Overview of the Federal Tax System

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The individual income tax is the major source of federal revenue, followed closely by Social
Security taxes. As a revenue source, the corporate income tax is a distant third. Federal estate and
gift and excise taxes play only minor roles as revenue sources.
In FY2007, individual income taxes accounted for 45% of total federal revenue. Social Security
taxes accounted for 34%. Corporate income taxes accounted for 14%; excise taxes accounted for
3%; and estate and gift, customs, and miscellaneous taxes accounted for the remaining 4% of
total revenue. Over time, corporate income tax has become much less important as a revenue
source while Social Security taxes have become much more important.
In 2000, total receipts were 20.9% of gross domestic output (GDP), which represented a post
World War II high. By 2004, federal receipts had fallen to 16.4% of GDP, the lowest level since
1959. Most of this reduction was attributable to legislated tax cuts. Receipts haven since risen to
18.5% of GDP in 2006 and 18.8% in 2007, although the percentage is expected to decline in
2008. Taxes (including all levels of government) in the United States are low compared to those
in most other developed countries.
There are four individual income tax filing categories: married filing jointly, married filing
separately, head of household, and single individual. The individual income tax base is wages,
salaries, tips, income from investments, and business income. The base is reduced by certain
adjustments, such as contributions to traditional IRAs, producing adjusted gross income (AGI).
Standard or itemized deductions and personal exemptions reduce AGI to taxable income, which is
taxed at graduated rates of 10%, 15%, 25%, 28%, 33%, and 35%. Preliminary tax liability is then
reduced by tax credits to arrive at a taxpayer’s final income tax liability.
Corporate taxable income is subject to a set of graduated rates: 15%, 25%, 34%, and 35%, but
most income is taxed at the top rate. The base is approximately earnings from equity investments.
Social Security and Medicare tax rates are, respectively, 12.4% and 2.9% (half paid by the
employer and half by the employee). In 2008, Social Security taxes are levied on the first
$102,000 of wages, with the wage cap adjusted annually for increases in average wages in the
economy. Medicare taxes are assessed against all wage income.
The major federal excise taxes are levied on transportation fuels, alcohol, tobacco, telephones,
and domestic air transport.
This report will be updated on enactment of major changes in the federal tax system.

Federal Taxes: A Description...........................................................................................................1
The Structure of the Federal Individual Income Tax.................................................................1
Base and Adjustments.........................................................................................................2
Deductions and Exemptions...............................................................................................2
Tax Rates.............................................................................................................................3
Tax Credits..........................................................................................................................4
Alternative Minimum Tax...................................................................................................5
The Corporate Income Tax........................................................................................................6
Payroll Taxes.............................................................................................................................7
Estate and Gift Tax....................................................................................................................7
Excise Taxes..............................................................................................................................8
Tax Statistics..................................................................................................................................10
Composition and Size of the Federal Tax System...................................................................10
The U.S. Fiscal Position Compared to Other Nations..............................................................11
Distribution of the U.S. Federal Tax Burden Across Income Classes......................................11
Selected Tax Concepts...................................................................................................................12
Tax Expenditures.....................................................................................................................12
Capital Gains...........................................................................................................................13
Marriage Penalties and Bonuses.............................................................................................14
Tax Deferral............................................................................................................................15
Depreciation ............................................................................................................................ 16
Forms of Business Organization.............................................................................................17
Taxes and Competitiveness.....................................................................................................18
Table 1. Statutory Personal Exemptions and Standard Deductions.................................................3
Table 2. Statutory Marginal Tax Rates for 2008..............................................................................3
Table 3. Composition and Size of U.S. Tax Receipts....................................................................10
Table 4. U.S. Fiscal Position Compared to Other Industrialized Nations in 2006.........................11
Table 5. Average Federal Tax Rates for All Households: 1995, 2000, and 2005..........................12
Table 6. Sum of Tax Expenditure Items by Type of Taxpayer, Fiscal Years 2006-2010...............13
Author Contact Information..........................................................................................................19

he sources of federal tax revenue are individual income taxes; Social Security and other
payroll taxes; corporate income taxes; excise taxes; and estate and gift taxes. This report
describes the federal tax structure and provides some tax statistics. T

The individual income tax is the major source of federal revenues, followed closely by Social
Security and other payroll taxes. As a revenue source, the corporate income tax is a distant third.
Estate and gift and excise taxes play only minor roles as revenue sources.
There are four main filing categories under the individual income tax: married filing jointly,
married filing separately, head of household, and single individual.
The individual income tax base is composed of wages, salaries, tips, taxable interest and dividend
income, business and farm income, realized net capital gains, income from rents, royalties, trusts,
estates, partnerships, taxable pension and annuity income, and alimony received.
The tax base is reduced by adjustments to income, including contributions to Keogh and
traditional IRAs, some interest paid on student loans, and alimony payments made by the
taxpayer. This step of the process produces adjusted gross income (AGI), which is the basic
measure of income under the federal income tax.
The tax base is further reduced by certain deductions. Taxpayers can take a standard deduction or
they may itemize their deductions. The elderly and blind are allowed an additional standard
deduction. Itemized deductions are allowed for home mortgage interest payments, state and local
income taxes, state and local property taxes, charitable contributions, medical expenses in excess
of 7.5% of AGI, and a few other items. As a temporary measure in tax years 2005-2007, state and
local sales taxes can be deducted as an alternative to state and local income taxes.
The tax base is reduced further by subtracting personal and dependent exemptions. Personal
exemptions are allowed for the taxpayer, his or her spouse, and each dependent. For taxpayers
with high levels of AGI, the personal and dependent exemptions are phased out.
Taxable income equals AGI reduced by either the standard deductions or itemized deductions and
personal and dependent exemptions. Taxable income is the base on which federal income tax is
assessed.
The individual income tax has six marginal income tax rates: 10%, 15%, 25%, 28%, 33%, and
35%. These marginal income tax rates are applied against taxable income to arrive at a taxpayer’s
gross income tax liability.
Long-term capital gains—that is, gain on the sale of assets held more than 12 months—and
qualified dividend income are taxed at lower tax rates.
Tax credits are subtracted from gross tax liability to arrive at a final tax liability. The major tax
credits include the earned income tax credit, the child tax credit, the education tax credit, the tax
credit for the elderly and the disabled, and the credit for child and dependent care expenses. (See

