The recent congressional review of the Internal Revenue Service has rekindled discussions about the tax system. Many people want to dramatically change the tax system. Many different plans have been proposed. Rather than discussing or promoting any particular plan, this article will address some questions which any tax system must answer. I'll then leave it to you to answer these questions, and by extension, to construct your own tax system.
Which income should be taxed? One definition of fairness says that all income should be taxed, regardless of its source or use. That is, the tax system should be blind as to the earning and disposal of income. Any special treatment of certain kinds of income unfairly gives an advantage to this income and to the people earning it. It may surprise you that this principle is not followed in today's tax system. For example, income from some investments, such as municipal bonds, is not taxed. Also, income spent in certain ways, such as for home mortgages and charities, is not taxed. At the other extreme, some income is taxed twice! Corporate income paid as dividends is taxed once by the corporate income tax and taxed again by the personal income tax when shareholders receive the dividends. Advocates of one alternative tax system the consumption, or national sales tax purposefully want to exclude from taxation that income which is invested. They argue that by doing so, the long-run health of the economy will improve because the invested funds will be used to rebuild factories and improve infrastructure. Furthermore, they contend, most of invested money will eventually be withdrawn and spent, where it will then be taxed by the sales tax.
Should all income be taxed at the same rate? Promoters of the flat tax say the only fair system is one which taxes all income (or spending in the case of the sales tax) at the same rate, regardless of the taxpayer's income. Richer people still pay more tax with a flat tax because they have more income or spend more than poorer folks. Of course, today's federal income tax system does not have one flat rate. Currently, it has five rates ranging from 15 percent to almost 40 percent. This is called a "progressive" tax system. A progressive tax system means a richer person can not only pay more total taxes than a poorer person, but can pay a higher percentage of his income in taxes. Opponents of a progressive tax system say this is not only unfair, it's also counter- productive to the economy because it punishes achievement. Supporters of progressive tax rates say it is needed to equalize the "pain" of paying taxes. They argue that a marginal dollar to a rich person is worth much less than a marginal dollar to a poor person. Therefore, to equalize the burden of taxation, the logic goes, the rich must pay a higher percentage of their income in taxes. Any tax system must address this thorny and controversial issue about the number of tax rates.
Should spending on necessities not be taxed? Many tax experts, including some from very different ends of the political spectrum, say that income which is spent on necessities should not be taxed. If you accept this contention, then there are a couple of ways to accomplish it. One way is to allow a household deduction, based on family size, to be taken from a taxpayer's income. For example, a family of four might be allowed a household deduction of $36,000, meaning they would only be taxed on their income above $36,000. The $36,000 wouldbe an approximation of what a four-person family would need to spend on things such as food, clothing, housing, transportation, and medical care in order to achieve a reasonable standard of living. An alternative is to allow limited deductions for specific spending on necessities. Problems with this method include defining what constitutes "necessities" and deciding on the allowable limits of spending for the deductions. There is a tradeoff between the generosity of the deduction for necessities and the tax rate. The National Bureau of Economic Research estimates a rate of 17 percent would be needed for a national sales tax to replace today's income tax if no spending were exempt from the tax. However, the required tax rate rises to 30 percent if spending on housing, food, and medical care were exempted.
What are acceptable costs of complying with the tax system? It's been estimated that the federal income tax system requires taxpayers and their accountants to spend over 5 billion hours and between $160 billion and $360 billion to file their taxes. Obviously, this is time and money that could be spent elsewhere if the tax system were simplified. Any overhaul of the tax system should consider compliance costs and acceptable levels of these costs. Again, another tradeoff is at hand. Adding complications to the tax system, such as multiple tax rates and deductions or exemptions for certain kinds of spending, will increase compliance costs. Generally, the simpler the tax system, the less money taxpayers will spend on completing and filing their forms.
So here are four key questions which must be addressed by any tax system. Answering them will define your preferred tax system.
You decide how this system should look!