What’s Wrong With the American Tax System

American taxpayers complain about a wide range of tax features but studies by the Pew Research Center consistently reveal that a majority express concern that some corporations and wealthy individuals don’t 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. How can these issues be fixed?

Taxpayer Sentiment

A 2021 Internal Revenue Service (IRS) survey regarding taxes reported that 94% of Americans believe it’s “every American’s civic duty to pay their fair share of taxes.” The majority of taxpayers viewed IRS performance favorably but attitudes varied by age group and education level.

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

Most taxpayers recognize that some form and level of taxation are necessary to fund the government but 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 various groups and interests contribute to an expansive debate.

Individuals and corporations will do their best to use tax rules to their advantage when they’re in place. What’s important is to look at the disparate impact of those rules as well as who benefits and who doesn’t.

Biden’s Attempts at Tax Change

The 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 $80 billion to the IRS in funding over 10 years to restore personnel levels that have dropped significantly for over a decade. The allocation was also intended to enhance customer service and improve enforcement.

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, however. Opponents of the IRS budget increase argue that it will support increased, aggressive, and even threatening IRS audits of ordinary taxpayers.

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, however.

The IRA originally 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 to be fair. This type of system is commonly characterized as “progressive.” Critics are concerned, however, that the national tax burden isn’t sufficiently graduated according to income level among individuals and between individuals and businesses. This is particularly the case with 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 higher effective income tax rates on middle- and lower-income individuals than on many with higher incomes and allows some higher-income taxpayers to avoid taxation entirely. A large percentage of U.S. taxpayers consider the U.S. tax system unfair.

Some tax breaks are broadly recognized as appropriate and even necessary. Generally approved allowances include the deduction of “ordinary and necessary” business expenses to arrive at an economically accurate calculation of income. 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 taxes, gift tax, and generation-skipping transfer tax. Criticism generally has focused on the broad-based individual and corporate income taxes, however.

There’s understandably little enthusiasm for paying taxes but concerns about fairness rather than the actual dollar amount of tax liabilities generate most complaints. This is perhaps a tacit acknowledgment of the tax law’s current rates which are relatively moderate compared to far higher rates in the past.

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

Higher Benefits for Higher Tax Brackets

The U.S. tax code increases marginal tax rates on taxable income as taxable income brackets rise. This is the structure of a progressive tax system. Graduated rates and brackets aren’t the only driving force, however. A progressive tax is countered by:

• Exemptions and exclusions for certain types of income such as 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

These deductions can result in lower effective tax rates on the incomes of some very high-income individuals than those that apply to far lower incomes. They 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.

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

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

Corporate Tax Avoidance

Tax law has generally applied a corporate income tax of 21% since 2018 but many U.S. corporations pay far lower effective rates or no tax at all due to substantial business write-offs, carrybacks and carryforwards of losses, aggressive tax planning, and tenacious and lengthy negotiating if audited.

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

Alternative Minimum Tax Limitations

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

It also increased the exemption amount and the exemption phaseout under the individual AMT. Fewer individual taxpayers are subject to the AMT than they were before 2018 as a result.

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.

The enacted alternative corporate minimum tax recognizes the limitations in prior laws and applies its 15% to the “book” income that corporations report on their financial income statements beginning in tax years 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. The scope of the law is limited, however, because it applies only to corporations with three-year annual average financial statement incomes over $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 made up mainly of
investment returns famously acknowledged that the tax law should not allow him to pay a lower tax rate than his receptionist.

These lower rates make the system less progressive and undercut perceptions of fairness so they provoke debate. Critics question the need for the rules and the size of the benefits. Proponents of these benefits believe they encourage desirable economic investment.

The difficulty of addressing fairness issues is exemplified by the controversial carried interest rule that benefits certain investment professionals, particularly managers of private equity and hedge funds. The carried interest rule allows them to pay only a 20% capital gains tax plus a 3.8% investment tax on these gains, a combined rate that’s lower than ordinary income rates which range up to 37%.

Efforts to eliminate this special treatment in the IRA were defeated but 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 can use losses from such activities to offset earnings or investment income from other activities. This includes those who participate in a real estate business as a real estate professional.

