Proposal for an Ideal Tax Code – 1

It’s obvious:  We need taxes and the current tax code needs to be changed.

Why do we need taxes?  How should we change the tax code?  We need taxes at all levels of government to fund government activities.  We, the citizenry, need to pay taxes to fund government activities.  Government entities need a reliable, predictable source of revenues to fund their activities, so they can provide reliable, predictable services.  Every tax code should be Equitable, Effective, Efficient and Enforceable.  I refer to these criteria as the “four E’s” (which I discussed in the previous post).  To recap:

  • “Equitable” means “fair” in the sense that it “recognizes that some dollars are worth more than others to individual taxpayers, if not to the tax collector, but does not values dollars differently by their sources”.  The dollars we earn to buy shelter, food, clothing, transportation and security are more valuable to us taxpayers than the dollars we earn to buy restaurant dinners, cruises and theater tickets; the dollars earned from dividends or capital gains, whether from the sale of real or financial assets are no more or less valuable than the dollars received from building machines or selling wine.  Each unit of currency with a given denomination has a different value according to its use, but, not according to its source.
  • “Effective” means “tax codes enable governments to collect enough money to provide the services that it’s citizens ask it to provide”.
  • “Efficient” means “the tax code enables governments to minimize the cost of managing the code, viz., identifying the taxpayer economic activities to tax, determining equitable rates or amounts of taxation, calculating taxes owed by taxpayers, collecting taxes due, and accounting for and administering all of these activities.
  • “Enforceable” means “enables the identification of all taxable revenues and the collection of the taxes due on them”.

Our current federal tax code is deficient on three of four counts.  Surprise, surprise, the IRS is efficient!  State and local tax codes are deficient, as well, on the same three counts.  Again, although their results vary widely, they tend to be efficient.

First, it’s not equitable. While it’s progressive and, thereby, recognizes that the first dollars earned are more valuable to us than the last dollars earned, it distinguishes their values according their sources, too, by taxing capital gains and dividends at lower maximum rates than wages or salaries earned from work.  Money spent by businesses on travel expenses, office supplies, loan interest, employee compensation (including medical and retirement plans) is excluded from taxation because the code taxes net income (before tax), not revenues, and offers the option of accounting for income on an accrual basis as well as a cash basis.   In the case of individual taxpayers, the code taxes their revenues, excludes some expenses selectively and doesn’t offer the accrual method of reporting income as an alternative.

Second, it’s not effective.  The annual federal budget deficit fiscal 2012 is $1.089 Trillion.  Need I say more about effectiveness?

Third, although it’s efficient (contrary to conservative Mitchology), it could be materially more efficient.  The federal tax code’s complexity and the vagueness of its statutes drive the cost of managing the IRS up.  These relationships are positive; as complexity increases, the cost of management increases, and as rule vagueness increases, the costs of, at least, calculation and collection increase.  From 1966 to 2011, the cost of running the IRS has grown from $625 million to $12.4 Billion, never a huge number in the federal budget.  During this period, the cost of collecting $100 in taxes due has increased only from $0.48 to $0.51 (that’s right—cents!), about ½% of collections.  Which private enterprise generates revenues on a ½% cost base?  (Btw, this metric peaked in 1993 at $0.60/$100, six years after the Tax Simplification Act of 1986 and bottomed out in 2000 at $0.39/$100).  There are footnotes to this analysis, but the message is still clear.

Fourth, it’s not enforceable.  In my business career, I had a few opportunities to aid the IRS in its investigations of tax avoidance activities.  And, I’m familiar with ways in which their enforcement mechanisms allow a great deal of “tax management”, especially in the case of privately owned business expenditures by and for business owners.

There is one more, huge, issue:  whether the tax code is an effective or efficient tool of economic behavior management.  Congress attempts to use it surgically to encourage or discourage behavior they deem desirable or undesirable at different times.  Targeted exclusions are too numerous to discuss in this post (already too long) and the links between their usage and their intended outcomes are tenuous, if there are any at all.  Their economic value is dubious.  As interesting as they are (to me), these topics will be discussed in other posts.  My conclusion as their usefulness as tools to manage national, state or local economies is that “surgical” applications of tax policy (exclusions, increases, reductions, eliminations, additions) of taxes rarely generate the outcomes intended and frequently result in unintended outcomes that are detrimental to their purposes.  Thus, increased taxes on gasoline purchases, because they are flat taxes, encourage automakers, with some success, to build cars with better mileage, they increase the cost of transportation more for lower income drivers than for higher income drivers.  As increased taxes drive the price of cigarettes up, the incidence of smoking among teenagers and the size of the black market for stolen cigarettes grow relative to the size of the total market for tobacco products.

