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.)