How to FIX the INCOME Tax.
The case for a Personal Expenditure Tax...
America has an addiction, an addiction to trying to do everything, and I mean EVERYTHING through the tax code. Want to strengthen the middle class? Just boost the Earned Income Tax Credit and increase the standard deduction! Seeking to reduce Child Poverty? Well, then just give a tax credit to parents with children and allow them to deduct more per child! Trying to stop climate change? Obviously, the solution is to provide tax credits to owners of electric vehicles. It seems almost as if every problem in America can be solved by some new addition to the tax code, or at least that appears to be what the politicians are convinced of. Unfortunately, this approach doesn't seem to be working as intended.
According to the IRS's Taxpayer Advocacy Service, Americans spend over 6 billion hours every year complying with tax-filing requirements, leading to a cost in dollar terms of around 431.1 billion dollars annually! The reality is that the current tax code distorts private incentives, has sky-high administrative and compliance costs, struggles with large avoidance issues, and raises an insufficient amount of revenue.
Further, the current tax expenditures in place meant to target legitimate issues like child poverty, rising inequality, and the unaffordability of medical care often have let many of the people they are trying to help fall through the cracks. Based on estimates from the IRS and US Census Bureau, every year, 20% of people eligible for the Earned Income Tax Credit never claim it. Of the 80% that do receive it, approximately 60% of them use a paid tax preparer, which charges a fee of usually a couple of hundred dollars, which can easily cost them equal to 50% of the benefit for single filers with no dependents.
So the question then follows, what in the world can we do to make this situation better? The good news is, luckily, a lot. A ton of our current issues come from our elaborate overlapping scheme of credits and deductions, a simple set of reforms that consolidated these tax expenditures into a few streamlined programs would go a long way! Additionally, further reforms that expanded the definition of income to include capital income and transfers could even further reduce complexity while offering substantial improvements in overall tax equity and progressivity.
I. TAX EXPENDITURES
In 2021, Total Tax expenditures were projected to cost the government a whopping 1.579 trillion dollars. For reference, that is enough money to send to every single American adult around 7,550 dollars! So, it goes without saying that these tax expenditures cost a lot of money, and the massive majority of them come from provisions within the income tax in the form of deductions and credits.
For those who don't already know, a tax deduction is a reduction of taxable income that comes from some form of eligible expenditure or income source. Currently, individuals are given the option of using a standard deduction or an itemized deduction. A standard deduction is a set amount that each individual can deduction which fluctuates based on several criteria, including the number of dependents they have, their age, etc. Meanwhile, an itemized deduction is one that allows filers to deductions for an assortment of qualifying expenditures, including business expenses, local taxes, and reclaimed income from the sale of property. Filers are expected to choose the option that maximizes the amount they can deduct.
Then there are tax credits; similar to tax deductions, tax credits reduce the tax bill you are liable for at the end of the year, but they do this in a slightly different way. Instead of reducing the base of income that you are taxed on, tax credits act as an after-the-fact reduction of the final tax bill. So, a hypothetical 1000-dollar tax credit for adopting a child would simply reduce the taxes owed at the time of filing by 1000 dollars.
Tax credits and deductions have one useful purpose and one only; they can serve as helpful modifiers that ensure no one is treated inequitably by the tax code. Several current measures currently meet this criterion. The deduction for business expenses is a great example. It doesn't make any sense to tax income that goes towards business activities because, in reality, that is not an individual's income. If you have a lemonade stand that sells a cup for 1 dollar, but the cost of making a cup is .50 cents, your income is .50 cents, not a full dollar! The business deduction makes sure you only get taxed on the money that stays in your pocket at the end of the day, not the money you spend just to keep your business going.
Unfortunately, the massive majority of current credits and deductions are not designed for this purpose. Some current credits and deductions have absolutely no justification whatsoever. The Mortgage Interest Rate Deduction, Gambling Loss Deduction, SALT Deduction, and Moving Expense Deduction all stick out as clear examples of tax measures that not only make the code more complex but are even worse, regressive and distortionary. Yuck!
Others have more admirable goals, whether that be to subsidize education and health expenses or to reduce poverty and inequality. The issue is the tax code is simply a bad way about achieving these ends. Everything an added tax expenditure can do, a separate social spending policy can likely do drastically better. Issues of poverty and inequality are best addressed via direct transfers; meanwhile, health policy is best addressed by regulatory reform, consolidated public price negotiation, and direct public insurance subsidies, not a deduction here and credit there.
So, a common-sense move to streamline the tax code would be to eliminate all the current deductions and credits and start fresh with a shortlist of just the necessary ones. When we do that, we are left with, in my estimation, four. Though it should be noted, there may be a couple of justifiable additional ones.
Reclaimed Income Deduction - a deduction for the resale of an item purchased with already-taxed income. This deduction would be primarily for the sale of homes, cars, and other expensive items and ensure no one gets double taxed on income reclaimed. Importantly, the deduction would only go up to the original purchase price of the item. So a person that bought a house for 150k (I live in Houston, so bear with me) and sold for 200k would only be eligible for a deduction of 150k.
