Which Tax System is Best?

As we saw from last weeks posting, Adam Smith provided 10 principles for a desirable tax policy. Let us take a moment and review these policies.

1. The tax policy must promote equality
2. The tax policy must be convenient. This means the costs and means of collecting taxes must be low and the administrative costs to taxpayers must also be low.
3. Certainty meaning the taxpayer can readily predict when, where and how a tax will be levied. The taxpayer also needs to be aware of the tax consequences of a particular type of transaction.
4. Economy meaning the tax policy has nominal collection costs and nominal compliance costs to taxpayers.
5. The tax system should be simple
6. The tax policy should be neutral in terms of its effect on business decisions
7. The tax should not reduce economic growth and efficiency
8. The tax should be easily understood by taxpayers.
9. The tax should be structured to minimize noncompliance.
10. The tax policy should enable the government to predict the amount and timing of revenue production.

Taxation is necessary in order for governments to provide basic protection, security, and services to the public they serve. With these guidelines as our guide we can now determine what method of taxation is best for the United States. I will first compare the present progressive income tax against the guidelines. We will then look at two alternative methods of taxation being considered and compare them against the guidelines. I will conclude by offering my opinion of which method I believe is best.

Progressive Income Tax:

As we saw from last weeks posting, the present progressive income tax system has become corrupt. However, how does it fair against Adam Smith’s guidelines?

1) Equality – Many mistake equality with fairness. They believe the present system promotes equality since it taxes lower income individuals at a lower rate. This is not equality but is fairness. Equality would mean everyone is taxed at the same rate where as fairness understands that certain individuals need a break so they can more easily provide for their basic needs. Our present system does not promote equality.
2) Convenient – The fact that the present system requires that we take time out or our busy lives and prepare a tax return is not convenient. Many individuals also have to pay someone to prepare their return since it is not easily understood.
3) Certainty – Since taxpayers cannot predict their tax rate until the end of the year, because it is dependant on their taxable income, the present system provides little certainty other than the fact we will have to pay something.
4) Economy – The IRS is the collection agent for the federal government and is a large blotted bureaucracy and the fact that many taxpayers have to pay a professional to prepare their annual tax return does away with any belief that the present system is economical.
5) Simple – The tax code is huge and written in highly technical language by politicians. Many tax professionals and lawyers have difficulty interpreting it. What is simple about that system?
6) Neutral – The effect of taxes enters into many business decisions. One example is an individual’s decision to purchase a home. Individuals who currently rent can take the same money they presently pay for rent and purchase a home so they can receive a tax deduction for interest on the mortgage plus a deduction for property tax and insurance. For many this becomes their primary reason for buying a home. However, the current housing crisis has shown that some people should continue to pay rent until their financial position improves and they can afford a home. Taxes should not be a consideration instead the financial condition of the individual should.
7) The progressive nature of the present system punishes achievement. This punishment of achievement slows economic growth. In addition, the costs of collection and compliance make the system inefficient.
8) The complexity of the tax code coupled with constant changes to the code makes it difficult for both tax professionals and non-tax professionals to understand.
9) The complexity of the tax code means that it is easy for a taxpayer to be in noncompliance without even knowing it. Tests have been conducted where several tax professionals prepared the same tax return and they all came up with a different result. All these tax preparers believe their return is in compliance but they cannot all be in total compliance.
10) The government collects revenue quarterly through withholding and estimated tax payments. However, between January 1 and April 15 as returns are filed they issue refunds and tax credits to individuals who qualify for them. This situation makes it virtually impossible for the government to predict the amount of revenue they will receive.

It should be obvious that the present tax system fails to meet even one of Adam Smiths guidelines. For this reason, many believe the time has come for a reform of our tax system. Two proposals are currently on the table so let us see how each of these proposals holds up against Mr. Smiths guidelines.

The Flat Tax:

Under a flat tax system, every taxpayer is taxed at the same rate. Since this is viewed by some as placing an undue burden on lower income individuals, the proposal also includes a $10,000 personal exemption for each family member. This means the first $40,000 of income for a family of four is exempt from any income tax. Any income over the amount of exemptions would be taxed at a flat rate of 15%.

