The US Tax System – Reform or Reformation

The US Federal income tax system is in desperate need of replacement. It is a system skewed to the rich and powerful, built in an ad hoc, thoughtless fashion, and one that does not meet the basic criteria of a tax system – to be fair and efficient. It is indisputable that the current US federal income tax system is neither fair nor efficient. Any worthwhile tax code should meet both criterions. What would a fair and efficient tax code look like? Most proposals include simplifying the code, closing loopholes, and lowering tax rates. Others would go further and eliminate it altogether, replaced by some other tax system, or have just a simplified flat tax whose main virtue is that it treats everyone equally. While all these proposals have their attractions, none really get at the root of why our system is so out of balance or what really would reform the system. A modest proposal follows. What does it really mean for a tax system to be fair? What does it mean to be efficient? And how do they determine the bona fides of a good tax structure? First, fairness can be seen as a system that asks the same of everyone, so that no one pays a greater proportion of their income than anyone else does. Fairness can also be seen as a tax structure that is progressive, i.e. one that asks more of the taxpayer as income rises. Fairness in this context, however, would seem to mean that the system does not disadvantage anyone, which is not the same as a flat tax. Fairness is also inextricably linked to efficiency. Efficiency, for the purposes of this argument, means that the tax system does not advantage or disadvantage any part of the economy. There would be no distortions attracting money to one area or away from another or affecting investment strategies to take advantage of a tax break. The two concepts, therefore, must both be met to create the best system. What would it mean then for a tax system to be both fair and efficient? First, everyone would be treated as the same. There would be no distinctions between an individual, corporation, or organization. The same set of laws, rules, and rates would apply to each. Why should one taxpayer be treated differently just because of their legal standing? The current system bestows advantages on one kind of taxpayer and disadvantages on others without any real economic justification. Second, there would be no (none, zilch, zero) exemptions, deductions, incentives, etc. to the code. Again, these change how people behave and who wins or loses. This prohibition puts everyone on the same level to compete for the resources available in an economy. Money should flow to the best and highest uses and will be accomplished by equal treatment. What is the best measure for determining how taxes are determined? The simplest way would be to make every dollar of income the same regardless of its source, who receives it, or who pays it. With no offsets such as deductions, losses, or tax expenditures. Thus, a babysitter and GM are equivalent when determining how much income they have to be taxed on. Income is a better means for determining a tax since it is far too easy to manipulate profits (no movie ever made one) and losses. In addition, why should the tax system subsidize the inefficient? Governments would not be given the privilege of tax-free financing; public projects would compete with the private sector as to which had a higher return. This would be the baseline from which any reform of the tax system should begin. Think of it as akin to zero-based budgeting where everything has to be justified to be included. There are many reasons, some justifiable most not, for creating “distortions” in the tax system. The problem with our system is that it has been built by Rube Goldberg wannabees with no logical thought given as to the exemptions, let alone the system as a whole. The real question is not whether we should make distortions to the tax code, but which ones and why. Changes should only be made if the benefits outweigh the effects it causes on the rest of the tax system and how much it advantages or disadvantages different taxpayers. The system works best that is least complicated, but some changes may reap more than a simple system and should be considered. But only after carefully weighing the balance of costs and benefits. We have built a terrible system precisely because we have not given any thought to why we make changes. How to ensure this? This would require a major change in how Congress deals with approving changes to the tax code and spending (on which taxation is based). First, contrary to most proposals, tax increases should require only a majority vote and tax cuts a supermajority (60-66%). Why? Tax increases carry their own inherent disincentive in that the voters often react by dismissing public officials they see as passing unnecessary tax hikes. Second, tax cuts and exemptions are very popular and easy to do so they are done – repeatedly. The only way to control tax reductions is to force every action that decreases tax revenue to be subject to a supermajority. Every bill that includes such provisions would have the same requirement so no riders could be snuck in to bypass the restriction. The fairest, simplest tax system would soon be riddled with distortions without a restriction on introducing them. Third, spending would also require a supermajority (55-60%) to ensure that spending remains controlled. Governments could still deficit spend (there are times when this is vital), but it would be more difficult to do unless in the most dire straits. The lack of a tax exemption on debt would also serve as a brake on deficit spending. The only “distortion” that I would recommend is to make tax rates progressive rather than flat. In part, this is because it seems more “moral” that those who benefit most should pay the most. The Federal income tax cannot be viewed in isolation from other taxes and fees since those affect how the total tax burden falls on a taxpayer. A large number of states and local governments have very regressive tax structures, payroll taxes disproportionately affect lower income workers, and user fees have the same effect. The regressiveness of other taxes needs to be taken into account when designing an income tax system that is fair to all. The main reason, however, is that a flat tax would not promote enough investment to grow an economy at its fastest pace. This is in opposition to the arguments by most for a flat tax, that a flat tax would promote more investment by allowing the rich to keep more of their money to invest. It is true that they keep more money, but their tendency is to invest for safety and not risk when an economy needs risk-takers to take advantage of opportunities. A higher tax rate, one not offset by shelters, trusts, etc., would force the higher income earners to invest in higher risk, higher return investments. They would be forced to be more entrepreneurial and less stewards. Otherwise, the economy is likely to underinvest in the long run and be less prosperous. (There is some historical evidence in this in that higher economic growth has been associated with higher marginal tax rates.) This change, however, would have the effect of favoring the rich over other taxpayers to the extent that the higher returns from their investments would increase their incomes relative to the other taxpayers. This would be offset at the end of their lives by an estate tax to bring balance back into the system. The standard objection to a higher rate is that the rich would just invest in tax shelters, but there are no God-given tax shelters, only Man-made ones and these would be unavailable. Tax reform should be a bottom-up process with an eye to consistency and the interplay of the various parts on the tax system as a whole. It must go hand-in-hand with some political changes, however, or we will just renew the cycle of distortions multiplying until the tax code once again becomes a nightmare. To do otherwise is a waste of time and harms our economy. The continual tinkering with the tax code makes investment more uncertain and leads to a less productive economy. It is time to set up a rational tax system and leave it alone.