What Are Tax Reforms and How Do They Work?

Tax reform is the process of making fundamental changes to how a government collects and manages taxes, involving a significant restructuring of the tax system rather than minor annual adjustments. These changes can be broad, affecting nearly every citizen and business, or targeted toward specific areas of the economy. The motivations range from stimulating economic activity to addressing social goals.

For individuals, reforms can alter take-home pay and the incentive to save, while for businesses, they can affect profitability, hiring decisions, and global competitiveness. Because of these high stakes, major reform proposals spark considerable public debate.

Core Objectives of Tax Reform

A primary driver of tax reform is the pursuit of economic growth. Proponents argue that a well-designed system can foster a more robust economy by improving incentives for work and investment. Lowering tax rates on income or business profits may encourage individuals to work more and businesses to invest, reducing market distortions and allowing capital to be allocated more efficiently.

Another objective is enhancing fairness, or equity. This has two sides: horizontal and vertical equity. Horizontal equity is the principle that taxpayers in similar financial situations should pay a similar amount of tax. Vertical equity suggests that those with a greater ability to pay should contribute a larger percentage of their income, often through a progressive tax structure.

Simplifying the tax code is a third common goal. Over time, tax laws can become filled with provisions that are difficult for an average person to understand. This complexity creates a compliance burden, requiring taxpayers to spend time and money on record-keeping and tax preparation. A simpler code can reduce these administrative costs and improve voluntary compliance.

Key Mechanisms for Implementing Reform

One direct tool for reform is altering tax rates. Lawmakers can make the rate structure more progressive, where higher incomes are taxed at higher rates, or move toward a flat tax, where all income is taxed at the same rate. These changes have an immediate effect on the amount of tax owed and can influence economic behavior.

Reforms also involve changing the tax base, which is the total amount of income, property, or spending subject to taxation. A government can broaden the tax base by eliminating deductions and other preferences, which allows for lower overall tax rates. Conversely, narrowing the base creates new tax breaks to encourage specific behaviors like charitable giving.

Modifying tax deductions and credits is another mechanism. A tax deduction reduces taxable income, providing a benefit proportional to a taxpayer’s marginal tax rate; a mortgage interest deduction, for example, is more valuable to someone in a higher tax bracket. A tax credit reduces the final tax liability on a dollar-for-dollar basis, offering the same value to all eligible taxpayers.

A more fundamental approach is shifting the tax burden from one source to another. This could involve reducing income taxes while increasing consumption taxes, such as a national sales tax or a Value-Added Tax (VAT). The rationale is to encourage saving and investment, as income is not taxed until it is spent.

Major Areas of Tax System Reform

The individual income tax is a frequent target of reform because it is the largest source of federal revenue. This tax is levied on personal income from wages, salaries, investments, and retirement distributions. Reforms often focus on adjusting tax brackets, the value of the standard deduction, and modifying tax credits for things like children or education.

Corporate income tax is another focus area. This tax on corporate profits influences business decisions related to investment, hiring, and global competitiveness. Reform proposals center on the corporate tax rate, rules for depreciating assets, and the tax treatment of income earned in other countries. The goal is to create a more favorable environment for businesses to operate and invest within the United States.

Payroll taxes are levied specifically to fund Social Security and Medicare. These taxes are paid by both employees and employers as a percentage of an employee’s wages, up to an annual limit for Social Security. Changes to payroll tax rates or the wage base can address the long-term solvency of these programs.

Consumption taxes are levied on the purchase of goods and services. While the federal government lacks a broad consumption tax, it imposes excise taxes on goods like gasoline and tobacco. Many state and local governments rely on sales taxes, and federal reform discussions sometimes include proposals for a broad consumption tax to supplement or replace income taxes.

The Federal Legislative Process for Tax Reform

The process of enacting federal tax reform begins in the House of Representatives, as the U.S. Constitution requires all revenue bills to originate there. Tax legislation is developed in the House Ways and Means Committee, which holds hearings and drafts the initial bill. Once the committee approves a bill in a process called a “markup,” it is sent to the full House for debate and a vote.

If the bill passes the House, it moves to the Senate and is referred to the Senate Finance Committee. Similar to its House counterpart, the Finance Committee holds its own hearings and can amend the bill significantly. After committee approval, the legislation proceeds to the full Senate for debate. The Senate’s rules for debate are generally more flexible than the House’s, which can sometimes lead to a more prolonged process.

If the House and Senate pass different versions of a bill, a conference committee with members from both chambers is formed to negotiate a compromise. This final, unified bill must then be passed by both chambers before being sent to the president for signature or veto.

A legislative tool known as budget reconciliation can play a role in passing major tax reform. This process allows certain budget-related bills to pass the Senate with a simple majority vote. This avoids the 60-vote threshold typically needed to overcome a filibuster.

Landmark US Tax Reforms in Practice

The Tax Reform Act of 1986 is a significant example of comprehensive, bipartisan reform. Its objectives were to promote fairness and simplify the tax code, reflecting a broad consensus that the existing system was overly complex. The act was designed to be revenue-neutral, meaning it redistributed the tax burden rather than changing the total amount of tax collected.

To achieve its goals, the 1986 Act dramatically lowered marginal income tax rates, collapsing numerous brackets into just a few with a top rate of 28%. To offset this, it broadened the tax base by eliminating many deductions and tax shelters, including limits on deductions for consumer interest and passive investment losses. The law increased the corporate tax burden while lowering it for many individuals.

The Tax Cuts and Jobs Act of 2017 (TCJA) was another major overhaul, aimed at stimulating economic growth and business competitiveness. Unlike the 1986 act, the TCJA was a significant tax cut projected to reduce federal revenue. It was passed using the budget reconciliation process without bipartisan support.

The TCJA permanently reduced the corporate tax rate from 35% to 21%. For individuals, the act lowered income tax rates, nearly doubled the standard deduction, and expanded the child tax credit. However, these individual tax changes are temporary and scheduled to expire at the end of 2025. To help pay for the cuts, the TCJA eliminated personal exemptions and placed a $10,000 cap on the deduction for state and local taxes (SALT).