The U.S. tax code is incredibly complex, and this complexity comes with a price tag of nearly $150 billion in annual compliance costs for U.S. businesses.
While complexity is a convenient punching bag for commentators and policymakers, they should instead focus more on how the design of the tax code can contribute to high compliance costs. If the policies in President Biden’s most recent budget proposal became law, for example, complaints about compliance costs and complexity will likely skyrocket among businesses and taxpayers alike.
Take the president’s approach to taxing large companies. The existing tax code has a corporate income tax rate of 21%, a minimum tax on corporate foreign earnings, and many more credits and deductions featuring a wide variety of expiration dates that contribute to uncertainty for taxpayers.
However, the president does not seek to address those current complexities in his budget. Instead, he does the opposite with his call for a number of tax changes, particularly for large companies. If Biden’s tax changes are enacted, many taxpayers will face an increase in both their tax bills and the costs of calculating their taxes.
A Multiplicity of Minimum Taxes
The president’s budget would adopt a minimum tax on the financial earnings of companies; additionally, it would implement a more cumbersome approach to taxing foreign earnings. On top of that, a minimum tax would apply when a foreign jurisdiction attempts to apply one of its own minimum taxes to U.S. companies. The budget also proposes a separate minimum tax on wealthy individuals.
These minimum taxes layer additional rules on top of the already complicated foundation of the tax code, and the U.S. is not alone in taking this approach. The U.S. minimum tax on foreign income was first adopted in 2017, when the Tax Cuts and Jobs Act lowered the corporate tax rate from 35% to 21% and provided a new approach to taxing foreign income through a complex policy called the Global Intangible Low-Tax Income.
That Trump-era law inspired a worldwide discussion centered on taxing foreign earnings of companies. And now the U.S. and other jurisdictions are all trying to adopt similar approaches as part of a global minimum tax. But the U.S. approach would still be an outlier, in terms of both policy design and complexity. Compared with the proposed global minimum tax, Biden’s proposal will affect a broader set of businesses and profits and will not shield payroll costs in the way that the global rules do.
Every time policymakers call for an additional tax to make up for the failures of existing policies, they are admitting defeat. They are saying that the existing corporate tax regime is broken, but rather than attempting fundamental reform, they have chosen to pursue a quick, politically palatable fix that, in most cases, makes matters even worse.
Minimum taxes reflect lawmakers’ incentive to avoid disrupting the normal rules in the tax code and simply attack a perceived problem with a new tool. This sometimes reflects a desire to protect certain tax benefits for a narrow group of taxpayers while wielding tax rules against other groups—such as individuals with high incomes or large, profitable companies. What’s ignored is the bloat of the compliance challenges and the need for companies to redirect resources away from productive activities simply to figure out how to follow the law.
Why Complexity Matters
Why does focusing on complexity matter? Because competition matters—and because our global competitors are focused on it too. A complex tax code means that for every dollar of a company’s taxable profit, part of that dollar will be channeled into figuring out how much tax is owed. By contrast, if a tax system is simple and straightforward, taxpayers will have fewer compliance costs and will be able to keep more of their dollar. Thus, a tax code’s complexity can affect where businesses thrive or choose to invest.
Each year, the Tax Foundation publishes the “International Tax Competitiveness Index,” which ranks the tax policies of developed countries based on their simplicity and neutrality. Many small countries tend to rise to the top of the ranks—in fact, Estonia has taken first place in every edition of the “Index” since it was first launched in 2014. This is because small countries often do not have the benefit of a large, established industrial base or a powerful consumer market, so they often choose to make things as simple and transparent as possible for their taxpayers.
The lessons of radical simplicity are not only applicable to small countries, though. Because so many resources are channeled into tax compliance, the U.S. is missing out on innovation and investment. This problem is easy to ignore because the country has such a large economy, but that does not make those economic impacts any less real.
A main driver of the difference between the best tax systems and the worst is the layers of taxation that policymakers choose to adopt. In some instances, policymakers have chosen to tax the same income multiple times, that is, taxing corporate income at the company level and then again at the individual level in the form of taxes on capital gains and dividends. Some tax systems also have special rules for certain types of businesses; these rules add layers of taxation and increase complexity.
What sets Estonia apart from the rest of the field is its clear and simple approach to taxation. Estonia is not home to multiple layers of taxation, nor does it have complex credits and deductions. Instead it employs a simple, flat, three-part tax code:
- A 20% corporate tax, applied only when profits are distributed to shareholders.
- A 20% value-added tax on consumption.
- A 20% flat personal income tax.
The U.S. should take these lessons to heart. The costs of managing, enforcing and complying with the current tax code are enormous. Resources caught up in complexity would add much more value if deployed elsewhere.
The Biden administration and many members of Congress are focused on companies paying their “fair share” of taxes, however ambiguously defined or justified (corporate revenues are expected to rise to an all-time high this year, which seems to indicate companies are already paying quite a bit). The policies the administration is pushing will certainly increase tax burdens, but they will also come with more than their fair share of compliance costs.
If Build Back Better or any of the president’s tax proposals become law, supporters will claim victory. From my standpoint, until the hard work is done to simplify the tax code, they may as well be admitting defeat. Rather than introduce one new minimum tax after another, Congress should have the courage to fundamentally reform and strip away the complexity from our tax code.