CRS Report RL30110, Federal Individual Income Tax Terms: An Explanation, by Pamela J.
Jackson, for a further discussion of tax terms.)
The tax base for the individual income tax approximates the sum of labor and capital income and
thus, bears a resemblance to national income as measured by economists. There, are, however, a
number of exclusions; in addition, certain income transfers are subject to tax.
Wage income of employees is taxed, although most contributions to employee pension and health
insurance plans and certain other employee benefits are not included in wages subject to income
tax. Employer contributions to Social Security are also excluded from wages. When pensions are
received, they are included in income to the extent that they represent contributions originally
excluded. If the taxpayer has the same tax rate when contributions are made and when pensions
are received, this treatment is equivalent to eliminating tax on the earnings of pension plans.
Some Social Security benefits are also subject to tax.
Passive capital income, in the form of interest, dividends, and capital gains on financial
instruments, is also taxed, although the tax base excludes gains that are unrealized and interest on
tax-exempt securities issued by state and local governments.
Income from operating a business through a proprietorship, partnership, or small business
corporation that elects to be treated similarly to a partnership (Subchapter S corporation), or
through rental property (which reflects returns to both investment and effort) is also subject to
tax, although it is always difficult to measure such income precisely. This income is the net of
gross receipts reduced by costs such as payments to labor, depreciation, costs of goods acquired
for resale and other inputs, interest, and taxes. Some investment income of small businesses is
subject to favorable treatment through provisions that allow costs of capital equipment to be
expensed when incurred. Other income such as miscellaneous income, gambling winnings, and
royalties is also included in the tax base.
Transfers are sometimes included in income of the recipient and sometimes not. Among those
subject to tax are pension earnings, a portion of Social Security benefits for higher-income
individuals, unemployment compensation, alimony, and the portion of scholarships and
fellowships not used for tuition and books.
There are several adjustments to this income base to yield adjusted gross income. Probably the
most well known of these are deductions for individual retirement accounts and self-employed
pension plans, interest on student loans, alimony, certain education expenses, and moving
expenses.
Individuals subtract from their adjusted gross income either the standard deduction or itemized
deductions, along with an exemption for each family member. Extra standard deductions are
allowed for the blind and elderly. These statutory components of the income tax are indexed for
inflation.

Individuals may elect to itemize their deductions; these itemized deductions include deductions
for excess medical expenses, mortgage interest, state and local income taxes (or, alternatively,
state and local sales taxes), state and local property taxes, charitable contributions, and certain
miscellaneous deductions.
Personal exemptions and itemized deductions are limited for certain high-income taxpayers.
Table 1. Statutory Personal Exemptions and
Standard Deductions
²⁰⁰^{4 200}^{5 200}⁶²⁰⁰^{7 200}⁸
^{Personal Exemptions}^$3,10^{0 $3,20}^{0 $3,30}⁰^$3,40^{0 $3,50}⁰
^{Standard Dedu}^ctions
^—Joint^$9,70^{0 $10,0}^{00 $10,3}⁰⁰^$10,7^{00 $10,9}⁰⁰
^—Single^$4,85^{0 $5,00}^{0 $5,15}⁰^$5,35^{0 $5,45}⁰
^—Head^of^Household^$7,15^{0 $7,30}^{0 $7,75}⁰^$7,85^{0 $8,00}⁰
^{Add. Standar}^{d Deductions}^fo^{r the Elderly and the Blind}
^—Joint^$95^{0 $1,00}^{0 $1,00}⁰^$1,05^{0 $1,05}⁰
^{—Single/Head}^of^Household^$1,20^{0 $1,20}^{0 $1,25}⁰^$1,30^{0 $1,30}⁰
^Source:^Int^{ernal Reve}^{nue Code}
There are also limitations on allowances for children and students filing their own tax returns,
while claimed on someone else’s returns. (See CRS Report RS20072, Standard Deduction and
Personal/Dependency Amounts for Children Age 14 and Over or Students, by Pamela J. Jackson.)
Tax rate schedules for individuals include joint returns for married couples, head of household
returns for single individuals with dependents and single returns. (Married couples can file
separate returns; the brackets in these schedules are half as wide as brackets in the joint return, so
there is no tax rate advantage in filing such a return.) The individual income tax rate schedules are
shown below in Table 2.
Table 2. Statutory Marginal Tax Rates for 2008
^{Joint Returns}
^{If taxa}^{ble income is:}^Then,^tax^is:
^{$ 0}^to^$16,0⁵⁰^{10% of}^{the amo}^{unt over}^$0
^$16,0⁵⁰^to^$65,1⁰⁰^$1,60⁵^{plus 1}^{5% of t}^{he amou}^{nt o}^{ver $}^16,0⁵⁰
^$65,1⁰⁰^to^$13^1,45⁰^$8,96²^{plus 2}^{5% of t}^{he amou}^{nt o}^{ver $}^65,1⁰⁰
^$13^1,45⁰^to^$20^0,30⁰^$25,5⁵⁰^plus²⁸^{% of the}^amount^{over $1}^31,4⁵⁰
^$20^0,30⁰^to^$35^7,70⁰^$44,8²⁸^plus³³^{% of the}^amount^{over $2}^00,3⁰⁰
^$35^7,70⁰^plus^$96,7⁷⁰^plus³⁵^{% of the}^amount^{over $3}^57,7⁰⁰
^{Single Returns}

^{Joint Returns}
^{If taxa}^{ble income is:}^Then,^tax^is:
^$0^to^$8,02⁵^{10% of}^{the amo}^{unt over}^$0
^$8,02⁵^to^$32,5⁵⁰^$80^{2 pl}^{us 1}^{5% of t}^{he amou}^{nt ov}^{er $8,0}²⁵
^$32,5⁵⁰^to^$78,8⁵⁰^$4,48¹^{plus 2}^{5% of t}^{he amou}^{nt o}^{ver $}^32,5⁵⁰
^$78,8⁵⁰^to^$16^4,55⁰^$16,0⁵⁶^plus²⁸^{% of the}^amount^{over $7}^8,85⁰
^$16^4,55⁰^to^$35^7,70⁰^$40,0⁵²^plus³³^{% of the}^amount^{over $1}^64,5⁵⁰
^$35^7,70⁰^plus^$10^3,79²^{plus 3}^{5% of t}^{he amou}^nt^{over $3}^57,7⁰⁰
^{Heads of Households}
^{If taxa}^{ble income is:}^Then,^tax^is:
^$0^to^$11,4⁵⁰^{10% of}^{the amo}^{unt over}^$0
^$11,4⁵⁰^to^$43,6⁵⁰^$1,14⁵^{plus 1}^{5% of t}^{he amou}^{nt o}^{ver $}^11,4⁵⁰
^$43,6⁵⁰^to^$11^2,65⁰^$5,97⁵^{plus 2}^{5% of t}^{he amou}^{nt o}^{ver $}^43,6⁵⁰
^$11^2,65⁰^to^$18^2,40⁰^$23,2²⁵^plus²⁸^{% of the}^amount^{over $1}^12,6⁵⁰
^$18^2,40⁰^to^$35^7,70⁰^$42,7⁵⁵^plus³³^{% of the}^amount^{over $1}^82,4⁰⁰
^$35^7,70⁰^plus^$10^0,60⁴^{plus 3}^{5% of t}^{he amou}^nt^{over $3}^57,7⁰⁰
^Source:^Int^{ernal Reve}^{nue Code}
^Note:^Prel^{iminary, based on info}^{rmation contained in “A Summa}^r^y^{of 20}⁰⁷^{Inflation Adjustme}^{nts I}^mpacting
^{Individuals,” by James C. Young,}^{Tax Notes Today}^{, Septem}^ber^{18, 2}^006.
Long term capital gains and dividend income are taxed at lower rates: 5% for those in the 10%
and 15% brackets, and 15% for those in higher brackets. (See also CRS Report RL30007,
Individual Income Tax Rates: 1989 through 2007, by Gregg A. Esenwein.)
Many tax provisions are phased out as income increases, which has the effect of increasing
marginal tax rates.
Income may also be taxed under the alternative minimum tax (AMT), whose rates are set at 26%
and 28% on an expanded base (see below).
The current tax rates, which were reduced by the 2001 tax cut are technically scheduled to return
to their prior values after 2010, although they may be extended or made permanent. The lower
rates on dividends and capital gains also expire after 2010; if not extended, dividends will be
taxed at ordinary rates and long-term capital gains tax rates will rise (although they will still be
subject to favorable rates).
Tax credits offset tax liability on a dollar-for-dollar basis and have become an increasingly
popular method of providing tax relief and social benefits in general. If a tax credit is refundable
and it exceeds tax liability, a taxpayer receives a payment from the government. If credits are not
refundable, then they provide no benefit to many lower income individuals who have no tax
liability. The earned income credit is refundable, and the child tax credit is refundable for all but
very low income families. Many credits are phased out as income rises and thus do not benefit

