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While there are a number of different ways to debate the appropriateness of an income tax system, most academicians would agree that there are four broad categories that encompass the basic principles of a good tax system fairness, ease, minimal interference and conduciveness to economic growth, and adequacy.
Is the tax fair? Fairness at the basic level suggests that all people who are in similar circumstances should pay similar taxes. Under this principle of 'equal treatment of equals', one would expect families with the same ability to pay to have the same tax liability. Though not everyone will agree on the definition of fairness, most Americans will accept as fair the principle that the poor pay nothing, the middle class something, and the rich the highest percentage.
Is the tax easy to comply with and to administer? Whether a tax system is easy to comply with and easy to administer is a matter of subjectivity. In judging a system against this principle, however, one should examine the costs of compliance by taxpayers (out of pocket expenses such as tax preparation fees and legal fees as well as time spent on compliance) and the government's costs of administering the system. Complexity in a tax system has a tendency to feed upon itself, making efforts to produce a simpler and more equitable tax system even more complex. First, a progressive personal income tax structure complicates the collection process. Second, many IRS regulations exist solely to combat tax evasion and avoidance. As an example, one need only look at the cost of complying with IRA distribution reporting regulations put in place to assure that distributions are properly reported in income. Third, complexity arises from efforts to influence economic and social behavior. The charitable contribution deduction is an example.
Does the tax interfere as little as possible with private economic decisions and is it conducive to economic growth? In theory a good tax system is one where goods and services would be allocated in exactly the same manner with or without taxes. However, from a practical standpoint, the best one could hope to achieve is a minimal interference with economic transactions.
Does the tax produce adequate revenues? Deciding whom to tax, what to tax, and how much to tax requires social as well as economic judgments. Acceptance of tax increases depends not only on the government's current need for finance, but also on public values and opinions. The current status of the income tax system as our major source of federal revenue reflects the American commitment to taxation in general as the preferential (and fairest) funding method available.
History of the U.S. Income Tax
Prior to 186, the federal government relied primarily on tariffs to finance its expenditures. This reliance on tariffs served two goals first, to protect U.S. manufacturers from foreign competition and second, to
impose little or no burden on U.S. farmers, who were largely self-sufficient from their own production. Tariffs did, however, impose a burden on consumers who purchased significant foreign goods and services.
Beginning with the Civil War, wars have been a key element in shaping the U.S. income tax system.
On July 1, 186, Abraham Lincoln signed into law an income tax to finance the Civil War. Income between $600 and $10,000 ($10,00 and $17,400 in comparable 00 dollars) was taxed at %, and income over $10,000 at 5%. This early income tax lasted only ten years; in 187, under the Grant administration, it was repealed due to significant government surpluses. In 184, at the insistence of the Democratic Party, the income tax was reinstated in order to offset expected tariff decreases from the 184 Tariff Act. One year later, the Supreme Court struck down the income tax for not being apportioned among the states as required by the Constitution.
In 11, the Sixteenth Amendment to the Constitution was ratified, allowing Congress to tax income from whatever source derived. In October of that year Congress reenacted the income tax with a top rate of 7%. Secretary of the Treasury Andrew Mellon was successful in reducing the top rate down to 5% when he left office in 1.
While World War I secured the income tax as a part of our society, World War II served to extend the tax to the masses. The income tax levied in 11 applied to fewer than 400,000 Americans. During World War II, the tax was extended to middle-income Americans, and top rates reached 4%. Following World War II, income tax rates declined, but that trend came to an abrupt halt with legislation in 150 and 151 to finance the Korean War.
