My Hideous Tax Reform

(With apologies to economist and author Joel Slemrod, author of the paper, My Beautiful Tax Reform)

As an accountant, I get involved in the practical and tedious task of applying tax laws (and related loopholes) to our clients’ fact situations.  Rarely do accountants get the time to contemplate (or fantasize about) tax reform, nor to consider systems used effectively by other countries.  But, before tax season gets truly underway this year, I have been spending some time educating myself about these matters so that I can combine my practical knowledge with the wisdom of economists and policy analysts around the world.

Professor Slemrod has spent many years evaluating our tax system and expresses the view that a business Value Added Tax (VAT), combined with a highly progressive but simplified individual income tax would deliver the best combination of Fairness and Simplicity (my two objectives for tax reform), and would achieve what he calls “elegance”.  He proposes an individual income tax that would exempt most individuals from filing returns, basically by eliminating all deductions and credits, thus broadening the tax base, and then relying on wage withholding to create the proper and equally applied tax to all labor income.  The VAT tax would apply to ALL business income, and at a flat rate.  Shareholders of corporations would be able to get a credit from the portion of their income already taxed at the corporate level, with the goal being to eliminate all double taxes, and to eliminate all preferential treatment now available through special deductions, credits and business entity selection.

Our current system attempts to tax income (roughly defined as increases in consumption power) by dividing it into 3 pots:  labor income, business income, and income from the employment of capital.  However, there is little consistency in how these different categories actually work.  For example, if I am Mitt Romney and earn my income from “carried interest” I get to pay taxes at a flat capital gains rate of 15%.  If I am Warren Buffet’s secretary, I get to pay taxes at much higher rates, depending on my income and deductions, and I also have to pay social security taxes.  Publicly traded corporations are subject to a double tax whenever they pay dividends to their shareholders, whereas when they pay interest to their bondholders, they are not.  If I lose money on a capital transaction, I can’t deduct the loss unless I have made money on other capital transactions.  If I sell my home at a profit, I can exclude the gain up to $500,000 if I am (legally) married.  If I earn all my income from dividends and capital gains, I might not have to pay ANY taxes.  And, if I am a worker earning a good living, I may be subject to the Alternative Minimum Tax and lose the deductions that my neighbor, who earns less, gets to deduct, thus vastly increasing my marginal tax rate.  These are just a few, selected examples of the way our tax system is both complex and unfair.

Fairness in taxation by definition would have to include progressivity as its underpinning.  In fact, Professor Slemrod rejects consumption taxes outright, as they can never be made progressive enough.  By taxing only consumption, such as through a national sales tax, those who would pay the highest effective rate of tax would be the poor and middle classes, who have to consume certain basic amounts in order to survive.  That would be highly unfair, but would admittedly be a simpler tax to administer than our current income tax.

One reason tax reform is so hideous is that anything that affects the federal system will also affect all the states who are connected to the federal system for purposes of defining and determining taxable income.  Any major reforms at the federal level will require these states to seriously evaluate and reform their own systems of taxation.  Another reason is that by trying to achieve simplicity, one may introduce unfairness, and vice versa.  For example, it might be fairer to measure and subtract inflation before taxing capital gains, but now you have introduced a highly complex calculation into the system.  You can eliminate this problem by using a consumption tax instead of an income tax, but as noted previously, a consumption tax is a regressive tax, and thus, unfair.

In order to restore legitimacy and moral authority to our government and its system of taxation, the current system MUST be reformed, and it must become fairer and simpler, yet still provide adequate funds.  Any steps in those directions are to the good, hideous or not.  President Obama’s recent budget proposals include some movements in the right direction:  indexing and making permanent AMT exemptions,  taxation of carried interest as ordinary income (too bad, Mitt), and simplification of the earned income credit.  However, when you read the summary of the President’s budget (spanning 215 pages) you start to feel pretty queasy.  More and more tax expenditures (credits and deductions) are being proposed in a desperate effort to insert more fairness into the system, but the end result is more, and much more, of the same highly complex and unfair system that we currently have.  Can we give up our favorite deductions and tax credits in exchange for lower and more progressive tax rates?   What might be beautiful is restoring the portion of total income taxes once borne by corporations in 1950 (30% of total revenues) from the shockingly low 7% today, something which could be achieved through a VAT tax.

Tax Reform: Lies, Damned Lies, and Statistics

There are a number of ideas being parlayed by presidential candidates, policy makers, and politicians regarding how to reform the U.S. tax code.  Unfortunately, none of the ideas mentioned recently are new, nor do they address the fundamental reasons to reform the code, those being:  Fairness and Simplicity, which I am capitalizing here as a way of elevating these concepts above other policy goals (involving unfairness and complexity).

History can be a great teacher.  But, numbers CAN lie, and everyone has an agenda, including me.

But, let’s take a look at history and see if we can put it in today’s context.  First, let’s look at tax rates.  Currently, the top marginal rate is half of what it was in 1975 on incomes over $375,000 – 70% vs. 35%.  All of the other rates are lower as well, but not by nearly as much.  So, the bulk of the benefits of the tax bracket “flattening” has gone to those in the top tax bracket (not surprised, are you?)