Having made this point, I will admit the possibility that tax policy can be useful as a tool for managing aggregate economic behavior.  For example, we may use it to manipulate citizens’ decisions about their personal ratios of saving and spending, thereby, managing aggregate saving and spending without discriminating among different groups on an unrelated basis.  Taxing consumption instead of income could achieve this outcome.  Success just depends largely on the level of aggregation; tax policy may be an effective sledgehammer, but it’s a lousy scalpel (just look at the patient).

What, then, should federal, state and local tax codes be?  They should be progressive exclusively, simple enough to automate completely, easy to implement and to automate their enforcement, and they should tax economic “rent” income at equal or higher rates than income that results from productive work (redundancy for emphasis).  The tax code I propose achieves all of these goals and meets the standard of the four E’s.  It also offers powerful incentives for creating strange political bedfellows who may, as a result, work together to achieve common outcomes.  For those who want to see a consumption tax, I have something, too.  The devil is in the details of the tax rates and the total revenues to achieve, which are different discussions in which we need to engage.

First, I would reduce the tax code to almost no code at all:

  1. Eliminate all deductions from income and exemptions to taxation,
  2. Eliminate all taxes on business or commercial activities;
  3. Eliminate all flat taxes or restructure them on a progressive basis, for example
    1. Sales taxes,
    2. Alcoholic beverage taxes,
    3. Gasoline taxes,
    4. Licenses, permits and fees for auto registration, professions and trades, construction and other typical activities at the state or local levels,
    5. Real estate taxes,
    6. Public utility rates, and
    7. Road tolls;
  4. Eliminate or restructure Social Security and Medicare taxes,
  5. Eliminate preferential treatment of income from capital gains, dividends or interest.
  6. Eliminate such targeted tax schemes as lotteries for education funds, or taxes on gambling to be used for waterfront preservation or taxes on offshore oil set aside for ocean front development (Long Beach California’s harbor, beaches and roads were some of the outcomes of the largesse that resulted from the California oil boom).

Second, I would implement a new tax code:

  1. Tax individuals and users of shared resources and nothing else.
  2. Tax Income, capital gains, dividends, interest and all asset sales at a graduated structure, with:
    1. Eight income brackets,
    2. $45,000 upper bound on the bottom bracket
    3. $1,000,000 lower bound on the upper bracket,
    4. Top tax rate of 72% of marginal income above $3,000,000
    5. Seven other brackets at 64%, 56%, 48%, 40%, 32%, 24%, 16%, and 8%.
  3. Tax income from work according to the same rate structure, but, with a higher lower bound on the top bracket (and, therefore, the other brackets):
    1. Eight income brackets,
    2. $45,000 upper bound on the bottom bracket,
    3. $1,000,000 lower bound on the top bracket,
    4. Top tax rate of 72% of marginal income above $1,000,000,
    5. Seven other brackets at 64%, %56%, 48%, 40%, 32%, 24%, 16%, and 8%.
  4. Tax water, air and food crop pollutants and abuses as well as all activities that accelerate global warming at aggressively progressive rates—pollute more, pay more per unit of pollution, use “too much” of a shared resource, pay more per unit of that resource.
  5. If we decide that we can’t trust our legislators to manage the federal budget so as to allocate sufficient funds to maintain Social Security and Medicare, then simply write into the code that a percentage of all taxes collected would be set aside for them.
  6. Require digital, online filing of tax forms and returns of all taxpayers.  The federal government would provide this service for those who could not afford it.  Require that all transactions be reported electronically.

I’ve advocated for the four E’s and a simplified tax code at each level of government in previous posts.  I’ve also attempted to make a case against using tax policy as an instrument of behavior management.  I’ve made this case simply on the observation that tax policy cannot be used to manage behavior surgically.  By that claim, I mean, for example, that although tax policy can be used to encourage exports of heart monitors, there would be, inevitability, unintended, unanticipated consequences to such policy the costs of which outweigh the benefits of that policy, and there may have been no need to encourage such exports, anyway.  Yet, here I am advocating taxes on activities that pollute air, water, and food, that is, all shared resources in order to discourage polluting activities and activities that accelerate global warming.  Is this aspect of my proposed tax code inconsistent with the Equity principle and with my assertion that tax policy is not an effective behavior management tool?  How, then, does this proposed code satisfy the four E’s?

The proposal to eliminate taxes on commercial activities is counterintuitive to populists, liberals, progressives, and just about anybody except someone who owns a business privately or who believes that the government at all levels must be reduced in scope to a small fraction of its current levels in order to optimize the material and personal well being of the citizenry.  Let’s think this issue through carefully.  In my next post, I’ll do just that.

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8 Comments

Filed under Economics, Government, Policy, Taxes

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