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“Should 5% appear to small…be thankful I don’t take it all” George Harrison

March 27, 2012

It is hard for me to work on completing my taxes without thinking of George Harrison’s “Taxman” from 1966. And of course doing my taxes has reminded me of one of my favorite topics: tax reform.

And  in my mind, tax reform is not rhetorical tinkering with the current code which seems to be what we are generally hearing from the political candidates and the Administration. Instead, tax reform should be a complete wholesale destruction of the current ridiculously complicated and inefficient tax code and replacement with a simple and efficient system instead. Perhaps the countless thousands of pages of tax laws and regulations could be printed out and a giant bonfire produced which would provide us all with some sorely needed closure!

The best way to approach tax reform is to start with first principles. What are we trying to accomplish with a tax system? I would argue that there are three main objectives:

(1) A tax system should be designed that raises revenue in the most efficient and cost-effective manner possible–in other words, the system needs to be simple such that paying taxes is automatic and a simple  procedure in stark contrast to the rather painful and costly process that exists today for most taxpayers. It needs to make compliance virtually universal rather than the current system where non-compliance (in many cases unintentional) is increasingly the norm.

 (2) A tax system should be fair— This means that everyone pays taxes (except those below the poverty line) AND wealthier people pay MORE taxes than less wealthy people.  How much more is a legitimate topic of debate of course.  BUT the current convoluted system where some middle class citizens pay ZERO federal income taxes  and some of the wealthy pay a lower percentage of their income as taxes than other middle class citizens is “unfair” by virtually anyone’s standards.

(3) A tax system should not appreciably harm the economy or distort it in any way–In other words, taxes shouldn’t subsidize certain industries, activities, or interest groups while penalize others. This creates an economy which is less efficient and grows more slowly. Unfortunately, our tax system is replete with such subsidies for real estate, homes, special types of energy production, renewable energy, agriculture, charities, non-profits and borrowers in general. At the same time, it penalizes the most important group to our economy: savers and investors.

The current system fails on all three of these principles. We have a startlingly high rate of non-compliance (mostly unintentional) estimated at 40% of the public by the IRS. Tax evasion amounts to some 16% of taxes due. Not even included in this figure is that we are not taxing some $1 trillion per year from the “criminal economy”. Our tax code has contributed mightily to the housing bubble and the massive overbuilding and speculation that occurred during the last decade. Our tax code has also contributed to the consumer debt problems that plague our country to this day.

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My favorite tax reform proposal to rectify these serious problems is something called the Fair Tax. See FairTax.org. The proposal represents a simple and effective way of raising tax revenues and having a system which is fair and positive for the economy.  To quote the website: “The FairTax is a comprehensive proposal that replaces ALL federal income and payroll based taxes with an integrated approach including a progressive national retail sales tax” … and
” a prebate to ensure no American pays federal taxes on spending up to the poverty level”. Of particular note:

  •  Simplicity– The FairTax is a 23% national retail sales tax on all goods and services plus a prebate to cover consumption up to the poverty level. This  eliminates ALL federal personal income, corporate income, gift, estate, capital gains, dividends, alternative minimum, Social Security, Medicare and self employment taxes. It is very simple and straightforward to collect and eliminates the incredibly complicated federal tax system we have in place today.
  • Efficiency—Compliance with the FairTax would be far better than under the current tax system due to its simplicity and its collection at the point of sale. (Something most states already do). In fact, even the $1 trillion criminal economy would be taxed as they would consume goods and services with their ill-gotten gains. The costs of personal and corporate tax accountants, tax lawyers, HR Block, TurboTax and the IRS would disappear entirely and filling out your tax forms would no longer be necessary.
  • Great for the Economy and Jobs–By eliminating the large amount of unproductive activity associated the current tax code, resources are freed up to produce more goods and services more efficiently across the economy. In addition, the elimination of subsidies and penalties in the current tax code, will eliminate overconsumption which is also inefficient, and encourage savings and investment which are badly needed in our debt laden economy.  Net retail price increases in the first year of the tax should be relatively small because the 23% tax on prices will be mostly offset by the elimination in corporate and other business taxes (which are estimated by economists to account for about 20%+ of  retail prices today). The US will become the mecca for foreign investment and US companies will no longer produce as much offshore given the elimination of these embedded taxes on exports. This will mean many more jobs in the US and better paying jobs as well.
  • Fair and Progressive—The system provides a prebate in the form of monthly check equal to the sales taxes paid on consumption at the poverty level for each family. This means that  the first approximately $30000 of spending is completely tax-free and the effective tax rate for those that spend at or below the poverty level is zero. In addition, all used goods (e.g. cars, appliances, furniture, homes etc.) are completely tax exempt. This means that necessities to live are NOT taxed while discretionary items are taxed. Also, those who are frugal and save more, get taxed less. This is very different from the system today where the working poor pay significantly more federal taxes (when payroll taxes are included) than under the FairTax.  Studies also demonstrate that spending on goods and services are generally proportional to income (e.g. someone earning twice as much usually spends twice as much) . Thus, the tax is progressive ( a higher effective rate is paid for those who earn and spend more).

