The Problem With Federal Income Taxes

Our federal tax code in the United States needs to be simplified and needs its base of taxpayers broadened if we as a nation are going to regain fiscal health and responsibility in the future.

Currently, 40% of Americans pay almost all (99%) of all federal income taxes. Ari Fleischer explains in the Wall Street Journal:

[You] find 100 people standing on the sidewalk. Forty of them will be excused from paying income taxes thanks to Congress. Twenty of them, the middle class, will pay barely a thing. The 40 people who remain, the upper middle class and the wealthy, will pay nearly all of the income taxes.

Look at that crowd again and find the richest person there. That individual will pay 37% of all the income taxes owed by those 100 people. The 10 richest people in the crowd will pay 71% of the income-tax bill. The 40 most successful people will pay 99% of everyone's income taxes. Yet for some lawmakers in Washington, these taxpayers aren't paying enough.

Fleischer follows this up with a CBO report, citing the data:

According to a recent study by the nonpartisan Congressional Budget Office, those who make more than $43,200 (the top 40%) pay 99.1% of all income taxes, the taxes that support our troops in Iraq and Afghanistan, and, for example, fund the federal portion of transportation, education, environmental and welfare spending.

Those who made more than $87,300 in 2004, the top 10%, paid 70.8% of all income taxes, an increase from their share of 48.1% in 1979. Think about it. Ten percent pay seven out of every 10 dollars and their share of the burden is rising...

The combination of across the board marginal income tax rate cuts and repeated expansions of the earned income tax credit (EITC) for lower-income Americans has created this situation in which fewer people are responsible for paying more and more of the income tax...

The EITC program redistributes money from those who pay income taxes to 22 million families and individuals with incomes less than $36,348. These workers not only don't have to pay any income tax, they're given a government check as a subsidy to help make ends meet. The EITC is also designed to relieve them of the cost of paying for their share of Social Security and Medicare.

If Republicans, including their presidential candidates, wonder why their calls for tax relief don't resonate like they used to, it's because there aren't that many income taxpayers left. They've been taken off the rolls.

As for the Democrats, they historically have raised taxes and redistributed income as a core philosophy. It doesn't matter to them how much money some people pay -- the argument is that the wealthy can always pay more. According to this point of view, it's immaterial that the tax code is highly progressive; it can always be made more progressive. While raising taxes on the few to benefit the many might be a political winner, it's an increasingly risky policy to pursue.

If, as now happens, 60% of the people in our democracy can force 40% to pay the bills, what's to stop 65% from making 35% pay it all? Since no one wants to pay taxes, what's to stop 90% of people in a democracy from making 10% pay it all? Or why not let 99% of the country off the hook, as long as the remaining 1% picks up the tab?

In another article for the WSJ, Fleischer further explains why this is a problem:

Picture an upside-down pyramid with its narrow tip at the bottom and its base on top. The only way the pyramid can stand is by spinning fast enough or by having a wide enough tip so it won't fall down. The federal version of this spinning top is the tax code; the government collects its money almost entirely from the people at the narrow tip and then gives it to the people at the wider side. So long as the pyramid spins, the system can work. If it slows down enough, it falls.

Furthermore, Fleischer argues, the myriad of tax credits handed out to seemingly everyone, for any reason, is also cause for alarm:

In addition to exempting almost 50% of the country from income taxes, today nearly every other social cause is given a loophole -- or a preference -- in the tax code. Want to buy a hybrid vehicle? You get a tax break. Do you own a solar water heater? You get a credit. Want to give to charity? You get a deduction. Own a house? There's another tax deduction for you. How about college savings, certain medical costs, and retirement savings? Yes, yes, and of course yes. Did you move, pay alimony, or "provide housing to a Midwestern displaced individual"? More deductions, credits and exemptions there too, if you qualify.

Everyone now has a sacred cow in the tax code. For my money, the most sacred thing of all is our country and its growth, but the sacred cows have turned into a pack of wolves. On both the spending and the tax side, the wolves are devouring our children's future.

The solution? A system where everyone in society pays taxes. Again, Mr. Fleischer:

A certain amount of income redistribution in a capitalistic society is healthy, but this goes too far. The economic and moral problem is that when 50% of the country gets benefits without paying for them and an increasingly smaller number of taxpayers foot the bill, the spinning triangle will no longer be able to support itself. Eventually, it will spin so slowly that it falls down, especially when the economy is contracting and the number of wealthy taxpayers is in sharp decline.

Under an Economic Growth Code, everyone in American would pay income taxes -- everyone. Such a system would be designed to foster broad-based growth for all, in contrast to the loophole-ridden system we have today. Not only is the current code flawed from top to bottom, it is used by politicians to divide the public along class lines and fails to promote prosperity.

Growth is the key to keeping the pyramid spinning, and to keep spinning the pyramid's tip needs to be broadened. Otherwise a country that was raised to believe that national bankruptcy happened elsewhere may have to think again. Given the state of the economy and trillion-dollar deficits projected as far as the eye can see, we need to return to an era of more conservative, fiscal discipline.

