A Proposal for a
Dual-Rate Income Tax
Testimony to the
President’s Advisory Panel on Tax Reform
Chris Edwards
Director of Tax Policy, Cato Institute
May 11, 2005
1. Proposed Dual-Rate Tax
• A simpler income tax that treats Americans more
equally and promotes economic growth.
• Individual income tax rates of 15% and 27%.
• Corporate income tax rate of 15%.
• Cuts marginal tax rates on savings and investment,
which moves toward a consumption-based
system.
• Takes steps toward the Hall-Rabushka flat tax.
For dual-rate tax details, see Chris Edwards, “Options for Tax Reform,
Cato Institute, February 2005, www.cato.org/fiscal/tax-policy.html.
2. Dual-Rate Tax: Individuals
• Individual income tax rates of 15% and 27%. The top rate
begins at $90,000 (singles) and $180,000 (married). This
rate structure integrates with the federal payroll tax to
create a roughly consistent marginal tax rate on earnings at
all income levels.
• Itemized deductions are eliminated, including the mortgage
interest deduction and state/local tax deductions.
• Middle income families would have their marginal tax rate
fall from 25% or 28% to 15%.
• The top individual rate on dividends, interest, and capital
gains would be 15%. This structure builds around
President Bush’s dividend and capital gains cuts of 2003.
• Savings vehicles such as 401(k)s, IRAs, and HSAs would
be retained. Indeed, Congress should consider liberalizing
Roth IRAs and HSAs.
• Revenue neutral in 2004 based on Tax Foundation static
microsimulation model.
3. Marginal Income Tax Rates
Single Taxpayer Taking the Standard Deduction
35%
Marginal Tax Rate
30%
Current law
25%
20%
15%
Proposed dual-rate tax
10%
5%
0
20
40
60
80
100
T axable Income ($000s)
120
140
160
4. Combined Income and Payroll Tax Rates
Marginal Tax Rate on Wages, Single Taxpayer
45%
Current law
Marginal Tax Rate
40%
35%
30%
25%
Proposed dual-rate tax
20%
15%
0
20
40
60
80
100
T axable Income ($000s)
120
140
160
5. Dual-Rate Tax: Corporations
• Corporate tax rate cut from 35% to 15%.
• Equal treatment of interest and dividends. Both are
taxed at 15% at individual level and 15% at corporate
level.
• Corporate tax base broadeners include deductions for
interest, employee health care, and state and local taxes.
• The corporate base should not be broadened with antiinvestment provisions, as in 1986.
• Dynamic feedback effects from a corporate rate cut
would be large. A March Joint Tax Committee report
showed that a corporate rate cut would give a much
bigger boost to GDP growth than an individual tax cut.
• The dual-rate tax structure could incorporate territorial
treatment for international investments and capital
expensing.
6. Dual-Rate Tax: Simplification
• Nearly all individual deductions and credits eliminated.
All taxpayers would take the standard deduction.
• While that would be a huge simplification, the dualrate tax retains an income tax structure and would not
be as simple as a consumption-based tax such as HallRabushka.
• For corporations, the sharply reduced tax rate would
greatly cut incentives for both legal tax avoidance and
illegal tax evasion. The compliance costs of current tax
rules on multinationals are enormous because the rules
are complex and because firms are so responsive to the
taxes.
• Capital expensing and the territorial treatment of
international investment would be simpler and more
efficient.
7. Dual-Rate Tax: Fairness
• The dual-rate tax would greatly increase “horizontal
equity.” Americans with similar earnings would pay
similar amounts of tax.
• About 95% of households would pay tax at the 15%
rate.
• I support proportional taxation and the dual-rate tax
takes a small step in that direction, but it is still very
graduated or “progressive.”
• For higher earners, tax rates are cut but itemized
deductions that favor this group are eliminated.
• For lower earners, the plan retains the earned income
tax credit.
• For all earners, the plan retains the current standard
deduction, while expanding the personal exemption
from $3,200 to $4,500.
8. Dual-Rate Tax: Economic Growth
• The top marginal tax rates on dividends, interest, wages,
and small business profits are cut.
• Reduced marginal tax rates would increase productive
activities and reduce “deadweight losses” of the tax
system.
Top Marginal Tax Rates
50%
45%
44.8%
Current law
Dual-Rate Tax
40%
40.6%
35.0%
35.0%
35%
30%
27.8%
27.8%
29.7%
27.0%
25%
20%
15%
10%
Dividends
Interest
Wages
Small business
profits
8. Economic Growth, continued
Top Marginal Tax Rates
Current Law
Dual-Rate Tax
1. Corporate income tax
Dividends
35%
15%
Interest
0
15%
Wages
0
0
2. Individual income tax
Dividends
15%
15%
Interest
35%
15%
Capital gains
15%
15%
Wages
35%
27%
Small business profits
35%
27%
3. Federal payroll tax
Wages below $90,000
15.3%
15.3%
Wages above $90,000
2.9%
2.9%
Combined tax rates
Dividends
44.8%
27.8%
Interest
35.0%
27.8%
Wages
40.6%
29.7%
Small business profits
35.0%
27.0%
Note: the employer half of the payroll tax is deductible against the
corporate tax.
9. Global Tax Competition
• The U.S. needs to respond to the global corporate tax
revolution. KPMG data show that the average
statutory corporate income tax rate in the 30-nation
OECD has fallen from 38% in 1996 to 30% today
(including national and subnational taxes).
Average Top Corporate Tax Rate in the OECD
40%
38%
37.6%
Note: The U.S. federal plus
average state rate is 40%
36.8%
35.9%
36%
34.8%
34.0%
34%
32.8%
31.4%
32%
30.9%
30.0%
30%
28%
1996
1997
1998
1999
2000
2001
2002
2003
2004
10. Conclusions
• Recent tax reforms (individual rate cuts, 15% dividend and
capital gains rates, partial expensing) should be extended
permanently. The dual-rate plan would build on these reforms.
• The president’s call for a revenue-neutral reform necessitates
trade-offs. The dual-rate plan eliminates most deductions and
credits but cuts marginal tax rates on labor and capital. That
would reduce tax complexity and increase fairness and growth.
• International competitiveness is a much more important today
than during the last big tax reform in 1986. Multinationals are
increasingly responsive to taxes with regard to real investment
and the movement of paper profits. A corporate tax rate cut
would attract inflows of profits and investment to the United
States, and is the single best reform that policymakers could
pursue.