Cato Institute Proposes Dual-Rate Income Tax System

by Mike Godfrey, Tax-News.com, Washington

09 February 2005

With the Bush administration having committed itself to some form of simplification of the US tax code, libertarian think-tank, the Cato Institute has proposed the adoption of a dual-rate income tax system intended to both simplify and reduce taxes for businesses and individuals, and act as a bridge towards a simple consumption-based system.

In a recent report on the plan authored by Chris Edwards, Cato’s Director of Tax Policy Studies, it is proposed that most deductions and credits would be swept away, while virtually all families would pay tax at a rate of 15%. A 27% rate would kick in at $90,000 for single taxpayers and $180,000 for married couples (the threshold at which the social security payroll tax cuts out).

According to Mr Edwards, this broadly revenue-neutral solution would not only place 95% of individual taxpayers into the more favorable 15% income tax bracket, but would also create a consistent marginal rate of about 29% on wages, representing a sizeable cut for the majority of taxpayers, and significantly lower than the top combined marginal rate on wages of more than 40% under the current system.

Moreover, the Cato proposals would cut the marginal rate on singles with taxable income between about $30,000 and $80,000 from 25% and 28% to just 15%.

Meanwhile, in an effort to promote savings and economic growth, the maximum individual rate on dividends, interest, and capital gains would be set at 15%, whilst the corporate tax rate would also be dropped to 15% from 35%, and interest would be excluded from the corporate tax base, to ensure equal treatment of debt and equity.

These changes would equalize and cut the combined top federal tax rates on dividends, interest, wages, and small business profits to 28%, which compares to 35% to 45% under the current system.

The standard deduction of $5,000 (singles) and $10,000 (married) would be retained under the dual-rate tax system while personal exemption levels would be increased from $3,200 to $4,500. Additionally, the plan would keep the earned income tax credit and all pro-savings features of the US tax code, including 401(k)s, individual retirement accounts, and Health Savings Accounts, although other deductions and credits would be phased out.

A further step to offset the revenue loss caused by the corporate rate cut would be to end the deduction for state and local taxes. This would have the added effect of exposing businesses and state governments to a greater degree of tax competition, and would also act as a restraint on fiscal policy at the state and local level.

“The dual-rate tax plan would cut tax rates on wages, income from savings, and small businesses. It would simplify the tax code and increase horizontal equity, while providing low-income tax relief,” Edwards noted in the report.

“The corporate tax rate would be cut sharply. The dual-rate tax would increase fairness and spur growth, while taking a big step toward a simple consumption-based tax system,” he concluded.

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