Right From the Start
Last week President Donald Trump unveiled his tax reform proposal. It was a broad outline and, as usual, the devil will be in the details. However, I am encouraged that it is a step in the right direction. But it most assuredly is not the final step.
Let’s leave aside the arguments over whether a flat tax, value-added tax or national sales tax would be better. Let’s assume that there is not the political courage – particularly among Republicans – to abandon the graduated income tax in favor of one of those alternatives. Let’s also ignore the liberals/progressives who have decried Mr. Trump’s proposal as a “gift to the rich” because they get a larger tax reduction in terms of dollars paid, than do middle income earners. Of course they do, they pay more in taxes, they pay on a larger base of income and they pay at a higher rate. For those of you forced endure a teachers union led education in the Portland public school system, let’s do the math.
First, there is an old saying that figures lie and liars figure.
According to a March 4, 2017, report in the Motley Fool there were approximately 150 million federal income tax returns filed. However, only 99 million of those returns resulted in the payment of any income taxes – the remainder owed and paid nothing. One third of those filing a return paid nothing. A tax rate reduction will have no impact on them. Any rate reduction will result in more money for the other two thirds. Is that fair?
It is difficult to calculate the amount of federal income tax paid by the average family because the number of deductions and exemptions vary so greatly from family to family. For these purposes we will assume effective tax rates – the amount of taxes paid divided by the total income earned – for two different levels of income. The first family has a household income of $75,000 annually and pays $7,500 in federal taxes – a ten- percent effective tax rate. The second family has a household income of $500,000 annually and pays federal income taxes of $110,000 – a twenty-two percent effective tax rate (which is greater than the 18.5% paid by President Barack Obama.)
Now let us assume that each is going to receive a tax reduction of ten percent. For the first family that will mean that their effective tax rate will go from 10 percent to 9 percent and the amount of taxes paid will be reduced from $7500 to $6,750 – a reduction of $750 dollars. The second family – again with a ten percent tax reduction will see their tax rate go from 22 percent to 19.8 percent and the amount of taxes paid will be reduced from $110,000 to $99,000 – a reduction of $11,000. They both received the same rate of reduction but because the latter family paid taxes at a higher rate and on a higher level of income, their realized savings will be greater.
So how much would you have to reduce the first family’s tax rate in order to equalize the actual dollar reduction achieved by the second family? Well, since the second family achieved a savings of $11,000 you would have to eliminate the first family’s taxes completely and give them a check for $3500 – an absurd result but that is the kind of absurd thinking that Democrats like the clueless House Minority Leader Nancy Pelosi (D-CA) routinely roll out.
Any tax cut to the very wealthy is going to result in a larger dollar benefit for them than tax cuts for the average worker. Even a smaller percentage decrease for large income tax payers usually results in a larger dollar reduction that a larger percentage decrease for modest income tax payers. It’s just math. That is what a graduated income tax does. Get over it.
But there are other actual important elements of Mr. Trump’s proposal that need to be discussed. His proposal to nearly double the standard deduction goes a long way towards simplifying the filing of returns for the overwhelming number of individual taxpayers. However, I think the proposal is flawed by retaining deductions for charitable contributions and mortgage interest but excluding taxes paid to state and local jurisdictions.
In the past I have objected to high income tax states like Oregon excluding the payment of federal income taxes as a deduction for calculating state income taxes. Some states, like Montana, excluded the deduction but reduced the income tax rates to “levelize” the effect – not Oregon, a state that seemingly cannot find enough things to tax. The effect of it is to require individuals to pay taxes on taxes already paid to the federal government. Mr. Trump’s proposal compounds the problem by doing the same things at a federal level. In high tax states like Oregon, individuals will have to pay federal taxes on payments made to the state and local jurisdictions for income taxes and property taxes. What benefit is derived from increasing the standard deduction is eliminated by excluding these taxes paid to state and local jurisdictions.
And finally, Mr. Trump’s proposal is silent as to the treatment of the individual exemptions. If those too are lost, middle income taxpayers could find themselves actually paying more under the proposal.
I have previously advocated a far better proposal that will simplify taxes for most Americans and result in a far more responsible participatory democracy. My proposal has five key elements:
1. Taxes should be designed to produce the revenues necessary to fund the legitimate functions of government – that’s it. Nothing more, nothing less. Taxes should not be used to encourage or discourage investment in particular lines of business. Taxes should not be designed to redistribute income or wealth. And taxes should not be designed to encourage or discourage a particular form for doing business.
2. Everyone should be required to pay taxes. The whole concept of a representative democracy is that the law, having been adopted through the representatives of the people, should apply equally to all. If you start carving out exceptions for the application of the law – even the tax laws – we are no longer a nation of laws but rather a people subject to the whims and caprice of the powerful.
Unless all pay taxes, all are not equally impacted by the decisions of government – and particularly not impacted by increases in taxes.
3. The calculation and payment of taxes should be simple and efficient. Today, the Internal Revenue Service employs slightly over 82,000 people. There are at least that number in the private sector who attempt to provide guidance, preparation and defense for taxpayers. Not one of them provides any benefit. In fact, they represent a sword (IRS) and a shield (tax consultants) both paid for by the same taxpayers. The tax system should be so simple and transparent that anyone who can perform a job can complete and file a tax return. The elimination of tax deductions – all tax deductions – would further simplify the tax system and ensure that Congress does not engage in picking winners and losers in the competitive markets.
4. If progressive tax rates are used, they should result in no more than four categories. There are good policy arguments for a single tax rate applicable to all levels of incomes. However, we have become accustomed to graduated rates for increasing levels of income. If that is to continue under a “tax reform” they should be limited in number and correlated to a specific economic measures.
The first category should be the minimum amount paid by all. The next three categories are graduated. The percentage levels suggested by Mr. Trump may be fine but the level of income to which they apply needs to be fleshed out and indexed for inflation.
5. Taxes should allow for self-funding of retirement. The one exception that I would recommend to such a simplified tax system would be the continuation of special treatment for retirement savings. According to a 2014 study by the Tax Foundation:
“However, over the last fifty years, U.S. saving and investment have eroded substantially, and during the most recent financial crisis, they collapsed almost completely. At the national level, the U.S. is essentially treading water. Citizens are barely running enough household surplus to make up for government deficits, and businesses are barely investing enough new capital to make up for the depreciation of old capital.”
The degree to which we provide for our own retirement has a direct and significant impact on the amount required from tax funded sources – welfare, Social Security, etc.
I filed my taxes recently. I am retired. I do not have a business. I do not have any complex investments. My income is derived from Social Security and my investment portfolio which results annually in a couple of pages of 1099-Misc. forms prepared by my broker. And yet my tax return was over two dozen pages long and took me the better part of two days to organize, record and post. Mr. Trump’s proposal does very little to alleviate that burden.
In the end, it does not appear that we are going to have any real tax reform. We are going to reshuffle the deck and the special interests in Congress will be served well before the individual taxpayers and voters.
And even at that, Mr. Trump’s proposal is better than what we have. I am not a believer in the idea that perfect should be the enemy of good and, therefore, it this is all there is I still support it.
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