Tax Fact Sheet

November 7, 2011

Click here for PDF version

The information in this publication is general educational material and must not be considered to be legal or tax advice. Despite its length, this publication does not cover all applicable issues, and there may be other issues that are not analyzed in this publication. You may not rely on this publication to avoid tax penalties or liabilities, and you may not use this publication for any purpose other than the consideration of the issues discussed herein. For more information about your own tax or legal situation, please consult your own tax or legal advisors. 

Federal Deficit Reduction:
About Revenue and Taxes

“…Over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change… So tonight, I’m asking Democrats and Republicans to simplify the system. Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years – without adding to our deficit.”

President Barack Obama, 2011 State of the Union[1]

Taxes 101

- Common Tax Terms
- Tax Expenditures
- A Closer Look at Federal Corporate Income Taxes
- A Close Look at Federal Individual Income Taxes
- Tax Terms for New Tax Systems

Throughout the deficit reduction debate in Washington, some politicians have championed the need to reform the federal tax code. According to some reports, the Super Committee may be more likely to address federal corporate tax issues rather than addressing federal individual income taxes[2].

While there are disagreements on the specifics of how to reform the tax code, most scholars agree that a simple, equitable, and efficient tax code has great potential to both lower the federal deficit and promote economic growth. Furthermore, this September John Riccitiello, CEO of Electronic Arts, said, “…we simply have to recognize that our tax policies is one of potent weapons to attract and retain jobs in the United States, it’s as simple as that[3].”

Common Tax Terms

Many Americans understand basic tax terms because, each year, they spend hours dealing with the tax code when they file their taxes by mid-April. But below, we aim to give the reader a deeper understanding of common tax terms.

What are deductions? 

In general, deductions are subtracted from your taxable income. In other words, if you qualify for a deduction of $3,000, this does not mean your tax bill is reduced by $3,000; it means that your taxable income is reduced by $3,000. For an individual in a 35% tax bracket, each $100 deduction means he or she would pay $35 less in taxes[4].

Taxpayers can take deductions in one of two ways:

- The standard deduction, which is $5,800[5] for a single taxpayer and $11,600 for a married couple filing jointly; the taxpayer gets this automatically with no need for itemization.
-The itemized deduction, which is generally used if you have deductions over the standard deduction. In this case, you generally have to itemize each deduction. Examples of itemized deductions include the mortgage interest deduction and the charitable contribution deduction.[6]

What are adjustments to income?

Adjustments to income are deductions that all taxpayers can take, in addition to the standard deductions. They include such things as moving expenses, regardless if you used a standard or itemized deduction[7].

What are personal exemptions?

Personal exemptions “are allowed for the taxpayer, his or her spouse (if married and filing a joint return), and each dependent[8].” A dependent can be a qualifying child or relative[9]. In 2011, the value of each personal and dependent exemption, for most taxpayers, is $3,700[10]. Similar to a deduction, each personal exemption reduces your taxable income.

What are exclusions?

Exclusions are something that are not included in taxable income “because the tax code explicitly exempts [them] from tax.” An example of an exclusion is the interest earned on state and local bonds.[11]

What are credits?

Generally, tax credits are subtracted directly against the total taxes you owe. Unlike a deduction, which is subtracted from your taxable income, a credit is subtracted against your tax bill on a dollar-for-dollar basis, without regard to if you itemize your deductions or not.[12]

Generally, there are two types of credits:

- A refundable credit, which can exceed the amount of taxes you owe. In other words, it is a direct payment from the U.S. government[13]. An example of a refundable credit was the first-time homebuyers credit that was created in the 2009 stimulus.

- A non-refundable credit, which can only be used up to the extent that you owe taxes[14]. An example of a non-refundable tax credit is child care expenses.

Tax Expenditures

The ideas behind all of the concepts explained above are key because, generally speaking, they fall into tax expenditures, which are considered to be forms of government spending accomplished through the tax code instead of through direct government spending[15].

- Although there are various estimates on what qualifies as a tax expenditure, the non-partisan Joint Committee on Taxation determines a list of tax expenditures.

