What’s Fair About Obama’s Tax Proposal?

President Obama, in his recent speech about how he intended to pay for his latest spending increases and reduce the deficit, returned to his favorite campaign whipping boy – class warfare. In demanding that the Congress immediately pass a $1.5 Trillion tax increase he noted that his plan was:

“. . . a plan that asks the most fortunate among us to pay their fair share, just like everybody else.  [Emphasis added]

When I was a young lawyer – a year out of law school and working for the Montana Attorney General – I was handed an appeal filed by one of Montana’s top trial attorneys. He was an imposing figure – big, but with a kindly grandfather’s face – whose principle talent was connecting with juries. He was less a legal scholar than he was an engaging orator. A lower court had dismissed his tort case and he was appealing to the Montana Supreme Court for reinstatement of the case. His theory of the case rested on a principle he enunciated as “fundamental fairness” – his client had suffered a loss and fundamental fairness demanded that he be compensated.

I spent weeks searching the Montana statutes and case law for the underpinnings of “fundamental fairness” and found nothing. Neither Montana’s constitution nor its statutes incorporated the notion of fundamental fairness. There was no case law embracing the principle. I argued to the Supreme Court that the concept of “fundamental fairness” – as appealing as it was emotionally – had no basis in Montana law and for good reason. “Fundamental fairness” was a subjective standard – one that is in the eyes of the beholder – and the law required objective standards. Montana’s Supreme Court agreed and dismissed the appeal.

The same can be said of trying to impose “fairness” as a standard for taxes. What is fair to you may not seem fair to me. At a federal level, policymakers have settled on the concept of a graduated income tax – which means that not only do you pay more as you make more, your tax rate also increases as you make more. Those states that have imposed an income tax have followed the concept of graduated income taxes. (Those states that have declined to impose a state income tax have generally faired better at attracting businesses to locate, grow and retain business and thus employment.) The whole concept of a graduated income tax is based on the Biblical notion “from each according to his ability, to each according to his needs.”

The result of that system has been two-fold.

First, the tax system has become replete with exceptions – most generally those exceptions apply to those who have curried favor with Congress. Tax policy today is not so much designed to raise revenue for the legitimate functions of government as it has to pick the winners and losers in what would otherwise be a free-market. The most notable examples of late are the significant tax advantages granted to “renewable” energy projects: i.e. solar power, wind power and biofuel projects. None of these industries are sustainable in a competitive marketplace without significant tax advantages – and in many cases, significant financial support in the form of grants, guaranteed loans and government mandated purchases (think about the Oregon Public Utility Commission requirement that Oregon’s electrical utilities must purchase a certain percentage of their power from “renewable” sources). Those receiving the tax advantages and subsidies regard this as a “fair” result because their business could not survive without them; while those who must pay more because those receiving the tax advantages pay less, see the system as being grossly “unfair” because it puts them at a competitive disadvantage.

And second, over time, the number of people who are exempt from paying any income tax grows. Today, over fifty percent of working Americans pay no federal income taxes. For many, they not only pay nothing in federal income taxes, they can in fact qualify for “refunds” from the government in the form of “earned income tax credits” and “tax rebates” under “stimulus” plans. Those on the receiving end of these tax policies – those paying nothing and those receiving refunds after having paid nothing – find this system to be abundantly “fair.” Those working hard and paying more because others pay nothing find this system to be “unfair.” This latter group includes those who are at the lower end of the income scale who, having worked hard, make just enough money to pay taxes while watching others receiving “refunds” for doing nothing.

There is a duty in civilized societies to provide care for those who cannot provide for themselves. Unfortunately, the application of welfare programs has resulted in indistinguishable benefits to both those who cannot and those who will not provide for themselves. Tax policy designed to redistribute wealth is generally deemed “fair” by those who receive and “unfair” by those who are forced to pay.

Because “fair” is in the eyes of the beholder, it can equally be argued that the benefits from the application of basic government functions fall equally on all and, therefore, all should contribute to the funding of those functions. There are three basic forms of taxation – income, property and consumption taxes. Not all people have incomes. Not all people have property. But all people consume.  Thus a consumption tax is the only means of ensuring that all contribute to fund the basic functions of government.  Of late there have been a number of proposals to implement a consumption tax on the basis that it is fair.

The Fair Tax Plan embraced by a number of conservatives envisions repeal of all forms of federal taxes (income, capital gains, estate, etc.) and replacement with a national retail sales tax accompanied by a “prebate” of an amount that represents the sales tax on spending up to the poverty level. Its supporters argue that shared responsibility in the payment for government will coincide with the responsibility for government decisions – and, as a bonus, one of the federal governments nastiest and most bloated bureaucracy (the IRS) will be rendered unnecessary.

Herman Cain’s 9-9-9 Plan envisions a flat tax on individual and corporate income and a nine- percent national consumption tax. His proposal eliminates all deductions except charitable deductions for individual income taxes. His flat tax for business would be based on gross income less all investments, all purchases from other businesses, and no double taxation of dividends.

Fox’s Bill O’Reilly has proposed a two-tier flat tax for individuals and businesses with no deductions (except for charitable deductions) and a smaller national consumption tax dedicated solely to paying for Social Security and Medicare.

Each of these proposals is based on the advocate’s sense of fairness. However, unlike Mr. Obama’s suggestion that is only “fair” that those who make more should pay even more, these proposals have other economic justifications. In each instance they boost participatory democracy – those who make decisions bear the financial responsibility for those decisions. They also boost economic growth by allowing the free market, rather than tax policy, to decide the winners and losers and they stabilize market expectation while ensuring an adequate supply AND deployment of capital for growth.

But let me add one further twist to this debate. My proposal is for a two-tiered flat tax on individual and business income. The first tier would commence at the minimum wage level and the second tier would begin at $150,000 ($250,000 for a couple) and would be indexed for inflation. There would be no deductions, including charitable deductions. Instead there would be a tax credit for donations made to charities supporting public and private elementary and secondary educational institutions (similar to that used in Arizona currently) and charities providing healthcare and food and shelter to those below the poverty level. (I would require that such charities demonstrate that eighty percent or more of the contributions actually benefit the targeted recipients – that is twice the level of efficiency of the state and federal governments.) My proposal not only advances the concept of other flat tax/consumption tax proposals but adds an element of competitive efficiency in the delivery of education and welfare services – donors will not make contributions to inefficient programs when others are available.)

The current tax system is broken. It is neither fair nor efficient. It’s time to give “fair” another look.

And by the way, the concept of “from each according to his ability, to each according to his needs” comes not from the Bible but rather from Karl Marx.