During the Kennedy administration, the use of tax cuts to stimulate the economy became commonplace, and was used to stimulate a lagging economy in 164, 171, 175, and 181. Ironically, however, the 181 tax cut was followed a year later by the largest peacetime tax increase to date. Tax increases were enacted in 184, 10, and 1 to help combat huge federal deficits. During this period, tax code 'missions' became more numerous, adding to the complexity of the system. In an effort to simplify the system, Congress enacted the Tax Reform Act of 184, which expanded tax coverage, reduced rates, and simplified filing for low-income taxpayers. However, any simplification gains from the Tax Reform Act were quickly eroded by the enactment of the earned income credit for low-income families. In 00, Congress passed a sweeping tax reduction act in an effort to provide economic stimulus to a floundering U.S. economy. The results of that tax reduction package remain to be seen.
Is the Current Income Tax System a 'Good' System?
Clearly, the majority of Americans have issues with one or more aspects of the current income tax system. Following is an analysis of the current system using the four basic principles discussed earlier.
Fairness. A majority of Americans (67% according to a recent NBC News poll) believe the current system is unfair. As discussed above, fairness in the basic sense suggests that all taxpayers in similar circumstances should pay similar taxes. The numerous tax breaks throughout the current tax code make it commonplace for families with equal incomes to have very different tax liabilities in a given year. Many will argue that these tax breaks contribute to fairness since income is not always a reliable indicator of one's ability to pay. For example, given the personal exemptions and medical expense deductions, a family of four with a chronically ill child will pay less in tax than a healthy family of four earning the same gross wages. Conversely, some tax breaks appear to contribute to a lack of fairness in one's tax liability. Take for example two taxpayers with exactly the same income, one derived 100% from wages and one derived 100% from sales of investments. Are they in the same circumstances? Under our current tax code, the taxpayer with capital gains will have a much smaller tax liability than the wage earner. Taxpayers who choose to own a home have the mortgage interest deduction available to them, while renters do not. Theoretically, the lessor will pass his tax break through to the lessee; however, the perception of unfairness persists. The best known violation of the principle of equal treatment for equals is the marriage penalty, which penalizes couples for being married.
Ease of Compliance and Administration. Consider the following statistics In 11, the initial tax code was 14 pages; today the code and regulations together consist of 7.1 million words and 101,000 pages. The IRS currently has an annual budget of almost $8 billion and about 101,000 employees, almost one employee per ,000 citizens. The average estimated preparation time for Form 1040 and related Schedules A, B and D is 0 hours. If you have a business investment and file Schedule C, add another 10 hours. Last year, the IRS processed and compared over 1 billion information returns (W-, 10, 108) against taxpayer income tax returns. The current income tax code contains five separate conflicting definitions of a child, ranging in age from 1 to 4. In 17, Money Magazine invented a tax scenario of moderate, but not difficult, complexity and asked a number of professional tax return preparers to compute a tax liability. The forty-six responses they received back each had a different answer, ranging from $4,40 to $68,1 (the correct answer was $5,64). Not one professional preparer turned in an error-free return. Former Internal Revenue Service (the "IRS") Commissioner Charles Rossotti has been quoted as saying "the cost of taxpayer compliance with this code is [more than] $80 billion per year, more than eight times the costs of the IRS budget. The size and complexity in itself can be a source of disrespect for the law." For millions of lower-income Americans, however, compliance costs are relatively minimal. Forty-two percent of all taxpayers file a single page tax return, whether 1040A or 1040EZ, and spend, on average, less than ten hours per year on income tax matters. Despite this percentage, most Americans continue to resent the tax code for its complexity due to the widespread perception that only the rich, through accountants and lawyers, can take advantage of the various tax breaks, shelters, and loopholes in the code.
Minimal Interference with Economic Transactions and Conduciveness to Economic Growth. Our current tax system is inherently non-neutral since it changes taxpayers' incentives to engage in various activities. Three particular examples follow. First, an argument can be made that a progressive tax disincentivizes workers who are successful in their efforts to earn more money by taxing higher incomes at a higher rate. To the extent the workers reduce their efforts in response, the economy as a whole suffers slower growth. Second, there is little doubt that the tax code influences the choice and composition of taxpayer investment portfolios. A taxpayer in the 5% tax bracket, when faced with a choice between a corporate bond earning 8% and a tax-free municipal bond earning 6% would choose the municipal bond, ceteris paribus. Third, the marriage penalty discourages entrance into the workforce. A study by William Gale of the Brookings Institution found that married women are less inclined than single women to enter the workforce because they are faced with higher taxes.
