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Federal Budget

The 5-Minute Tax Reform

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One of the fundamental issues facing the American economy is the complexity of the tax code, both individual and corporate. The Individual Income tax code is 70,000 pages long and has suffered more than 10,000 changes in the last ten years. Since 1975, the code has tripled in size. Such a degree of complexity and of instability has many large, negative impacts on people and their economic decisions:

  • It is a major drag in productivity – anyone who can’t use the 1040 EZ form is facing hundreds of hours of utterly banal and unproductive administrative work to prepare the requisite forms and filings;
  • It is highly inefficient – a complex tax code makes enforcement difficult and costly. Not only must the IRS review a much higher percentage of returns to correct the unintended errors of honest citizens, but it also requires more audits to detect those who attempt to evade taxes;
  • It is inequitable – the notion of progressivity in the tax code is belied by the sheer number of loopholes, deductions, credits and subsidies hidden in its multitudinous volumes, all of which are perfectly legal, and which favor those groups with the wealth and knowledge of how to exploit them – not the average 1040EZ filer;
  • It distorts economic decisions – the current tax code creates major distortions in the economic decisions of individuals and, indirectly, companies. The mortgage interest deduction discriminates against renters, who are typically lower income, and causes housing prices to rise by the amount of the subsidy. The health care deduction of employers favors jumbo plans which drive up overall health care costs in the system. Furthermore, the rapidity with which the code changes makes long-term planning and investment decisions very difficult for individuals and families.

Common Sense has already explored these issues in greater detail previously.[1] This article lays out what that simplified tax code might actually look like: brackets, rates, and the estimated tax impact on individuals.

Shared Sacrifice

Let’s be clear about one thing before I continue. This is a national emergency measure. Our fiscal situation is so perilous and our national debt so monumental, that only radical measures will be able to save the ship. We have more public debt outstanding today than at any time since the Second World War, and no end of deficits in sight.

Since we, as citizens, are ultimately responsible for the actions and inactions of our elected leaders, we are also responsible for fixing the mess we’re in. That’s why I am proposing a tax reform that hurts. It won’t hurt all Americans the same, but it will hurt us all at least a little. That’s fair and that’s square – we must share the sacrifice if we want to save our country and our children’s future. Once the deficit and national debt are back under control (see here), then the tax rates can be lowered: though not at the cost of returning to deficit financing!

The Fastest Filing in the West

One of the fundamental principals I hold is the equality of treatment for all citizens. We don’t tax people differently based on their race or religion, but we do based on their marital status. This seems inequitable to me. For this reason, Common Sense recommends the elimination of the filing status:

  • Consolidate the four current filing statuses into one: Instead of “single”, “married filing jointly”, “married filing separately” and “head of household”, all with different income brackets, you would have one individual filing status with the same brackets for everyone. In reality, the vast majority of Americans file as “single” (43%) or “married filing jointly” (42%)[2]anyway. “Married filing separately” is on 2% of all returns and “Head of Household” is the rest (13%).Implication: There would be slightly more work for married filing jointly and head of household filers, since now there would have to be separate returns for each of the adults in the family. This would be more than compensated for by the reduction in complexity and filing times for each return. Two 5-minute returns are still a huge savings in time and cost over one 20-hour joint return[3].There is also an implicit inequality in the difference in the income brackets between the various filing statuses. At the highest income levels, the “married filing jointly” bracket substantially penalizes families filing together. Let’s look at the following table to see the difference:The left-hand column is the income of a person filing singly versus a family filing jointly. There are six examples of different income levels, in each case the single filer earns exactly half as much as the married couple. The middle two columns are the total tax paid (assuming only standard deductions and no other credits or subsidies) by the single filer and by the married filing jointly couple for each level of income. The right-hand column is what the married couple would have paid if they had each had to file separately, if the filing statuses were eliminated.Under current law, filing status makes no difference for those earning less than $50,000 as individuals or $100,000 as families – they would pay the same amount if they each filed separately.Starting with incomes around $75,000 singly or $150,000 jointly, married couples are penalized for filing jointly. The higher the couple’s income, the greater the penalty – from a few hundred dollars at $150,000 to over ten thousand dollars for incomes above $500,000. I’m in favor of a progressive tax code, but not one based on marital status.

    This arrangement is excessively complex for the purpose of revenue generation. The tax burden for single filers, married filers and heads of households should be identical.

The inequities based on marital status exist for “married filing separately” and “head of household” as well. “Head of Household” pays far less tax under standard rates and deductions than any other category, and only exists for unmarried persons with dependents, who can then claim the Qualifying Child Tax Credit.

If Congress wants to benefit single adults caring for dependants, such as unwed mothers, or children taking care of an elderly parent, it can do it through the regular appropriations process in a far more controllable and transparent manner.  Don’t misunderstand me: I’m not against funding socially desirable behavior; I just don’t think it should be through the tax code.

