Republicans talk about “Tax Reform” a lot. Democrats talk about “Tax Reform” too, but not so often. Not a single member of either party has ever disclosed what he means by “tax reform.” Soak the rich, soak the poor, subsidize the poor, subsidize the rich? Doesn’t matter, they’re not talking. But you know what they mean, don’t you? Well, "tax reform" doesn’t mean anything, it is just a slogan that politicians think will earn them some electoral gravitas. But when they do begin to get a little specific, you can count on all of them talking about tax cuts, as though they are not aware of our National Debt, $18 trillion and counting.
The first thing to consider in designing proper tax reform is the variety of “tax schemes.” So, let’s talk first about tax schemes, for federal income taxes.
· A “progressive” or “graduated” tax is a tax scheme that is characterized by higher tax rates for higher wage brackets. For example, the wage bracket between $50,000 and $75,000 is taxed at 25% while the wage bracket between $75,000 and $100,000 is taxed at 30%. The man whose taxable income is $100,000 does not pay 30% (the higher tax rate) on his entire income, but only on the wages between $75,000 and $100,000.
· The “Flat Tax” applies a single tax rate, say 23%, to every tax payer’s entire taxable income, whether that is $25,000 or $25,000,000. The Flat Tax also has a high exemption so that the poor are not hit so hard from their first dollar of income.
· The “Fair Tax” is a consumption tax, called a VAT (value-added tax) in Europe and a simple sales tax in the USA. That’s right: no tax returns at all.
The upside of the graduated tax is: we have always done it this way, Congress has always seen fit to choose a graduated tax as the way to assess taxes on the people. The downside of the graduated tax is: it is complicated to understand and to calculate if you prepare your own tax return without the aid of a computer (in consequence of which millions of tax payers need to hire and pay professional tax preparers). It is unfair to high wage-earners as a portion of their wages are taxed at much higher rates, it “punishes success.”
The upside of the “Flat Tax” is: it is easier to understand (a single tax rate on your entire taxable income) and to calculate if you prepare your own tax return without the aid of a computer. And it is intrinsically “fair,” as it taxes every dollar of income at the same rate. The IRS need not be as large or frightening as it is now.
The upside of the “Fair Tax” – a sales tax that completely replaces the income tax (unlike the VAT in Europe which is only part of the taxing regimen) – is: everyone is treated the same, there is no April 15th tax day for tax payers to worry about, there are no tax returns to fill out, no need to pay professional tax preparers, no need for an IRS to collect taxes, and no need to audit tax payers.
It would seem at first thought that the Fair Tax is an ideal way to collect taxes. But the downside is: now that retailers, wholesalers, manufacturers and other middlemen collect taxes from consumers, and then have to forward them to the federal Treasury, we have a new set of people who are as motivated as individual tax payers were before to avoid paying taxes (we may still need an IRS to audit these tax payers). Consumers will seek out ways to purchase what they need without having to pay the sales tax. Black markets and bartering will spring up to satisfy the need for tax-free exchanges. The economy will suffer from reduced demand for goods and services that are now too expensive. Not to mention, the need for the Fair Tax to bring in adequate revenues will cause its tax rate to be higher than any of its proponents will admit, even putting aside the problems I have just mentioned. And the cruelest cut of all is that the less you earn, the more of your wages are taxed; the more you earn, the less of your wages are taxed; a high-wage CEO spends 5-20% of his salary, he saves / invests 80-95%, and he is not taxed on this larger portion. So much for the Fair Tax.
What about the Flat Tax? The Flat Tax is easier to understand and to calculate than the graduated tax, but it is unfair in a different way than the graduated tax. The graduated tax was unfair because it taxed high wage brackets at a higher rate than low wage brackets. But if you think about it, taxing someone earning $25,000 at the same rate as someone earning $250,000 is unfair because $25,000 is a survival wage and taxing it is cruel. “Ah,” says the Flat Taxer, “we exempt the first $25,000 from taxes entirely.” But the logic behind that exemption is that the first dollars of a wage are more crucial than later dollars, and that logic goes all the way up. You end up with a graduated tax when you heed the logic that understands that the first dollars are more crucial than the second, and the second dollars are more crucial than the third, etc. First dollars go toward food, and a roof, second dollars go toward public transportation, third dollars go toward clean clothes, etc. The high wage earner has no such worries at all. And what real needs are satisfied by a wage of $25,000,000? The need for a private jet? Or a third home in Biarritz?
What else the Fair Tax and the Flat Tax have in common – besides benefiting the well-off more than anyone else – is that they raise less tax revenues than a comparable progressive / graduated tax (for the math, see my essay Flat Tax, Fair Tax in To My Countrymen). Less tax revenues means a bigger deficit. A bigger deficit means a greater addition to the National Debt. The only really “fair” tax is a “graduated” or “progressive” tax, the same as we have always had ever since income taxes were collected, ever since 1913. Congress has not been wrong all these years in designing a taxation system around a graduated tax.
But if reasonable tax reform keeps the graduated tax, how does it differ from what we have today? Here, one man’s ideas for “tax reform.”
The Individual Income Tax will be a tax on Income and a tax on Wealth / Net Worth. In the process, the separate Capital Gains tax will disappear, being absorbed into the tax on Income and/or the tax on Wealth / Net Worth. The reason that wealth / net worth should be taxed annually is that some of the wealthiest men in America have no taxable income whatever, they live off their wealth. It is a technical detail that shielded them from individual income taxes for decades. No more.