Adequate Revenues. Adequacy of the current system is in the eye of the beholder. Given the current size of the U.S. deficit, most Americans would either argue that the tax system is inadequate or that government spending is excessive, or both. As the above history of our income tax system shows, tax rates have generally been increased to finance wars. This year will break precedence with the past, as the administration and Congress have elected to combat the slow U.S. economy with a large-scale tax reduction even in the face of huge deficit spending resulting from the Iraq War.
Other Issues. Other issues often cited as reasons for the need to replace our existing tax system include the straying from American values, the undue influence of lobbyists on Congress, and the lack of enduring principles. From the very beginning of taxation in the U.S., taxes were designed with one eye toward morals and American values. Alexander Hamilton, the first Treasury Secretary, suggested early taxes be imposed "more as a measure of social discipline than as a source of revenue". Many Americans today argue that the current tax code promotes immorality, and cite the fact that a man and a woman with dual incomes will pay less tax by living together than by getting married. Political Action Committees ("PACs") and other interest groups continually lobby Congress for favorable tax treatment for their constituents; treatments that exacerbate the tax code's complexity and lack of fairness. In 15, for example, members of the Congressional tax writing committees comprised only 10% of Congress, but received over 5% of PAC money contributed. Finally, opponents of the current tax system cite a lack of enduring principles as a major objection to the system. To be effective, the tax code should be stable and reliable, not subject to revision and rewriting every year.
Alternative Tax Systems
The major tax systems available to replace the current graduated income tax system are a consumption tax and a flat income tax. Alternatively, the current income tax system could be modified to better fit the four principles of a good tax system.
Consumption taxes fall into two broad categories retail sales taxes/value added taxes ("VAT") and personal consumption (expenditures) taxes. Like state sales taxes, a national retail sales tax would add a surcharge to the cost of retail goods and services. A 'pure' sales tax would exclude all production inputs (goods and services purchased by businesses to produce their products) and would tax all sales of goods and services to the consumer. In practice, most states exempt 'necessities' such as food and medicine to ease the burden on the low-income taxpayer. Robert McIntyre of the Citizens for Tax Justice estimates that if goods and services typically state-tax-exempt are excluded from the national sales tax, a sales tax rate of 56% would be required to replace the current level of income tax revenues. The VAT, a close cousin of the retail sales tax, is currently levied in over one hundred countries around the world. The base taxed by the VAT and by the retail sales tax is exactly the same; the primary difference is that the retail sales tax collects the tax at the retail stage, where the VAT collects the tax piece by piece along the production process.
The most widely circulated proposal for a personal consumption tax is the Unlimited Savings Allowance ("USA") Tax, originally sponsored by Senators Sam Nunn, Pete Domenici and Bob Kerrey. Under a pure personal consumption tax all income is included in the individual tax base, and there is an unlimited deduction for net additions to savings and investment accounts (sort of an unlimited, unrestricted Individual Retirement Account). The USA Tax plan is a modified personal consumption tax in that deductions for home mortgage interest, charitable contributions, and Social Security contributions are retained, along with a annual percentage allowance for withdrawal of past savings. The USA Tax then taxes the net expenditure at graduated rates of 0%, 1%, 7%, and 40%.
Under a consumption tax, on the positive side, individuals would no longer be required to file tax returns (except for the USA Tax) and significant dollars would be saved in tax preparation and advice. Assuming the system is implemented and administered effectively, all individuals would pay the same rate for the same goods or services; that is, equal treatment of equals. Savings would be encouraged under a consumption tax.