higher income individuals; these phase-out points vary considerably. There are credits for a
variety of purposes; the major individual income tax credits are described below.
This credit for children under 17 was adopted in 1997 and was originally set a $400 for each
qualifying child. Subsequent legislation in 2001, 2003, and 2004 increased the credit to $1,000
and extended its refundability. (See CRS Report RS21860, The Child Tax Credit, by Gregg
Esenwein and Max Shvedov.)
This credit is provided for the costs of paid care for dependents, mostly children. The maximum
credit is 35% of costs up to $3,000 for one individual, $6,000 for two or more individuals. The
rate is reduced when the taxpayer’s adjusted gross income (AGI) exceeds $15,000, but is no less
than 20%. The credit is nonrefundable.
The earned income credit is allowed against wages for lower- income families and individuals
and is designed to supplement wages so that working families can have sufficient resources to
stay out of poverty. The EIC is refundable (otherwise, it could not fulfill its function) and is
phased out at lower and moderate income levels. (See CRS Report RS21477, The Earned Income
Tax Credit (EITC): Legislative Issues, by Christine Scott.)
These credits, enacted in 1997, provide benefits for post-secondary education. A credit of 100%
of a portion of tuition and 50% of an additional portion (varying by year) applies for the first two
years of undergraduate tuition. There is also a lifetime learning credit of 20% that applies to all
education and to a larger base. This credit is not refundable. (See CRS Report RL32507, Higher
Education Tax Credits: An Economic Analysis, by Pamela J. Jackson.)
Individuals may also pay tax under the alternative minimum tax (AMT). Under current law, to
calculate the AMT, an individual first adds back various tax items, including personal exemptions
and certain itemized deductions, to his regular taxable income. This grossed up amount becomes
the income base for the AMT. Next, an exemption of $66,250 for joint returns and $44,350 for
single and head of household returns is subtracted from this income base to obtain AMT taxable
income. (These exemption levels are temporary levels for 2007, and are scheduled to revert to
their prior law levels of $45,000 for joint returns and $35,750 for unmarried taxpayers in 2008.)
The basic exemptions are phased out for taxpayers with high levels of AMT income. A two-tiered
rate structure of 26% and 28% is then assessed against AMT taxable income. The taxpayer
compares his AMT tax liability to his regular tax liability and pays the greater of the two.
Even though a taxpayer may not actually pay any AMT, it can affect his regular tax liability
because nonrefundable tax credits under the regular income tax are limited to the excess of

regular income tax over AMT liability. Thus, a taxpayer who has a net $4,000 regular income tax
liability ($5,000 tax liability less $1,000 in nonrefundable tax credits) but has an AMT liability of
$4,300 will, effectively, see his regular income tax credits reduced by $300. Temporary
provisions, first enacted in 1998, that allow individuals to use all personal tax credits against both
their regular and AMT tax liabilities. This change is effective through December 31, 2006.
Although the AMT was originally designed to prevent high-income taxpayers from escaping what
was perceived to be their fair share of the income tax burden, there will be a significant increase
in the number of middle- to- upper -middle- income taxpayers affected by the AMT. (See CRS
Report RL30149, The Alternative Minimum Tax for Individuals, by Steven Maguire, for further
information).
Corporate taxable income is subject to a set of graduated rates: 15%, 25%, 34%, and 35%, with
the lower rates applying to firms with lower taxable incomes. Since smaller firms tend to have
smaller profits, small firms benefit more often from the 15% and 25% rates. And since the bulk of
corporate income is earned by large firms, most corporate income is subject to either the 34% or
35% rate. The benefits of the lower rates are phased out, and during the phase out range, marginal
tax rates are actually higher because an additional dollar of income not only has a direct tax rate
but also reduces the benefit of lower rates.
The base of the corporate income tax is net income, or profits, as defined by the tax code. In
general this is gross revenue minus costs. Deductible costs include materials, interest, and wage
payments. Another important deductible cost is depreciation—an allowance for declines in the
value of a firm’s tangible assets, such as machines, equipment, and structures.
In broad economic terms, the base of the corporate income tax is the return to equity capital, as
follows. Wages are tax-deductible, so labor’s contribution to corporate revenue is excluded from
the corporate tax base. Income produced by corporate capital investment includes that produced
by corporate investment of borrowed funds, and that produced by investment of equity, or funds
provided by stockholders. Profits from debt-financed investment are paid out as interest, which is
deductible; thus, the return to debt capital is excluded from the corporate tax base. Equity
investments are financed by retained earnings and the sale of stock. The income equity
investment generates is paid out as dividends and the capital gains that accrue as stock increases
in value. Neither form of income is generally deductible. Thus, the base of the corporate income
tax is the return to equity capital.
Because of the nature of its base, the corporate income tax has several broad effects on the
allocation of capital investment. First, it favors non-corporate investment—for example,
unincorporated business and owner-occupied housing—over corporate investment. Second, it
favors corporate debt over corporate equity investment since the former is not subject to the tax.
However, while the base of the tax is equity income, the flow of capital out of the corporate
sector and other economic adjustments probably cause the burden of the tax to spread to all
owners of capital: owners of unincorporated business, bondholders, and homeowners. The tax can
also shift from capital income to labor income, or even benefit labor income (with capital bearing
more than 100% of the tax). The government agencies that provide distributional analysis allocate
the corporate tax to capital in general.