Another fundamental principal of tax systems, at least in the West, is progressivity. People who are rich can usually afford to pay more in taxes than people who are poor. That’s not class warfare, that‘s just Common Sense. It seems ridiculous that I would even have to mention a point of equitability which has been largely agreed upon for over 100 years, but we live in a topsy-turvy country where the truly wealthy pay less as a proportion of their income than there secretaries.

  • Maintain a graduated marginal tax rate: The 5-Minute tax reform would maintain the current structure of the income tax. It adjusts the income brackets to align more closely with the current distribution of income in the United States, and it introduces a new income bracket for all income above $1,000,000.Because the reform proposes to eliminate tax expenditures, the tax rates within each bracket can be reduced and still generate increased tax revenues. The new tax structure would look like this:



Implications:
The reformed tax code has the aforementioned goal of minimizing complexity, burden to the taxpayer, and removing “hidden subsidies”, which does not imply that these subsidies cannot be recreated in more transparent fashion through the legislative process.

Additionally, the reformed tax code aims to fill a part of the gaping hole in federal finances through an increase in revenues. The elimination of tax expenditures and the elimination of other deductions ensures that everyone pays something in income taxes, even if that amount is a token amount.

Thus, the tax liability of every American will increase under the new regime, in spite of the reduction of the marginal rates for most taxpayers. How much will the increase be? For the majority of the filers (75%) the average increase will be below 15%. A family earning between $50,000 and $52,500 a year would pay $6,687 instead of $5,738 (+17%) under current law. Lower income individuals and families would be less affected: below $37,500 in income, the increase over current law is less than 5%.

This is true except for the very lowest incomes, where the increases would be substantial. This is because most of these earners currently pay no income tax, and so any increase is proportionately large. Earners in the $10,000 to $12,500 income range would go from paying an average of $266 in taxes to $556 (+110%) under the new code even thought the tax rate for that bracket would be half of the old rate (5% vs. 10%).  It is possible that Congress would have to provide income support for these earners to prevent hardship.


The biggest impact will be felt by the most affluent 25% of Americans. They will see substantial increases in the tax burden, mainly arising from the change treatment of capital gains and dividends. Additionally, the new bracket for incomes above $1,000,000 would drive a much higher liability among the top 1% of earners. :

Overall, the reformed tax code explicitly aims to minimize any increase in tax liability among members of the middle- and lower-income classes by focusing on the most evident sources of income inequality and inequity, which is the differential treatment of income sources. At the same time, Common Sense believes that the national hardship must be shared by all, since all of us had a hand in bringing about the current lamentable state of the union.

Show Me the Money

The new tax code would not only free Americans of millions of hours of pointless and frustrating labor, and generate an estimated $160 billion dollars in productivity gains to the US economy[4]; it would generate a substantial increase in federal revenues at a time when reducing the budget deficit and the national debt are becoming major priorities for both parties.

Under FY2009 conditions, the 5-Minute Tax would have generated 47% more revenue than current law, equivalent to $450 billion dollars. Under FY2011 conditions, the current tax code generated approximately $1.1 trillion in income taxes. We could expect the 5-Minute Tax to have brought in approximately $1.6 trillion. This would have cut the federal deficit from $1.27 trillion to $750 billionwhich means that there is still plenty to be done in smart reductions of spending to balance the budget.

It is important to understand: neither party is going to achieve their stated goal (a balanced budget) through their stated means (Democrats = tax increases, Republicans = spending cuts).

The Devil in the Detail

Clearly, no change so sweeping and involving so large an impact on the finances of individuals and families can be implemented overnight. It seems plain that a gradual approach to implementation, over three or four years, would allow citizens time to prepare themselves for the new system. The implementation plan might be as follows:

Year One:

  • Elimination the itemization of deductions. All filers must use the standard deduction;
  • Elimination of the “Married Filing Separately” status (2% of returns);
  • Elimination of the Mortgage Interest deduction on second mortgages;

Year Two:

  • Elimination the “Head of Household” status*;
  • Elimination of the Child Tax Credit*;
  • Elimination of the Social Security and Unemployment benefits as income (these have already been paid for through the payroll tax, there is no reason to tax them a second time);
  • Elimination of the Student Loan interest deduction. Elimination of the Domestic Production Activities Deduction;
  • Elimination of the Education credits (Form 8833);
  • Elimination of the Retirement Savings Contribution credit;

Year Three (the year of the big changes):

  • Elimination of the “Single” and “Married Filing Jointly” statuses. All taxpayers now file under a single common status;
  • Elimination of the Mortgage Interest deduction on all mortgages;
  • Treatment of capital gains, all dividends, and pensions and annuities as regular wages and earnings;
  • Removal of categories of “business income”, ”rental real estate”, “royalties”, “partnerships”, “S corporations”, “trusts”, etc. from the personal income tax. These will be covered in the corporate income tax (see separate article);
  • Elimination of all health care related deductions. Self-employed SEP, SIMPLE and qualified plans will be covered in the corporate income tax (see separate article);
  • Elimination of the Alternative Minimum Tax;

Year Four:

  • Elimination of the Earned Income Tax Credit;*
  • Elimination of all other deductions and credits (e.g. Federal Fuel Tax Credit, First-Time Homebuyer Credit, American Opportunity Credit, Making Work Pay Credit, Additional Child Tax Credit).

