Complexity has characterized the United States’ personal income tax system virtually since it’s permanent inception 100 years ago. At last count, the Internal Revenue Code itself measured roughly 74,000 pages; the regulations governing the Code’s implementation run to many thousands more; and the annual estimated cost of “voluntary” compliance with the Code was roughly $400 billion, or nearly 21% of federal revenue.
In major part, the complexity of the American income tax system stems from three factors: (1) difficulty in determining what constitutes income; (2) the many credits, deductions, exceptions, exemptions, and special privileges granted or punishments inflicted on certain taxpayers or classes of taxpayers, usually to promote or to punish certain behaviors or activities and commonly known as “loopholes”; and (3) the varying rates at which income is taxed, depending on who earns it, how, and when.
Some of these complexities are inherent in an income tax, and some are purely political. Some we can do something about and some (short of repealing the Sixteenth Amendment and abolishing the income tax forever) we can’t.
What constitutes income, for example, presents both philosophical and practical problems that derive in part from the language of the Sixteenth Amendment. That amendment grants Congress the power to “lay and collect taxes on incomes, from whatever source derived,” but does not define “incomes.” The salary that an employer pays its employees is obviously income, for example, but what about the value of the health care premiums or the FICA contribution that employers pays on employees’ behalf, which benefit employees even more than straight salary because they are currently exempt from income taxation? What principled reason distinguishes the two? Do barter participants receive income when they trade goods or services that are presumably of equal value (else the transaction would not take place)? If not, then why is a merchant presumed to receive “income” when a customer trades cash for goods or services of presumably equal value? (And why doesn’t the customer receive “income” in return?) Is a return on what a person saves after paying my living expense and my taxes really “income” to me at all, especially if it does not even keep up with the rate of inflation?
The full system of credits, deductions, exceptions, exemptions, and other special privileges and punishments is far too complex to describe fully here. Suffice it to say by way of example that such things include the Earned Income Tax Credit, deductions for mortgage interest and property taxes, exemptions for dependent children, and the Alternative Minimum Tax. (Even the taxpayer guide for the EITC, created to help the working poor, is 66 pages long.)
Many such things should probably be changed, if not eliminated outright, but a Congress that for nearly four straight years has not even been able to pass a budget (much less balance one) is not likely to make meaningful or coherent change any time soon.
But it should. “All incomes, from whatever source derived,” should be taxed at exactly the same rate, without regard to who earns the money, when, or how. Before rejecting this proposal as radical, regressive, impractical, or unfair, consider two observations not easily denied: First, conservatives generally dislike the so-called “progressive” income tax, which nominally imposes higher rates of taxation on higher incomes. (This means not only that people with higher incomes generally pay more absolute dollars in taxes than people who earn less, but also that those with higher incomes pay a higher percentage of each dollar earned to the government than those who earn less.) The reason I say “nominally” is that, taking into account deductions, credits, and the different rate structures for capital gains and ordinary income, higher incomes can actually be taxed at lower rates.
And that brings us to the second observation: so-called “progressives” absolutely cannot stand the fact that Warren Buffett supposedly pays a lower income tax rate than his secretaries, even though each executive pays vastly more each year to the United States Treasury than their secretaries’ likely do in their entire working lives.
Yet both criticisms arise for exactly the same reason: because different rates apply to different incomes, depending on who earns how much, when, and how.
Starting at least with Woodrow Wilson, “progressives” have argued that it’s only fair for “the rich” or “the wealthy” pay higher income tax rates than the rest of the population. This politically popular but totally misleading mantra confuses wealth with income, assumes that income is stable or increases over time, doesn’t define “fair,” and never says why paying ten times as much tax on ten times the income is any less “fair” than paying twenty or fifty or an infinite number of times as much. (Some people with incomes pay no income tax at all, and you can’t divide by zero.)
The Sixteenth Amendment, after all, authorizes a tax on “incomes,” not on wealth. It is entirely possible to be wealthy (to own multiple expensive homes and to have large accumulations of cash, for example,) without having any income at all, especially in today’s zero interest environment with falling property values. It is equally possible to have a large income, at least for a few years, but not to be wealthy because (a) the government taxes you at disproportionately high rates during those few years and (b) you had to spend most of the rest on emergency health care or uninsured casualty losses.
Income isn’t always distributed evenly over time either, particularly as between employed and self-employed individuals. Putting aside the differences in federal tax treatment for health insurance premiums and FICA tax for employed versus self-employed persons, why should a self-employed person who makes $50,000 one year, $100,000 the next, and zero dollars the next pay $4400 more in federal income taxes over those three years (roughly $29,990.50 at 2012 rates) than an employee with a guaranteed $50,000 salary (roughly $25,590 over three years at 2012 rates).
More starkly, imagine a beginning entrepreneur who makes no income at all for three years before making $200,000 in his fourth year. At exiting rates, the entrepreneur would pay $59,058 over those four years while the $50,000 per year employee paid less than half that amount (the same $25,590 as above). Which one has had the harder time of it and made more sacrifice? Why should one pay more than twice what the other does?
Now let’s turn to the other side, from taxing different taxpayers differently based on when they earned their money to taxing them differently based on how they earned their money. Since 2003 and through December 31, 2012, absent Congressional action, six marginal income tax rates have applied to ordinary income: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent. For the roughly ten years expiring December 31, 2012, for a married person filing jointly, the 15 percent income tax bracket expired at $70,700; above that, the rate increased incrementally to as high as 35 percent.
If taxation is really about “fairness,” then the complaints of conservatives and progressives alike can readily be solved by taxing “all incomes, from whatever source derived,” at the same rate. Laborers, employers, entrepreneurs, and – yes, corporations – could all be taxed at the same rate.
Computing the rate would be easy, akin to a municipality establishing this year’s property tax rates: find out how much money the taxing body needs and then apportion the required revenue based on each taxpayer’s share of total income. Perhaps initially the rate would be 17 percent (in a hypothetical world) and the next year it would be 12 percent; perhaps it would be the other way around. Over time, however, a national consensus would develop over how much of each person’s income it is “fair” for the government to take and Congress could adopt a permanent fixed, flat rate. In the event of a national emergency – such as the need to go to war – then the nation could approve a genuinely temporary tax increase that would affect everyone proportionately and that, like the income tax during the Civil War, would end with the war and its aftermath. And no one could vote in favor of higher taxes without personally experiencing the consequences.
The process would require Congress actually to pass a budget, of course, and to live within its means, but both of those would be good things for the future of our republic. Once that was done the system would be relatively easy to administer and compliance costs would drop to near zero. Whatever deductions remained would be relatively equally valuable to everyone, and the tax avoidance industry would shrivel if not die.
Most important, the result would be good for democracy because everyone would have some skin in the game; no longer could half the population vote to transfer money from the other half’s pockets into their own. Politicians would lose power as a result, and the United States could continue as a nation of the people, by the people, and for the people.