Tax Reform in America

Since the topic of taxation came up in one of my recent blog posts, I thought that I would do a little more research into the matter and write an article. It is clear that the tax system as it is written now is way too confusing and that changes are needed. The tax code by the way is more than 66,000 pages long! Who has time to read that? The average American spends 26 and ½ hours a year filing his/her taxes[1] as it is. There is and has always been a long list of complaints against the system but since the mismatch is widening between revenue generated by taxes and the cost of running the government, tax reform is now especially urgent.

Revenue comes from various sources such as selling bonds (the government is currently paying $260 billion a year in interest on this form of funding alone[2]), Social Security taxes, Medicare taxes, individual income taxes, corporate taxes, excise taxes, etc. Listed in order from largest to smallest they are: individual income at 43.4%, social insurance and retirement at 34.8%, corporate taxes at 14.7%, other taxes at 4.1%, and excise taxes at 3.1%[3].

Since the largest amount of tax revenue comes from individual income taxes and that is what affects most of us the most, let’s take a closer look at that one. Income tax rates around World War II were at about 94% for the top tax bracket (if you made $200,000 a year you had to pay out 94% on anything above that) and since then have fallen steadily to the point when George W. Bush enabled his tax cuts which dropped the rate from about 50% down to about 35%.  These tax cuts by the way are about to expire and there has been much debate about whether or not to extend them. If one looks at the facts about the budget deficit before and after Bush took office I think that these cuts really speak for themselves. In 2001 when Bush took office we had a budget surplus of 236 billion with a projected ten year surplus of 5.6 trillion, at the end of his term he had run the deficit up to a 1.3 trillion shortfall with a projected 10 year deficit of 8 trillion! [4] Of note too is the fact that when Bush took over there were 31.6 million Americans living below the poverty line and at the end of his term there were 37 million. Also, I would take a look at the job losses. It has been said that if you raise taxes on the wealthy you will cause them to cut back on job creation. Well, when Bush passed those tax cuts what happened? Jobs were lost and we are arguably coming out of the worst recession since the Great Depression!  

Keep in mind that there are many millions of Americans that earn so little that they don’t even have to file a return. Look at college students for example, a kid coming from a poor or middle class family has to borrow money to pay for college tuition (or just not go at all) while working at a summer or part time job. The system is biased to the wealthy for whom the thought of college is a certainty beyond a doubt.

Now let’s take a look at Social Security.  Did you know that individuals that earn over a certain amount ($102,000 in 2008) pay no Social Security taxes on anything above that amount? That hits lower income people especially hard and it lets the people that are making the most off the hook. This is its own subject in and of itself, but I for one am not crazy about paying into a broken program that may or may not ever pay out any benefits to me or my immediate family. Now, I am no mathematical genius, but doesn’t it make sense that if everyone had to pay in based on their total income that the shortfalls would be taken care of? Even if it was “tweaked” a little and maybe the cut-off amounts were raised a few thousand dollars. It seems to me to be a pretty simple fix.

So get this, according to a study by the Government Accountability Office, two thirds of U.S. businesses paid NO FEDERAL INCOME TAXES between 1998 and 2005 and almost 70% of foreign companies avoided paying taxes in the same time period.[5] A corporation is its own “entity” so is it not fair that they should pay their fair share of taxes?

So, I guess it is pretty well documented that there are issues with the tax system as it now stands. The flat tax rate is certainly worth looking into as far as the income tax goes but it is not without problems itself. With the flat tax rate system, everyone would pay a percentage of their income to the government. The biggest problem with this system is that it has been estimated that to generate enough income to sustain the government programs on the books now, the tax rate would have to be up around 30% of income and support for legislation absolutely disappears when anything over 20% is brought into the equation. The highest tax rate right now under the prorated system is only 35%. This would also however reduce the amount of charitable contributions, reduce incentives to certain types of businesses (for example green technology and hybrid technology which are currently being offered tax breaks to increase research and development), increase the tax burden on very low income people, reduce investment in municipal bonds (currently not taxable or very low tax on gains), etc.

The problems except for working out the percentage issue could probably be worked out with a series of loopholes, exemptions, and proration but remember we don’t want to over-complicate the system and get back to the same system we have now.

Other ideas have been floated, such as making a national sales tax and abolishing the income tax completely[6]. Advocates say that this would curb spending by those that really couldn’t afford it anyway and bring transparency and accountability to the tax process. Fairtax.org states other advantages that include letting workers keep their entire paychecks, retirees would keep their entire pensions, it would refund in advance taxes paid on basic necessities, it would ensure Social Security and Medicare funding, and it would abolish the IRS, and close all loopholes and bring fairness to taxation. Capital gains taxes and other financial and investment taxes would also disappear with a national sales tax. 