Business Expenses Deduction – as I have already elaborated on earlier, this would include any and all business expenses and would also include additional language on the business use of home and car, similar to what is specified in the current code.
Foreign Income Exclusion – to the frustration of ex-pats everywhere, US citizens are required to file yearly US income taxes even if they don't live in the United States at the time. The Foreign Income exclusion makes doing the paperwork a lot less painful by allowing them to exclude all income accrued from sources exterior to the United States.
And finally, one super useful entirely new one I will elaborate a bit on in part II!
Yep, that's it. In place of our several dozen tax measures, only four seem to be all that helpful. With the new money the government has gotten from plugging all these holes in the tax code, it could actually afford some proposal that would actually solve the problem it targets. A universal child allowance, perhaps, to end child poverty once and for all! Or maybe higher education vouchers for all to ensure everyone has access to some level of tertiary education. The possibilities are endless when the government starts using large targeted social programs instead of measly additions to the tax code.
II. DEFINING INCOME
The other big problem with the income tax is that it doesn't actually tax all income! Instead, it taxes certain sources of income, specifically wages, salaries, commissions, tips, and short-term capital gains, and leaves other types of income to entirely separate taxes. For instance, long-term capital income is taxed through the Capital Gains Tax, which has a separate personal allowance, rate structure, and set of rules to the Income Tax. Meanwhile, income in the form of Gifts and Inheritance is taxed through the Gift Tax and (in a roundabout way) the Estate Tax.
This is an unnecessarily complicated and inequitable way of taxing income. A streamlined income tax would benefit from a new broader definition of income, one that requires only one filing, has consistent rates, and doesn't double tax anyone!
A really easy way to do this is to reverse the way we look at the taxable base of income. Instead of looking at what is defined as income, then defining what portion of our positive cash flow (the money we receive through the year) is taxable, we could take the reverse approach, start with the entirety of our income and then see what few things can be subtracted from there. In practice, this would allow us to consolidate both gift, inheritance, and long-term capital gains into the income tax with only a few additional rules needed to make everything go smoothly.
Under this system, the taxation of transferred cash/items would be as simple as possible. For instance, a transfer of, let's say, 10000 dollars and/or the gift of a car you then sell for 10000 dollars would be taxed at the same rates as any other type of income. Non-liquid gifts or inherited items would not be taxed until they were sold. This avoids the compliance, valuation, and liquidity issues that would otherwise exist with a tax on the transfer of items.
Capital Income could also be pretty easily consolidated into the income tax. Currently, Capital Gains are taxed at a maximum rate of 20% as long as the asset produced the gain was held in excess of one year. This reduces investment and lock investors into assets for longer periods than they may want to otherwise.
A potentially superior alternative to the current method may be to make investments temporarily tax-deductible. So instead of taxing the income you used to invest initially at 30% and then taxing the gains from that investment at 20%; under this model, your initially invested income would not be taxed at all and then eventually taxed all at once at 30% whenever you inevitably withdraw the income from investments. Crucially this would avoid the lock-in effect of the current Capital Gains Tax structure, equalize rates, and make enforcement/compliance a jiff!
To make sure no one tries to game the system by never withdrawing their investments and attempting to pass them down to their benefactors, tax-free, we could add in an additional rule where all untaxed investments will be treated as income at the time of attempted transfer, which would automatically apply to all remaining untaxed assets in the year of death. This would ensure that for each individual, every dollar is taxed one time. No dollar of genuine income ever avoids taxation, and just as importantly, no person's dollar is taxed twice.
With all these reforms in place, the government would be awash with cash it could use to either fund new priorities like single-payer healthcare or across-the-board rate cuts. Poorer folks would be left better off, as now the tax burden would truly be evenly dispersed among all the different types of income (including the types the rich disproportionately benefit from).
America would be in a new era, an era of easy, fast, and non-confusing tax filings. CPAs could discover new ways to pass their time other than burying their heads in mind-numbingly boring paperwork. To make the process even easier, we could copy other countries and make it where the IRS sends each person a bill annually after they fill out a really basic questionnaire. No calculator needed!
If we wanted to make the process maybe even a little fun, we could make it where people could choose where 1% of their taxes go, whether that be to fighting climate change, the education system, or foreign aid.
Ultimately, fixing the income tax is a necessary prerequisite to further inroads in building a more egalitarian and prosperous society. With a streamlined tax on total income, America would be well placed to combat rising inequality and finance an expansion of universal economic rights, doing so crucially without jeopardizing the strength of the macroeconomy.
As activists, as citizens, and as humans we should hope and pursue vigorously the realization of these reforms, for the sake of not only building a better nation for Americans, but also a nation more suited to positively contribute to the people of the world.
An automated payment tax on total payments in the economy could be one answer. Instead of taxing the $23 trillion of income, we could look at the $9,184 trillion of total payments made. A payment tax of 0.25% on this could drastically reduce the overall tax burden. Scott Smith in ‘The Tale of Two Economies’ provides a very compelling way to solve our problems.