A New Tax Code

Shortly after I wrote “It’s the Tax Rate Stupid” I realized I had fallen into the rhetoric trap.  Americans are constantly debating about the marginal tax rate – should the Clinton-era tax rate be restored or should the Bush tax cuts be made permanent?  We are literally bickering over 3.6 per cent as though our economy hangs in the balance over single percentage points.

So what changed?  I posted the Tax Rate article on April 18th– the same day I mailed, or more accurately, my wife mailed – a more-than-mortgage-sized check to the IRS to cover our outstanding taxes for 2010.  No, despite my disdain for the IRS on the 18th– it was not paying my taxes that changed my views – it was actually the tax return itself.

Based on our gross adjusted income, we fell squarely into the 28 per cent tax bracket, yet according to my CPA, TurboTax, our actual tax rate – after deductions – was only 14.6 per cent.

14.6 per cent?  That couldn’t be!  We paid all kinds of taxes to the IRS throughout the year AND had to write a big check on tax day and yet, there it was – we’d only paid 14.6 per cent.  I felt pretty foolish – after all, that does beat the heck out of 28 per cent huh?

So what is the point of having a 28 per cent tax bracket if we don’t come close to paying that amount?  If we aren’t paying that amount, it’s a good bet few people are paying that amount.  In the real world, it really won’t make a difference if the highest Marginal Tax Rate is 38.6 per cent (Clinton-era) or 35 per cent (Bush-era to current), no one actually pays that amount and if anything, it will simply encourage more monies to be diverted into deductions.

The problem of the budget deficit is a simple mathematical problem – and it really doesn’t even involve advanced algebra – the government wants to spend $XXX and needs to raise $XXX dollars to cover the expense.  The tax code is designed to bring in revenues, but more importantly, the tax code is written NOT with the idea in mind of raising enough dollars to cover expenses – it’s written in a way to influence the behaviors of the citizenry.

We complain, greatly, when we find out that not only did businesses like General Electric not pay any corporate taxes, but actually received money back from the government in credits – to the tune of $3.2 billion by the way!  But the same incentives corporations use to avoid paying taxes (or getting kick backs) are the same ones we as individuals also use – to a lesser extent.

If I apply surplus discretionary income to an Individual Retirement Account, or to adopt a child, or buy a home or a hybrid car, or have an energy efficient home improvement done, or give to charity, I can deduct it from my taxes.  As TurboTax tells me:

“We reviewed over 350 deductions and credits so you can be sure you didn’t miss a thing and that you got the maximum refund – guaranteed.”

What it all boils down to is that the Marginal Tax Rates that we fight so bitterly over is the equivalent of a shell game.  We need to abandon the bickering over single-digit percentage points and overhaul the tax code if we are to have any hope of instilling actual revenue-generation to fund the government.

First off, an agreement is required that the government should not be in the business of influencing or directing social/fiscal behavior – very much a libertarian stance.  Every tax credit or deduction amounts to nothing more than a governmental bribe to do a certain thing or behave a specific way.  How this was ever allowed to begin is beyond me and why we’ve allowed it to go on this long is just as bad.  I could be wrong, but I think the mortgage interest deduction has more to do with it than anything.  So if we agree that the government should not be able to dictate behavior with bribes, then we can address realistic tax rates.

While there have been Flat Tax advocates for years, the fact is a flat tax disproportionately taxes incomes at all levels and does not amount to a “Fair Tax;” but that leaves the definition of what constitutes a “fair tax” open to debate – so let’s start the discussion.

Let’s take a given that those earning less than the poverty line in America should not be required to pay income taxes.  This year for a family of four the poverty level is $22,350. As of 2009, 43.6 million Americans, or 14.3 per cent of the population, met that criteria.  Source

If a flat tax is not a fair tax, then the alternative is a progressive tax.  For what it’s worth, since the income tax was established in 1913, America has utilized a progressive tax. Yet a progressive tax, fairly applied, could provide equitable distribution of the tax burden. Again, any of these tax rates proposed are simply illustrative and open for debate.

22,350 (Poverty level) and below – no tax
22,351 – 50,000 – 7% on income beyond the poverty level
50,001 – 80,000 – 10% on income beyond the previous tax bracket
80,001 – 125,000 – 12.5% on income beyond the previous tax bracket
125,001 – 175,000 – 15% on income beyond the previous tax bracket
175,001 – 300,000 – 17% on income beyond the previous tax bracket
300,001 – 500,000 – 20% on income beyond the previous tax bracket
500,001 and beyond – 22.5% on income beyond the previous tax bracket

I think it is important to make the distinction that only the amount of earned income beyond the previous tax bracket is made across the income spectrum. For example, a family reporting earnings of $40,000 a year would only be required to pay 7% on $17,649, the amount above poverty level and not on the full amount of income. Similarly, a person that gets a raise from $120,000 to $130,000 would pay only pay the 15% tax rate on the $5,000 above and beyond the next lowest tax bracket.

In this example, the person reporting earnings of $130,000 would pay $11,310.50 in taxes. Here’s how it would work:

On income up to $22,350 – no tax
On income up to $50,000 – $1,935.5 (7% on $27,650)
On income up to $80,000 – $3,000 (10% on $30,000)
On income up to $125,000 – $5,625 (12.5% on $45,000)
On income up to 130,000 – $750 (15% on $5,000)

There shouldn’t be a disincentive, by landing in a higher tax bracket, on total income – only the income beyond the last tax bracket should be taxed at the higher rate.

This example shows that the tax rates presented may be slightly lower than needed to fund government operations, but the principle applies.

With tax credits and deductions eliminated, the tax code is simplified to a single page – in fact, the IRS could potentially be eliminated altogether. The downside is the potential rise in unemployment as tax firms and CPAs will no longer be necessary to assist in tax preparations.

Someone much smarter than I am might actually apply such a progressive tax to current American earnings and determine the actual amount of revenue such a progressive tax would provide the government, but the other side of the equation is to establish a budget that only spends based on realistic projections of revenues received.

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