Fixing the American Income Tax System Organized by: Jason M. Fields This white paper will not cover everything in the area fully, but will give some brief solutions. Disclaimer: All of the recommendations and solutions are cited and derive from articles and websites referenced at the end of each article listed in light blue. 1
Our nation s tax system is badly broken. Everyone knows that. The income tax law inflicts huge distortions on our economy. The only area of the economy where the tax system creates jobs is in tax planning, tax controversies, and tax compliance. Daunting income tax complexities confront taxpayers at every income level. They sow confusion and create the perception that those who can afford clever advisers escape paying their fair share of taxes. Front page stories throughout the country confirm that the IRS is unable even to answer taxpayers simplest questions. All of this, in turn, erodes the goodwill and honesty crucial to the system s functioning, making it ever more vulnerable to tax avoidance and evasion. In Congress, everyone talks about the need for major tax reform. After all, it has been nearly thirty years since the income tax got a good cleansing, and the 1986 Tax Reform soon unraveled. Last year, House Ways and Means Chairman Dave Camp (R. MI) unveiled a massive tax reform proposal an effort to reprise the 1986 reform by broadening both the corporate and individual tax bases and lowering their rates. Unlike the 1980s, however, this time there was no obvious target like widespread tax shelters, to help finance rate reductions. So Chairman Camp had to attack income tax s sacred cows things like itemized deductions for home mortgage interest, state and local taxes, and charitable contributions, as well as exclusions from income of employerprovided health insurance and state and local bond interest. Even so, rather than the twenty-two-point reduction in the top marginal rate from 50 percent to 28 percent that Ronald Reagan accomplished, Congressman Camp was able to move the top rate from about 40 percent to 35 percent. This spotlighted the limited gains from income tax reform. After Republicans and Democrats all kept a safe distance from Camp s plan, he retired from Congress and moved to the private sector, passing the torch to former vice-presidential candidate Paul Ryan, who now heads the House tax-writing committee. In the Senate, the new Republican chairman of the Finance Committee, Utah s Orrin Hatch, has created task forces to work on tax reform and insists he can get it done. Talk about tax reform abounds. But how can anyone remain optimistic about fixing our nation s tax system without radical surgery? A Little History Although an income tax helped finance the Civil War, it did not become permanent until World War I. From the end of the Civil War until 1913, when the Sixteenth Amendment was ratified, the Federal government raised its revenue almost exclusively from tariffs on imported goods and assorted excise taxes. Tariffs and excise taxes, however, raised the costs of goods for everyone, while large fortunes accumulating in real estate, corporate stock, and other investments were left untaxed. The extraordinary public support necessary to amend the Constitution and impose an income tax arose to fund a reduction in tariffs and to balance the taxes on consumption with a tax more closely linked to people s ability to pay. The income tax was expected to contribute only a small portion of ordinary government revenues and to supplement other revenue sources in times of emergency. It was not supposed to play the central role in financing the Federal government that it does today. Until World War II the tax law shielded most Americans from having to pay. From 1918 until 1939, only about five percent of the population filed taxable income returns. Even after the economic shocks of the Great Depression and the creation and expansion of the New Deal the reach of the income tax remained extremely limited. True to its original conception, it was a low-rate tax on a relatively small group of higher-income Americans until World War II. In 1940 41, Congress increased the number of Americans subject to the income tax by 400 percent, from 7.4 million to 27.6 million. By 1943, 50 million Americans, or nearly 70 percent of the population, were required to file tax returns. 2
Where We Are Now Our nation s basic tax structure has remained fundamentally unchanged since. In the decades following World War II, the United States essentially had all the money there was. Even a horrid tax system with income tax rates up to 91 percent could not stall our nation s economic progress. From 1946 73, when OPEC quadrupled the price of oil, the economy grew by an average of 3.8 percent per year, and unemployment averaged 4.5 percent. Since then, however, the economy has grown more slowly, and middle-class wages have stagnated. Our nation s workers today face stiff worldwide competition for jobs and wages. Given the internationalization of economic activity during the past 25 years and the increased competition from abroad, we need to attract capital to create better conditions for American workers and businesses, goals which the current tax system stifles. Our competitors tax systems are dramatically different from ours. They have not stuck with their archaic World War II era tax systems. The United States is a relatively low-tax country, but not with respect to income taxes. With total Federal, state, and local taxes at about 25 percent of our total economic output, the