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Federal Budget

3.1 Simplify the Tax Code


3.1.      Simplify the Tax Code

Our first step towards fiscal fitness focuses on three categories of the tax code: individual income taxes, payroll taxes and corporate income taxes. Together, these account for 91% of all Federal income. What’s more, individual income taxes are 43% and payroll taxes are 36% of all revenues. Corporate taxes are only 11% of revenues, but they’re very important in growing the economy and creating new jobs, so they’re included in this section.

It makes sense to focus on the big levers.

Part One – The Individual Income Tax

April is everyone’s favorite time of the year. Everyone at H&R Block that is. But unless you’re a tax attorney or married to one, April is that depressing time of the year when you have to waste hours of your precious spare time gathering documents, peering through inscrutable IRS guide books, filling out multitudinous forms, all with the end result of realizing that you still owe Uncle Sam money.

The Individual Income Tax Code is 70,000 pages long. There have been nearly 10,000 changes to the code in the last 10 years. Between 1975 and 2005, the code tripled in size. As a result, Americans spend approximately 6.1 billion hours and $160 billion in lost productivity preparing their tax returns, the equivalent of 1% of GDP. (1)

Not only is it unnecessarily long and confusing, it is highly inequitable. The farcical illusion of progressiveness in tax rates is undermined by the sheer number of potential subsidies and deductions available to informed individuals, and their clever tax advisors.

A recently published paper entitled “The Incentive Effects of Marginal Tax Rates: Evidence from the Interwar Years” (2) studied the effect of different tax rates on income and economic activity for people of different income levels over time. In summary, the study shows that marginal tax rates have very little impact on how hard people work – less wealthy people still have to work to cover their expenses, while more wealthy people still attempt to maximize their revenue opportunities. What marginal tax rates do impact is income deferment and tax avoidance, both legal and illegal.  This is correlation grows stronger the higher you go up the income ladder. In other words, high tax rates don’t stop the wealthy from working; they cause the wealthiest to hire more tax attorneys and legal advisors to avoid paying taxes. This conclusion is very important later on, so remember it.

The tax code also makes numerous value judgments which may or may not make any societal sense, but certainly make no fiscal sense. For example, the tax code favors homeowners by allowing them to deduct the interest payments on their mortgages from their taxable income. Are renters such wicked people that they should be forced to pay their taxes in full, while homeowners reap the benefits of their propertied virtue? For that matter, what does the government have against landlords, who find their market unnaturally depressed as the price of housing falls due to the indirect tax subsidy?

We’ve all had a recent lesson in the odd nature of the tax system thanks – inadvertently – to Mitt Romney. Mr. Romney has an effective tax rate of about 14%, even though he earned over$20 million in 2011. This is because the government taxes “unearned income” – capital gains and dividends, for example – at a lower rate than “earned income”. Expressed in those terms, it sounds even more illogical than it is. And while there are some sound arguments for a low capital gains tax, there are some equally sound arguments against it.

The fact, universally agreed upon, is that the American tax code is too complex and too judgmental for a modern society. It is justly loathed by citizens and businesses; it is highly inequitable in outcomes; and it is inefficient and costly to audit for revenue generation.

A Modest Proposal

What’s to be done? No one likes the current taxation system except politicians who use it as a reward system for whichever particular demographic is in favor at the moment. Let’s start with the Individual Income Tax (the “IIT” from now on).

The best and simplest answer is to scrap it and start over. That’s exactly what I propose we should do. In fact, the President and Congress should challenge the IRS to create a new IIT with the following characteristics:

  • The new IIT should fit on a single sheet of 8.5 x 11 inch paper. If it doesn’t, it’s too long;
  • A preparation time for the average American taxpayer (3) should be 5 minutes. For people with more investments and diverse sources of income, the preparation time should be no more than 30 minutes, and mostly consist of collecting the various declarations sent by the bank, the fund, the company accountant, etc…;
  • A guarantee of equal treatment of all citizens. It should do away with all distinctions based on marital state (“single”, “married filing jointly”, “married filing separately”), residency (“deductible mortgage interest”), parenthood (“child tax credits”). Different – standard – deductions based on number of dependents would remain, regardless of whether they were children, elderly, handicapped or other category;
  • A minimum tax bracket such that every working American pays some amount in income taxes. A 5% tax rate starting just above the poverty line could be a starting point for analysis;
  • A maximum tax bracket such that no working American is being taxed more than 45% of their income within that bracket;
  • A graduated system of taxation between the minimum and maximum brackets;
  • An equal treatment of income categories. Sole proprietorships, investments, interest income, dividends, capital gains, alimony, rental income, pensions and annuities, farm income – all should fall under the same tax treatment.
  • The only exceptions to this rule would be: social security income, Medicare/Medicaid payments, and unemployment compensation. These have already been paid for through payroll taxes;
  • The elimination of “tax expenditures” (4). These are the deductions, exemptions and credits that reduce taxable income or which create a liability for the government. I would admit the following exceptions:
  • The previously mentioned standard deduction for dependents; and,
  • Charitable donations;
  • Limits to be placed on these categories and automatic annual revision through pegging to a benchmark rate;
  • An online tax form with provisions for uploading scanned tax documents (e.g. W2) and includes bank account details for automatic debit or credit of taxes owed o refunds, thus greatly reducing paperwork and administration costs;
  • A goal of generating $2 trillion in revenues in Fiscal 2013 assuming full employment (5) and GDP growth of 2% this year. (6)