* Congress may enact legislation reproducing the effect of this deduction or credit;

The four-year proposal is only one possible way of arriving at this 5-minute tax; however, more complex modeling than is possible with the data I have available of the individual impacts of each of the changes in the tax code should be undertaken with the goal of spreading out the impact more or less equally over all four years.

The Necessary Reform

Some might argue that the proposed reform is too radical, that it does too much. I would argue that the current tax code is so complex and ungovernable that it is no longer salvageable.  The benefits of a simplified individual tax code are also so large that it is worth a strenuous effort to get there. The end result will be a tax code that generates more revenue, more equitably, at a far lower cost to the public in compliance and enforcement. Americans will never come to love April Tax Day, but at least they can view stop viewing it as an unending headache of forms, filings and receipts.


 

Sources and Notes:

[1]“Reinventing Everything: Four Steps to Fiscal Fitness: Step 1. Simplify the Tax Code”, March 2012. The objectives of the reformed tax code were:

  • Fit on a single sheet of 8.5 x 11 inch paper;
  • A preparation time for the average American taxpayer should be 5 minutes. For people with more investments and diverse sources of income, the preparation time should be no more than 30 minutes;
  • A guarantee of equal treatment of all citizens. It should do away with all distinctions based on marital status (“single”, “married filing jointly”, “married filing separately”), residency (“deductible mortgage interest”), parenthood (“child tax credits”);
  • A minimum tax bracket such that every working American pays some amount in income taxes;
  • 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;
    • 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 all “tax expenditures”;
    • 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  and GDP growth of 2% this year.

[2] FY2009 IRS Statistics of Income
[3] Estimated Average Taxpayer Burden for Individuals by Activity, pg. 95, IRS Form1040 Instructions, FY2010:

Primary Form or Type of Taxpayer:

Average Preparation Time (hours)

Average Cost

All taxpayers

18

$240

Primary forms filed:

 

 

     –  1040

23

$300

     –  1040A

9

$130

     –  1040EZ

7

$60

Type of taxpayer:

 

 

     –   Non-business

12

$160

     –  Business

32

$410

 [4] 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
[5 ] The “5-Minute Tax Model” is included to permit readers to test different variations of fiscal impacts within certain restrictions. Click on the link to access the spreadsheet:  20120510_5 Minute Tax Model

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Discussion

3 Responses to “The 5-Minute Tax Reform”

  1. Do I see correctly that you propose taxing incomes of less than $10,000 a year, i.e. way below the poverty level? Is this fair or even realistic?

    More personally, if I am reasonably well-to-do and my wife does not work, how do we file our separate returns? Is my whole income taxed, and she gets/pays nothing, or can we split the income in two? She is an expense to me, afterall. On a progressive tax scale, this makes a big difference.

    Posted by H. P. Clamann | May 21, 2012, 12:44
    • Dear Mr. Clamann,

      Incomes under $10,000 a year would be taxed under the reformed code. However, I would expect Congress to include income support that would effectively cancel out the liability. There are – in my mind – valid reasons for adopting this somewhat more cumbersome process. One reason is frankly political: to end the unfair accusation by Republicans that some people “get off” paying any income tax at all. Now all would pay something, but those under the poverty line would get a wage subsidy that would leave them approximately as well off. For those earning less than $12,500 per year (slightly above the 2012 single person poverty threshold), the total subsidy would be $2.6 billion per year.

      There are other possible arguments in favor, but I’m not strongly wedded to this particular point and would be happy to simply exempt certain income levels if it made passage of other key elements of the reform easier.

      Regarding your case personally, under the proposed reform you would each have to file your whole income individually. You could not split your income between the two of you, any more than you could split it in four if you had two kids (who are also an “expense”). I would personally disagree that a stay-at-home parent is an expense, given that they are providing free services in childcare, home cleaning, laundry and cooking which might otherwise require real cash payments to a third party. I assume that each couple would have calculated whether it is worth their while from an economic and parenting point of view to keep one wage earner at home with the kids.

      It is a substantial penalty, I agree: at $100,000 in gross income, it is about $5,400 more in taxes per year. If Congress so deems, it can always propose a “Stay-at-Home Parent” Act that would provide a subsidy to families in that condition … say $3,000 per year. That would help lower income families more than the current filing status, which is proportional to income (the difference is $1,200 for families earning $30,000 per year); while still compensating upper middle class families for slightly more than half the difference.

      I much prefer this method since it is neither automatic (Congress would periodically have to reauthorize it) nor “hidden” in the tax code – we could see as citizens how much we were actually paying for this support and decide whether it is truly worth it. As it is, it is very difficult to calculate the true taxpayer cost of this subsidy.

      Posted by fdbetancor | May 21, 2012, 13:19

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