United States enjoys considerably lower taxes than the average (36 percent of GDP) of the thirty countries of the Organization for Economic Cooperation and Development (OECD). Our income-tax level is comparable, however. We typically collect about 12 percent of GDP in corporate and individual income taxes, while the OECD nations average about 13 percent. The biggest difference is that most other nations rely much more heavily on consumption taxes than we do: 11 percent of GDP in the OECD compared to about 5 percent in the United States. Indeed, we are the only OECD nation that does not impose a national level tax on sales of goods and services. Where Do We Go from Here? The United States hobbles itself in today s international economy by continuing to rely so heavily on income taxation. The truth is that we need a tax reform that is considerably bolder than either Congress or the president is now contemplating. We need to rebalance our federal tax system to take advantage of our status as a low-tax country by relying less rely less heavily on income taxation. To create a simple, internationally competitive and viable long-term solution to our fiscal requirements, we should return the income tax to its original purpose: the collection of a simpler tax on high-income earners who tend to have multiple income sources. In order to do that, we need to tax consumption that is, sales of goods and services. By enacting a broad-based tax on sales of goods and services now used by more than 150 countries worldwide, we could use the revenues to finance an income-tax exemption of $100,000 of family income to lower substantially the individual income-tax rate on income above that amount freeing over 150 million Americans from ever having to deal with the IRS. Through payroll-tax cuts and debit cards to be used at checkout counters, we can protect low- and middle-income families from any tax increase. With this kind of reform, most Americans would owe no tax on their savings and all Americans would face lower taxes on savings and investments. The United States would become a much more favorable place for economic growth, without shifting the burden down the income scale. A low corporate tax rate would solve the problems caused by international tax planning by multinational corporations and the current competition for corporate investments among nations. Rather than trying to leave, companies would want their headquarters to be located in the U.S. By taxing imports and exempting exports, this system would yield hundreds of billions of dollars for the U.S. Treasury in the decade ahead from sales of products produced abroad $600 to $700 billion at current trade levels. 3
By returning the income tax to its pre-world War II role as a relatively small tax on a thin slice of high income Americans, there would be no temptation for Congress to use tax breaks as if they are solutions to America s social and economic problems. We have tried that, and it doesn t work. And for the vast majority of Americans, April 15 would just be another spring day. They would never have to deal with the IRS again. - Michael J. Graetz is a Professor of Law at Columbia University Law School.: http://blog.yupnet.org/2015/04/11/how-dowe-fix-americas-tax-system/ 4
10 things Congress could do to simplify the income tax and reduce costs significantly for both taxpayers and the IRS. 1. "Modify or repeal the alternative minimum tax: Originally designed to ensure that high-income households paid at least some income tax, the alternative minimum tax (AMT) now affects 4 million filers, most of whom already pay significant amounts of income tax and are far from the top of the income distribution. Congress raised the AMT exemption and indexed both the exemption and other relevant parameters for inflation in 2012, but did not fix the AMT s basic problems. Modifying the AMT so that it only affects higher-income taxpayers who would otherwise pay little tax would return the tax to its original purpose. But it would hardly make the tax system simpler for those still subject to it. Repealing the AMT would both simplify the income tax and eliminate the need for annual patches, but revenue would decrease by roughly $30 billion annually. 2. Eliminate or align income limits and phaseouts: Many preferences in the tax code are denied to higherincome taxpayers or phased out over different ranges of income. These inconsistencies complicate tax returns; several worksheets are required to calculate taxable income, deductions, and credits. For example, the tax code reduces the $1,000-per-child credit by 5 percent of adjusted gross income (AGI) over $110,000 for married couples ($75,000 for single parents and $55,000 for married couples filing separately); the share of expenses allowed for the child and dependent care credit falls from 35 percent to 20 percent as AGI increases from $15,000 to $43,000; and the deduction for interest paid on student loans phases out for single taxpayers with modified AGI above $65,000 ($130,000 for joint filers). Eliminating such restrictions would simplify tax filing, but the benefits would go to higher-income taxpayers. Retaining income limits on tax preferences but setting them at uniform levels (at least for related activities), would reduce complexity while still focusing benefits on taxpayers with low-to-moderate incomes. Note, however, that if multiple benefits phased out over the same income range, effective marginal taxes in that range could reach unacceptably high rates. 3. Consolidate tax benefits for education: Families with students in college may qualify for multiple tax benefits to defray educational expenses, but often may claim only one of them. For example, a family may be able to claim either the American opportunity credit or the lifetime learning credit, but not both, for the same student. If the family supports more than one student, it may claim one credit for one student and the other for the second student. Determining which alternative is best requires multiple calculations and can conflict with other tax benefits for education, such as Coverdell savings accounts and 529 savings plans. Combining or at least coordinating the various tax benefits would help taxpayers both determine their eligibility for benefits and calculate them. 5
