U.S. Tax Code Hampers Competitiveness

By Michael Franc
Friday, November 2, 2007

In July, the Treasury Department released a study cataloguing the ways our deplorable tax code restricts U.S. competitiveness. "Our tax system," it said, "disrupts and distorts a vast array of business and investment decisions" that "lowers the productive capacity of the economy and reduces living standards." Ultimately, Treasury Secretary Hank Paulson explained, "our workers pay the price."

Paulson wants lawmakers on Capitol Hill to follow the lead of other industrialized nations and lower U.S. corporate tax rates. He also advocates pruning the corporate code of "complex, targeted provisions; depreciation schedules without clear rationale; taxation of capital income that discourages saving and investment; and, double taxation of corporate profits that can lead to misallocation of capital." Why? According to the Tax Foundation, the top U.S. corporate rate of 39.3% (the combined federal and state rate) is second only to Japan’s 39.5% top rate. This decades-old trend accelerated in 2006 when five large industrialized countries cut their corporate income tax rates further; eight more, including Germany, plan to do so by January.

Paulson’s message must have reached Rep. Charles Rangel (D-N.Y.), who chairs the tax-writing House Ways and Means Committee, but apparently, it only penetrated the supply side of his brain. Last week he unveiled an ambitious, but schizophrenic, tax-reform plan that is downright Reaganesque (for the most part) on corporate taxation, but succumbs to the siren song of class warfare on individual taxation.

Rangel targets "unfairness" in the tax code, especially the Alternative Minimum Tax (AMT). Created in 1969, Congress enacted the AMT to extract tax payments from wealthy individuals who were using legal deductions to avoid all income tax liability. The AMT cancels many popular tax deductions for high-income filers.

But, because Congress didn’t index the AMT to inflation, it has begun to ensnare more and more unsuspecting taxpayers. Last year, it hit 4 million; by 2010, one in three taxpayers could be paying this "millionaires" tax.

Rangel is right: The AMT must go.

But when tax policy threatens to disrupt the oxygen supply of the modern welfare state, liberals don their boxing gloves. This accidental tax, after all, will accidentally raise close to $1 trillion over the next decade. Liberals won’t return those dollars to the taxpayers without a fight.

Thus, Rangel’s legislative blueprint would keep those dollars flowing to Washington. Rangel proposes to replace the AMT with perhaps the largest tax increase in history - a new 4% surcharge on single and married filers with incomes of $150,000 and $200,000, respectively. The surcharge would be set even higher -- 4.6% -- for those with incomes above $500,000. He also has additional tax increases in mind for savers, investors and entrepreneurs.

Because his blueprint envisions allowing the Bush tax cuts to expire, it would effectively increase the top marginal tax rate from 35% to 44.2%. The current tax burden -- i.e., the amount that would be collected if the Bush tax cuts were extended and Congress continued its recent practice of "patching" the AMT -- would explode by $3.5 trillion over the next decade. Yet Rangel doesn’t consider this $3.5 trillion a tax increase. Only Washington liberals can argue that your exploding tax bill isn’t really a tax increase!

From an international perspective, the higher rates move our tax code in exactly the wrong direction. Most countries have abandoned the sort of confiscatory marginal tax rates that prevailed when Ronald Reagan was first elected. According to The Heritage Foundation’s Index of Economic Freedom, the highest marginal rate in the world today -- Chad’s 65% -- is lower than the top U.S. rate (70%) in 1980.

With our current top rate of 35%, the U.S. ranks 84th in the world, tied with such economic powerhouses as Rwanda, Ethiopia, Sierra Leone and Azerbaijan. Under Rangel’s proposal, the U.S. would plummet to 132nd, alongside moribund European welfare states such as Spain, France, Denmark, the Netherlands and Sweden. Add in state tax burdens, and the picture darkens: Taxpayers in 29 states face top rates of 6% or more, enough to push their combined federal-state tax rate above 50%.

On the corporate side, though, Rangel donned a rare supply-side hat. He proposed a significant drop in the top corporate rate, from 35% to 30.5%, and the elimination of various corporate tax deductions.

Of course, we could do better. The Treasury study estimates that we could lower the top corporate rate to 27% simply by eliminating special-interest deductions and redirecting those lost revenues to rate cuts.

The rest of the world isn’t waiting. Time to catch the wave.