Federal Taxes Fair and Simple?

Updated 4 July 2013.

Introduction

This rather longish essay will only scratch a very large surface by laying out the principles of Federal and related state and local tax reform.  If you are philosophically convinced that the so called  flat tax is both fair and simple then this essay was written with you in mind.  I hope to convince you that equality of tax rate, while undeniably simple, is not as fair as equality of sacrifice.

As the question mark in the title implies, this essay is also a work in progress that can only be improved by suggestions from readers, even if they are made with a serving of scorn.  I promise not to reply in kind -- unless you think that Grover Norquist is on to something.

What Can We Do?

Is it even possible for America's federal taxes to ever be both fair and simple?  To a heartening degree, yes; completely, no.  These two goals always clash when either is pushed to an extreme.  A simple tax can be inherently unfair.  A fair tax can never be perfectly simple. To get to a synthesis will require thought and give and take, but the result can be better than either extreme.  This essay reaches for that goal.

To achieve it will also take patience, for a comprehensive change can fail if too abrupt. Change is best implemented in digestible phases stretched over time so people can adjust. During meaningful reform taxes will  at first be more complicated than ever even as they become more fair.. Only if we stay a steady predictable course can we transit to a more fair and simple system 

What we should seek would be far more sweeping than the deal President Ronald Reagan and Speaker Tip O'Neil struck 25 years ago.  For example every special tax break in the federal code needs to be reconsidered,  if not repealed root and branch.  No lingering sacred cows. No important tax left unexamined and unchanged.  We must rebuild the house we live in while already in residence.  This is never easy.

Federal, state and local taxes all complicate our lives, especially when their rules and formulas unnecessarily differ. We will look for ways to reconcile tax structures among levels of government consistent with each level's independent constitutional power to raise (or lower) revenues.  However, state and local taxes taken alone, are  beyond our scope; except for those corporate and personal income taxes and gift and inheritance taxes levied below the federal level. 

It's time to broadly define what are we talking about  What are the important federal taxes and how to approach their reform?  For that matter, how to define "fair" and "simple," and which is the more important?  What else has to adjust as the tax codes are overhauled?  Finally, what can we -- and should we -- do when?

One aspect of tax reform we need not talk about is revenue.  A fair and simple tax code can raise as much or as little money as the country requires -- or will stand for -- by adjusting rates.   Rate adjustment in turn depends on the needs and politics of the moment.

Another point of silence is math.  We will elucidate principles and leave to those with super computers and modeling skills to compute the impact of those principles on taxpayers when they are married to specific rate structures.


A Fair and Simple Definition

Fair means equality of sacrifice.  If you and I are stripped naked to the world -- no shoes, no clothes, no income, no assets, no service -- the first dollars we earn are all-important equally to both of us.  As we struggle to earn more, our earnings will begin to diverge.  One of us will fall behind.  If I stay poor and you get rich, the last  dollar I earn is more important to me than your last earned dollar is to you. 

If I am poor enough, I need every last dollar.  If you are rich enough, you don't need any more dollars.  Would it be fair, then, for you to pay all the taxes?  I might think so, but you and most people would not.  However, everybody except you will agree that you ought to pay more taxes than me. Finally persuaded, you propose that we both pay at the same tax rate. You make ten times as much as I do, so you would pay ten times as much in taxes.  This is usually called a flat tax because the tax rate is the same for everyone.

Fair enough?  Not quite. There is a point, call it the "survival level." below which I cannot sustain life itself.  There is another point, let's call it the "satiation level,"  beyond which you  simply can't find the time or energy to spend any more.  If my income is one more dollar than survival  and your income is one more dollar than satiation, should we both pay the same amount of that dollar in taxes?  Of course not.  And that goes for every dollar in between these two levels if our sacrifice is to be as equal as math and politics mixed will allow.

Complete fairness, then, would mean that no income above the survival level should be totally exempt from taxation, and that the wealthy should be taxed at 100 percent beyond the satiation level.  Such a rule would be elegantly simple as well.  But what it wouldn't be is aspirational. Income just beyond enough for survival doesn't need the ambition stifling burden of an immediate tax bite. Equally, income beyond what any human can spend (even if married) is not income beyond what a financially successful person can risk by innovative investing, or can competently contribute to or manage for worthy causes. 

