What's Wrong With the American Tax System

Depending on their perspectives, American taxpayers complain about a wide range of tax features; however, studies by the Pew Research Center consistently reveal that a majority express concern that some corporations and wealthy individuals do not pay their fair share.

They believe that the tax system often requires low- and middle-income individuals to pay a greater percentage of their income in taxes than is required from individuals with higher incomes. So what are the aspects of the American tax code that are fundamentally wrong, and how can these aspects be fixed?

Taxpayer Sentiment

An Internal Revenue Service (IRS) survey regarding taxes in 2021 (the latest release), reports that 94% of Americans believe it's "every American's civic duty to pay their fair share of taxes." Although the majority of taxpayers view IRS performance favorably, attitudes vary by age group and education level.  By 2021, taxpayer trust and satisfaction in dealing with the IRS had declined.

Some of the change corresponds to political party affiliations. Republicans’ and Democrats’ views have diverged, with Democrats increasingly skeptical and Republicans more positive, especially after the 2017 individual and corporate tax cuts.

Although most taxpayers recognize that some form and level of taxation are necessary to fund the government, differing views about the appropriate size of government and its funding level, the optimal structure of a tax system, the system’s effective rates, and its impact on different groups and interests contribute to an expansive debate that would require time to appraise.

Once tax rules are in place, individuals and corporations will, not surprisingly, do their best to use them to their advantage. What's important is to look at the disparate impact of those rules, as well as who benefits and who doesn't.

Accordingly, this article focuses primarily on the current U.S. income tax regime and emphasizes features and effects that raise issues for taxpayers and policymakers alike. (It does not discuss excise taxes, which apply more narrowly to specific products and activities.)

Biden's Attempts at Tax Change

The enacted Inflation Reduction Act (IRA) of 2022 includes a 15% alternative corporate minimum tax on corporate book profits that constitutes a significant attempt to prevent tax avoidance by some of the largest corporations. The IRA also allocated to the IRS $80 billion in new funding over the next 10 years to restore personnel levels that have dropped significantly for over a decade, enhance customer service, and improve enforcement.

However, the passage of the IRA with the support of all Congressional Democrats in the face of opposition by all Republicans indicates the difficulty of addressing tax avoidance. For example, opponents of the IRS budget increase argue it will support increased and aggressive, even threatening, IRS audits of ordinary taxpayers.

On the other hand, President Biden has emphasized—and Treasury Secretary Janet Yellen has instructed the IRS—that the legislation and its administration should not increase taxes for families earning less than $400,000.

Originally the IRA contained a statutory provision addressing protection for individuals with incomes below $400,000, but it was dropped when the Senate Parliamentarian ruled that this type of provision could not be enacted under the legislative Reconciliation process chosen for the IRA’s passage.

Unfair Distribution of the Tax Burden

Most U.S. taxpayers consider an income tax system that applies graduated, higher rates to higher levels of income—commonly characterized as “progressive”—to be fair. But, currently, critics are concerned that the national tax burden is not sufficiently graduated according to income level among individuals and between individuals and businesses, particularly large corporate businesses.

News reports about major corporations paying no income taxes—and alleging that former President Trump paid no more than minimal income taxes for decades—undercut taxpayers’ confidence in the system. The alternative corporate minimum tax was passed in 2022 to address tax avoidance by the largest corporations.

Many people object to a system that often imposes on middle- and lower-income individuals higher effective income tax rates than apply to many with higher incomes and that allows some higher-income taxpayers to avoid taxation entirely. Judged from this relative perspective, a large percentage of U.S. taxpayers consider the U.S. tax system unfair.

Some tax breaks are broadly recognized as appropriate, even necessary. Generally approved allowances include the deduction of “ordinary and necessary" business expenses to arrive at an economically accurate calculation of income. Similarly, the standard deduction, itemized deductions for medical expenses, charitable contributions, mortgage interest, certain losses, and refundable tax credits for individuals have broad support.

The Internal Revenue Code (IRC) includes individual and corporate income taxes, payroll taxes, excise taxes, estate, and gift tax, and generation-skipping transfer tax; however, criticism generally has focused on the broad-based individual and corporate income taxes.

Understandably, there is little enthusiasm for paying taxes. Still, concerns about fairness and not the actual dollar amount of tax liabilities currently generate most complaints—perhaps a tacit acknowledgment of the tax law’s current rates, which are relatively moderate compared to far higher rates in the past.