A question that economists find is reasonable to ask is: why tax corporate profits at all? Corporate
equity profits are taxed twice, once at the corporate level and once under the individual income
tax when they are received by stockholders as dividends or capital gains. As a consequence, taxes
tend to steer investment away from the corporate sector. Further, corporations are not persons
who can bear the burden of taxes, but merely legal entities through which individuals earn
income. From this point of view it is misleading to compare the tax burden of a corporation with
that of an individual. The corporate tax, some argue, should be combined (“integrated”) with the
individual income tax in some manner. Some of the reasons that have been put forward for having
a separate corporate tax are: it discourages the use of corporations as shelters from the individual
income tax; it probably adds to the tax system’s progressivity; integration of the individual and
corporate taxes would present administrative difficulties; and the corporate tax has a degree of
public support. It also raises significant revenue.
In 2003, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) took a step in the
direction of relieving the double-taxation of corporate income by reducing the tax rate individuals
pay on corporate-source dividends and capital gains to 15% for 2003 to 2008. In 2006, the Tax
Increase Prevention Reconciliation Act (TIPRA) extended the reduced rates through 2010. For
more information, see CRS Report RL31597, The Taxation of Dividend Income: An Overview
and Economic Analysis of the Issues, by Jane G. Gravelle. For a discussion of who bears the
burden of corporate (and other capital) income taxes, see CRS Report RL32517, Distributional
Effects of Taxes on Corporate Profits, Investment Income, and Estates, by Jane G. Gravelle.
Payroll taxes are used to fund specific programs, largely Social Security and Medicare. Social
Security and Medicare taxes make up the largest share of federal payroll taxes by a wide margin.
Social Security and Medicare taxes are paid at a combined rate of 15.3% of wages, with 7.65%
being paid by the employee and employer alike. In 2008, the Social Security part of the tax (6.2%
for both employees and employers) is only levied on the first $102,000 of wages, with the cap
adjusted annually for increases in average wages in the economy. The Medicare portion (2.9%) is
applied to all wages.
The other categories of federal payroll taxes are unemployment insurance taxes (FUTA) and
employees’ contributions to the federal retirement system. The federal portion of the
unemployment tax is applied at a 6.2% rate to the first $7,000 of wages. However, the states
apply the tax at a 5.4% rate that is credited against the federal tax so that the net federal rate is

0.8%.

The federal estate tax is imposed when property is transferred at death. The taxable unit is the
estate, in contrast to an inheritance tax, which is levied on heirs. The base of the federal estate tax
is property transferred at death, less allowable deductions and exemptions. The base is subject to
graduated rates that rise from 18% to 45% as estate size increases. An unlimited marital deduction
is allowed for property transferred to a surviving spouse. Other allowable deductions include
estate administration expenses, transfers to charity, and certain other items. A tax credit (the
unified credit) is allowed against the tentative estate tax liability, which has the effect of
exempting the first $2 million of an estate from tax. The credit is scheduled to provide a $3.5
million exemption in 2009. Under the provisions of the Economic Growth and Tax Relief

Reconciliation Act of 2001 (EGTRRA; P.L. 107-16), the estate tax is repealed in 2010, although,
along with other provisions of EGTRRA, the repeal is currently scheduled to expire at the end of

2010.

The federal gift tax operates alongside the estate tax to prevent individuals from avoiding the
estate tax by transferring property to heirs before dying. (Note that the first $12,000 of gifts from
one individual to another is excluded from taxation. Thus, a married couple could each give a
child $12,000 each for a total gift of $24,000.) The gift and estate taxes are unified because the
same rates and unified credit amount apply to the cumulative taxable transfers over an
individual’s lifetime and at death. For example, a gift tax credit of $25,000 claimed during a
person’s lifetime reduces the credit that can be claimed at death under the estate tax by $25,000.
The rate bracket that applies to a transfer at death is based on cumulative gifts over the decedent’s
lifetime as well as the size of the estate. EGTRRA gradually reduces the top rate of the gift tax
parallel to the estate tax reductions. The gift tax will remain in place after 2010; its top rate will
be the top individual income tax rate applicable under EGTRRA.
The estate and gift tax occupies a minor role in the federal fiscal structure, accounting for only ¹
1.0% of gross federal tax collections in FY2007. Further, because of the exemption (the unified
credit) and deductions, few estates pay the tax. In 2004, only 1.3% of deaths resulted in estate tax ²
liability.
Aside from raising revenue, the estate tax has been defended as a means of increasing the overall
progressivity of the tax system. The tax falls on those with the greatest wealth, and wealth is
widely regarded as a good measure of an individual’s ability to pay. Some have argued, however,
that the tax impairs operation of the economy by discouraging lifetime saving and capital
formation. Whether the estate tax does so, however, is unclear.
The possible impact of the estate tax on small business and farms has often been the subject of
debate. Some have argued, for example, that the tax inhibits the transfer of farms and small
businesses to heirs and prevents them from staying in the decedent’s family. As a result of such
concerns, the estate tax currently has a number of special rules designed to ease its burden on
farms and small businesses. However, tax return data show that the farm and business estates
most likely to dispose of assets to pay the estate tax tend to be larger estates.
For more information, see CRS Report RL30600, Estate and Gift Taxes: Economic Issues, by
Donald J. Marples and Jane G. Gravelle, and CRS Report RL31061, Estate and Gift Tax Law:
Changes Under the Economic Growth and Tax Relief Reconciliation Act of 2001, by Nonna A.
Noto.
Excise taxes are a form of consumption tax—levies on the consumption of goods and services
rather than income. Unlike sales taxes, they apply to particular commodities, rather than to broad
categories. While the federal government has left sales taxes to the states as a revenue source, it

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levies a variety of excise taxes. Federal excise tax revenues are small compared to other federal
taxes. In FY2007, $65.1 billion in excise taxes were collected, amounting to 2.5% of total federal ³
receipts and 0.5% of Gross Domestic Product.
Federal excise taxes are levied on a variety of products; their collection point varies, ranging from
the production level to retail sales. In terms of receipts, the single largest tax is the excise tax on ⁴
gasoline, which made up 33.5% of all excise tax receipts in FY2006. Other prominent excise
taxes are those on diesel fuel, domestic air passengers, distilled spirits, beer, cigarettes, and
telephone services.
Most federal excise taxes are paid into trust funds devoted to various federal activities rather than
remaining in the federal budget’s general fund. In FY2007, 83% of excise tax receipts went into ⁵
trust funds. The largest amount went into the Highway Trust Fund, and consisted of highway
motor fuels taxes (including the gasoline tax), retail sales taxes on tractors and heavy trucks and
trailers, and an annual heavy vehicle use tax.
Excise taxes serve a variety of fiscal purposes. Some were enacted simply to raise revenue (for
example, the telephone tax and fuel taxes enacted for deficit reduction). The taxes linked with
trust funds serve to fund expenditure programs by taxing their beneficiaries, or by taxing those
responsible for certain problems addressed by expenditure programs. Some excise taxes adjust for
the effects of negative externalities—that is, they seek to ensure that the price of products that
produce side-effects like pollution reflects their true cost to society. Other purposes of excise
taxes include adjusting the price of imports to reflect domestic taxes, regulation of certain
activities, and regulation of activities thought to be undesirable.
The burden of excise taxes is thought to fall on consumption and more heavily on individuals
with lower incomes. The tax is believed to be usually passed on by producers to consumers in the
form of higher prices. And because consumption is a higher proportion of income for lower-
income persons than upper-income individuals, excise taxes are usually considered regressive.
However, the incidence of excise taxes in particular cases depends on the market conditions, and
how consumers and producers respond to price changes. Further, some economists have argued
that consideration of the incidence of excise taxes over an individual’s lifetime reduces their
apparent regressivity. The effects of excise taxes on economic efficiency vary, depending on the
particular tax. For example, taxes that counter negative externalities probably enhance economic
efficiency; others may hamper efficiency and reduce economic welfare by distorting prices and
consumption choices.
For further materials on excise taxes, see CRS Report RL33382, The Telephone Excise Tax: An
Economic Analysis, by Steven Maguire and Brent W. Mast, and Brent Mast; CRS Report
RS20172, Excise Taxes on Alcohol, Tobacco, and Gasoline: History and Inflation-Adjusted Rates,
by Brian Cashell, Pamela J. Jackson, and Louis Alan Talley; and CRS Report RL30304, The
Federal Excise Tax on Gasoline and the Highway Trust Fund: A Short History, by Pamela J.
Jackson.