Thus taxes at these margins will not be strictly fair and far from simple, but perhaps we can make them equitable.  Quantifying definitions of "survival," "satiation," "innovative investment," and "worthy causes," will be crucial exercises involving not so much higher math as fuzzy math.  But, later on, we will make an attempt.

That is the case for choosing the graduated tax over the flat tax.  The term graduated tax means that each increment (bracket) of income subject to tax is taxed at a higher rate than the previous increment.  The size of each rate increment is calculated to maintain equality of sacrifice, i.e. fairness.  Obviously the graduated tax lacks the simplicity of a flat  tax.  Indeed the traditional process of setting increments  and the tax rate to be applied to each has been more political than mathematical.  We need to reduce the political part  to a minimum in the name of both fairness and simplicity.

Fairness also requires that all income -- wages, salaries, bonuses, interest, dividends, capital gains, pensions,  gambling winnings -- be treated equally.  (One exception to this rule is also fair: the stock paid as options in lieu of salary, or held by early investors, ought to be saleable untaxed when a start up company first goes public.   Great risk deserves great reward.)  Another exception is the earned income tax credit, an elegantly simple way to supply enough income for a living wage to the working poor.  The EITC's potential remains high, as unfortunately does its potential for abuse.

Simplicity is close to fairness in importance, if only because it is human nature to reason that if something is too complicated to understand it's probably not fair either.  Tax calculations should be simple in principle and easy to do with the aid of a computer program that embodies way more detail and nuance about the subject than you could, or should, ever need or want to know.  Consider searching the Internet.  It is easy to do: enter some search words and wait a few seconds.  But in those few seconds mathematics of hideously impenetrable complexity have been at your service.  Your tax bill, continuously calculated  from basic inputs, will never be as popular as the Google-retrieved address of a  lost lover, but if they are both easy for you to use why mind how complicated the formulas may be?

What can be simple and easy is aggregating income from all sources.  Fortunately this improvement is happening already:  tax preparation programs today can retrieve income numbers from employers, banks,  brokers, etc., via the Internet. Our need to collect and file odd shaped slips of paper for use at tax time is already ending. (The next improvement will be for the IRS, which gets this information too, to provide it to your program electronically on its responsibility.) 

Simplicity especially requires reform of deductions (which reduce taxable income) and credits (which reduce taxes directly). Another name for deductions and credits -- aside from "tax payers beloved friend" -- is tax expenditure.  Tax expenditures attempt to reward you for perceived good behavior or to induce you to behave well.  The big examples are deductions for mortgage interest, health costs, state and local taxes, dependents and charitable contributions, and credits for disabilities, old age, and energy conservation.

For those who don't itemize, about half of filers, taxes are already irreducibly simplified.  It's the higher income itemizers that have a valid beef about complexity.  Yet it will be this crowd that squawks the loudest when their favorite deduction items are dropped, chopped or capped. (Don't tax you/ don't tax me,/tax that fellow behind the tree!)

The ultimate in simplicity is to not tax at all.  While that will happen when pigs fly, there is a strong case for the gradual elimination of the corporate income tax.  (Simultaneously, though, the practice of wealthy individuals incorporating themselves to avoid taxes will have change, if not go away, if they are to pay any tax at all, let alone their fair share.)

Another area of simplification that the several states might consider is to adopt federal definitions and rules wholesale for what income is taxed and and exempted, setting tax rates as an add-on to the federal schedule.  Some states do this already, letting the feds collect the money from individuals and transfer a lump sum to them for an administrative fee that is a fraction of what a separate state system would cost to operate.  State legislatures retain the ultimate power to set and to change their tax rates

Simplicity is more important to the less well off, than to individuals well able to hire lawyers and accountants.  In fact it is the government and the rest of us that benefit when taxes on the well to do are simple, transparent and unavoidable.  


The Important Taxes

We will consider taxes on incomes, expenditures and wealth. The same criteria of fairness and simplicity will be applied to each one.

Incomes. 

The personal income tax.  The usual reform deal on offer is a reduction in tax rates and brackets in return for eliminating, capping or bracketing (as income is bracketed), such middle class sacred cows as the home mortgage deduction,  tax exemptions of  medical, retirement and other benefits and the deductability of state and local taxes.  This inadequate deal is off the table.  Tax rates should  roughly follow the path of the economy: up in good years, down in bad ones.  The number of tax brackets needs to be increased, not reduced.  The so called flat tax is a non-starter, even if dressed up as a European style value added tax.  It just isn't fair.