- To do this, they determine if the provision is part of the “normal income tax law” or not. If it is not part of the “normal income tax law,” the tax provision is considered to be a special provision and thus is a tax expenditure.[16]

- Treasury also identifies tax expenditures. In 2011, they estimate tax expenditures total $1.3 trillion for this year alone[17].

“Tax expenditures, in many ways, are similar to entitlement spending” such as Medicare, Medicaid, and Social Security because they “…often remain in the tax code until changed or eliminated by congressional action[18].” In fact, if tax expenditures are included in total government expenditures in fiscal year 2010, they made up nearly 24 percent of total expenditures[19]. In that same year, mandatory spending such as Medicare, Medicaid, and Social Security made up more than 42 percent of total expenditures[20].

For individual income taxes, one of the biggest tax expenditures is the mortgage interest deduction, which is estimated to cost nearly $100 billion a year[21].

- The former director of the non-partisan Congressional Budget Office, Douglas Holtz-Eakin, claimed the mortgage interest deduction is the “last tax shelter.”

- He also claimed “owner-occupied housing in the United States may grow at the expense of more productive investments elsewhere in the economy.” [22]

For corporate taxes, one of the biggest tax expenditures is accelerated (i.e., bonus) depreciation.

- Generally, businesses are able to deduct capital costs, such as a new piece of equipment, over the useful life of the asset since it is a business expense.

- Bonus depreciation allows businesses to recover these costs in a shorter period of time through larger deductions.[23]

According to the non-partisan Congressional Research Service, tax expenditures such as the mortgage interest deduction, “…are seen as targets to be reduced or eliminated…” should the current Congress decide to enact comprehensive tax reform.[24]

What are “loopholes?”

What one person may see as a benefit, another person may see as a loophole. “Special deductions, exclusions, and exemptions (sometimes characterized as ‘loopholes’) have been in the tax code since the passage of the progressive income tax in 1913[25].”

A Closer Look at Federal Corporate Income Taxes

In the last fiscal year, the federal corporate income tax comprised nearly eight percent of the federal government’s total revenue[26]. According to the Mercatus Center, “Like individual income tax rates, corporate income tax rates are progressive, increasing with higher levels of income.” When a person hears the discussion of the corporate tax rate, it is usually in context of the highest rate. For corporations that earn profits greater than $18,333,333, they are taxed at the top rate of 35 percent.[27]

But due to the complexity of the tax code, credits, and deductions, among other reasons, virtually no one pays the top tax rate of 35 percent.

- The effective tax rate, which accounts for all “deductions, credits, depreciation, and preference in the tax code[28],” is estimated to be between 22 and 27 percent[29].

- No matter if you are looking at the actual rate or the effective rate of taxes, “the United States has one of the highest corporate tax rates in the industrialized world[30].”

Not only does the U.S. tax system tax corporations at an extremely high rate relative to the rest of the world, but it also taxes certain profits “…on all income regardless of whether they earn that income domestically or internationally.”

- Not all overseas profits are treated this way because certain overseas profits are not taxed unless the corporation transfers those foreign earnings back to the United States.

- Although U.S. corporations may take a tax credit for certain taxes paid to foreign governments, so the same income is not taxed twice in theory, Mercatus reports that “…complex rules limit U.S. corporations from taking full credit for foreign taxes.”

- For a developed country like the United States, it is unusual that the U.S. does not use a territorial taxation system where corporate income is taxed in the country where the income is earned.[31]

Mercatus goes on to explain that “[i]f the foreign tax rate is less than 35 percent, as it is in most developed countries, U.S. firms have a tax incentive to keep their profits overseas[32].” Further, “the high corporate income tax rate distorts firms’ incentive structures and investment behaviors. It sometimes becomes more ‘profitable’ for companies to invest in lobbyists who can expand tax preferences than to use those resources to expand business output.[33]

According to a scholar the Urban Institute, the time is ripe for corporate tax reform: “Add in rising concern about America’s international competitiveness and slow economic recovery, and you have a recipe for a bipartisan push to cut corporate tax rates[34].”