The rules permitting current, carryback, and carryforward deductions for such losses by an active participant permit eligible taxpayers to claim substantial write-offs that reduce or even eliminate their overall net taxable income.

Questions About Non-Income Taxes

The tax code imposes payroll taxes and estate and gift taxes in addition to income tax. These are generally less discussed than income taxes but some of them 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% of wages on both the employer and employee and 12.4% on net earnings of the self-employed. This is applicable on up to $176,100 in income in 2025. The Medicare tax of 1.45% applies to covered wages with no wage cap. This tax is 2.9% for the self-employed.

These taxes are imposed at flat rates regardless of income level and are therefore referred to as “regressive.” All wages are subject to these taxes. There’s no exclusion or zero-rate level. They can therefore be a substantial burden for individuals with low incomes.  

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

Estate and Gift Taxes

Estate and gift taxes apply to a small portion of the population and don’t generate the breadth of interest or concern raised by income taxation. The estate tax exemption for 2025 is $13.99 million and the rate is 40% on assets over this exemption amount. Many wealthy individuals and families engage in substantial tax planning, however, so the impact of the estate tax has been limited.

The tax code also imposes a generation-skipping transfer tax. This is a tax on transfers of assets valued at more than the exemption level to beneficiaries who are more than one generation younger than the transferor.

The code also imposes a gift tax but it provides a $19,000 annual exemption for gifts that a taxpayer makes to a single recipient in 2025. There’s generally no actual gift tax due until the total amount of a transferor’s gifts in excess of the annual exemption level together exceeds the lifetime exemption of $13.99 million as of 2025.

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. The applicability of the gift tax to average taxpayers is limited because of these high exemption levels.

Are Tax Laws Enforced Fairly?

A fundamental question about any law is whether the law and its application are fair and effective. Reports released by the Internal Revenue Service and analyses published by independent experts indicate that 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 that’s adequate to support the 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 are effectively audited each year when their returns are matched against these information forms.

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

Budgetary limitations on the Internal Revenue Service’s ability to address non-compliance have resulted in substantial shortfalls in tax revenue for years. Audit rates and resulting declines in headcount and enforcement decreased for all individual returns at all income levels between 2010 and 2019 because of the IRS budget reductions. The difference between the tax revenue owed to the government and the amount collected has increased significantly.

The audit rate for all taxpayers fell between 2010 and 2019 although audit rates for lower-income groups were lower than those for higher-income taxpayers. The number of audits for returns with $5 to $10 million of income fell 81% during these years. Audits for returns with income over $10 million of income fell 66%. The number of returns filed for the two groups increased by 92% and 84% respectively over the same period.  

The IRS failed to collect $496 billion due in all tax categories between 2014 and 2016. It’s estimated that the IRS failed to collect $600 billion in taxes in 2022. The tax gap will rise to $7.6 trillion between 2020 and 2029 unless IRS resources are increased. The IRS complains that 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 it disquieting that IRS budgets and enforcement activities have declined markedly since 2010. The IRS statistics as well as expert analyses and general media reports revealed that it’s 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.

The Biden administration proposed and Congress enacted an allocation of an additional $80 billion for the IRS in the IRA. 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? U.S. policymakers have evaluated alternative tax regimes from time to time 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. It would be necessary to adopt a rate so high, however, that the burden on lower-income taxpayers has been judged economically and politically unrealistic.

The exemptions required to avoid overly burdening low-income taxpayers entail significant complexity when a value-added tax (VAT) or consumption taxes on goods and services are examined. 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.

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 by the goal of increasing revenue.

Many economists and political scientists have expressed concern about the concentration of wealth but 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.   

The transition from the present income tax laws to an alternative regime presents challenges that have so far been judged prohibitive even if such alternatives to the present system were deemed feasible. The enactment of some supplementary tax regime or the revision and expansion of the 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 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.

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, however.    

Several major areas remain unaddressed:

• 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 were reduced or eliminated, particularly special interest write-offs.
• Rules to prevent business losses from offsetting income from unrelated sources could be more broadly applied.

Effective use of the 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. The increased funding should allow IRS auditors to devote the time required to evaluate the complex facts and circumstances presented in tax returns filed by business organizations and wealthy individuals.

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