Tax Reform v. Tax Cutting

As noted in the prior post, taxes impose two distinct burdens on society. The first is the actual tax revenue taken from the public. This is known as the direct burden of taxation. The second type include excess burdens, compliance, and administrative expenses. These are known as indirect costs of taxation. They provide no additional tax revenue yet impose significant costs on the overall economy. Tax experts estimate that these can range from 30 cents to well over $1 per tax dollar collected.

The terms tax cut and tax reform are frequently used interchangeably. Yet they mean quite different things. Tax cutting refers to efforts to whose primary goal is to reduce the direct burden of taxation, or the tax revenue taken from the public. Tax reform measures, on the other hand, are aimed primarily at reducing the indirect costs of taxation.

Most of these indirect costs arise because people alter their behavior in response to tax changes. A person who may work 40 hours a week in the absence of an income tax, for example, may only work 35 hours after one has been imposed. Because of this, tax experts often stress the importance of designing a tax system that alters individuals’ behavior as little as possible. This is known as pursuing tax neutrality.

The existing tax code is rife with nonneutral provisions. The two that concern tax experts the most, the tax system’s impact on working and saving, will be discussed in future posts. For now, a few of the well-known business and individual provisions that needlessly alter decision making and reduce overall wellbeing are highlighted below.

Subjecting Corporations to Higher Taxes Than Other Businesses

The existing federal tax code taxes so-called pass-throughs (sole proprietorships, partnerships, and S-corporations) at lower rates than traditional C-corporations. This encourages some firms who would otherwise organize as C-corporations to structure themselves as pass-throughs. This can be very pernicious since there are significant benefits to organizing as C-corporations that make companies extremely efficient producers of high quality/low-cost products. These can be lost when firms organize as pass-throughs for tax reasons.

Interfering With Other Business Decisions

In addition to influencing their overall structure, taxes also affect the day-to-day operation of businesses. The federal tax system, for example, encourages firms to finance new projects with debt rather than equity, potentially overleveraging them. Tax considerations also influence the mix of capital (buildings, machines, etc.) firms employ.

Meddling in Personal Lives

The federal tax system also meddles in what most people consider private, personal decisions. It has long been criticized, for example, for influencing people’s decisions about marriage by creating so-called ‘marriage penalties’ and ‘marriage bonuses.’ Numerous provisions in the individual income tax code also promote homeownership even for those for whom it makes little economic sense, such as people whose careers require frequent moves. Other provisions influence decisions about how much to save and where to invest.