A Closer Look at Federal Individual Income Taxes

In the last fiscal year, federal individual income taxes comprised nearly 47.5 percent of the federal government’s total revenue[35].  Like corporate income tax rates, individual income tax rates are progressive, meaning the rates increase with higher levels of income. For a person that earns an income greater than $379,150, he or she is taxed at the top rate of 35 percent[36].

But due to the complexity of the tax code, loopholes, among other reasons, virtually no one pays the top income tax rate of 35 percent.

- The non-partisan Congressional Budget Office last studied the effective tax rate, which accounts for all “deductions, credits, depreciation, and preference in the tax code[37],” in 2007. For the highest income earners (the top five percent), they found the effective individual income tax rate to be 17.6 percent in 2005[38].

- This same report documented that the lowest income category (i.e., the lowest quintile) paid an effective tax rate of -6.2 percent in 2005[39].

Tax Terms for Possible New Tax Systems

Washington is also buzzing about alternative tax systems. Below is a breakdown on the terms for certain alternative tax systems.

What is the Value-Added Tax?

Generally speaking, it is a consumption tax that taxes “the value that a firm adds to a product at each stage of production.” This tax is collected during every stage of production. It is similar to a national sales tax but is broader in its scope since it applies to every level of production — not just the retail level when a sale is made.[40]

What is a Flat Tax?

Essentially, it is a modified value-added tax; however, it takes wages and pensions and taxes them separately relative to the other parts that make up a value-added tax.[41]

What is a Fair Tax?

Generally speaking, it replaces the individual income tax, corporate income tax, payroll taxes, the self-employment tax, and the estate/gift taxes and replaces it with a national sales tax.[42]

In Conclusion…

As the Super Committee discusses ways to cut the federal deficit, many options for comprehensive tax reform could be discussed and implemented. Bankrupting America believes that while tax reform is key, we shouldn’t be giving Washington another dollar through higher tax rates unless Washington proves it can be wise with the money we’ve already given them.

During this time, a strong knowledge of current tax policy and reforms may help Americans sort through rhetoric and hold elected officials accountable for any tax policy decisions they make.

 


[1] National Journal. FULL TEXT: Obama Declares ‘The Rules Have Changed.’ January 26, 2011.  http://www.nationaljournal.com/whitehouse/exclusive-obama-to-declare-the-rules-have-changed–20110125

[2] Reuters: Deficit panel grapples with corporate taxes. October 13, 2011. http://www.reuters.com/article/2011/10/13/us-usa-debt-supercommittee-idUSTRE79C6M320111013

[3] CEO Series Luncheon Featuring John Riccitello Chief Executive Officer. September 22, 2011. http://www.uschamber.com/webcasts/ceo-series-luncheon-featuring-john-riccitiello-chief-executive-officer-electronic-arts

[4] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 2.

[5] TurboTax: Tax Tips After January 1, 2012. http://turbotax.intuit.com/tax-tools/tax-tips/Tax-Planning-and-Checklists/Tax-Tips-After-January-1–2012/INF12070.html.

[6] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 2.

[7] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 2.

[8]CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 3.

[9] IRS: Dependents & Exemptions. Accessed October 31, 2011. http://www.irs.gov/faqs/faq/0,,id=199707,00.html

[10] IRS: Press Release, In 2011, Many Tax Benefits Increase Slightly Due to Inflation Adjustments. December 23, 2010. http://www.irs.gov/newsroom/article/0,,id=233465,00.html

[11] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 1.

[12] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 5.

[13] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 5.

[14] CRS:  Federal Income Tax Terms: An Explanation. June 20, 2006. P. 5.