There does seem to be a bit of confusion out there about how much the tax would actually be. It ranges from 23-30 percent with Fairtax.org stating the 23 percent number[7] (a sale that would normally cost $75.00 would be $92.25 after tax). They also say that enforcement would also be easier since the individual would not have to do a tax return, making the tax universe way smaller since it would only consist of businesses that collected the tax at the time of the sale.  Fairtax.org also states that the fair tax would not be regressive, with those below the poverty line paying no tax at all and those 2x the poverty line paying just 11.5 percent. How this would be achieved at the point of sale is not mentioned. To date Fairtax.org has spent about 22 million dollars on researching their idea.

Disadvantages to this idea include the loss of about 100,000 jobs at the IRS, the closure of many companies like H&R Block, and almost every tax accountant out there going out of business. The government would have to monitor the income of every American to determine their sales tax rate (maybe a good job for all those people that lost their jobs at the IRS?). Black markets and bartering would also be a prevalent and major problem. Politically this idea is going to be a hard idea to get passed. The idea was first fronted back in 1997 by Rep. John Linder of Georgia and to this day has not really gotten anywhere other than being talked about a lot. A link to the current bill can be found here http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.25:

It might be better to take a look at the system as it stands now and revise, simplify, and close loopholes, without drastic changes. Small changes can make a big difference. One of the reasons that two thirds of corporations don’t pay federal taxes is that they are set up as “S” corporations which means that they divide their profits and losses amongst their shareholders, who in turn pay income tax based on individual profits and losses. So even though the corporation is its own entity it doesn’t have to pay taxes. That is one loophole that could potentially bring in a lot of extra revenue for the government.

There is a bill being floated right now in Congress called the “The Bi-partisan Tax Fairness and Simplification Act of 2010” that does just that.  The bill can be viewed at http://wyden.senate.gov/imo/media/doc/bill_draft1.pdf. The bill revises and simplifies the existing tax code. Special interest exemptions and tax breaks are scaled back. Better yet, the bill is bi-partisan, collaboration between Sen. Ron Wyden (D-Ore.) and Sen. Judd Gregg (R-NH.). It is very refreshing to see that two parties can actually work together on a hot topic such as this.

“For too long, our tax system has been overly complicated, burdensome and unfair to taxpayers and to small business that are the economic engines of our nation”, says Senator Gregg. He goes on to talk about common sense tax laws that encourage small business development and job creation and about how the proposed tax return will be one page long. Key elements of the bill are a 24% flat corporate tax that will allow American companies to stay competitive in the world markets while paying their fair share of the tax burden.  The bill was inspired by the Tax Reform Act of 1986 which eliminated a lot of special interest tax breaks. The Wyden-Gregg bill will provide tax relief to Americans making up to $200,000 a year in part by eliminating the Alternative Minimum Tax. It also reduces the number of tax brackets from six to three. Middle class and low income workers will benefit from the near tripling of the of the standard tax deduction meaning that we will not only have to save a lot less of the  receipts that are needed for itemized deductions, but the tax burden will also be lessened drastically for many of us.

Only time will tell if this piece of legislation will gain traction and a tax reform law will finally be passed. I for one think that this last option is one of the most politically and economically viable options that I have seen and I will definitely be following it and keeping my blog up to date with the progress.  

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[1] National Taxpayers Union, “Tax Filing Burdens Worsen, with Little Respite in Sight, Citizen Group’s Annual Study Finds” April 15^th 2008, available at www.ntu.org/main/press_release.php?PressID=1004&org_name=NTU

[2] Students Face Up to the Nation’s Finances, “Can We Bring More Fairness to the Tax System AND Make Revenues Match Spending?”, available at www.FacingUp.org/students

[3] Students Face Up to the Nation’s Finances, “Can We Bring More Fairness to the Tax System AND Make Revenues Match Spending?”, available at www.FacingUp.org/students

[4] Politifact.com “Axelrod claims Bush saddled Obama with a big deficit” available at www.politifact.com/truth-o-meter/statements/2010/jan/15/david-axelrod/axelrod-claims-bush-saddled-obama-big-deficit/

[5] United States Government Accountability Office, “Comparisons of the Reported Tax Liabilities of Foreign and U.S. Controlled Corporations, 1998-2005”

[6] Fairtax.org “About the Fair Tax”,  available at http://www.fairtax.org/site/PageServer?pagename=about_main

[7] Fairtax.org “The Fair Tax Rate: a 23% tomato or a 30% tomato?” availahttp://www.fairtax.org/site/News2?news_iv_ctrl=1541&page=NewsArticle&id=8248ble at