Presidential candidate Steve Forbes ran in 1996 essentially on a platform of the flat tax. Steve Forbes did not win the nomination but he did bring national attention to this tax alternative and still promotes its benefits in Forbes magazine. Now let us see how the flat tax plan holds up against Mr. Smith’s guidelines.

1) Equality – Since all tax payers are taxed at the same rate, this plan is more equitable than the current plan. It is also fair because of the deductions for exemptions.
2) Convenient – Everyone would file his or her taxes on a simple form each year. There would no longer be the need of hiring an accountant to determine what deductions a taxpayer could take since all they will need to do is count how many exemptions they have.
3) Certainty – Since we will begin the year with knowledge of how many exemptions we have, taxpayers will easily be able to determine their taxable income.
4) Economy – The simplicity of the form means compliance and collection costs will be low.
5) Simple – Again, a simpler form that taxpayers will be able to fill out doing simple math with a calculator.
6) Neutral – Individuals and businesses will easily be able to predict their tax liability and factor it into business decisions.
7) Under this plan, even if a taxpayer’s income increases, his of her tax rate will not. This removes the disincentive that exists under the current progressive system to make more income because the tax rate increases. In addition, for those interested in fairness, these ambitious individuals will still pay more tax dollars, just at the same rate.
8) Easy to understand as long as you can count and do simple math and we have calculators for that.
9) Easy to comply with – Simply fill out the form, make out the check, and mail it to the IRS
10) Easy for the government to predict revenue – Employers will send quarterly reports showing the income of their employees as well as the number of exemptions they are claiming. The government will be able to predict taxable incomes for each taxpayer and can budget accordingly.

It is clear that the flat tax eliminates many of the problems that exist in the present system. This is primarily due to its simplicity. It also does not punish achievement so proponents of this program believe it will promote economic growth something drastically needed in these recessionary times.

One of the drawbacks is that there will be no withholding or refundable tax credits. This will eliminate tax refunds and mean that individuals will have to actually write a check for their taxes each year. However, this will make individuals aware of their real tax liability, something that is missing in today’s system.

Unfortunately politicians looking to earn votes could also corrupt the flat tax system. They could accomplish this by adding deductions or tax credits to the code just as they have done with the present system. In the legislation for the new flat tax language would have to be added requiring a super majority of a 2/3 vote to make changes to the code.

The $10,000 personal exemption also needs to be indexed to inflation so that it will increase during inflationary times. If this is not done, individuals will pay a higher percentage of their income during these times as incomes usually increase with inflation.

The Fair Tax:

The fair tax is essentially a national sales tax. For those disenchanted with the current corrupt system it seems to be a viable option. In fact a best selling book, The Fair Tax written by Neil Boortz outlines the specifics of the plan. However, how does this tax proposal hold up against Adam Smith’s guidelines?

1) Equality – The tax is paid at the point of sale with no regard to the income level, race, gender, etc. of the consumer.
2) Convenient – For the taxpayer since the tax is levied automatically at the point of sale but the merchant becomes the tax collector for the government and will be required to fill out reports to remit taxes collected for the government. However, since most state and local governments already have sales taxes, these merchants are already required to keep records of taxable sales so the additional recordkeeping requirements are minimal.
3) Certainty – Consumers will be aware of the tax that will be added to their purchase. For merchants the taxes collected become a liability that is remitted to the government monthly or quarterly.
4) Economy – For the consumer, the recordkeeping costs are zero and the rate of tax is a fixed rate based on the amount of the sale. For the merchant there will simply be one additional form to prepare in addition to those already required by the state and local governments.
5) Simple – the consumer has nothing to fill out. The merchant has an additional form to fill out.
6) Neutral – the merchant will no longer have to pay an income tax and becomes a tax collector for the government. The consumer knows what his liability will be and pays it at the point of sale.
7) Consumers will have additional disposable income due to no longer paying an income tax or having withholding taxes taken from their paychecks. This additional income will more than pay for the additional cost due to the additional sales tax on purchases. In addition, since merchants will no longer pay income taxes, they will be able to pass on savings to consumers since they factor income tax liability into their costs when determining the selling prices for their goods under the present system.
8) The tax is easy to understand for consumers since they simply pay it at the point of sale. For merchants they collect an additional tax at the point of sale and remit it to the government just as they do with state and local sales taxes they already collect.
9) The tax is easy to comply with for consumers since they will have no choice but to pay it at the point of sale. The merchant will collect the tax and hold it until required to pay it. They are already accustomed to doing this with their state and local sales taxes so they already keep records for the collection and remittance of taxes collected.
10) The ability of the government to predict revenue collection will not be as easy since it will depend on the level of consumer spending. However, the government already collects data to estimate consumer spending so they could use this figure to estimate revenue collection for use in their budgetary process.