If these changes sound radical, so are some of the benefits. Consider the following outcomes likely to be obtained through a comprehensive reform of the IIT:

  • Increase in worker productivity and hours saved from record keeping and filing preparation equal to $160 billion per year; (7)
  • Reduction of IRS Taxpayer Services costs, equal to $1.2 billion per year; (8)
  • Reduction of IRS Enforcement costs, equal to $2.2 billion per year; (9)
  • Reduction of distortions in the housing market by eliminating the deduction for mortgage interest and property taxes, equal to $166 billion per year; (10)
  • Reduction of distortions in the health care & pensions market by eliminating the deduction for employer contributions for health insurance premiums and pensions contributions, equal to $286 billion per year; (11)
  • Reduction of distortions to savings rates by normalizing the treatment of income from dividend and long-term capital gains, equal to $75 billion per year. (12)

That’s $527 billion per year in revenue, $3.4 billion per year in cost savings, and $160 billion per year in increased GDP. Not bad for a day’s work.

State revenue officials should be invited to unifying their individual tax forms with the Federal tax form in the context of this reform. Why? One good reason is that it would reduce the need for 51 different agencies sending out 51 different forms and leading to a multiplicity of personnel and effort that costs taxpayers a lot of money. A taxpayer should be able to go online, fill out a single form, and file both their federal and state individual income tax statement in 5 minutes.

Lest this be viewed as more “rampant growth” of the federal government, or an infringement of the rights of state governments, let me be clear that the proposal is only to unify the filing of taxes. State legislatures would still have full competence to unify or not unify their individual income taxes with the federal procedure. Legislatures would also have full competence to set the marginal state tax rates within the unified form. It would constrain them, however, to adhere to the same types of deductions permitted in the federal IIT.

One additional change I would recommend. The requirement to file for Americans living abroad should be eliminated. (Full disclosure: I currently live abroad). The United States is the only country in the world with this requirement and it imposes a serious burden on expatriates, regardless of the reason. Ostensibly, this measure is supposed to reduce the opportunity for tax evasion, but I have not seen any studies confirming its success. The only practical effect is to force expats to file at least two totally different tax forms every year, and to pay for services they are not consuming.

Finally, the proposed changes to the Federal individual income tax does impact the Federal corporate tax as well, mainly in how businesses will react to changes to the treatment of capital gains, rental income, income from sole proprietorships or self-employment, and employer contributions to health insurance premiums. In any case, the corporate tax code is ripe for overhaul as well. That will be covered in Part 2 of this article.

Sources & Notes:

(1).        Testimony of Douglas Shulman, Commissioner, Internal Revenue Service, Hearing on Internal Revenue Service Operations and the 2011 Tax Return, 31 March 2011, U.S. House of Representatives, Committee on Ways and Means.(2).        Romer, Christina and Romer, David, “The Incentive Effects of Marginal Tax Rates: Evidence from the Interwar Years”, National Bureau of Economic Research, February 2012.
(3).         Assumes household income <= $100,000 per year.
(4).         A more complete treatment of tax expenditures will be provided in a separate article.
(5).         Assumes 5% unemployment rate. Tax revenues are highly volatile and sensitive to the economic cycle. Setting a goal of $2 trillion with full employment and a growing economy means that significantly less tax income will be generated during recessions or with high unemployment. The following graph shows the swing in tax revenues between a “boom” and “bust” economy;

(6).         As a comparison, individual income tax receipts were $1.13 trillion in 2011. However, the unemployment rate was 9%; additionally, the Office of Management and Budget estimated that “tax expenditures”, i.e. deductions, exemptions and credits, cost the Federal government approximately $1.2 trillion in foregone revenues in 2010.
(7).        See (1)
(8).        2009 IRS Data Book. Estimate based on a reduction of 42% in audits of individual income tax returns and corresponding reduction in personnel costs. See Table 1 below for more details on estimates.

Table 1. Number of IRS Returns and Examinations by Category, 2009

Savings in examinations and audits is estimated in the following manner:

  • Elimination of earned income tax credit reduces those examinations to zero = 483,825 examinations or 30.7% of total
  • Reduction of 30% in examinations of Non-business returns without earned income tax credit = 163,768 examinations or 10.4% of total
  • Reduction of 30% in examinations of Non-business returns with total positive income of at least $200,000 and under $1,000,000 = 21,463 examinations or 1.4% of total
  • Total reduction in examinations = 669,056 examinations or 42.8% of total

(9).        2009 IRS Data Book. Estimate derived from a 60% reduction in filing and taxpayer assistance activities and a corresponding reduction in personnel costs. See Table 2 below for more details on estimates.

Table 2. IRS Expenses by Budget Category, 2009 


(10).    “Tax Expenditures have a major impact on the Federal Budget”, Congressional Budget Office, 03 February 2012.(11).    Ibid.
(12).    Ibid.

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