As budget deficits increased, beginning in 2018 when major tax cuts reduced tax revenues—a trend intensified since the COVID-19 pandemic impaired the economy—concern grew not only about the fairness but also about the effectiveness and adequacy of the tax law and its administration.

Let's look at some of these issues in more detail.

Higher Benefits for Higher Tax Brackets

Although the U.S. tax code increases marginal tax rates on taxable income as taxable income brackets rise—the structure of a progressive tax system—graduated rates and brackets aren't the only driving force. Progressive tax is countered by:

• Exemptions and exclusions for certain types of income—for example, tax-exempt interest paid on state and local government bonds
• Special, lower rates for some income categories, such as capital gains and dividends
• Deductions for a wide range of expenditures, including some generous allowances for business expenses

Such adjustments—for simplicity, referred to collectively as "deductions" going forward—can result in lower effective tax rates on the incomes of some very high-income individuals than apply to far lower incomes. These deductions sometimes enable taxpayers with extremely high earnings and investment returns to avoid any tax liability.

Deductions vs. Credits

Deductions that produce lower taxable incomes benefit taxpayers in a regressive, rather than progressive, manner. The tax benefit for such items generally equals the amount of the reduction multiplied by the taxpayer’s marginal tax rate.

Thus, if an individual taxpayer’s income falls into the top 37% tax bracket, each reduction of $100 from income that otherwise would be taxed at this rate will save the taxpayer $37. If the applicable rate is 24%, the savings for a $100 reduction in income would be only $24.

This allowance of greater tax savings for higher incomes contrasts with the savings from a tax credit. A 20% tax credit generally will save all taxpayers $20 in tax liability for each $100 expended, regardless of income level and tax bracket. However, if the amount of the credit exceeds the taxpayer’s tax liability, the taxpayer will not enjoy the full $20 savings unless the credit is refundable. Many tax credits are non-refundable.

Corporate Tax Avoidance

Since 2018, the tax law generally applies a corporate income tax of 21%; however, many U.S. corporations pay far lower effective rates—or no tax at all—because of substantial business write-offs, carrybacks and carryforwards of losses, aggressive tax planning and, if audited, tenacious and lengthy negotiating.

Even as some challenge the existence of any corporate tax regime, others debate the appropriateness and level of corporate tax benefits, particularly those enjoyed by politically influential industries.

Alternative Minimum Tax Limitations

Over the years, corporate and individual alternative minimum tax (AMT) rules were enacted to ensure that taxpayers with high income but substantial deductions and other tax breaks pay at least some taxes. Then, the 2017 Tax Cuts and Jobs Act repealed the AMT for all C corporations.

It also increased the exemption amount and exemption phaseout under the individual AMT, with the result that under present law, fewer individual taxpayers are subject to the AMT than they were before 2018.

The minimum tax rules never fully accomplished the purpose of ensuring that all taxpayers are taxed. These laws generally failed in large part because they relied on tax law concepts and definitions for income rather than on economic or financial standards.

Recognizing the limitations in prior laws, the recently enacted alternative corporate minimum tax applies its 15% to the “book” income that corporations report on their financial income statements, effective for tax years beginning after Dec. 31, 2022.

A corporation is subject to this “alternative” minimum tax—not to the regular 21% corporate income tax—if its minimum tax liability exceeds the amount that would be its regular corporate income tax liability; however, the scope of the new law is limited because it applies only to corporations with three-year annual average financial statement incomes in excess of $1 billion.

Preferential Rules for Investment Returns and Business Losses

Lower rates for investment returns and certain tax write-offs for businesses are also subjects of controversy.

Capital Gains and Dividends

Special low rates applicable to capital gains and dividends can enable taxpayers with significant investment returns to pay effective rates far below those applicable to ordinary income, such as salaries, wages, or interest. Investor Warren Buffett, whose income is comprised mainly of
investment returns, famously acknowledged that the tax law should not allow him to pay a lower tax rate than his receptionist.

Because these lower rates make the system less progressive and undercut perceptions of fairness, they provoke debate. Critics question the need for the rules and the size of the benefits.  Proponents of these benefits, on the other hand, believe that they encourage desirable economic investment.