4. Coordinate tax benefits for dependent care: Taxpayers may reduce the net cost of dependent care through the child and dependent care credit and through flexible spending accounts set up by their employers. They may, however, use only one of the two options for a specific expense, which can make both planning how to finance childcare and completing tax returns difficult. Coordinating the two benefits or combining them into a single benefit would address both problems. 5. Simplify or eliminate the taxation of Social Security benefits: Whether and how much of a recipient s Social Security benefits are subject to tax depends on income: single beneficiaries with adjusted incomes below $25,000 ($32,000 for couples) pay no tax on their benefits; those with higher incomes must include up to 85 percent of their Social Security payments in taxable income. Determining the amount to include requires completing a 19-line worksheet that draws on information from other parts of the tax return. Making a fixed fraction of benefits taxable (possibly zero) for all beneficiaries would eliminate that worksheet and make tax filing easier. 6. Simplify the taxation of capital gains and dividends: The income tax currently imposes many different tax rates on capital gains and dividends, depending on the taxpayer s regular tax rate, the type of asset, how long an asset was owned before it was sold, whether dividends are qualified, and whether the taxpayer owes AMT. The IRS provides four different worksheets, one with 45 lines, to help taxpayers calculate their tax on capital gains and dividends. Allowing a percentage exclusion for qualified dividends and long-term gains (and perhaps other kinds of gain) and applying regular tax rates to the rest would sharply reduce the complexity of returns while maintaining different effective tax rates on different kinds of gains and dividends. 7. Combine tax incentives for retirement saving: Workers can currently save for retirement in various ways that receive different tax treatment among them deductible, nondeductible, and Roth individual retirement accounts; regular and Roth 401(k)s and similar plans; and traditional employment-based pension plans. Each type of saving has its own eligibility requirements, income limits, and tax benefits, which complicates the task of deciding how best to save for retirement. Combining existing options into fewer alternatives and setting the same income limits for all would simplify workers choices and reduce the cost of administering multiple programs. 6
8. Consolidate programs benefiting households with children: Personal exemptions, the child tax credit, and the earned income tax credit (EITC) all provide benefits for households with children. But each imposes different restrictions on participation, offers varying benefit levels, and requires beneficiaries to complete separate parts of tax returns. Combining all three benefits into a single refundable credit would both simplify tax filing and coordinate benefits. It could be difficult, however, to design a simple single credit that would approximate current benefits. 9. Simplify the earned income tax credit: Claiming the EITC currently requires completing a three-page worksheet to determine eligibility, and then a second worksheet to calculate the credit itself (though taxpayers may elect to have the IRS complete the second task). That complexity results from strict definitions of which children qualify, different credit rates and income limits depending on the number of children, and different accounting for different kinds of income. Relaxing the requirements and making the parameters the same across taxpayers with different characteristics could reduce complexity. But this would also limit flexibility in adjusting benefits to perceived need. 10. Use a single definition of child : Various income tax benefits are targeted at families with children. But the definition of child differs widely, particularly with respect to age. Children under age 19 (or under 24 and a full-time student) count in defining EITC benefits; those under 17 qualify for the child credit; and only those under 13 are eligible for the child and dependent care credit. Although these differences may result from deliberate congressional choices about who should receive benefits, they complicate tax filing and can lead to filing errors that the IRS has to correct. Other factors further complicate eligibility determination, including the child s physical residence, custody arrangements, and who pays the child s living costs. Establishing a single definition to determine whether taxpayers may claim tax benefits for children would simplify both tax filing and IRS processing of returns." http://www.taxpolicycenter.org/briefing-book/what-are-ten-ways-simplify-taxsystem 7