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“Yeah, I’m the Taxman”

April 19, 2017

With this years official tax due date of  April 18th just behind us, it is time for my annual tax blog. But as I purveyed my past blogs around tax time, I realized that I haven’t written an “annual” post in three years. So for now what is my “triennial”  post on taxes, I will focus on with the multitude of problems with the current system and why we must change it pretty radically. I am not naive on tax policy however, and the chances that anything close to the type of changes I am suggesting are minimal at best. Nonetheless, sometimes I like to dream.

The federal government collects money largely thru a system of personal income taxes and to a lesser extent corporate income taxes. In 2016, the government collected $3.3 Trillion in Taxes –almost $1.6 trillion thru personal income taxes,  $1.1 trillion thru payroll taxes (i.e. medicare and social security paid by employees and companies) and about $0.3 Trillion thru corporate income taxes with the balance of $0.3 trillion collected thru federal excise taxes and other taxes.

I won’t be focusing on corporate taxes as that is the most likely area to be reformed by Congress this year and frankly is not a major part (only about 10%) of our current tax picture. However, my main focus will be on personal income and payroll taxes which account for more than 80% of the total taxes collected by the government. However, the changes I am suggesting would replace all corporate taxes and personal taxes currently collected by the US government.

Why is our personal income tax system a problem?

  1. Federal income/payroll taxes provides a disincentive to “work” and for employers to hire U.S. workers – By taxing income, we are taxing the hundreds of millions of Americans who are working. This is particularly problematic for the lower-income worker who is often making only a bit more than welfare plus food stamps benefits because it discourages employment. (A single person making only $20,000 per year will pay about $2500 in taxes largely because of the mandatory FICA taxes of 7.65%). Studies abound about the importance of having a job to an individuals self-worth and the positive effects it can have on the family. But our current system actually financially discourages work which is obviously a big problem. More pernicious is that the payroll tax is also paid by the employer which discourages hiring and encourages more automation or outsourcing.
  2. Our Federal income tax system tax “savings” but not consumption – As a society one of the most important things we want to encourage is individuals saving for their retirements or for unexpected rainy days. More importantly, savings are the bedrock of capital that businesses need to expand and invest creating economic growth and jobs. However, our current system taxes savings by taxing interest, dividends and capital gains earned as well as eventually taxing all earnings in deferred tax accounts (e.g. IRA, 401K etc.). More importantly, we encourage consumption now because we don’t tax it at all. Partially as a result of this, we now are a nation of consumers and NOT savers with average savings of only about $40000 for those approaching retirement and only $9000 for all families. In contrast to our savings, our national debt has soared with total personal debt of $18.3 trillion almost as large as our US government debt. This personal debt burden is now more than double our personal debt burden in 2000 and TEN times our personal debt burden in 1980.
  3. Federal income and payroll taxes fail to tax the underground economy –  It is pretty obvious that income and payroll taxes miss the underground economy of illegal drugs, gambling and prostitution as well as legal professions such as maid, cleaning and other services which are often paid in cash and go undeclared. This underground economy is estimated to be not paying some $300-500 billion in taxes per year. In addition, the massive complexity of the tax code means that there are many knowing and more commonly unknowing tax cheats which cost the federal government significant tax revenues.
  4. Federal  tax deductions encourage home purchases and borrowing – The notion of home ownership is strong in the US and has a long history and individual home ownership is generally a good thing. However, by allowing deductions for property taxes and mortgage interest we significantly subsidize the cost of home ownership for many taxpayers. This has two negative effects: (1) it often encourages greater borrowing and the overconsumption of housing ( e.g. a bigger house than is truly affordable) and (2) it results in over-investment in the housing sector to the detriment of areas of our economy where investment would be more efficient (i.e. result in more economic growth and more jobs).
  5. Federal tax deductions for state and local taxes and tax-free interest for state and local governments encourage overspending by state and local governments –The largest itemized tax deductions for many tax payers are deductions for state and local taxes (both income and property). Also, state and municipal governments benefit from interest paid on their bonds being federal tax-free. The effect of these subsidies is to significantly subsidize state and local government spending and more state borrowing. Total state and local debt outstanding now totals $3.1 trillion some 10 times the amount of debt in 1980.
  6. High Marginal Tax Rates Discourage Small Business and Entrepreneurship  – Not surprisingly most small businesses and proprietorships pay individual taxes and with about a 50% marginal tax rate (when local and state taxes are factored in), it is not surprising that businesses are discouraged from expanding or for that matter even starting businesses since the venture or other capital needed is hampered by a low after-tax return on investment. Another effect of high marginal tax rates is to encourage tax deferred investment (401Ks and IRAs) and deferred income for the wealthiest tax payers. This actually reduces tax collections in the short run.
  7. The Current Tax Code is So Complicated that it Results in Much Wasted Spending –  According to the Tax Foundation the current federal tax code now totals MORE THAN 70,000 pages!!! The IRS estimates that the average individual tax payer spends about $120 per year to file taxes or a total of more than $18 billion per year across 175 million individual tax returns. Each individual taxpayer also spends about 8 hours on average preparing taxes. This is also a tremendous economic waste almost 1.3 billion hours (155 million tax filers x 8 hours) could have been spent on productive work, volunteering or leisure activities , were it not for our absurdly complex tax code. Valuing these foregone activities at a conservatively low $50 per hour (and arguably the number is higher as most of the tax preparation hours are spent by those in upper income brackets) means that there is an additional loss of almost $80 billion per year to the economy. In other words, just the costs of filing  for individual tax payers costs the US economy almost  $100 billion per year in wasted activity. And this doesn’t even include our corporate tax filing costs which are nearly as  significant.

