Fixing The Income Tax Code Once And For All - Fairly and Finally

Ex-Treasury Secretary William Simon once said: "The United States should have a tax system that looks like someone designed it on purpose." Our current tax code and system could not be any further from that objective. It has adapted, mutated, morphed, and changed over time as the political class has tinkered with it to serve various purposes, most of which involved garnering votes for politicians currently in office to enable them to stay in office.

As a result, we end up with the following abominations:

• Just under half of all American households (46%) paid no Federal income taxes in 2010, many of them actually using the income tax process to earn money via various deductions, credits, and other special treatments. Despite not paying anything in income tax, these same Americans get to enjoy all of the benefits of government services and programs including the nation's defense, infrastructure, housing, education, etc.
• The top 1% of all U.S. taxpayers pay 38% of all Federal income tax dollars received. The top 10% pays 70% of all income taxes. If these high payers should ever decide to leave the country or earn less because of the heavy tax burden, the burden on the rest of the American taxpayers, including the large numbers that do not pay any income taxes, would skyrocket. Relying  on a smaller and smaller base of taxpayers is a sure long term formula for economic disaster.
• A recent Wall Street Journal article, that was summarized in the April 29, 2011 issue of The Week magazine, estimated that U.S. taxpayers expend about $431 billion a year to comply with the complexity of the U.S. tax code. This money could be so much better spent on productive expansion of the economy and employment rather than tax paperwork.
• From a business perspective, the tax code now does such inane things like giving tax credits to companies for their expense of moving their domestic factory production to factories off shore, i.e. we pay companies to reduce U.S. employment. Insanity.
• The tax code can be so punitive that U.S. companies leave foreign profits overseas since it is less expensive to invest their profits overseas, expanding foreign economies, or they let their profits sit in an overseas bank, which is a better economic and tax decision than to bring those profits home to the U.S. for economic expansion.
• The tax code can also be so non-punitive that companies like General Electric can have billions and billions of dollars in profit but end up getting billion dollar tax credits from the U.S. government in any one year.

Much like Obama Care, the tax code is thousands and thousands of pages long, resulting in many unintended consequences and is virtually indecipherable by most educated people.

What a mess. How can a business, a family, or a government do long term, constructive planning when the tax code is such a mine field, a mine field that can be changed at any time by the whims of the political class? How do you explain the inequities in the code when everyone in this country is supposed to be treated equally: some people get full access to government services while others pay for those same services or how do billion dollar companies get away with paying no taxes? Craziness.

Thus, there should be no argument that we need to streamline, simplify, and interject equity into the tax code. This is relatively easy to do if we adhere to the following guidelines:

• In any tax reform initiative, the Federal government cannot end up with more revenue than if no changes had been made.
• The changed tax code needs to be locked in place for at least ten years so that certainty is introduced into business and family plans. No exceptions.
• The reformation would be a gradual process in order that businesses and families adjust their spending and purchases gradually over time in order to avoid any financial shocks and hardships.
• No additional "fees" or taxes would be implemented by the political class with the sole purpose of sidestepping the new tax code.

This would take a load of political discipline and leadership from the political class, qualities that always seem to be lacking. However, they are essential if we are to get ourselves out of this tax bog we are stuck  in now.

The basis of this proposed tax reform process is that it is a flat tax with only one or two tax brackets and absolutely no deductions. All income is treated the same so that wages, dividends, interest, capital gains, etc. are the same from a tax perspective, i.e. a dollar earned in any way is treated the same. How do we get from where we are now to this vastly simplified process without drastic financial pain and agony?

Simple. Given that most Americans now complete, compile and pay their taxes via a tax computer program, it is not that difficult for those programs to be adjusted to compute two different tax views, a business as usual view and a flat tax view. In fact, many taxpayers already compute two tax views in to comply with Alternative Minimum Tax requirements. In the first year, the difference  between the two views would be adjusted ten percent in the direction of the flat tax view. This would be the final tax bill for the first year of the reform process.