It is clear that the fair tax would be simple and convenient for the taxpayer since they simply pay it each time they make a purchase. The merchant will have an additional report to fill out but they are already accustomed to filling out similar forms for their state and local governments. In addition, these merchants will no longer be required to fill out a corporate tax return so they will most likely save money on their recordkeeping requirements.

My choice of plan:

One thing is clear. The present progressive income tax system fails to meet any of Adam Smith’s guidelines. If Adam Smith were here today, he would be leading the way for tax reform; after all, he led the tax revolt that was the main cause of the American Revolution that led to the founding of this country.

That leaves us to decide on either the fair tax plan of flat tax plan. Both plans represent a marked improvement over the current plan. The flat tax would be easier to implement since there is already a constitutional basis for it. All that congress would have to do is rewrite the current tax code. However, what would prevent opportunistic politicians from corrupting this plan just as they did the current one.

One way to prevent such corruption of the system would be to include language in the legislation requiring a super majority of 2/3 approval by the congress of any changes to the code. However, if one party were to gain such a majority with a person of their party in the White House, they could swiftly corrupt the tax code. That is why I recommend going the additional step and introducing a constitutional amendment requiring a super majority vote of 2/3 of state legislatures on tax issues so that no matter what party is in charge in Washington, tax changes will be difficult to implement.

To implement the Fair Tax proposal we must first repeal the 16th amendment so we do not end up with an income tax in additional to the fair tax. However due to its simplicity to collect and enforce, I believe this is the best proposal on the table. However, tax reform is so necessary that I do not believe the nation can wait for the amendment process to be completed. Therefore, I recommend initial implementation of the flat tax followed by introduction of the amendment to repeal the income tax. I understand that upon passage of the amendment the flat tax will be unconstitutional so the legislature will need to address this issue by changing from the flat tax to the fair tax. This action should then be followed by passage of another amendment to the constitution requiring a super majority vote of state legislatures on federal tax issues.

Political obstacles:

The main obstacle we will face in implementing tax reform is that the current tax system has become firmly ingrained on our governmental system and society. Politicians have grown accustomed to using the tax code as a political tool to earn votes. It will require a major outcry from the people and possibly the replacement of some legislators to implement this reform.

Our tax code has also become firmly ingrained in our society. Many have additional tax withheld every payday so they can receive a large refund check at the end of the year. However, since the IRS pays no interest on the money they hold until the tax return is filed, this makes little sense. I would advise these individuals to place this extra money in a savings account and earn interest on it until their taxes are due.

Perhaps the toughest obstacle to overcome will be the fact that the present tax code has become a welfare system with the introduction of refundable tax credits. Some politicians will accuse supporters of any tax reform that does not include these credits of not caring for the poor. This could not be further from the truth. The reason for tax reform is to spur economic growth. This economic growth will create additional jobs and business opportunities resulting in fewer people needing to be on welfare. It would be better to create opportunities for individuals to become self sufficient instead of keeping them on the government dole.

I encourage each of you who read this to go to the links provided on this blog and contact your senators and congressperson. If they are not supportive of the needed tax reform, tell them you will support candidates who do in the next election. The tax tea parties we witnessed on April 15 show the public support for tax reform. Washington needs to listen to the people who elect them. If they do not, the people need to invite them to become spectators and elect people who will listen.