[15] CRS: Tax Expenditures and the Federal Budget. June 1, 2011. P. 6. http://www.fas.org/sgp/crs/misc/RL34622.pdf

[16] CRS: Tax Expenditures and the Federal Budget. June 1, 2011. P. 6. http://www.fas.org/sgp/crs/misc/RL34622.pdf

[17] Urban Institute:  How Large are Tax Expenditures? March 28, 2011. http://www.urban.org/publications/1001526.html

[18] CRS: Tax Expenditures and the Federal Budget. June 1, 2011. P. 2. http://www.fas.org/sgp/crs/misc/RL34622.pdf

[19] CRS: Tax Expenditures and the Federal Budget. June 1, 2011. P. 5. http://www.fas.org/sgp/crs/misc/RL34622.pdf

[20] CRS: Tax Expenditures and the Federal Budget. June 1, 2011. P. 5. http://www.fas.org/sgp/crs/misc/RL34622.pdf

[21] Bloomberg: A Taxing Debate, The Mortgage-Interest Deduction. October 18, 2011. http://www.bloomberg.com/news/2011-10-17/a-taxing-debate-the-mortgage-interest-deduction.html

[22] Jason Fichtner and Jacob Feldman, the Mercatus Center. Working Paper: Lessons from the 1986 Tax Reform Act. April 2011. P. 4. http://mercatus.org/sites/default/files/publication/Fichtner.86Tax.4.12.11_0.pdf.

[23] CRS: Reducing the Budget Deficit, Tax Policy Options. April 26, 2011. P. 16. http://assets.opencrs.com/rpts/R41641_20110426.pdf

[24] CRS:  Tax Reform, An Overview of Proposals in the 112th Congress. April 20, 2011. P. 2. http://www.nationalaglawcenter.org/assets/crs/R41591.pdf

[25] CRS: Tax Expenditures and the Federal Budget. June 1, 2011. Pp. 5 – 6. http://www.fas.org/sgp/crs/misc/RL34622.pdf

[26] Congressional Budget Office.  Monthly Budget Review.  October 7, 2011.  http://www.cbo.gov/ftpdocs/124xx/doc12461/2011_10_07_MBR.pdf

[27] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 2. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[28] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 2. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[29] Congressional Research Service.  An Analysis of the “Buffett Rule.”  October 7, 2011.  P. 5.  http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=1870&context=key_workplace

[30] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 3. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[31] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 7. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[32] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 7. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[33] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 9. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[34] Tax Reform: The Wheels Are Beginning to Turn. Urban Institute. February 15, 2011. http://www.urban.org/publications/901407.html

[35] Congressional Budget Office.  Monthly Budget Review.  October 7, 2011.  http://www.cbo.gov/ftpdocs/124xx/doc12461/2011_10_07_MBR.pdf

[36] Tax Foundation.  Federal Individual Income Tax Rates History. http://www.taxfoundation.org/files/fed_individual_rate_history_nominal&adjusted–20110909.swf.

[37] Mercatus: Why the United States Needs to Restructure the Corporate Income Tax. Pp. 2. http://mercatus.org/sites/default/files/publication/Corporate_tax_FichtnerTuszynski_WP1142.pdf.

[38] Congressional Budget Office.  Historical Effective Tax Rates:  1979 to 2005. December 2007. http://www.cbo.gov/ftpdocs/88xx/doc8885/12-11-HistoricalTaxRates.pdf

[39] Congressional Budget Office.  Historical Effective Tax Rates:  1979 to 2005. December 2007. http://www.cbo.gov/ftpdocs/88xx/doc8885/12-11-HistoricalTaxRates.pdf

[39] CRS:  Tax Reform, An Overview of Proposals in the 112th Congress. April 20, 2011.

[40] CRS:  Tax Reform, An Overview of Proposals in the 112th Congress. April 20, 2011. P. 3. http://www.nationalaglawcenter.org/assets/crs/R41591.pdf

[41] CRS:  Tax Reform, An Overview of Proposals in the 112th Congress. April 20, 2011. P. 4. http://www.nationalaglawcenter.org/assets/crs/R41591.pdf

[42] CRS:  Tax Reform, An Overview of Proposals in the 112th Congress. April 20, 2011. P. 1-2. http://www.nationalaglawcenter.org/assets/crs/R41591.pdf

Leave a Reply

Your email address will not be published. Required fields are marked *