In the second year, the difference in the two views would be adjusted twenty percent in the direction of the flat tax view. This process would continue for ten years until we got to a flat tax view only.

This relatively simple concept is best illustrated with some examples. In the first example, let's assume that a family earns $50,000 a year from all forms of income. Via deductions, credits, etc. they end up owing $8,000 in income taxes. If the flat tax bracket is 15%, their flat tax liability would be $7,500. The difference between the two plans is $500. 10%  of $500 is $50 so they would end up paying only $7950 in taxes rather than $8,000 as they begin the move to the flat tax plan.

If this exact same situation was to occur in the second year then 20% of the $500 is $100. The family would owe $7,900 in taxes, $8,000 less $100. This would repeat every year for ten years with the difference between the two views increasing 10% a year.

Consider another example of another American family, also  making $50,000. However, given the numerous tax credits, tax deductions, and other favorable tax treatments, this family ends up paying no income taxes at all and, in fact, the Federal government sends them a check for $2,500. This American family falls into the category of those that pay nothing for all the government services they enjoy.

In this case, the difference in the first year of the reformation process is $10,000, $7,500 - (-$2,500). 10% of the difference is $1,000. Thus, in order to move to the flat tax plan, this family would no longer receive a check from the government for $2,500 but would receive a check for only $1,500, the original $2,500 reduced by the 10% difference movement of $1,000 to start bringing this family in line with the flat tax.

Let's look at General Electric for a business example. They recently announced they had 2010 profits of $5.1 billion on their U.S. operations. Very impressive. However, more impressive is that they paid no Federal income tax on those profits. Even more impressive, they were able to legally work the complexity of the tax code so that they actually received a $3.2 billion tax credit from the United States government.

This is really nice work if you can get it. Earn billions of dollars, pay no taxes on those billions, and the government will give you billions more. In our simple flat tax reformation plan at 15% tax rate, General Electric would have paid about $765 million on those $5.1 billion of profits. However, they got money back so we need to start making the adjustment.

The difference between what they should have paid ($765 million) and what they paid (actually received $3.2 billion back from he government) is about $4 billion. Under our ten percent rule, in the first year, their $3.2 billion credit would have been reduced to $2.8 billion ($3.2 billion less 10% of the $4 billion). Over a ten period General Electric would migrate to the flat tax calculation.

Now, business taxation is a little more complicated then maybe we presented it. The flat tax requirements might have to be adjusted so that it also becomes and more and more unattractive for General Electric to keep its overseas profits overseas. Thus, that is a wrinkle that may need to be planned into the business side of the flat tax plan so that we do not negatively impact the domestic economy with a new tax approach.

However, it is pretty obvious to everyone except General Electric and the political class that this is not a level playing field. According to a New York Times article by David Kocieniewsski that appeared in the may 13, 2011 issue of The Week magazine, business taxation in the United States comes out to about 1.3% of our GDP, making that about half of what the most industrialized countries receive from their businesses. Thus, there is probably benchmark reasons why companies like General Electric can and should pay more in taxes.

Another interesting assertion in the article is that the United States has one of the highest corporate tax rate levels (35%) vs. other countries. However, the complex U.S. tax code can be worked so well that 55% of companies studied in a seven year period, that was included in a 2008 government study, had at least one year where they paid zero in Federal income taxes.

Almost half of American families pay nothing in Federal income taxes. Companies can earn billions of dollars in profits and pay no Federal income taxes. The government gives companies tax credits to shutter American factories and move jobs and production overseas. Looks like William Simon got it right long ago. Our tax code is unfair, complex, and can be used to disadvantage American families and American businesses that actually pay their fair share of taxes.

By going to a simple, flat tax plan the chances of mischief and unfairness is reduced significantly. It also provides the political class less leverage and tricks to favor their campaign donors, both corporate and individuals. Most importantly, it would allow Americans a large degree of certainty in their tax and business planning and divert some of the money and resources from tax preparation to business expansion.

Isn't that what America used to stand for - fairness? About time we got back to the concept of a level playing field when it comes to taxes.



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