³^U^.^{S. O}^f^fⁱ^c^e^o^f^Ma^na^g^e^m^e^{nt a}^nd^B^udg^e^t^,^B^u^d^g^e^t^of^the^U^.^{S. G}^o^v^e^r^nm^eⁿ^{t, F}ⁱ^s^c^{al Ye}^ar²⁰⁰⁹^{, H}ⁱ^s^t^or^ic^{al T}^able^s
⁽^W^a^s^hing^{ton: G}^P^O^,²⁰⁰⁸⁾^{, p}^p^.³³^-^35.
⁴^U.^S^.^Iⁿ^t^e^rn^al^Reven^u^e^S^e^rvi^ce,^S^t^atistic^{s o}^f^Inc^o^me^Bulle^tiⁿ^{, v}^o^l^.²⁶^{, S}^p^rⁱ^ng²⁰^07,^p.²^89.
⁵^U^.^{S. O}^f^fⁱ^c^e^o^f^Ma^na^g^e^m^e^{nt a}^nd^B^udg^e^t^,^B^u^dg^et^o^f^t^h^{e U.}^S^.^G^o^vern^m^en^t^,^Fⁱ^sca^l^Y^e^a^r²⁰⁰⁹^,^Aⁿ^a^l^ytⁱ^c^a^l^P^e^rsp^ectⁱ^ves
⁽^W^a^s^hing^{ton: G}^P^O^,²⁰⁰⁸⁾^{, p}^.²⁶⁹^.

The federal tax system is composed of five major sources of tax revenue. In FY2007 the
individual income tax accounted for 45% of total federal revenue, the Social Security tax for 34%
of total revenue, the corporate income tax for 14% of the total, and excise taxes for approximately ⁶

3% of the total. The remaining 4% was collected through the estate and gift tax, customs duties,

and other taxes.
Since 1959, total federal revenues have fluctuated between 16.1% and 20.9% of Gross Domestic ⁷
Product (GDP), with the average over the period equal to 18.1% of GDP. After reaching a post-
World War II peak of 20.9% of GDP in FY2000, federal receipts measured as a percentage of
GDP declined to a 53-year low of 16.3% of GDP in FY2004. Approximately 39% of this decline
was a result of a downturn in the economy, while about 61% of the decline in federal revenues
was the result of policy changes (tax cuts). Since the mid-1940s, the individual income tax has
been the most important source of federal revenue. Over time, the corporate income tax has fallen
from the second to the third most important source of revenue. In the late 1960s, corporate taxes
were replaced by Social Security taxes as the second leading revenue source.
Table 3. Composition and Size of U.S. Tax Receipts
^{Major Sour}^{ces of}^{Revenue as a % o}^f^{Total Revenue}
^Fiscal^{Federal Revenue}^Social
^Year^{as a % o}^f^GDP^Individual^Corp^orate^Security^Excise^Other
^{Income Taxes}^{Income Taxes}^Taxes^Taxes^Taxes
¹⁹⁶^{0 17.9}^44.0^23.2^15.9^12.6^4.2
¹⁹⁶^{5 17.0}^41.8^21.8^19.0^12.5^4.9
¹⁹⁷^{0 19.0}^46.9^17.0^23.0^8.1^4.9
¹⁹⁷^{5 17.9}^43.9^14.6^30.3^5.9^5.4
¹⁹⁸^{0 19.0}^47.2^12.5^30.5^4.7^5.1
¹⁹⁸^{5 17.7}^45.6^8.4^36.1^4.9^5.1
¹⁹⁹^{0 18.0}^45.2^9.1^36.8^3.4^5.5
¹⁹⁹^{5 18.5}^43.7^11.6^35.8^4.3^4.6
²⁰⁰^{0 20.9}^49.6^10.2^32.2^3.4^4.5
²⁰⁰^{5 17.6}^43.0^12.9^36.9^3.4^3.8
²⁰⁰^{7 18.8}^45.3^14.4^33.9^2.5^3.9
^Source:^{U.S. Office of Managem}^{ent and Budget,}^{Budget of the U.S.}^{Government, Fiscal Year 2009, Historical Tables}
^{(Washington: GPO, 20}^{08), p}^{p. 32}^-33.

⁶^U^.^{S. O}^f^fⁱ^c^e^o^f^Ma^na^g^e^m^e^{nt a}^nd^B^udg^e^t^,^B^u^d^g^e^t^of^the^U^.^{S. G}^o^v^e^r^nm^eⁿ^{t, F}ⁱ^s^c^{al Ye}^ar²⁰⁰⁹^,^Hⁱ^s^t^or^ic^{al T}^able^s
⁽^W^a^s^hing^{ton: G}^P^O^,²⁰⁰⁸⁾^{, p}^.³³^.
⁷^Ibid^{, p}^p^.^34-³⁵^.

Further information on the level of federal taxes since 1940 is contained in CRS Report RS20087,
The Level of Taxes in the United States, 1940-2005, by David L. Brumbaugh.
Given congressional interest in the fiscal position of the federal government, the question of how
the U.S. public sector compares to other nations often arises. Using aggregate budget data for all
levels of government relative to economic output (budget aggregates as a percentage of gross
domestic product, GDP) as one measure of the size of public sectors, several observations can be
made.
• Compared with the other major industrialized nations, the public sector
(including all levels of government) in the United States is relatively small.
• In terms of revenue, Japan and the U.S. public sectors collect the least amount of
revenue relative to their economic output.
• In terms of outlays, the U.S. public sector has the lowest level of outlays relative
to its economic output.
The following table presents Organization for Economic Co-Operation and Development
(OECD) estimates of government receipts, outlays, and deficits/surpluses as a percentage of GDP
for the seven major industrialized countries in 2005 (or, in several cases, 2004).
Table 4. U.S. Fiscal Position Compared to Other
Industrialized Nations in 2006
^{Receipts as a}^{Outlays as a}^{Surplus/Deficit as}
^{% of GDP}^{% of GDP}^{a % of}^GDP
^Japan^31.7^38.1^-6.4
^{United States}^33.1^36.6^-3.5
^{Canada 40.7}^39.3^1.4
^{United Kingdom}^42.2^45.0^-2.8
^Germa^{ny 44.0}^45.7^-1.7
^{Italy 45.6}^50.1^-4.5
^{France 50.8}^53.4^-2.6
^Source:^Orga^{nization for Econo}^{mic Cooperation and Development,}^{OECD in Figu}^{res 2007}^{, p. 56.}
The distribution of the federal tax burden is a perennial topic of concern and debate. Tax burdens
could be distributed such that all taxpayers pay the same percentage of their income in taxes
regardless of their income level, a proportional distribution. Alternatively, the tax burden could be
distributed such that lower income taxpayers pay a higher percentage of their income in taxes
than do upper-income taxpayers, a regressive distribution. Or the tax burden could be distributed
progressively such that taxes as a percentage of income increase as incomes increase.

