August 22, 2011
An Exercise in Pragmatism — A 5 Step Plan to Overhaul the United States Tax Code
The tax system is quickly becoming a subject of discussion as the federal deficit cutting panel has finally been set. While Republicans keep promising there won’t be any revenue (read: tax) increases, the Democrats keep insisting that a cuts only package won’t fly either. Bottom line: the tax code will, in all likelihood, be going under the knife in the next 5-10 years for a major overhaul, presenting a juncture for major overhaul.
To be plain: I am not an advocate of the current tax system. However, it seems to be the will of the majority that taxes be at least continually administered if not increased. Thus, since the continued administration of a marginal, “progressive”, income tax seems inevitable, it is logical that we at least administer it in the most efficient and beneficial (read: least painful) manner possible.
How to fix the United States Tax Code in 5 Easy Steps (Easy compared to the alternative of not fixing it)
1) Make all income taxable and treat all income the same way – Okay, the first question most people ask about their incomes is “what do I have to pay taxes on?” Currently, income is classified as either “earned” or “unearned”, and this affects how, or even if, it’s taxed. Then, even after the “earned/unearned” question is answered, you have to determine your taxable income. This, contrary to popular belief, isn’t just the number on your pay stubs.
Now, I won’t go into just what constitutes taxable income because my argument is very simple: all income should be taxed. If money comes in the door, Uncle Sam gets a cut. It really can, and in my opinion should, be that simple.
As far as that’s concerned, I believe we should also do away with most other taxes and instead incorporate them into the income tax. Capital gains tax? Nope. Just count money earned on investments as income at tax it as such. Inheritance? Surprise! You got bumped up an income bracket this year, but you don’t have to pay the estate tax. The entire argument for this is a pretty simple one: the different taxes we have are all ways for the government to get its hands on various portions of peoples incomes. So, what if instead of doing this, and driving up administrative costs while doing it, you just call a spade a spade, and count everything people earn as income. Then, you just tax the income. It’s simple, it’s easy to administer, and it doesn’t leave as much grey area for people to hide their money in. Income is income, no matter how someone makes it. So why don’t we just tax it as such?
2) Forget deductions, use credits – A lot people hate this one, but it goes hand in hand with forgetting the whole “taxable income” thing in my first point. The truth is, allowing people to adjust their incomes by writing off certain expenses flies in the face of a bracketed tax system. If you want someone to pay taxes in a certain bracket, don’t give them the means to drop below it. In a marginal tax system, progressive or regressive, you need to make sure that everyone is in the bracket they’re supposed to be in. Deductions allow people to move down the scale taxing income at lower rates than it would be without them. Basically, income deductions allow the Government to leave tax revenue on the table.
Now, I know people are going to start saying “tax deductions help change consumers habits…” and so on. But, you know what’s A) a lot better at doing that, B) more helpful to people, and C) doesn’t have any of the problems a deduction system has? A system of tax credits. Granted, we’d have to curtail the list a great deal to keep people from paying negative taxes (getting a check from the treasury every year), but a tax credit is a much more potent force than a deduction, so it doesn’t have to be as big. Because a credit comes off the amount actually owed (AFTER income and taxation calculation) it has a real, definable benefit and is therefore extremely effective at incentivizing a certain behavior. In addition, a credit makes a tax behave even more progressively. Take the following example:
Two families each file taxes, one with a total income of $40,000 and another at $120,000. For purposes of this exercise we can assume a 20% flat tax rate (more on rates later, but a flat rate makes this example easier) let’s also say that each family has 2 children ($2500 tax credit each), and a hybrid car ($500 tax credit).
Each family will pay 20% of their income minus $5500 in tax credits. So:
Family 1: (.2*40,000) – 5,500 = $2,500 in taxes
Family 2: (.2*120,000) – 5,500 = $18,500 in taxes
Now, let’s look at the effective tax rate.
Family 1: 2500/40,000 = .0625 or an effective tax rate of 6.25%
Family 2: 18500/120000 = .1541 or an effective tax rate of 15.41%
The example clearly illustrates the progressive nature of tax credits. Simply put: credits help lower income earners more than upper income earners even though the amount is the same for both families. This model can also be used to provide work incentives, as well as financial support to the poor, through programs like the Earned Income Tax Credit, which gives a large tax credit to those who work but have extremely small incomes. The credit is so large that extremely low wage earners actually get money back from the government, but only if they’re employed and filing taxes, thus creating an incentive for people to work.
The bottom line here is that tax credits are an extremely effective tool. By doing away with tax deductions and moving to a more modest, credit-only system the tax code can be greatly simplified while still remaining effective in its goals.
3) Shift the tax burden up the income scale – Wage and income demographics in the United States have shifted much faster than our tax brackets. This one really is that simple. The majority of income brackets (the rates at which varying levels of income are taxed) still fall on those making under $175,000 per year. This means that the people who need to keep their money the most are facing increasing taxes on additional income. According to the IRS, marginal tax rates increase by 18 percentage points (from 10% to 28% in various increments) between incomes of $8,500 and $174,400, but only by a total of 7% for all income over $174,401 up to the maximum rate of 35%.