The tax on Income will include Gross Income from any source whatever, of whatever kind that is commutable into cash (wages, salaries, bonuses, stock options, gambling winnings, etc). Taxable Income will of course be a tax on Net Income, defined as Gross Income less Deductions.
A tax rate of 1% will be assessed on all Income below 1.5 times the poverty level (so that every wage earner will pay an Income Tax and feel some ownership in the economy). For upper incomes, a marginal tax rate* of 40% will be assessed on Income above the level of the top 4% of tax returns. A marginal tax rate of 50% will be assessed on Income above the level of the top 2% of tax returns. A marginal tax rate of 60% will be assessed on Income above the level of the top 1% of tax returns. A marginal tax rate of 65% will be assessed on Income above the level of the top 0.1% of tax returns. The tax rate schedule will be designed to produce surpluses during good times and deficits during bad times, with an emphasis on surpluses over deficits – three surpluses for every deficit – and it will be designed to pay down the National Debt over the next 30 years.
The tax on Wealth / Net Worth will be a flat tax of 1.5% on Wealth / Net Worth in excess of $5 million. So, most of you (the poorest 99% of you) will not be taxed on your Wealth / Net Worth. It will include property (real estate), cash, bank accounts (checking, savings, credit unions, money markets), securities (stocks and bonds), and other assets (for example, collectibles of any sort, like works of art, thoroughbred horses, vintage automobiles, antiques, rare coins and stamps).
The current year’s Gross Income reported as Income will be subtracted from Wealth / Net Worth for the purpose of tax assessments on Wealth / Net Worth.
Any Income or source of Wealth / Net Worth not reported to the tax collecting agency will be assessed an additional 15% of its value as a penalty for tax evasion.
Social Security will be collected as a separate FICA tax (I am open to argument on this). The so-called “cap” on Social Security collections will be eliminated and FICA taxes will be collected on ALL Income. FICA will also collect on the year’s increase in Wealth / Net Worth not attributable to Income. Social Security payments will be reduced by $1.00 for every $5.00 of Income above $50,000 for the current year, and/or $1.00 for every $5.00 of Wealth / Net Worth above $1 million. The “rate” of the Social Security tax will be the rate that equalizes collections and payments, leaving the current surplus intact. There will be no call to raise the retirement age, as more and more senior Americans are being involuntarily laid off before they reach Social Security's retirement age.
Your chance of being audited will correlate with your wealth; the wealthier you are the more likely your tax return will be audited. Not because you are more likely to be dishonest, but because it makes economic sense to go after big money before small change (more bang for the buck so to speak).
These tax proposals address the fact that many poor Americans pay no income taxes and many rich Americans pay no or little income taxes. Many federal agencies suffer from employee bloat; we can use the next five years to cut the size of the work force of many governmental agencies by 50%. We can also address the issues of repairs to our infrastructure, as long as we pay for them. The assertion that higher federal income taxes cause a downturn in the economy is not supported by any historical facts whatever.
The “constants” built into this first draft proposal will of course need to be adjusted for inflation.
And of course, see my blog post Redistribution of Wealth.
Comments welcome, of course.
* A marginal tax rate is the tax rate associated with a single tax bracket. For example, in 2015, for Single Filers, 25% is the (marginal) tax rate associated with the tax bracket $37,450 to $90,750. Your marginal tax rate is the tax rate associated with the highest tax bracket that applies to your taxable income. The top marginal tax rate is the tax rate that is associated with the highest tax bracket. Your effective tax rate is your total tax liability divided by your taxable income ($ total tax / $ total income). Your effective tax rate is always significantly lower than your marginal tax rate. Be careful: politicians like to trick you when they throw around some of these words.
Addendum: Friday, 10/23/2015
Paul Ryan, being asked to run for Speaker of the House, once again mentioned tax reform. Predictably. Tax cuts and loopholes closing. Funny thing: tax cuts are deadly to any serious attempts to keep the National Debt under control, and loopholes are never closed as they benefit Congress persons' best friends, the millionaires and billionaires whose wallets open up every campaign season. The fact is: tax reform needs to raise tax revenues; and the only reason no politician ever says that is that the American public would lynch him. American voters need to grow up. "You bought it and you have to pay for it." We are NOT broke; lots of people are doing real well, thank you. We need to ask them to pay more taxes, MUCH more taxes. Simple! But politically suicidal. It’s a pity we are such children!
Addendum: Sunday, 11/01/2015Some of you may object to the prime motive behind my thinking on tax reform, i.e., to collect more tax revenues. This flies in the face of Grover Norquist’s pledge (never to raise taxes), classical Libertarian thinking, and recent conservative thinking, where lower taxes are always the goal of a government that boasts of freedom. “The more taxes we pay, the less free we are.” But we owe $18 (19?, 20?) trillion, don’t we? And I believe it is irresponsible to ignore this fact. I am all for small government, but I am also for paying our bills and our debt. Do you really want to pay for our freedom by not paying our bills and our debt? What is the expression the same folks love to use, “freedom isn’t free.” Maybe they should take it seriously.
Addendum: Friday, 03/25/2016
The more I let "tax reform" fester in my imagination, the closer I get to wanting to abolish the individual income tax entirely and replace it with a tax on Wealth or Net Worth. But I am far from thinking deeply on this idea. Feel free to contribute your ideas.