Economic theory does not provide an answer as to how the tax burden should be distributed
among people with unequal incomes. While few would argue that the tax system should be
regressive, the degree to which it should be progressive involves subjective value judgements. A
consensus seems to have evolved that the federal tax system should be progressive, a goal that,
over time, has been achieved.
Studies by the Congressional Budget Office (CBO) show that while there have been some
fluctuations in the distribution of the tax burden over the last 20 years, the largest fluctuations
have been concentrated at the ends of the income spectrum. Families in the middle of the income
spectrum have experienced a stable level of federal taxes over the period. Tax law changes in the
early 1980s tended to increase federal taxes on low-income families while reducing taxes on
upper-income families. These trends were reversed in the early 1990s when tax law changes
raised federal taxes on upper-income families and reduced taxes for families at the lower end of
the income spectrum. Changes in 2001 and 2003 provided significant tax reductions for middle-
to upper-income families filing joint returns. The following table shows average federal tax rates
for both ends, as well as the middle, of the last decade: 1995, 2000, and 2005 (the latest year
available).
Table 5. Average Federal Tax Rates for All Households:
1995, 2000, and 2005
^{Income category}¹⁹⁹⁵²⁰⁰⁰²⁰⁰⁵
^{Lowest quintile}^{6.3% 6.4%}^4.3%
^{Second quintile}^{13.4 13.0}^9.9
^{Middle quintil}^e^{17.3 16.6}^14.2
^{Fourth quintile}^{20.5 20.5}^17.4
^{Highest quintil}^e^{27.8 28.0}^25.5
^{Top 10%}^{29.8 29.6}^27.4
^{Top 5%}^{31.8 31.0}^28.9
^{Top 1%}^{36.1 33.0}^31.2
^{All quintiles}^{22.6 23.0}^20.5
^Source:^{U.S. Congress, Congressional Budget Office,}^{Historical Eff}^{ective Federal Tax Rates: 1979 to 2005}^.
^{Available at the CBO website, at}^{http://www.cbo.gov/}^{ftpdoc.cfm?index=8}⁸⁸^5&type^{=2, visited Marc}^h^{17, 2}⁰⁰^8.
For more information, see CRS Report RS20059, Recent Trends in the Federal Tax Burden, by
Gregg Esenwein. Also see the CBO study, Historical Effective Federal Tax Rates: 1979 to 2005.

Tax expenditures are revenue losses from special tax deductions, credits, and other tax benefits.
The Joint Committee on Taxation lists revenue losses from these tax provisions by functional
spending categories. The table below reports the mathematical sums of tax expenditures. While it
is not precisely correct to add up all tax expenditures, which are estimated individually and have

some interactive effects, these totals provide some notion of the magnitude of these provisions. In ⁸
FY2007, individual income taxes yielded $1,163.5 billion. Thus, these tax expenditures are large
relative to total receipts.
Table 6. Sum of Tax Expenditure Items by Type of Taxpayer,
Fiscal Years 2006-2010
^{(in billions of dol}^l^ars)
^{Fiscal Year}^Individuals^Corp^orations^Total
²⁰⁰^{6 $86}^8.5^$74.9^$94^3.4
²⁰⁰^{7 906.}⁸^86.6^993.⁴
²⁰⁰^{8 951.}⁶^91.3¹⁰⁴^2.9
²⁰⁰^{9 101}^1.0^98.5¹¹⁰^9.4
²⁰¹^{0 104}^9.3^105.⁹¹¹⁵^5.2
^Source:^{U.S. Congress, Senate, Committee on the Budget,}^{Tax Expenditures—Compendium of Background}
^{Material on Individ}^{ual Provisions,}^December²⁰^06,^{p.7; u}^{pdated bien}^{nially based on data provided by t}^{he Joint}
^{Committee on Taxation.}
Tax expenditures measure the revenue effects of provisions on a cash flow basis, so they may not
reflect the true benefit to the taxpayer (e.g., when the value of a benefit arises from a deferral of
taxes). The initial revenue effects of a repeal of a provision may differ from the costs reflected in
the tax expenditure budget. For example, a new depreciation scheme usually applies only to new
investments, while the tax expenditure reflects effects on old assets.
For lists of tax expenditures see OMB’s Analytical Perspectives on the Budget and the Joint
Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011.
Under current income tax law, a capital gain or loss is the result of a sale or exchange of a capital
asset. If the asset is sold for a higher price than its acquisition price, then the sale produces a
capital gain. If the asset is sold for a lower price than its acquisition price, then the sale produces
a capital loss. Capital gains taxes were reduced in 1997, and the holding period to qualify for
long-term capital gain tax treatment was reduced in 1998. Under current law, capital assets held
longer than 12 months are considered long-term assets, while assets held 12 months or less are
considered short-term assets. Capital gains on short-term assets are taxed at regular income tax
rates. In 2003, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) reduced the
maximum tax rate on long-term capital gains income to 5% (0% for 2008) for taxpayers in the
10% and 15% marginal income tax brackets. JGTRRA reduced the maximum capital gains tax
rate to 15% for taxpayers in marginal income tax brackets exceeding 15%. These changes were
initially effective for assets sold or exchanged on or after May 6, 2003, and before January 1,
2009, but the Tax Increase Prevention and Reconciliation Act of 2006 (P.L. 109-222) extended the
applicability of reduced rates through 2010.

⁸^O^f^fⁱ^c^e^o^f^Ma^na^g^e^m^e^{nt a}^{nd B}^udg^e^t^,^Bu^dge^t^{of t}^h^e^U^.^S^.^G^o^v^e^r^nm^eⁿ^{t, Fis}^c^al^Ye^ar²⁰⁰⁹^,^An^aly^tic^al^Pe^r^s^p^e^c^tiv^e^s
⁽^W^a^s^hing^{ton: G}^P^O^,²⁰⁰⁸⁾^{, p}^.²⁴⁵^.