The corporate income tax.  It is said that we have the highest corporate tax rates in the world, and, once all the loop holes are plugged, this will be true.  Therefore, conservatives say, that the corporate rate should be lowered in the name of fair competition. I  propose that we lead, not follow, the rest of the industrialized nations and gradually eliminate corporate income taxation all together.  Our international competitors and trading partners will surely follow. 

This move is basic economics. Any corporate tax is an expense to the paying firm.  It is paid by higher prices for products or services and/or by lower profits on their sale.  The more a company dominates its market the more it can raise prices and thereby pass on the tax to purchasers.  In contrast, its smaller competitors, less able to raise prices and still be competitive, take the hit in their profits.  The ability of a few big firms to carve up a given market is boosted by corporate taxes. 

There is another perversity to the corporate income tax.  Business lobbying for breaks and loopholes, and the corruption that ensues, is an inevitable consequence.  So too are dodgy accounting practices, up to and including double sets of books.  Business decisions shaped by tax considerations are seldom the best.

As an alternative to taxing corporate income, we could tax corporate behavior. Two prime areas are (1) energy from fossil fuel usage, the so called carbon tax, and (2) environmental impact, including natural resources used, water consumption, air pollution, trash generation. The purpose of these taxes would not be to raise revenue but to change unsustainable behavior. 

These two taxes should apply mostly, perhaps exclusively, to the few thousand major corporations of international reach that dominate the national, and increasingly the world, economy.  Critics will term this a tax on bigness.  Without apologies, it is.   

Payroll taxes.  Unfairly characterized, they are those deductions that pick your pay packet before you ever see it by taxing you and/or you employer: social security, Medicare, Obamacare, unemployment insurance, worker's compensation insurance.  In sum  they fund that amorphous entity known as the social safety net.  Except as noted, most are not addressed herein.

Social Security. Conservatives say that retirees would be better off if social security were an investment plan akin to the 401k plans so popular with businesses keen to phase out guaranteed benefit pensions.   They have a reasoned case.  However, the train has left the station on this one.  The same money they would send to your personal retirement account is what today's retirees are counting on right now.  A separate blog essay deals with Social Security.

Medicare, Obamacare. Another blog essay deals with this complex issue.  We will be a generation before we get it right.  Perhaps by then it will be as cheap, helpful and administratively simple as that enjoyed by the French today.


Expenditures.
 
Use taxes.  Levies on an activity in order to create, staff and maintain the infrastructure the activity depends on.  These include charges for transportation (gas taxes, highway and bridge tolls, trucking fees, airline ticket fees, rental car fees, auto license fees), venues (entry fees to parks, museums, concerts, exhibits and the like), and services (parking fees, recording fees, law enforcement fines,court costs, catastrophic insurance policies, postal fees). 

The federal gas tax, which taxes gallons of gasoline used, and is for the benefit of the national highway systems, is dwindling as vehicles get more efficient and/or switch to electricity. A remedy that both raises funds for highway maintenance and rewards electricity use does not come to mind.

Sales taxes.  Mostly levied locally on most goods and services except for tariffs on imports from abroad.  A federal sales tax levied on Internet purchases and distributed to the states, perhaps on a per capita basis, is one way to reduce the inherent advantage of on line sellers, which no longer need or deserve the privilege.

Sin taxes. Gambling; tobacco and alcohol today; prostitution and recreational drugs possibly tomorrow. Obviously a special case of the sales tax, levied at rates designed to discourage legal behaviors that are bad for people and costly to society. 
 
Wealth.

Property taxes. These include residential and business real estate, land, business equity, capital gains and luxury taxes. 

The Inheritance and Gift tax.  Call it the death tax if you want.  It's certainly true that you die before it is paid, and your heirs are that much less compensated for their loss of your loving presence, but is not the community at large at least somewhat responsible for the fact that you successfully left a legacy.  For example, did you really pay as much into Social Security as you received?  Should your estate not pay it back?  No, family farms, businesses and ancestral homes should not have to be sold in order to meet this government levy.  A substantial deduction (law now), indexed for inflation (not in the law now), should allow for such transfers to deserving and responsible heirs as determined by the last wishes of the departed. 

Inherited wealth should not grant any person or entity unearned economic and political power in a democracy, especially in one where money is allowed to talk so eloquently.  The power of money in politics is bad enough without allowing it to speak from the grave. 


