of three million people working full time.

 

COMPREHENSIVE TAX REFORM 

The last major overhaul of the tax code was in 1986. Since then, there have been more than 15,000 changes to the tax code. President Bush’s bi-partisan tax reform panel, led by Sen. Connie Mack and Sen. John Breaux issued a report in 2005 that recommended comprehensive reform options. While tax reform is complicated, this report combined with further work by the U.S. Treasury provide an analytical basis for real reform that encourages economic growth and job creation. A renewed reform effort that simplifies the tax system while broadening the tax base and reducing tax preferences is long overdue.

 

TAXES AND INTERNATIONAL COMPETITIVENESS 

The U.S. combined corporate income tax rate, which includes the 35 percent federal tax rate and state taxes, was 39.21 percent in 2011. Only Japan’s is higher. By comparison, the average corporate tax rate of industrialized countries is just 25.5 percent. 

 

Further, the U.S. is one of the only major economies that still taxes companies on income regardless of whether it was generated in the U.S. Currently, a complex and unnecessary system of tax credits and deferrals is used to level the playing field with foreign firms operating on a territorial system. All of this, combined with the incredible complexity of the tax code, makes U.S. companies less competitive in the global economy. 

 

EFFECT OF INCREASED TAX RATES ON SMALL BUSINESSES 

Proposals to raise tax rates for high-earners will increase taxes on entrepreneurs and small businesses, which create two out of every three new jobs in the U.S. Most small businesses are structured as LLCs or other types of “pass through” entities that pass tax liability on business income to owners, regardless of whether that income is actually taken home or reserved for future hiring and expenses of the business. According to a National Bureau of Economic Research (NBER) study, raising the top income tax rate of high-earners from 35 percent to 39.6 percent would reduce the likelihood of hiring by affected small businesses by 8 percent. A separate NBER study found that the 1993 increase in the top tax rate to 39.6 percent reduced the likelihood of an upper middle class worker starting their own business by as much as 20 percent. Higher tax rates are especially problematic considering that businesses started by entrepreneurs are the primary source of job creation in the U.S. 

 

SOLUTIONS 

 

Given the vast complexity of the tax code, it is impossible in a short paper to discuss all of the reforms needed; however, in this paper we outline several of the more urgent priorities.

 

Expand IRS Forbearance and Support Programs for Small Business 

The Internal Revenue Service should expand its forbearance program for small businesses to allow accelerated removal of liens for back taxes and increased income caps for payment agreements that reduce amounts owed in back taxes. 

 

The IRS should also improve and expand the online tax information resources available to small businesses. Many of the materials currently provided are written in confusing, bureaucratic jargon. Materials answering basic tax questions should be provided in plain English and presented in a logical, easy to find fashion. The IRS should also expand resources to help small business owners answer basic tax questions through a small business hotline that provides quick access to IRS experts without excessive hold times. 

 

Extend Accelerated “Bonus” Depreciation of Equipment Purchases 

Maintaining cash is an urgent priority for businesses just starting out. When a business purchases equipment, normally it must depreciate the value of the equipment over several years, writing off a portion of it each year. However, Congress enacted a temporary provision as part of the 2009 stimulus bill that allowed businesses to depreciate the full value of equipment purchases in the first year. By expensing equipment in the first year rather than over time, businesses can take advantage of tax savings immediately, helping them to expand while maintaining cash to hire new workers. In addition, there is added incentive to purchase equipment, stimulating economic growth. Finally, it eliminates the need for complex calculations of depreciation rates. This provision was allowed to expire at the end of 2011. Congress should act to reinstate it. 

 

Extend Expiring Tax Cuts 

The Bush-era tax cuts are expected to expire at the end of this year. If they are not extended, tax rates will rise. At this delicate stage in the recovery, raising taxes would be unwise. Uncertainty over tax rates makes small businesses hesitant to expand and hire new workers. Congress and the President should encourage job creation and economic growth by extending these tax cuts now.

 

Reduce the Corporate Tax Rate to 25% 

As part of any fundamental tax reform initiative, the corporate tax rate should be reduced to around 25% to put the U.S. on par with foreign competitors. Similar reforms for small businesses should be enacted for those paying tax at the individual level as pass-through entities. Rate reductions should be coupled with the elimination of tax preferences to recover revenue and simplify the tax code. 

 

Move to a Territorial International Tax System 

Congress should replace the complex and unfair U.S. “global” tax system with a territorial tax system similar to that of most other industrialized countries. This will make American companies more competitive and remove unnecessary and burdensome foreign tax credit calculations.