In sum, the FairTax would broaden the tax base, aid the economy, create more US jobs and help us out of our budget and debt crisis. In addition, it can be easily modified to make it even more progressive by increasing the prebate and overall tax rate to account for the lost revenues, if that it is ultimately what US taxpayers want.

The only and perhaps insurmountable problem with the FairTax is POLITICAL. The benefits of the proposal is to the US population and economy collectively. However,  the benefits of the current tax system are to a multitude of special interests ranging from higher education, wind manufacturers, oil and gas drillers, public employee unions, the medical industry, real estate brokers as well as lawyers and accountants that thrive on the current hopelessly complex system. Any attempt to change the current system, let alone completely eviscerate it will be met with strong resistance. And of course those who are not serious about really cutting federal spending ( unfortunately many in Congress) will hate the proposal since it will force the government to be truly accountable about how much it needs in taxes.

But it doesn’t hurt to try. It’s a good idea whose time has come. It’s about time we changed a federal tax system that was born in the early 20th century.

More on other tax reform ideas in later blogs.

7 Comments
  1. 23% seems like extraordinarily good value, given that the UK has 20% VAT, income tax ranging up to 50% (40% is the typical marginal rate, 50% is above £150,000 income) and National Insurance contributions.

    Maybe our government is just horribly inefficient

    • Its a good question. The FairTax taxes basically ALL goods and services. I suspect the VAT coverage may not be so large. Also, when you consider all the deductions I suspect that the “average” UK income tax rate is like the US in the 15% range. Also, dont forget in the US , state and local income taxes and local property taxes and sales taxes would still exist and they are NOT insignificant. The FairTax replaces only the federal taxes. So in the end the UK government may not be that more or less efficient than the US government.

  2. Dale Heydlauff permalink

    I was unaware of the Fair Tax proposal. I like it for its simplicity. I completely agree that we need a fair tax code that delivers necessary revenues for essential government programs, and doesn’t overly penalize behavior we should incent, like savings and investments that create jobs. Personally, I’d like to see a higher tax on behavior we should discourage. Tobacco use is first and foremost since there is absolutely nothing good that comes from it, and tremendous harm and cost. After tobacco, I’d tax higher food and drink that contribute to our national obesity epidemic.

    The Herman Cain 9-9-9 proposal revealed significant public sentiment for tax reform. Other than those professions that make a living about exploiting the tax code, there should be near universal support for the Fair Tax idea. I hope our lawmakers are paying attention.

    • I agree with you on additional taxes on “bads” such as tobacco, alcohol, fats, sugar etc.

  3. Rob Carey permalink

    The FairTax proposal would eliminate capital gains taxes and estate taxes. To my mind that is *purely* political.

    • I could see the FairTax coexisting with federal estate taxes and wouldnt be opposed to that. (There is legitimate debate about estate taxes and what people should be allowed to pass on to the heirs. However, there is little debate about the economic efficiency of such a tax — as long as the rates arent too high–as it should not affect investment and savings greatly).
      Eliminating capital gains is extremely important on the other hand. Currently we have a strange system where you dont pay capital gains if you defer income into retirement plans which is what most Americans do for the vast majority of their savings, but then later pay income taxes when retirement is withdrawn. The FairTax would eliminate this complexity entirely and obviate the need for Americans to set up separate retirement accounts. Further, capital gains taxes tend to be a tax on inflation as are taxes on interest income. In other words, investors who are merely trying to keep up with inflation lose out because of these taxes.

  4. Rob Carey permalink

    Maybe, maybe not. But my point is that that is a political argument, not an economic one.

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