Now, what about tax deductions and tax credits?  These are also known as “Tax Expenditures” in the world of tax policy making.  They are special tax breaks designed to benefit only certain taxpayers, such as the oil and gas industry, home owners, or low income workers with families.  Tax Expenditures have risen 43% in the 3 years spanning 2006 to 2009 (think:  George W.), and have risen 78% over the last 30 years.  What this means is that Fairness has gone out the window, replaced by taxation bent on favoring certain taxpayers and disfavoring others.  One taxpayer’s tax on the same income may bear no resemblance to another taxpayer with the same income due to the existence of these special deductions and credits.

Now let’s look at where the taxes come from today vs. where they came from 60 years ago.  Employment taxes as a share of the total tax burden have risen 400% in the last 6 decades, going from 10% of total revenues in 1950 to a whopping 40% of total revenues today.  Conversely, corporate tax revenues as a percent of total revenues have dropped 428%, going from 30% of total revenues to 7% in 2010.  Meanwhile, total individual taxes (not payroll taxes) as a percent of total tax revenues have remained fairly steady for the last 60 years, at about 42%.  The rest of the tax revenues come from estate, gift, and excise taxes, and these have fluctuated over the years, but overall, contribute a much lower percentage to total revenues than they did in 1950.

It is quite striking to note that despite all the tweaking and complexity of the current tax code, individuals still bear, overall, about the same burden that they did 60 years ago.  The difference is in the mix.  Working people of all income levels now bear a much larger burden of the total budget than they did 60 years ago.  They contribute not only payroll taxes but income taxes as well.  Their total federal effective tax rate can easily exceed 45% if they are self-employed and in the middle class. Wealthy individuals who do not work and derive most of their income from capital gains and dividends enjoy a much lower tax rate. Some of them enjoy a ZERO rate.  And, in 2009, the top 10% of taxpayers, those with adjusted gross income exceeding $112,000 paid an overall average tax rate of just 18%.  It should be noted however, that those with AGI below the median income of $32,000 (the bottom 50%) paid an average rate of only 1.85% (remember this doesn’t include payroll taxes).  It is somewhat shocking to note that the incredibly low AGI number of $32,000 represents ½ of the taxpaying population, and it supports the recent census information indicating that nearly 50% of all Americans are living at or near the poverty level.  The biggest beneficiary of the tax burden shift among taxpayers has been corporations, however.  Maybe now that they are “people” we should tax them as individuals.  That would raise a lot of revenue.

Oddly, tax revenue as a percentage of GDP has remained fairly constant at about 18% for the last 30 years.  So, while tax revenues have been stable despite all the tweaking (an estimated 4,000 changes to the code just last year), the federal deficit has been skyrocketing, and WHO PAYS is really the question to ask yourself.

We are very far away from Simplicity and Fairness.  The recent proposals to lower rates and take away some deductions (charitable contributions and home mortgage interest) would further skew the Fairness meter, being another boon for the super wealthy.  However, taking away deductions does move us toward Simplicity.

In my next post, I’ll take on what I would do to bring about tax reform.  In the meantime, although I might be using statistics for my “damned lies,” every fact in this blog post was taken from one of three sources:  the Congressional Budget Office, the Joint Committee on Taxation, and the Internal Revenue Service.

When Pigs Fly: Waiting for Real Tax Reform

We all know that it is not fiscally possible to cut the national deficit/debt without raising someone’s tax bill.  I’ll include corporations in my definition of someone, since they are now “persons” with free speech rights.  The outlandish and bizarre tax code we currently labor under has been tweaked and pummeled into an unrecognizable amalgam of convoluted provisions, some of them well-meaning, but most not thoroughly or even barely understood by experts, much less by taxpayers.

The growing and shameful income and tax inequality in this country is now finally a topic of conversation among policy makers, thanks to the emerging “Occupy” movement.  Will this new dialogue impact tax policy?

Before the Occupy movement took hold, the showdown staged by Republican politicians over the debt ceiling sent shock waves and uncertainty throughout the financial markets all over the world.  Their insistence on cutting the debt/deficit without “raising taxes” was a frightening spectacle, and its premise was not only cynical and dishonest, but completely out of touch with reality.  Every single federal budget report by every single expert in the field points to the stark and frightening realities of the budget debt/deficit–we can’t grow out of it, we can’t spend out of it, and we may not even be able to tax our way out of it.  It is that bad.

I have been waiting for decades for real tax reform.  I started my career before the advent of the passive activity rules, which I mark as the beginning of the end for sanity in the world of taxation.  While it was important to curb the tax shelter abuses of the early 1980’s, the complexity of the passive activity loss rules opened the door to the idea that, with enough rules, regulations, court cases, and private letter rulings, tax planning can become a game only for the wealthy.  Any poor schmuck who can’t afford my fees is doomed.

While tax complexity was increasing, the income gap between the super-rich and the rest of the population continued to grow, grow and grow.  Then, during the Bush years, the super-rich finally received their blessings from on high.  Many multi-millionaires now find themselves in the ZERO percent tax bracket.  Also, during this time the Alternative Minimum Tax went out of control and began hitting middle and upper middle income taxpayers.  Yet, a family with the just the right mix of tax goodies will have a tax liability that bears no resemblance to another family with the exact same income.

Some people say that fairness is subjective.  No, it isn’t.  Fairness is something that society can agree on, just as we can agree on what is a crime and what isn’t.  The current tax system is patently unfair.  Hence, it has no moral legitimacy.  When this happens, you get the Occupy movement.  So, tonight I’ll count pigs flying while I dream about real tax reform.  Maybe pigs can fly.