The difficulty of addressing fairness issues is exemplified by the controversial carried interest rule, which benefits certain investment professionals, particularly managers of private equity and hedge funds. It allows them to pay only a 20% gains tax plus a 3.8% investment tax—a combined rate lower than ordinary income rates, which range up to 37%—on these gains. Efforts to eliminate this special treatment in the IRA were defeated, except that the holding period for carried interest benefits was lengthened from three years to five years.

Certain Business Losses

Individuals who materially participate in a trade or business operated directly or in a pass-through entity—or who participate in a real estate business as a real estate professional—can use losses from such activities to offset earnings or investment income from other activities. The rules permitting current, carryback, and carryforward deductions for such losses by an active participant (e.g., real estate professional, as applicable) permit eligible taxpayers to claim substantial write-offs that reduce or even eliminate their overall net taxable income.

Questions About Non-Income Taxes

In addition to income tax, the tax code imposes payroll taxes and estate and gift taxes. Although generally less discussed than income taxes, some of these taxes present issues similar to those arising under the income tax.

Payroll Taxes

Payroll taxes to fund Social Security benefits are imposed at the rate of 6.2% with respect to wages on both the employer and employee—and 12.4% on net earnings of the self-employed—up to $160,200 for 2023. In addition, the Medicare tax of 1.45% applies to covered wages, with no wage cap (tax is 2.9% for the self-employed).

Because these taxes are imposed at flat rates regardless of income level, they are “regressive.” All wages are subject to these taxes; there is no exclusion or zero-rate level. Thus, for individuals with low incomes, these taxes are a substantial burden.  

Some policymakers advocate imposing the Social Security tax at higher income levels, the way the Medicare tax already applies—or advocate extending it to unearned income. However, policy discussions tend to weigh the need to support trust funds against the risk that higher taxes on employers might adversely impact employment levels.

Estate and Gift Taxes

Estate and gift taxes apply to a small portion of the population and thus do not generate the breadth of interest or concern raised by income taxation. The estate tax exemption for 2023 is $12.92 million. Because many wealthy individuals and families engage in substantial tax planning, the impact of the estate tax, currently 40% on assets in excess of the exemption amount, has been limited.

In addition to the current estate tax, the tax code imposes a generation-skipping transfer tax. This is a tax on transfers of assets valued in excess of the exemption level to beneficiaries more than one generation below the transferor.

The code also imposes a gift tax but provides a $17,000 annual exemption for gifts that a taxpayer makes to a single recipient in 2023. Generally, there is no actual gift tax due until the total amount of a transferor’s gifts in excess of the annual exemption level together exceed the lifetime exemption, $12.92 million in 2023.

The amount of the excess over the annual exemption level reduces both the lifetime gift tax exemption and the estate tax exemption on a dollar-for-dollar basis. Because of these high exemption levels, the applicability of the gift tax to average taxpayers is limited.

Are Tax Laws Enforced Fairly?

A fundamental question about any law asks: Are the law and its application fair and effective? Reports released by the Internal Revenue Service and analyses published by independent experts indicate that, for more than a decade, the federal tax system has increasingly failed to meet these requirements.

Taxpayers’ satisfaction and compliance with the tax system depend on their perception that the tax code imposes—and authorities collect—a level of tax revenue adequate to support the current government budget and investments for the future and that all taxpayers are paying their fair share.

E-filed tax returns for most low- and middle-income taxpayers, whose earnings and investment income are reported to the IRS on information forms, effectively are audited each year when their returns are matched against information forms.

Many of these taxpayers suspect that wealthy individuals can reduce, or even avoid, their tax liability through aggressive strategies including by reporting questionable deductions and exclusions to offset income from their businesses and investment activities.   

For years, budgetary limitations on the Internal Revenue Service's ability to address non-compliance have resulted in substantial shortfalls in tax revenue. Because of the IRS budget reductions, and the resulting declines in headcount and enforcement, between 2010 and 2019 (latest study) audit rates decreased for all individual returns at all income levels. The difference between the tax revenue owed to the government and the amount collected has increased significantly.

In addition, between 2010 and 2019 (latest study), the audit rate for all taxpayers fell, although audit rates for lower-income groups were lower than those for higher-income taxpayers. During those years the number of audits for returns with $5 to $10 million of income fell 81%, while the audits for returns with income in excess of $10 million of income fell 66%. Over the same period, the number of returns filed for the two groups increased by 92% and 84%, respectively.  