On the negative side, administration of sales tax/VAT plans would be high because of the need for sales tax verification. As the rate increases, the potential for under-the-counter, off-the-books sales becomes greater. A national sales tax would likely be regressive, even with exemptions for necessities. As a percentage of annual income, consumption decreases as income increases. In addition, since most low-income families today pay little or no income tax, a consumption tax would hit the low-income taxpayer harder. The USA Tax will likely create a host of potential tax avoidance schemes centered around the incentive to inflate savings amounts and not to report withdrawals. A Treasury Department study of the USA Tax concluded that the plan would require "a more extensive system of information reporting and monitoring than does an income tax". Finally, since economic growth is directly proportional to consumption, any system which may curb consumption would likely lead to some type of slowdown in the economy.
As discussed above, the current graduated income tax system fails each of the principles of a good tax system, except perhaps for the adequacy test. Reforming the current system simply is not practical in the political environment in which we live today. Major revisions to the tax code have been enacted no less than ten times since the original tax was adopted in 11, and countless other minor revisions and 'corrections' have been adopted. The 186 Tax Reform Act, Congress' serious attempt at tax reform and simplification, has been almost totally eroded by subsequent changes, such as the Earned Income Credit. There are a number of advocates in Congress today pushing for tax reform; and yet, each proposal stops short of the level of reform needed to assure that the system meets the four principles necessary for a good system. For example, several proposals to eliminate tax preferences retain the charitable contribution deduction because "the effect on charitable organizations would be devastating".
Recommendations for A Flat Tax System
Unlike our current tax system that requires thousands of pages of code to decipher, a flat tax scenario can be explained in a matter of pages. Over the years, though many different flat tax scenarios have been proposed, the primary goals of each scenario remain relatively the same to promote freedom, fairness, and economic opportunity for Americans. Several members of the House of Representatives, including House Majority Leader Dick Armey, co-sponsored an ideal flat tax scenario. Their scenario, referred to as the Armey-Shelby flat tax, gives consideration to sources of income and family composition, and is indexed for inflation. Their version of the flat tax, which promotes equity among all classes and encourages saving as well as consumption, is discussed further below.
Under the Armey-Shelby scenario, double taxation of income is eliminated. Income becomes taxable only at its source, unlike the current system in which income derived from investments is taxed once when the income is received in the form of wages, retirement benefits, noncash compensation, profits from business activities, or winnings, and again when interest or dividends are earned on the original income. It is this feature that will promote savings by eliminating the penalty for investment. At the same time, consumption will also increase because taxpayers will retain a larger share of their wealth, increasing disposable income, rather than passing it on to the government.
Once income is categorized as an originating source, that income is taxed at a flat rate of 17% rather than the current marginal tax brackets that range from 10% to 5%. Taxes would thus be levied equitably on all taxpayer income derived from wages, retirement benefits, noncash compensation, profits from business activities, and winnings. This single all-inclusive rate eliminates the need for tax tables or the computation of the alternative minimum tax.
Allowances similar to current personal exemptions are made for the composition of the family under the Armey-Shelby scenario. Each taxpayer within a family is provided an allowance of $1,00; each dependent is provided an allowance of $5,00. Therefore, a family of four with dual wage earning spouses would receive an allowance equal to $5,00. The standardized $1,00 wage earner allowance eliminates one of the primary inequities of the current tax code - the marriage penalty. To allow for a transition period following the death of a spouse, surviving spouses are provided an allowance for their deceased spouse for three tax years following the spouse's death. A head of household is provided an allowance of $15,700.
Computation of the total tax liability would be a simple process. Income derived from an originating source would be subtotaled, and family allowances would be computed and subtracted from the income subtotal to arrive at taxable income. Taxable income would be multiplied by the 17% tax rate to determine the tax liability. Payments withheld from employees and any estimated taxes paid would be subtracted from the tax liability to determine the additional tax or refund due. Under this straightforward set of computations, a family of four that earns income of less than $5,00 would pay no taxes. Families with similar compositions would pay similar taxes on income above the $5,00 threshold, and regardless of the amount of income earned above the threshold, the tax rate would remain constant at 17%.