The Important Deductions

All deductions reduce your taxable income.  (Tax credits work differently.  They reduce your tax bill.)  Thus deductions are more valuable to higher earners whose income exposes them to the upper tax brackets than to poorer folk.  Keep this in mind for what follows.  Keep also in mind that eliminating one deduction, and retaining all others, or even eliminating almost all deductions while retaining a few, does little to simplify the tax code.  The end result may or may not be fairer.

Mortgage  Interest.  The purpose of this deduction is obviously to promote home ownership.  It has been successful at that, but it has also done much more, not all of it as beneficial.  Among the unintended consequences laid at the door of this most popular of deductions is that it has subsidized urban sprawl by allowing the middle and upper economic classes to afford larger homes and lots than they otherwise could.  Affluent homeowners in particular can more easily afford what are derisively called McMansions -- which they seldom need but often hugely enjoy -- partly at others' expense.

This deduction is capped for incomes above $1 million, which is no cap at all.  If it survives at all it should be drastically lowered.  The case for eliminating it altogether is that it helps many who don't need it and entices those who shouldn't to buy rather than rent.  A case can be made for helping the first time home buyer, perhaps with a tax credit matching the sum the buyer has saved for a down payment up to, perhaps, $5,000.  The credit would not be applicable just to the down payment itself, but would be spread out over at least two tax years as extra cash for any purpose related to home ownership: landscaping, furnishing, moving, etc.

One provision that definitely should be eliminated is the interest deduction on second homes. It helps mostly the well off and members of congress, who are perfectly capable of voting themselves an allowance for the expense of maintaining homes in their district and in Washington, DC.

Medical Expenses.  Now that the Affordable Care Act (Obama care) is constitutional and relatively safe from repeal, this deduction is a relic, and will fall into disuse even if left in the tax code.  Perhaps it is best ignored for now until we get a handle on who still needs it and why.  Chances are technical modifications to the ACA will do more to eliminate the need for a medical expense deduction.
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State and Local Taxes.  The familiar argument for this deduction is that one should not be required to pay a tax on taxes.  An apt rejoinder is: why not?  The obvious remedy is for voters in those states to take matters into their own hands, and vote for representatives who will reduce their state tax burden.  Or onto their own feet, and move to Florida or other low tax state.

Moving Expenses.  Involuntary moves should be paid for by the entity requiring or enticing the move.  Most are.  Voluntary moves are no business of the tax payer.  Beneficiaries of this break are moving companies and the affluent.  It can be eliminated.

Charitable contributions.  Phasing out this deduction would not be popular, nor is it called for.  It should be phased out as incomes rise and should be available to all whether they itemize or not.  Contributions to religious charities should be allowed, but deductibility of direct contributions to churches is a clear violation of the constitution's first amendment and should not be allowed at any level of government. 

Personal Home Sale Capital Gains Forgiveness.  In one way or another capital gains from the sale of a residence have long been avoidable.  Today, you don't even have to roll the gain over into a different home of equal or greater value.  Instead a gain of up to $500,000 for a couple, and $250,000 for a single filer is forgiven if rules are met about how long the home has been a primary residence and how long it has been since this deduction was last taken.  The recent collapse of residential property values has in many cases made this deduction moot except for long time owners of relatively high value homes.  The value to them of this popular tax dodge would rise considerably if, as recommended, long term capital gains were taxed as ordinary income.

A combination of the old roll over system and a one time forgiveness of gains when a home is sold after retirement is a better approach. I favor a two time roll over system: (1) when first home is sold and the next home bought and (2) when the last home is sold for a gain from the previous home. This would favor the careful home owner that buy wisely and stays put until old age forces a move.

The growing popularity of Continuing Care Retirement Communities (CCRC) would be boosted by this approach.  Such communities typically require a substantial entrance fee plus a monthly maintenance fee in return for a continuum of care for the balance of a person's life.  The writer lives in a CCRC and highly recommends this brand of retirement life.

Personal Deductions.  These should continue indexed, as they are, for inflation.  No useful tweaks come to mind.


IMPLEMENTATION. 

The train has already left the station.  A series of politically palatable tweaks will almost certainly be passed in the next few months in order to deal with the so called "fiscal cliff."  This will present reforms such as those proposed with new realities to ponder and critique.  Once the dust settles we can talk more again.
        



 

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