Based on the IRS’ calculation, it failed to collect $496 billion due in all tax categories between 2014 and 2016 (latest IRS information). It is estimated the IRS failed to collect $600 billion in taxes in 2022. Additionally, between 2020 and 2029, the tax gap will rise to $7.6 trillion unless IRS resources are increased. The IRS complains the largest portion of that gap is due to underreported taxes, then the underpayment of taxes, and lastly by individuals not filing taxes at all.

Taxpayers who complied with tax laws found reports that IRS budgets and enforcement activities have declined markedly since 2010 disquieting. As its workforce has become smaller, the IRS' statistics—as well as expert analyses and general media reports—revealed that it is conducting fewer audits, with the most significant reductions occurring in audits of wealthy individuals, large corporations, and pass-through businesses and their owners.

An expert review of data released by the Congressional Budget Office and the Treasury Department concluded that every $1 of additional investment in the IRS would yield $11 in increased tax collections.

With a growing tax gap and fairness concerns increasing, the Biden administration proposed, and Congress enacted in the IRA, an allocation of an additional $80 billion for the IRS. The CBO initially estimated that the increase in IRS funding would realize a net revenue increase of $204 billion, re-estimated at $124 billion from 2022 to 2031.

Tax-System Alternatives

Would some other tax system work better and be fairer? From time to time, U.S. policymakers have evaluated alternative tax regimes as substitutes for—or supplements to—the U.S. income tax.

A flat, single tax rate on all income has had some adherents who emphasize its simplicity and argue that it would be fairer to charge all taxpayers the same rate. However, to raise the level of revenue required for government operations, it would be necessary to adopt a rate so high that the burden on lower-income taxpayers has been judged economically and politically unrealistic.

Similarly, when a value-added tax (VAT) or consumption taxes on goods and services have been examined, the exemptions required to avoid overly burdening low-income taxpayers entail significant complexity. The need to devise rules to cover groups enjoying special benefits under the income tax system—not only specific industries but also the very significant charitable sector—would also be problematic.

Recently, a flat rate annual tax on wealth has been proposed by advocates generally motivated by growing economic inequality and greater concentration of wealth in a smaller percentage of the population, as well as the goal of increasing revenue.

Although many, including economists and political scientists, have expressed concern about the concentration of wealth, the wealth tax proposal has not gained widespread support. This type of tax would entail significant complexity, particularly the difficult and burdensome task of valuing assets, such as works of art or private businesses, lacking a readily available, objective market value.   

Even if such alternatives to the present system were deemed feasible, the transition from the present income tax laws to an alternative regime presents challenges so far judged prohibitive. The enactment of some supplementary tax regime—or the revision and expansion of the current excise tax and tariff rules to supplement the income tax—would avoid some complexities but would increase administrative burdens for taxpayers and officials.

The Bottom Line

Americans frequently complain about the structure of the U.S. Internal Revenue Code, the administration of the tax system, and the fairness of its operation. Legislation creating a new 15% alternative corporate minimum tax—and providing $80 billion in increased IRS funding to increase customer service, upgrade systems, improve enforcement, and decrease the gap between taxes owed and collections—is intended to address some of these concerns.

However, the legislation’s failure to increase the capital gains and income tax rates for the wealthy and the regular 21% corporate rate, and to reverse overly generous business deductions, has prompted criticism that further change is necessary.    

Several major areas remain unaddressed.

• First, the effective rates of tax might be more progressive, and corporate tax reforms could apply to a larger range of corporate entities.
• Taxpayers' perception of the law’s fairness could be enhanced if tax deductions were re-evaluated and any unnecessary, inappropriate, and excessive tax benefits—particularly special interest write-offs—were reduced or eliminated.
• Rules to prevent business losses from offsetting income from unrelated sources could be more broadly applied.

Effective use of the new IRS funding could contribute to taxpayer confidence. Studies indicate that more and better auditing of high-net-worth individual and large-corporation tax returns would substantially reduce the tax gap. With the increased funding, IRS auditors should be able to devote the time required to evaluate the complex facts and circumstances presented in tax returns filed by business organizations and wealthy individuals.

However, changes to the tax law itself require congressional and presidential action. Both substantive tax law changes and administrative improvement are needed to enhance both the performance and public perception of the tax system.