The examples below show that, as income increases, the effective tax rate under our current system also increases, but remains constant under the flat tax system.
Example 1 The Jones'
The Jones Family consists of husband and wife, John and Mary, and their two children, Bobby and Peggy. The Jones' have a combined income of $61,000, which includes $1,000 in dividend income.
Under the current tax system, the Jones' would be subject to taxes totaling $4,8, assuming a standard deduction of $7,850, personal exemptions of $1,000, and a child tax credit of $1,00. The effective tax rate on $41,150 of taxable income is 10.67%.
Under the proposed flat tax system, the Jones' taxable income would be $4,800 after subtracting their allowance of $5,00 and eliminating the $1,000 in dividend income. Their total tax bill would be $4,16. The effective tax rate on $4,800 of taxable income is 17%.
Example The Smiths
The Smith Family consists of husband and wife, Bob and Sue, and their two children, Mike and Sara. The Smiths have a combined income of $15,000, which includes $,000 in dividend income.
Under the current tax system, the Smiths would be subject to taxes totaling $1,77, assuming a standard deduction of $7,850, personal exemptions of $1,000, and a child tax credit of $450. The effective tax rate on $105,150 of taxable income is 0.67%.
Under the proposed flat tax system, the Smith's taxable income would be $86,800 after subtracting their allowance of $5,00 and eliminating the $,000 in dividend income. Their total tax bill would be $14,756. The effective tax rate on $86,800 of taxable income is 17%.
Example The Thompsons
The Thompson Family consists of husband and wife, Larry and Barbara, and their two children, Fred and George. The Thompsons have a combined income of $00,000, which includes $10,000 in dividend income.
Under the current tax system, the Thompsons would be subject to taxes totaling $44,866, assuming a standard deduction of $7,850, personal exemptions of $1,000, and no child tax credit. The effective tax rate on $180,150 of taxable income is 4.0%.
Under the proposed flat tax system, the Thompson's taxable income would be $154,800 after subtracting their allowance of $5,00 and eliminating the $10,000 in dividend income. Their total tax bill would be $6,16. The effective tax rate on $154,800 of taxable income is 17%.
Why the Flat Tax System is Preferable to the Current System
Advantages of the flat tax system over the current tax system are numerous. These advantages, discussed below, include simplicity, cost reduction for the taxpayer and the government, increased fairness, and taxpayer privacy.
Simplicity. The proposed flat tax scenario would prove to be a simpler and more efficient tax system than the current system. The tax return to be used under this scenario would consist of a form the size of a postcard, with a line for income, the allowances based on family composition, a subtotal of taxable income, and total tax due based on the flat 17% tax rate. As the form would be much simpler than the current forms used to compute taxes, the time needed to prepare a return would be dramatically reduced from hours to minutes. No longer will time be spent searching for the correct forms and accompanying schedules, or through the mountains of receipts required to reduce tax burden by an additional $5. Record keeping would also be unnecessary since the only requirements would be statements of income. Simplification of the tax return would significantly reduce the cost of income tax enforcement. The IRS time currently required to audit and review selected returns would virtually be eliminated, decreasing the necessary manpower needed to support the current tax system.
Taxpayer Cost Reduction. In 16, taxpayers spent an estimated $5 billion to comply with the current tax system a figure that came close to surpassing the entire defense budget for that year. As shown in the Money Magazine survey described earlier, the current tax system's complexity and the subtle nuances of the Internal Revenue Code make it nearly impossible for a taxpayer to file a tax return correctly. Professional help and advice that is essential for many taxpayers during the annual filing process does not come cheaply. These costs are evidenced by the sheer size of the tax preparation industry, and its steady growth over the years. If the current system were replaced by a flat tax system, taxpayers would be afforded the opportunity to spend tax preparation fees on improving their quality of life rather than on making sure that they are not overpaying their taxes.