Some economists argue that lowering capital gains taxes would significantly reduce “lock-in”
effects and make resource allocation more efficient. Taxes on increased capital gains realizations
would offset some of the initial cost of cutting capital gains taxes. However, there is considerable
uncertainty about the magnitude of this unlocking effect. Alternatively, lock-in could be reduced
by taxing capital gains on an accrual basis or by taxing capital gains passed on at death. These
alternative solutions, however, face a variety of technical problems, and the idea of taxing gains
at death has been unpopular.
Arguments have also been made that cutting capital gains taxes would increase savings and
stimulate economic growth. While evidence on the effect of tax cuts on savings rates and, thus,
economic growth is difficult to obtain, most evidence does not indicate a large response of
savings to an increase in the after-tax rate of return.
A case might be made for cutting capital gains taxes on corporate stock since corporate equity
capital is subject to taxation both under the corporate and individual income taxes. This double
taxation encourages corporations to take on too much debt and directs too much capital to the
non-corporate sector. On the other hand, reducing the capital gains tax would increase the relative
penalty that applies to dividends and introduce tax distortions into the decisions of firms to retain
earnings.
A major complaint made by some is that cutting capital gains taxes would primarily benefit very
high-income individuals. Capital gains are concentrated among higher- income individuals both
because these individuals tend to own capital and because they are especially likely to own
capital that generates capital gains income.
Some argue that taxes on capital gains income should be reduced as a means of simplifying the
tax code. Part of the problem with taxing capital gains income has always been the trade-off
between taxing capital gains more efficiently and equitably and the added complexity in the tax
code that this would entail.
Finally, many economists argue that a capital gains tax appears unlikely to provide much stimulus
to the economy in the short run.
For more information, see CRS Report RS20250, Capital Gains Tax Rates and Revenues, by
Gregg A. Esenwein; CRS Report 96-769, Capital Gains Taxes: An Overview, by Jane G. Gravelle;
and CRS Report 98-473, Individual Capital Gains Income: Legislative History, by Gregg A.
Esenwein.
Defining the married couple as a single tax unit under the federal individual income tax violates
the principle of marriage neutrality. Some married couples pay more income tax than they would
as two unmarried singles (a marriage tax penalty) while other married couples pay less income
tax than they would as two unmarried singles (a marriage tax bonus).
The most important structural factors affecting the marriage neutrality of the income tax are the
earned income tax credit (EITC), the standard deductions, and the tax rate schedules. Under the
current tax system, single individuals, heads of households, and married couples are subject to
different standard deductions and tax rate schedules. In addition, the EITC amounts and phase-out

ranges vary based on the number of dependents claimed. These differences give rise to structural
marriage tax bonuses and penalties.
Generally, the more evenly divided the earned income of the two spouses, the more likely they
are to have a structural marriage tax penalty. Hence, married couples in which each spouse earns

50% of the total earned income have the largest marriage tax penalties. On the other hand,

married couples where one spouse earns all the earned income have the largest marriage tax
bonuses.
The actual determination of whether any given married couple has a marriage tax penalty or
bonus depends on how their income, deductions, and personal/ dependent exemptions are split
between the two spouses for calculation purposes. It also depends on the filing status under which
each spouse’s tax liability is computed—single or head of household. CBO uses assumptions that
some economists believe may overstate marriage tax penalties. However, even under these
assumptions, CBO estimated that in 1999, only 43% of married couples incurred a tax penalty,
while 52% experienced a marriage tax bonus.
It is a widely accepted goal that the individual income tax should not influence the choice of
individuals with regard to their marital status. Marriage neutrality, however, conflicts with two
other widely accepted concepts of equity: progressivity and the equal income taxation of couples
with equal incomes.
Regardless of how these three concepts of equity are juggled, under current definitions an income
tax can achieve only two of the goals; it cannot simultaneously achieve all three. The current
income tax has chosen progressivity and equal taxation of couples with equal incomes at the
expense of marriage neutrality. A critical point in this debate is that there are no unambiguous
right or wrong answers to the question of which of these three competing goals of equity is the
most important.
Legislation in 2001, 2003, and 2004, addressed marriage tax penalties by increasing the standard
deduction for couples to twice that of singles and broadening the 15% tax bracket to twice the ⁹
width of singles’ bracket. (These changes also increase the marriage tax bonuses experienced by
many married couples. Because of procedural rules in the Senate, however, these changes are
scheduled to sunset after 2010.)
For further information, see CRS Report RL30800, The Federal Income Tax and the Treatment of
Married Couples: Background and Analysis, by Gregg A. Esenwein, and CRS Report RL30419,
The Marriage Tax Penalty: An Overview of the Issues, by Jane G. Gravelle.
One perplexing problem associated with taxing income involves the issue of tax deferral. Ideally,
a tax levied on income should be assessed when the income accrues to the taxpayer. However, as
a result of many factors (some income is taxed when it is realized rather than when it accrues,
there can be a mismatch between income and the expense of earning it, or the tax code

⁹^T^h^e^a^c^t^s^w^e^re^the^Ec^onom^ic^G^r^o^w^{th a}^{nd T}^a^x^Re^lief^Re^c^onc^ilia^{tion A}^c^{t of}²⁰⁰¹⁽^P^.L^{. 1}^07-¹⁶^{), t}^h^e^J^obs^aⁿ^{d G}^r^ow^th
^T^a^x^Re^lie^f^a^{nd Re}^c^onc^ilia^ti^{on A}^c^{t of}²⁰^{03 (}^P^.L^{. 1}^08-^27),^aⁿ^d^the^W^o^rk^ing^Fa^m^ilie^{s Ta}^x^Re^lie^f^A^c^t^of²⁰^{04 (}^P^.L^{. 10}^8-
³¹¹⁾^.

specifically permits it), taxes are often deferred into the future. Since money has a time value (a
dollar today is more valuable than a dollar in the future), tax deferral effectively lowers the tax
rate on the income in question.
Illustrating the benefits of tax deferral is the case of income from capital gains in which the tax is
assessed when the gain is realized rather than as it accrues. If a capital asset is acquired for $100
and appreciates at a rate of 10% per annum, by the end of the first year it has appreciated in value
to $110 and by the end of the second year it is worth $121. Assuming a marginal tax rate of 15%
(the top marginal tax rate on long-term capital gains), if the gain were realized at the end of the
second year, then a tax of $3.15 ($21 times 15%) would be levied on the realized appreciation.
The after-tax return would be $17.85.
In contrast is the case of a $100 investment in an interest-bearing account earning a 10% rate of
return. At the end of the first year, the account would yield $10 in interest. Tax on the interest,
assuming a 15% marginal income tax rate, would be $1.50, leaving $108.50 in the account. By
the end of the second year, the account would yield $10.85 in interest. Tax on the second year’s
interest would be $1.63, leaving $117.72 in the account, for an after-tax return over the two-year
period of $17.72.
It is apparent from the examples above that the investment in the asset yielding capital gains
income earns a higher after-tax return than the comparable investment in an interest-bearing
account. In essence, the reason for this result is simply that, for the asset producing a capital gain,
the tax on the appreciation in the first year was deferred, with the deferred tax remaining in the
account and earning interest. The benefits of tax deferral increase the longer an asset is held and
tax can be deferred.
(It should also be noted that the top marginal tax rate on long-term capital gains income is
currently capped at 15%, while the top marginal tax rate on interest income can reach 35%.)
Tax deferral not only affects the taxation of assets producing capital gains income, but also is of
concern in other areas of tax policy, such as the taxation of contributions to retirement accounts
and depreciation allowances.
When a business purchases a tangible asset such as a machine or structure, it is not incurring a
cost; it is simply exchanging one asset—for example, cash—for another. The full purchase price
of an asset is therefore usually not tax deductible in the year the asset is bought. Assets do,
however, decline in value as they age or become outmoded; this decline in value (depreciation) is
a cost. And because assets gradually depreciate until they are worthless, the tax code permits
firms gradually to deduct the full acquisition cost of an asset over a number of years.
The tax code contains a set of rules that govern the rate at which depreciation deductions can be
claimed. The rules determine the tax depreciation rate by specifying a recovery period and a
depreciation method for different types of assets. An asset’s recovery period is the number of
years over which deductions for the asset’s full cost must be spread; the applicable depreciation
method determines how depreciation deductions are distributed among the different years of the
recovery period. The slowest method is straight-line, in which equal deductions are taken each
year. Declining balance methods, in which a fixed fraction of the cost less prior depreciation is
deducted, cause larger shares to be taken in earlier years.