The effect of this rate structure is that it becomes very burdensome to increases ones standard of living within the middle class, because gained income is taxed at a higher rate. In order to solve this problem of class mobility, we need to rethink how the brackets are structured, with the steepest rate increases coming at the high end of the income scale instead of the lower-middle. This would transition the burden up the scale onto those trying to move between the upper income levels rather than the middle or lower echelons. As an added bonus, reducing the number of brackets would simplify the system and give more people reason to earn additional income. The more brackets there are, the higher the chance of hopping between brackets is, which makes people less willing to earn more income (examples of earning more income vary. Some include: working harder, getting more education or experience to command better pay, or inventing a technology to make their work more efficient). As a rule, people earning more income is good, so it’s logical that the government make this as easy and painless to do as possible, especially at lower and middle income levels. Here’s an example bracket system that’s designed to both shift the burden of a tax up the income scale and to incentivize earning.
| Income level (annual) | Tax Rate |
| $0-$49,999 | 5% |
| $50,000 – $199,999 | 12% (+7%) |
| $200,000 – $749,999 | 20% (+8%) |
| $750,000 – &1,499,999 | 32% (+12%) |
| $1,500,000+ | 40% (+8%) |
Notice how the biggest jump in this sample scale is when one moves from a moderately high income to a very high income, as opposed to among varying levels of middle income. In addition, this sample uses one fewer bracket than the current system and makes marginal taxes on much higher income levels than the current system (currently, rate increases stop at an income just short of $380,000 a year for families and $190,000 a year for individuals, leaving large amounts of marginal revenue uncollected, especially as compared with the above bracket structure). Disclaimer: the sample bracket system is not intended to be implemented as policy. But, the trend in its layout: placing major increases later in the scale as well as using fewer brackets, is a solid framework for any overhaul of the current bracket system.
Note: The current maximum marginal tax rate is 35%, but has historically been as high as 92%, so 40% represents a reasonable tax rate ceiling.
4) Make it easy to file and audit taxes – If you’ve ever tried to file your taxes yourself, and I mean actually yourself. No TurboTax, no H&R Block it’s like being a rat in a maze. Legal mumbo jumbo, tedious calculations, and pages of paper create a perfect storm that leads to most people either requiring assistance to file or running the risk of being audited, and audits are only necessary because the system is so complex and convoluted in the first place. The IRS has stated on many occasions that, if not a majority, then a substantial minority of its audit cases are caused by people who simply didn’t properly understand the tax code or how to file correctly. By implementing the steps already outlined, as well as taking other steps to streamline the tax system, these needless and expensive audits could be eliminated. This would also free up IRS resources to combat actual tax fraud, leading to stronger deterrence, increased federal income, and an overall decrease of abuse within the tax system. Remember: if it’s easy to file, it’s even easier to audit.
Ideally, people would be able to print out a single page form, fill it out themselves, send it in with a check and a W-2, and call it a day. While this kind of simplicity may be pie in the sky, the truth is much more down to earth. The simpler our tax system is, the cheaper it will be to run, fewer people will abuse it, and more people will file their taxes properly and on time.
5) Keep the system progressive, but shift the paradigm – This is the part where I get up on my ideological soapbox, so feel free to skip this if you want. I don’t like taxes. There. I said it. A tax is inherently coercive. It’s nothing more than the government using its monopoly on force to take money away from its citizens. Just because it’s been done from the dawn of time doesn’t mean its right.
That all said, I acknowledge the necessity of taxes. We all want and need government services, which is why I don’t gripe about filling out a 1040 like everyone else. We need things like roads, tanks, and bridges. We need funding for our schools, our emergency responders, and our communities. But, we must remember to take sparingly. The point of a tax isn’t to redistribute income, alter behavior, or fund a senators pet project and we must bear that in mind whenever the subject is raised. Taxation should not be an issue of morality. It’s an issue of fiscal policy.
The point of a progressive tax system is to extract the marginal value of government services from all citizens who use them. To get the same value from higher income earners, a higher amount must be taxed to overcome the diminishing value of money at higher incomes.
This is not a justification for using the tax system as a tool of extortion as it has been in the past, with upper bracket income taxes, historically speaking, approaching 90% for substantial periods of recent history. A citizen having something should never be an excuse for the government to take it. That is why, to this day, there is an amendment to the US constitution banning the quartering of soldiers in people’s houses. Why? Because the citizenry doesn’t believe the government should be able to use their house because it’s in the right place.
This logic must be applied across the board. Just because someone has money is not a rationale for taking it. “They should be taxed more heavily because they can afford it” is perhaps the most flawed, insipid, and tyrannical rationalizations in the history of government.
The wealthy must bear their share of the tax burden just as the rest of the populace does. However, I truly believe it is wrong to excessively tax high earners. Are we taxing them excessively now? Absolutely not. Is there a risk of that changing? Probably. There’s nothing wrong with making high earners pay for services, even at a higher rate. But, they cannot be used as a ‘cash cow’ who pays high taxes and receives very few services, if any. The bottom line: If you want to tax the wealthy, fine. But, they need to be fully included in the envelope of government services.
I’ll close with a final argument about the role of taxes. There is a fallacy that a tax must be fair. Taxes should not be fair because fairness is based on ends instead of means. If a tax system is based on the ends it generates, rather than the means it generates them by, the government has failed to protect the liberties of its citizens, which is its central and sacred duty beyond any other obligation. To preserve the liberty of the citizenry, a tax must be just. Justice is derived from the methodical application of a process, ensuring that all subject to it are treated in an equal manner. This is how a tax must be administered. A uniform process that is easily understandable must be implemented for every citizen regardless of income or class. That is what I’ve tried to outline in my above steps. We can no longer afford to center our revenue and spending policies around what is “fair”, or what is “ideal”. Rather, we must ensure that whatever ends are desired by the public are carried out by a means that is just. This is the only true way to stop building one success on the backs of a thousand failures.
The time has come to stop designing a tax system with a goal in mind. If one must levy a tax, the goal of any tax system should to be extracting that tax. Nothing more, and nothing less.
