Tax Reform 101

Alternatives to Our Current Tax System

Tax Reform 101
March 27, 2015

Very few, if any, Americans like our current tax system but there is little agreement on how to change it. The fault lines are usually along the same philosophical arguments.

  • Progressivity – What is the proper definition of “fair share” of taxes? Is it based more on pure percentages, where everyone pays the same percentage of their income in taxes (a “flat tax”), or should higher-income taxpayers be expected to pay more (brackets with progressively higher taxes as income increases)?

  • Loopholes – Exceptions are usually aimed at the rich to raise revenue or at the poor to provide behavioral incentives. At the upper end, they are derided as loopholes, at the lower end they are hailed as credits. However, one person’s tax credit or deduction is another person’s loophole.

  • Simplification – The tax code is now so complex that few people who do not qualify for a 1040A or 1040-EZ can file their own taxes. Even the IRS can give conflicting advice on some of the more esoteric tax laws. However, simplification requires taking away somebody’s tax credits/deductions (or loopholes, take your pick).

  • Total Tax Burden – Do you believe that tax revenue must be increased to pay for badly needed programs and infrastructure, or do you believe that Congressional spending is out of control and must be starved down to a lower level through revenue control or limitations? Perhaps there is a middle ground….

At the moment, most Democratic proposals are targeted at specific progressive issues like raising taxes on corporations and the wealthy – such as Sen. Elizabeth Warren’s proposed “Millionaire tax” to assist student loan refinancing, and Rep. Chris Van Hollen’s proposed tax on stock trades to increase tax breaks and credits targeted at the middle-class.

However, Republican efforts are more often pointed toward a complete overhaul. Let’s look at some of the options from the last Presidential (2012) campaign as an example.

  • Flat Tax – Gov. Rick Perry and Newt Gingrich, among others, advocated a switch to a flat tax (15% or 20%) with selective closing of loopholes and exemptions of capital gains. Corporate tax rates are lowered significantly to spur economic growth.

  • Fewer Brackets – Rick Santorum, Mitt Romney, and others recommended a two or three-tier system instead of the current seven brackets. The top rate is reduced to around 23-28% from the current 39.6%, various loopholes are closed, and capital gains are exempted. Corporate tax rates are lowered somewhat.

  • Consumption Tax – Herman Cain (remember him?) suggested a complete repeal of individual and corporate income taxes with a series of 9% consumption taxes, such as a retail sales tax and individual and business flat taxes. Consumption taxes can work reasonably well on the state and municipal level or for targeted applications (such as gas taxes to maintain highways), but are a hard sell nationally since they are generally regressive (the poor tend to pay a higher percentage of their resources in tax).

The most comprehensive effort was put forth last year by Dave Camp, the former Chair of the House Ways and Means Committee. The Tax Reform Act of 2014 settled on two main brackets for "production income" (10% and 25%), with a 35% bracket set aside for rare "other income", a lower corporate tax rate (down to 25% from 35%), a slight increase in capital gains and dividend taxes, and elimination of the Alternative Minimum Tax and the personal exemption, among other deductions and credits. Other provisions were modified and phase-outs adjusted to keep the plan revenue-neutral.

It must have achieved balance, because most in Washington praised the bill as a serious effort, but very few supported it. Sadly, too many people look at successful tax reform as “I pay less and you pay more”, regardless of the mechanism used to get there.

Until we elect enough people who can look at the broad picture of taxes and are willing to make specific local sacrifices for the good of the nation, tax reform is unlikely to include simplification and more likely to include targeted provisions and loopholes. The effect on progressivity and the total tax burden likely depends on which party is in power.

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