Wednesday, September 29, 2010

Tax Reform Idea

Why is income tax reform so difficult? The modern tax code is an attempt to incentivize certain (many) behaviors without disincentivizing certain (many) others.

The classic division between taxpayers is those who work for income and those who live off financial income. The current income tax code allows lower rates for qualified dividends as a nod to seniors who need this kind of income to survive.

It's simple to make this work similarly to our current tax code:

1) Establish one progressive rate structure for earned income. Use a standard exemption, perhaps based on the minimum wage. Compute the "earned income tax" solely from income in this category. Save the number for later.

2) Establish a second progressive rate structure for financial income (i.e., dividends, capital gains, interest, etc.). Use a standard exemption, perhaps based on the social security benefit. Compute the "financial income tax" solely from income in this category. Save the number for later.

3) Establish a third, inverted progressive rate structure for deductions. (The idea is to weight the first quantiles of the deductions more than the last. Use the sum of the earned income and financial income when designing the rate structure, but apply it uniformly regardless of the breakdown in the two incomes.) Use a standard deduction if deductions are not itemized. Compute the "deduction tax credit" and save the number for later.

4) Add the "earned income tax" and "financial income tax" and subtract the "deduction tax credit". Pay the resulting tax.

This structure is easy to implement: Use the existing withholding mechanisms for earned income, and add withholding mechanisms to financial institutions. Taxpayers would use withholding allowances based on the expected "deduction tax credit" and total income in each category.

Why is this better than what we have now? It comes down to marginal incentives.

Case 1: A retiree who is living on financial income might like to take a job for supplemental income. Under today's income tax code, that extra income will be taxed at the (higher-than-average) marginal rate, even if the work is at minimum wage. Under the proposed tax reform, that extra income would be subject to a low tax rate (if it is larger than the exemption).

Case 2: A worker early in their career is living off earned income and is saving for large future expenses (e.g., home down payment, car replacement, college, etc.). The amount of savings (and resulting income) is small at first but grows. Under today's income tax code, that extra income will be taxed at the (higher-than-average) marginal rate if it is interest, or at one of two lower rates if it is dividends or capital gains. Under the proposed tax reform, that extra income would be subject to a low tax rate (if it is larger than the exemption).

Case 3: Mr. Rich lives richly on financial income. Under today's income tax code, that income is taxed under the cumulative progressive rate structure if it is interest, or (up to a point) at one of two lower rates if it is dividends or capital gains. Above that point, higher taxes might kick in. Under the proposed tax reform, that income would be subject to a progressive rate structure of its own, which would be less advantageous as a percentage of total income to Mr. Rich than to lower- and middle-class workers.

The earning rate on financial income is usually at or above the rate of inflation, so up to a certain point there is no tax for nominal-only growth. (This reform idea does not directly address taxation of nominal-only growth, despite doing so indirectly here.) This can help save-and-spend types if the exemption is set high enough to allow tax-free growth up to an amount useful enough to make a down-payment on a house or vehicle.

There is still a place for qualified retirement accounts (e.g., 401(k), IRA, 403(b), etc.). Rather than supplant them, the proposed reform seeks to increase non-retirement, short- and medium-term savings by protecting part or all of that savings from the bite of taxes.

By encouraging non-retirement savings, more taxpayers could have savings that could be tapped for emergencies, unexpected larger expenses, and planned expenses, and these savings could be replenished with little to no tax impact. Fewer taxpayers could be laden with consumer debt (the most expensive type) if they could save more in advance.

Savings whose income is reasonably exempted from income is heritable wealth for lower- and middle-class workers, which can improve the prospects of their offspring (e.g., education, home ownership, liberation from poverty) without reliance on government or third parties.

The common complaint about "the rich" paying lower tax rates would similarly be addressed. "Excess savings" would generate "excess financial income" which would be taxed progressively. Similarly, by inverting a progressive rate for deductions, "excess deductions" would be given little or no tax credit, essentially tapering down as the total deduction increases. If the financial tax rates are similar to those for earned income, then the complaint is resolved.

By changing the broad incentives in the individual income tax, it is possible to incentivise labor and savings simultaneously without disincentivizing one over the other. This can lead to positive effects in the economy at the individual level, including greater resilience during downturns, fewer bankruptcies, greater long-term thinking about major expenses (including retirement), fewer complaints about the divide between "rich" and "poor", and lower reliance on government for assistance in current and successive generations of lower- and middle-class workers.

I am not a fan of progressive rates. I instead advocate a tax on property (assets or wealth--I am undecided), since part of what the government defends is the integrity of property and the right of citizens to use that property in the way they see fit (subject to reasonable constraints). In place of income taxes, I would use a flat-rate consumption tax (exempting basic necessities) combined with a property tax. This reform idea is solely a way of improving our tax code in a small, simple-to-understand, incremental way, yet with significant positive consequences. I fully expect (and would demand) further reform.

I also make the assumption that rates would be set in such a way as to be revenue neutral overall from the old system to the new system. I don't have IRS data, so I am not making specific numeric recommendations.

Finally, any time I hear about the "poor", it is usually in a relative sense. I believe that we should have an absolute definition of poverty that is independent of the distribution of wealth or income, a definition that can be applied globally. For example, to what extent does one have food, water, shelter, clothing, medical care, education, etc.? Once we agree on what "poverty" is, then we can argue about who bears responsibility for assisting. But now that is a spending discussion, not a tax discussion.


  1. I still favor the Fair Tax. The 16th Amendment is repealed. We pay taxes when we choose. The big spenders pay more, so it is progressive without taking away their freedom. The prebate ensures that the poor and elderly will pay no tax. Entitlement programs will be funded through general revenues, and there will be no payroll deductions. The only IRS agents necessary are to prevent fraud in sales tax collections. There are no tax forms, no April 15 or quarterly payments or Alternative Minimum Tax. Frugality and saving are encouraged. No tax on corporations makes them competitive and able to grow and create jobs. Illegal aliens and criminals must pay tax when they buy, but they should not receive the prebate.

  2. I agree with most of the Fair Tax. I'm skeptical that we can jump straight to it.

    But I am not certain that the Fair Tax correctly pays for the defense function of government. A property tax is defective if the value of the property fluctuates according to external forces, but if its book value becomes considerably different than actual value, then the reason for the tax (defense of property, in my suggested case) falls apart.

    My view is to examine each function of government and to allocate its cost to people, property, income, and consumption. That's hard to do.


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