The Trump Administration and Republicans in Congress promise to reform taxes. I believe that this will happen with respect to corporate income taxes, but it is lot less likely to happen with personal income taxes. Even if they do succeed, my fear is that it will only affect matters marginally. Certainly, reducing all the tax rates some will help (particularly IF deductions are phased out for the wealthy or capped to pay for the tax rate reductions). However, something much more fundamental is needed. We simply can’t afford as a nation to continue to operate with a tax code that is costing our economy hundreds of billions $ and maybe even trillions$ per year.

My favorite tax reform proposal to rectify these serious problems is something called the Fair Tax. See FairTax.org. I blogged about this proposal five years ago, but it seems more important than ever today. So with apologies to those who actually read my first blog post on taxes :), the remaining section is largely from that post in 2012.

The Fair Tax 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 national sales tax that treats every person equally and allows American businesses to thrive, while generating the same tax revenue as the current four-million-word-plus tax code. Under the FairTax, every person living in the United States pays a sales tax on purchases of new goods and services, excluding necessities due to the prebate”. Of particular note:

  •  Simplicity– The FairTax is a 23% national retail sales tax on all goods and services plus a prebate to offset the 23% tax rate on 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.
  • Revenue Neutral – The Fair Tax is estimated to be revenue neutral relative to the current set of federal taxes. However, with the economic benefits that it would unleash, it probably will result in even more tax revenue for the federal government being raised.
  • 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-$2 trillion underground economy and others that don’t pay enough taxes (either knowingly or unknowingly) would be taxed fully as they would still consume goods and services. The costs of personal and corporate tax accountants, tax lawyers, HR Block, Turbo Tax 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 national sales taxes paid on consumption at the poverty level for each family. This means that  the first approximately $30000 of spending for a family of four 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. used cars, used appliances, used furniture, used clothing, etc..) are completely tax exempt under the proposal. This means that many necessities to live are NOT taxed while discretionary items are taxed. Also, those who are frugal and save more, get taxed even 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 short, 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 biggest 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 and solar power manufacturers, oil and gas drillers, public employee unions, state and local governments, 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. Also, there will be many who won’t feel that the Fair Tax is progressive enough particularly when it comes to the very wealthy.

Accordingly, I would add either one of two provisions (or both) to the Fair Tax IF NEEDED to get consensus around the proposal. The first would be additional federal excise taxes on “bads” including all tobacco, alcohol content and sugar content. See my Post from 2012  “No Sugar Tonight” for the value of doing this on sugar. This could be used to supplement tax revenues and allow for a higher income for which there would be no effective taxes (by raising the probate) AND/OR to lower the fair tax rate of 23%.  Second, if it would help  would be a 10% earned income tax on joint filers with earned income of say over $400,000 per year (or whatever income level is deemed necessary for high income earners). This would be simple addition which would tax salary over this threshold and only require a relatively small number of filers.

I know the obstacles are considerable and I am clearly dreaming. 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 and clearly has outlived its usefulness.

From → Public Policy

2 Comments
  1. dchone permalink

    Bruce, you should do a comparison of the US situation with the UK situation as many of the tax proposals you make are quite well aligned with the UK. We have a relatively simple system, lower income people pay nothing or very little and there is a 20% VAT on all goods and services, But it still doesn’t work and the spending to income gap isn’t being addressed. Maybe then compare it with somewhere that is working (is there anywhere).
    David

  2. David, Per usual you peaked my curiosity. So I looked and what I would observe is that there is still a significant income tax in terms of revenues in the UK which is comparable in size to the US system, and the top rate at 45% is comparable to the US 40% (and closer to 45-50% when counting state and local US income taxes on average). Also there is a significant social insurance tax which is very similar to the US payroll taxes for medicare and social security. The difference is the VAT in the UK which as you note is 20% and means that the UK taxes are much more proportionately than the US today.

    So its probably not a good case to look at for what I and the Fair Tax proponents are advocating in the US since the idea would be to eliminate ALL income and payroll taxes and replace with the Fair Tax. Most of the rest of Europe is comparable in that there is both a VAT and income taxes.

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