Tuesday, February 14, 2012

A Real Tax Fairness Plan

Obama's proposals to tax the rich more are red herrings; they may appeal to the class warfare instincts of his base, but have little to do with raising the revenue necessary to fund the federal government. Our tax policy is a mess, there are huge loopholes, gifts to special interests with marginal rates left too high to make up the shortfalls. His proposals do nothing to alleviate these problems. The result is that corporate and personal tax lawyers can offer their clients positive return on investment by gaming the system to avoid taxes, all in a legal manner. The complexity of the tax system matters, because inefficiencies in tax collection and complexities in compliance are a drag on the economy People want the rich to pay their "fair share," but the left seems intent on making a show of punishing the rich for their success. That is not the same as actually punishing the rich, which might dry up donations, as their is no taste for closing off exemptions.

Given the income tax structure and the desire for fairness, a flat tax with no deductions and credits seems the fairest system. But what forms of income should be taxed? My initial instincts would be to only tax ordinary income, and leave investment alone. But that results in some truly unfair situations. Billionaires whose income derives from their investments would not be taxed at all; which situation would be politically unpalatable, even if you thought it was appropriate. The problem with taxing the rich is that they can shift their income among three sources, corporate profits, dividends, and capital gains; effectively arbitraging income sources to reduce their tax rate. However, taxing all of these sources of income at the same rate has the effect of double taxation on ordinary investors who lack the ability of the super-rich to reallocate sources of income.

Consider two examples. Joe Sixpack puts away a little money that he invests in Microsoft to get a better rate of return than the bank. Microsoft's profits are taxed, and then they can pay a dividend. In turn, Joe pays taxes on the dividends as income, resulting in a double taxation rate. If there was a flat tax of 20% on all income, the effective tax rate for Joe's investment income is 40%. From a policy perspective we need Joe to save, so the double taxation is a disincentive. But what about Jane Billionaire? She may own her own company, so she can retain the profits in the firm, not pay a dividend, too avoid a double taxation; its her company. If we made dividends tax free, then she could declare big dividends and reap the tax free income. Her wealth gives her options that Joe lacks. We want to tax Jane fairly, but don't want her to have an effective rate less than Joe's.

I haven't even argued about the need to eliminate all the loopholes in the system. The loopholes are the scraps that attract the vermin of lawyers and lobbyists to keep invading the House (and Senate). Given that a single flat tax without loopholes is preferable; we need to solve the Joe vs. Jane issue. My proposal would be to eliminate all capital gains and dividend taxation for individuals earning less than $500,000 and couples earning less than $1,000,000 per year. This would have the added advantage of encouraging savings, which the country desperately needs to counteract the effects of the recession. It is standard economic theory that a country's GDP growth can't outstrip its savings rate. Setting these limits would also prevent the wealthy from using tax policy arbitrage to avoid taxes, making this the fairest system imaginable.

We would also want a reasonably high standard deduction to prevent the working poor from experiencing the highest marginal tax rates. Coming off tax free welfare and into a paying job shouldn't result in a reduced standard of living due to income taxes. (This is the theory behind the earned income credit.) We could probably set a flat tax rate at about around 16%-18% and still bring in enough income to fund the federal government at its historic percentage of GDP. Further, even the if the wealthy were getting double taxation on dividends or gains, it would only be at the 32%-36% range, hardly a historically unprecedented level.

If the President really cared about the tax fairness he would propose something like this, and the "rich" would definitely pay their fair share; certainly a higher rate than the rest of us. But I don't think they would mind, because they could fire their tax lawyers and stop worrying so much about taxes.

(I ran the numbers on my own situation using a $20,000 standard deduction plus $5,000 for each dependent and continued destructibility of my 401(k) at the 17% flat rate. I found that my taxes would increase by about 15% over what I am paying now. It would be worth it to get my savings into tax free status and to not worry so much about taxes.)


  1. What about a flat "tierred" system. Similar to current system, but get rid of most or all deductions. And perhaps add a cap on the few deductions allowed. So for example all the mortgage interest on a half million dollar home might be deductible, but only a portion of it on a million dollar home. It would be very similar to current system, but should patch the worst of the abuses. It might be a less frightening alternative.

  2. That was very clear, but for the same reasons you name, lawyers & lobbyists would be cut from the loop, depriving them of an honest living.

  3. I understand what you are saying, but I don't think that it's fair for government to pick winners and losers by having any deductions, with the possible exception of charitable giving, since it ameliorates the need for government programs. I would like a straight flat tax, because it is fair and predictable. Eliminating deductions allows the marginal tax rate to be as low as possible.

  4. Not to nitpick, but to address your second example, corporations who accumulate in excess of $250,000 in cash and retain it without paying a dividend have to specify a reason or pay tax on the excess accumulation. Acceptable reasons are anticipated investments, acquisitions, etc. Most of the accumulated cash we hear about is held offshore for this reason.

  5. It is undeniable that the current U.S. Income Tax Code has been falling apart for years!
    The Income Tax code is almost 75,000 pages long and that does not even include all the tax publications, instruction booklets, revenue rulings, tax court cases, etc.etc.etc.
    The problems with the Income Tax code are so obvious. Just pick it up and read it.
    It is obvious that it cannot be fixed by adding more and more regulations to fix the earlier regulations. The basic model just does not work.
    In addition, there are currently about 26 countries in the world who do not have an Income Tax code like the United States (no country in its right mind would set up such a system).
    And on top of all this, this Income Tax code system makes it illegal to not do bookkeeping the way the government wants you to, has billions of dollars in compliance costs and is constantly being added to with new regulations every single month. Not once in a while, but every single month (go read the monthly revenue rulings that are constantly coming out).
    This is not a system that can sustain itself and will eventually collapse.