BOX 8-1

Distortions in the Current Tax Code

Provisions in the tax code that favor one source of income or another can distort private financial decisions.

One example of such a distortion is that there generally is a single layer of income taxation for noncorporate business profits but two layers for corporate profits: returns to corporations’ investments are taxed at both the business level and at the individual level, in the form of dividend and capital gains taxes (see Gravelle, 2004).

The tax code also creates numerous distortions for capital investment. For example, for businesses, the system of asset depreciation is distorted by the ad hoc rules that govern the time period over which investment costs are deducted and by price inflation, which lowers the depreciation deduction below replacement costs (Congressional Budget Office, 1997:39; Jorgenson and Yun, 2002:317).

The tax code can distort decisions for personal savings as well. The income tax favors consumption over saving because consumption is not taxed but the returns to saving are, encouraging people to spend their earnings rather than save them. Because policy makers have long recognized the favored treatment of consumption over savings, they have enacted many special provisions for savings. The tax code has different rules for dividends, interest, tax-exempt bonds, capital gains, simplified employee pension plans, individual retirement accounts (IRAs), 401(k) retirement plans, Keogh Plans (which also allow individuals to tax-defer savings from earnings), and other retirement arrangements, life insurance, estates and inheritance, and annuities. Although in some cases these disparate rules may only subsidize the transfer of existing wealth into tax-favored accounts rather than spur new saving, they do reduce the anti-savings bias of the income tax. Yet they are so complex as to defeat most taxpayers’ (and some specialists’) understanding of them.

advantage of the tax code rather than in ways that bring true benefits for the individual or business. That is, tax-induced distortions risk reducing the long-term benefits that arise when individuals use their incomes as they choose. They thus interfere with the wise choices of both individuals and businesses for income, consumption, savings, investment, and production.

Marginal Tax Rates

Marginal tax rates are the rates that individuals and businesses pay on an additional dollar of income, or save for any item (such as an itemized deduction) for which there is a tax preference. The economic distortions in the tax code are magnified when marginal tax rates are high or differ among otherwise similar economic options. The economic waste (“deadweight



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