Government Cost Reduction. Of the Internal Revenue Service's 00 budget of almost $10 billion, more than one-third, or $.8 billion, was used for enforcement and compliance. With the introduction of the proposed flat tax system, these monies could be used to serve better purposes. The funds that could be cut from the Internal Revenue Service's budget would be put to better use improving social welfare systems such as education, healthcare, and social security. Reallocating budgeted IRS dollars will improve the overall growth and health of the nation.
Many opponents of the flat tax system have suggested that the flat tax system would not be able to generate the same level of revenues as does the current tax system. This is simply not true. By some estimates, government revenues would actually increase by 1.8 percent annually. According to the National Center for Policy Analysis, "the increase in government revenues is driven by the increases in the majority of sectors in the economy and accompanying increases in employment of labor, capital and land." Taxpayers who are allowed to keep more of their income will be incentivized to earn more since marginal increases in income will not be offset by an increased tax rate. As discussed earlier, one of the barriers to married women entering the workforce is the marginal tax rate. This effect will have a positive outcome on the growth of the economy. In addition, the magnitude and associated costs of the Internal Revenue Service would be downsized in a flat tax environment.
Fairness. Arguably the largest complaint about the current tax system is that it is highly unfair specifically, taxpayers are not treated equally with regard to their respective tax burdens. Under a flat tax system, equality would be realized immediately. Since all originating source income would be taxed at the same rate, taxpayers would pay the same amount of tax regardless of the amount that he was willing to pay for professional advice or lobbyist influence. The need to seek loopholes or invent tax avoidance schemes would disappear. Unlike the current tax system, the simplicity of the flat tax system provides a tax code that is clear and concise with no room for interpretation, making tax avoidance nearly impossible. Another frequent taxpayer complaint is related to the perception of the Internal Revenue Service's unchecked authority. In reality that is not the case, but taxpayers often feel that they are at a disadvantage due to the overwhelmingly complicated Internal Revenue Code. The taxpayer lacks trust in the Internal Revenue Service, and its integrity has been compromised by its own inability to decipher the Internal Revenue Code successfully. With the passage of the flat tax, the lengthy tax code and the confusion and complexity that surround it would be eliminated, thereby improving the perceived fairness, trust, and integrity of the Internal Revenue Service and the tax system as a whole.
Privacy. Another benefit derived from a flat tax system would be increased taxpayer privacy. Over the past few years, significant privacy concerns have surfaced. The ease and availability of private information about consumers is staggering, allowing identity theft as well as providing companies with excessive amounts of information about their clients and non-clients. The alarming level of consumer concern for their privacy resulted in the passage of Regulation P, designed to curb the selling and exchange of consumer information. Consumers in general are at a point where they prefer not to release any more personal information than is absolutely necessary. The information contained a single tax return under our current system provides a wealth of personal knowledge about the consumer, including sources of investment income, assets owned, home ownership, medical expenses, and occupation. Taxpayer returns are seen by countless Internal Revenue Service employees. Under a flat tax system, the majority of this personal information would be eliminated from the filed return.
Summary
The above arguments clearly show that our current graduated income system fails to meet the tests of a good tax system. 67% of Americans believe the system is unfair. shown above that the current A national retail sales tax is an unproven alternative, and is likely to be an administrative nightmare at the rates necessary to replace the current income tax system. A VAT, while a proven alternative, is similar to the sales tax in that both forms of consumption tax will likely lead to a radical shift in the tax burden from the wealthy to the low-income taxpayer. Given the premise that Americans accept as fair the principle that the poor pay nothing, the middle class something, and the rich the highest percentage, the sales tax and VAT alternatives are not likely to be acceptable to the American public at large. The personal consumption tax (the USA plan) will likely be more complicated than the current income tax system, which also is not likely to be acceptable to the American public. Reforming the current graduated income tax system is not a practical alternative given today's political environment and the nature of special interest deductions and preferences.
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