And just how, exactly, should such a system be implemented? Glad you asked:

Congress should start by refusing to go along with Mr. Obama's promise to cut taxes for 95% of the country. With the government running an almost $2 trillion deficit, no one should have their taxes cut -- no one. Given the size of the deficit, fiscal responsibility demands nothing less.

Republicans in Congress need to develop their own version of an Economic Growth Code, an alternative tax code that directly targets the current mess and helps us to grow our way out of it. Republicans should not doodle in the margins -- they should use their minority status to launch the next big movement in policy and politics. Nothing creates revenue like growth and that's where Republicans should make their mark.

I favor the abolition of all Social Security, Medicare and estate taxes. In their place, we should create a simple income tax system that has no deductions or credits at all. The result would be a progressive, multi tiered income tax in which everyone pays. The bottom 50% won't be excused from paying the cost of government and top earners will no longer have the loopholes they're used to. The middle-class, whose wages have stagnated, will benefit from economic growth. Social Security and Medicare will be funded from income taxes, ending the myth that these programs are supported through government trust funds and payroll taxes. The tax base will broaden dramatically, allowing rates to fall and helping to foster what's most important -- economic growth.

I'd also create a mechanism so tax rates go up or down for everyone -- no more dividing the country by lowering taxes for some or raising them only for others. A revenue system whose purpose is to pay the government's bills should apply fairly to one and all. If Congress wants to raise or cut taxes, it should do so for everyone.

Another benefit is that such a system will create an environment in which spending programs receive the scrutiny they deserve. It's funny what happens when everyone pays the bills; Americans may want less spending so they can pay fewer bills.

I could not agree more with this assessment. Progressive taxation is one thing, and that's fine. But exempting huge swaths of the nation from taxation is simply wrong and, more importantly, unsustainable. I've mentioned before on this blog the looming bankruptcy of the United States, and this is one of the reasons why the US is financially unstable (the other reason being unsustainable spending habits).

The goal of a tax system should be to generate revenue for the general operation of the government (and by extension, society at large). Taxation should generally not be used to punish certain segments of the population (such as the Estate/Death Tax, which taxes savings/wealth that has already been taxed several times via the income tax, sales taxes, property taxes, etc); however, I do not discount the right of the state to tax certain things that they may want people to engage in less often (such as smoking cigarettes, for example).

Tax credits only confuse and complicate something that should be simple and straightforward for everyone and not only easily understood, by easily complied with. And everyone should pay.

When I worked for the state legislature, I proposed to my boss a new income tax system for the state which would have brought relief to lower income individuals, more revenue to the state's coffers, and simplicity to the tax code, all while giving voters important checks and balances against the powers of the Commonwealth. My rough draft was as follows:

The state should impose a simple progressive bracket structure, as follows:

$0 - $24,999: 2%
$25,000 - $49,999: 4%
$50,000 - $74,999: 6%
$75,000 - $99,999: 8%
$100,000 - greater: 10%

These numbers and rates are/were only a rough draft/brainstorming starting point and open to revision. For example, rates could be sctructured in this way as well:

$0 - $34,999: 1%
$35,000 - $69,999: 2.5%
$70,000 - $99,999: 5%
$100,000 - $149,999: 7.5%
$150,000 - greater: 10%

The basic point of this system was/is to provide relief to those who do not make a lot of money while keeping revenue income to the state neutral or in the black, and at the same time not discouraging growth and investment by the more affluent in the Commonwealth. As importantly, such rates are not burdensome or morally unfair to the more productive members of society, who are so often punished under the federal tax code, with rates currently at 35% (but which have been 90% in decades past, which is basically government sanctioned theft).

Many would reject such a system out of hand, especially in "progressive" Massachusetts, because as "progressive" as our citizens are, we have a strong anti-tax streak, epecially since our elected leaders saddled us with the "Taxachusetts" moniker during the days of Dukakis. To avoid a repeat of tax-happy legislators dolling out taxpayer dollars at will, a few simple checks and balances would help to keep order to the system. First, any increase or decrease in one bracket would automatically trigger a corresponding increase or decrease in the other brackets. This could be done on a one-for-one basis or on a proportional basis. This would ensure that our elected officials could not play class warfare, pitting one bracket against the others (as Congress and our political parties do on a regular basis). Second, any increase or decrease approved by the Legislature would be subject to voter approval at the next general election. The tax could take effect immediately upon passage by the Legislature, and then either be affirmed or rejected during the subsequent vote. If affirmed, then life would go on as normal. If rejected, then the tax would revert back to the previous rate.

These checks on the powers of the Legislature by the people would not only ensure that each member of society had a stake in the fight, but also ensures that the people would have the fate of their own wallets in their hands, and could blame no one but themselves for their own governmental financial fortunes. Furthermore, it would force elected leaders to stop forcing unfunded mandates and large bureaucracies onto the backs of the voters by forcing them to cut funding to various special interest sacred cows with small but powerful constituencies.

Personal responsibility has a nice civic ring to it, doesn't it?

This could not only work on the state level, but I believe it could work on the national level as well, with some variations. The bottom line is that we as a society need to have more of a stake in our government's operations at all levels, and hold leaders accountable for their actions with our money. Keeping the nation on autopilot will only lead to disaster in the long term. Without positive fiscal health and balanced books, almost nothing else really matters policy wise.