Importantly, a tax deduction of a given dollar amount is worth more to a business the sooner it
can be claimed; the sooner a tax deduction can be claimed, the sooner the tax savings it generates
can be invested and earn a return. It follows that the tax rules governing when depreciation
deductions can be claimed are quite important to businesses. If depreciation deductions can be
claimed faster than an asset actually declines in value, a tax benefit exists; depreciation is said to
be accelerated. If, on the other hand, depreciation deductions can be claimed more slowly than
the corresponding asset actually depreciates, a tax penalty occurs. Only if depreciation deductions
are claimed at the rate an asset actually depreciates do taxes confer neither a tax benefit nor a tax
penalty.
According to some estimates, current tax depreciation for some types of equipment is somewhat
accelerated compared to economic depreciation. “Bonus” depreciation allowances that recent tax
acts have provided for temporary periods may have further accelerated depreciation for certain
equipment. (See, for example the depreciation provisions of the Jobs and Growth Tax Relief and
Reconciliation Act of 2003, P.L. 108-27.) Depreciation for most structures is probably not
accelerated. Thus, firms have a tax incentive to use more equipment and fewer of other types of
assets in their production process than they otherwise would. This influence of taxes in the
allocation of capital probably reduces economic efficiency.
The Internal Revenue Code recognizes several different forms of business organization; their tax
treatment varies. The principal forms are C corporations, S corporations, partnerships, and sole
propriet orships.
Apart from taxes, corporations are a legally defined form of business organization, with
ownership stakes represented by shares that may or may not be publicly traded. Shareholders’
liabilities are limited to their stake in the corporation. The Internal Revenue Code normally
subjects corporate profits to the corporate income tax under its subchapter C; corporations subject
to income tax are thus often referred to as “C corporations.” As explained more fully above, in the
report’s section on the corporate income tax, the part of C corporation income generated by equity
investment is subject to two layers of tax: the corporate income tax and the individual income tax.
In contrast, corporations that qualify as “S corporations” are not subject to the corporate income
tax. Instead, their net profits are passed on a pro rata basis through to the individual shareholders
who are taxed on the profits under the individual income tax. To qualify, S corporations may have
no more than 100 shareholders.
Taxes aside, partnerships are like corporations in that they have multiple owners. In contrast to
corporations, some partnerships convey a liability for debts that is not limited to partners’
contributions to the enterprise. Partnerships are also less likely than corporations to be publicly
traded, although some forms of partnerships (“master limited partnerships”) are. Like S
corporations, partnerships are not subject to the corporate income tax; partners are subject to their
share of partnership earnings under the individual income tax.
Limited liability companies (LLCs) have some of the characteristics of both partnerships and
corporations. Under IRS “check the box” regulations, LLCs can elect to be taxed either as
corporations or as partnerships. Other specially defined business entities include real estate
investment trusts (REITs), which are required to engage primarily in passive investment in real
estate and securities. Qualifying REITs are permitted to deduct dividends they pay to
shareholders, which effectively exempts REITs from the corporate income tax. Regulated

investment companies (RICs), who invest primarily in securities and distribute most income, are
also permitted to deduct dividends. The simplest forms of business organization are sole
proprietorships. Sole proprietorships have only one owner; there is no legal distinction between
the business and the business’s owner. For tax purposes, business profits earned by a sole
proprietor are taxed to the owner under the individual income tax. The corporate income tax does
not apply.
For more information, see CRS Report RL31538, Passthrough Organizations Not Taxed as
Corporations, by Jack H. Taylor.
Competitiveness can be defined in a variety of ways (indeed, some would argue that it has no
concrete meaning at all, at least at the national level). But regardless of how competitiveness is
defined, standard economic analysis suggests that most tax measures can do little to enhance it.
Indeed, some observers argue that many of the tax provisions designed to improve U.S.
performance in the world economy actually reduce U.S. economic welfare, world economic
welfare, or both.
An individual firm or its employees might defend competitiveness as its ability to withstand the
threat of foreign competition. If asked, they might recommend some manner of tax benefit
targeted at their industry: perhaps favorable depreciation rules or tax credits for consumers who
buy their product. Economic analysis predicts that such measures might well improve the position
of the targeted industry: its costs would fall because its taxes have fallen, introducing the
possibility of reduced prices, larger market shares, and more jobs.
But economic theory also predicts that the effects of a targeted tax benefit will ripple through the
economy and ultimately confound the policy’s competitiveness goals for the economy as a whole.
Because the nation’s resources are limited, the theory holds, a narrowly targeted tax benefit will
simply reshuffle the way resources are employed, drawing them into the favored industry and
away from alternative uses. And while exports in the favored sector may rise (or imports fall), the
theory predicts that the performance of other sectors will decline. Further, economics predicts that
the effect of taxes on how the economy’s resources are deployed diminishes the nation’s
economic vitality: market forces, not tax rules, this theory holds, are usually the best way to
guarantee that resources are used efficiently.
Policymakers or others at the national level may take a broader view of competitiveness and
define it as the ability of the country as a whole to sell its exports—not just the performance of
one sector. Such a view might recommend, for example, a tax incentive for exporting, regardless
of the product. But in this case, economic theory suggests that exchange rate adjustments will
stymie any effect the export subsidy may have in improving the trade balance. Although
implementation of an export subsidy may initially increase exports, the increase in exports raises
the price of the dollar in currency markets, which, in turn, makes U.S. exports more expensive
and imports cheaper. As a result, exports are predicted to fall and imports increase until any initial
improvement in the balance of trade that may have occurred disappears. Further, to the extent that
part of the export tax benefit is passed on to foreign consumers as lower prices, this analysis
indicates that the measure transfers economic welfare from U.S. taxpayers to foreign persons.
Many economists would argue that taxes can alter the balance of trade in the short and medium
term, but not in the way that is perhaps commonly thought. If a country runs a trade deficit, it is

using more than it produces, and to do so, it must, in effect, borrow from abroad, importing the
foreign investment that finances the deficit. The trade balance thus mirrors the balance on capital
account, and it follows that taxes alter the trade balance not by their direct application to exports
or imports, but by altering capital flows. For example, a cut in taxes on business investment in the
United States increases the U.S. appetite for investment; foreign capital inflows accordingly
increase and net U.S. exports (imports minus exports) fall. Or, a tax cut that increases the federal
budget deficit can be expected to exert upward pressure on real interest rates, thereby attracting
additional foreign capital and expanding the trade deficit. Conversely, a tax increase that reduces
the budget deficit can also reduce the trade deficit.
What of taxation of capital flows rather than trade? For example, can taxes improve the economy
by making U.S. firms that operate abroad more competitive, cutting their costs and helping them
compete more effectively against foreign firms? Again, economic theory is doubtful, holding that
economic performance is enhanced by a neutral tax policy that neither discourages nor
encourages overseas investment.
For further information, see CRS Report RS22445, Taxes and International Competitiveness, by
Donald J. Marples.
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