In my previous post, I gave an overview of what an optimal tax code would look like in theory. Following are my thoughts on the current tax code and how it might be improved specifically. I’m sure few people will agree with all my thoughts, but hopefully it will spur some thinking. Here are my not so modest proposals for reform of the tax code:
- Mortgage interest deductions should be eliminated. The current system of allowing mortgage interest to be deducted is confused for three reasons: 1) why should the government favor buying over renting? This simply makes no sense, especially since renting is more advantageous for lower income people. 2) Since the mortgage interest is a deduction, the subsidy is greater for high income people. Indeed, the subsidy is non-existent for people who don’t itemize (largely the poor, again). 3) The deduction is only available for those who incur debt. Again, the tax code irrationally encourages leverage. (Not to mention the ridiculous subsidization of second home ownership under the current tax code!)
- Taxes on expatriates should be simplified. The U.S. is the only developed country that taxes its citizens on worldwide income even if they are not residing in the U.S. This is done through a complicated system that forces people to plan so they don’t spend “too many” days in the U.S. in a particular year. This should be replaced with a simple calculation: (worldwide income for the year) x (# of days in the U.S. or its territories during the year) / 365 = U.S. taxable income.
- All taxes should be paid directly by each individual so that each person is aware of his true tax burden. Tariffs, Value Added Taxes (VAT), corporate taxes, etc. all obfuscate the actual burden of the tax. For example, when a corporation is taxed, there are only three possible sources for those funds: a stockholder receives lower dividends, an employee receives lower wages, or a consumer pays higher prices. Further, the current code encourages debt by making it tax deductible to corporations when dividends are not. Eliminating corporate taxes removes this disparity in treatment. A realistic change would be to tax all corporations like REITs.
- Personal exemptions should be eliminated. Additional people are a drain on government resources and shouldn’t be subsidized. Family size isn’t a proper area of concern for Congress to attempt to influence through the tax code, and child tax and adoption credits should be eliminated as well. It is unfair to force the childless to subsidize those who choose to have children.
- Deductions for state and local taxes (sales taxes, income taxes, property taxes, etc.) should be eliminated. Allowing deductions for these taxes effectively shifts those taxes to taxpayers in other (more frugal) states.
- Social Security taxes should be eliminated. This would remove the fiction that people somehow have a pension in Social Security. In reality, Social Security is a socially acceptable welfare system in which money is taken from people who are working and given to people who aren’t working. Folding it into the regular tax system would clarify that. To alleviate the concern that people would be unprepared for retirement, they could be required to save a certain portion of their income in a designated account and those accounts could be restricted to investing in treasury bonds. This has the added advantage of funding the transition from traditional Social Security if older participants are kept in the old system.
- Medicare taxes should be eliminated. Taxing earned income to fund Medicare gives those with unearned income a free ride and again complicates the tax code. In addition, the “sharing” of Medicare (and Social Security) taxes with the employer leads to concealing the true cost.
- Deductions, in general, should be eliminated in favor of tax credits. If a person in a 40% bracket wants to donate (net) $300 to what he considers a worthy cause, the charity can get $500. (The individual donates $500 and gets 40% or $200 back on his taxes). If a person in a 20% bracket wants to donate $300 (again net) to a charity, the charity would get $375. (The individual donates $375 and gets 20% or $75 back on his taxes.) Why should higher income individuals’ charitable choices get a larger subsidy than lower income individuals’ choices? This holds true for other deductions as well. Assuming the taxpayer has high enough medical expenses to claim them at all, each additional dollar of expense is more subsidized by the tax code for high income (tax bracket) people than it is for lower income (and tax bracket) people.
- Almost everyone should have “skin in the game” and be paying something in taxes. Allowing approximately half the population to avoid all income taxes (though not FICA taxes) and yet still vote will eventually cause societal breakdown. (As Frederic Bastiat said, “Government is the great fiction through which everybody endeavors to live at the expense of everybody else.” Also Margaret Thatcher observed, “… eventually you run out of other people’s money.” )
- Graduated tax rates cause inequities, and should be eliminated. Absent a flat tax or taxation of individuals instead of families, there is no way to arrange the tax code to not penalize some group for decisions about marriage.
- Capital gains taxes at different rates from ordinary income cause gaming of the system and should be eliminated. A business owner can do three things with profit: 1) take it out in salary, 2) take it out in dividends, or 3) allow it to increase the value of the company and sell it later taking the profits out as a capital gain. Having disparate tax treatments for those three items leads to incentives to structure things in different ways which, in turn, leads the IRS to try to combat that restructuring giving rise to costs and tax disputes. Having the same rates for everything removes the incentives completely. It then doesn’t matter how the individual is paid. (This is another reason to remove the payroll taxes as mentioned above.)
- Estate taxes should be eliminated, however recipients of large gifts or inheritances should have to include them on their income tax returns as ordinary taxable income if it is not a capital asset and have a basis set to zero if it is.
So, in keeping with the principles above, here is how the tax code might be overhauled. It has the advantages of being simple, fair, transparent, etc. Since this is more of a thought experiment than an actual proposal the percentages given below are what seem roughly appropriate to me.
- Taxpayers (people, not entities) are taxed on “all income from whatever source derived” on a cash basis. (This is the definition we have now, but we have an enormous number of exceptions and special cases.) In addition, there should be 100% expensing for capital investments and no limit on recognizing capital losses (which also may be carried forward if necessary).
- Taxes are assessed on that net income at a flat 20% rate.
- Non-refundable credits against that tax are given for a very few items:
- 50% credit for medical expenses paid (for anyone). This gets the government out of the healthcare business while helping those with legitimate needs. This seems reasonable if we consider Rawl’s “veil of ignorance” approach (i.e. you don’t know whether you will be the unfortunate one with high medical expenses).
- 50% credit for charitable contributions made. This is to enable private charities to supplant the government assistance that exists now. Charity would become directed by private individuals to what they perceive to be the real needs.
- 20% credit for education expenses paid (for anyone at any level). Education has societal benefits that “spill over” and is thus an externality that should be subsidized. (A 20% credit combined with a flat tax rate of 20% is mathematically equivalent to education expenses being 100% deductible.)
- 20% credit for savings in accounts for retirement. However, these would be fully taxed upon withdrawal (essentially like the IRAs of today). These accounts could also be used for medical expenses or education expenses, but those expenses would not get the additional credit mentioned above.
- Unused credits may be carried back 5 years and forward indefinitely.
That’s it. Simple and straightforward. The definitions of medical expenses, charitable contributions, educational expenses, etc. would be the same as they are currently. Many families at lower income levels still wouldn’t pay taxes and no one would pay more than 20%. Education, healthcare, charity, and retirement savings are all privatized enabling the government to easily fulfill its proper functions with the remaining revenue.