Fiscal & Debt Crises – Tax Reform Essential!

May 27, 2011

G’Day!

Like our government, our federal tax system is broken (see “Is Our Government Broken?”). Our tax code is complex, unfair, damaging to our economy, and its thousands of pages of code are completely beyond understanding by all but a few highly specialized lawyers and accountants! On national television recently it was disclosed that 51% of AMERICAN HOUSEHOLDS PAID NO FEDERAL INCOME TAX last year, the so-called “rich” paid 76% of all income taxes, and 31% of households not only paid no income taxes but receive monetary benefits from the government. Less than half of households are paying for the services and benefits for the all the American people. Our federal tax system is broken and must be reformed as part of the solution to our fiscal and debt crisis. The basic goals of this reform should to stimulate our economy, simplify the tax code and its administration, broaden the taxable base so that all except those in real poverty pay federal tax, and is fair to the American people.

For over a century, federal income taxes were unconstitutional because our Founding Fathers believed that Federal Government should be limited. They believed (correctly as it turned out) that a direct tax on incomes would provide revenues that bureaucrats would find increasing ways to spend, triggering the desire for bigger and bigger government and more and more taxes! Our federal government successfully served the American people from the founding of our nation until 1913 without an income tax, fought several major wars, and we survived and prospered. It required the passage of a Constitutional Amendment (Article XVI) in 1913 to initiate the mess we currently have. In 1913 seven (7) tax brackets with rates from 1-7% were introduced. Five short years later under President Wilson, the top tax rate was 77%! President Coolidge reduced the top rate to 25% by 1925, avoided a post-war recession, and America enjoyed nearly a decade of prosperity. In the Great Depression under F.D. Roosevelt (FDR), while the economy stagnated, taxes were increased to a top rate of 81% by 1940 and reached 94% by the end of WW II.

History since 1913 has repeatedly shown that when income TAX RATES ARE REDUCED, the economy is stimulated, economic growth occurs, and FEDERAL REVENUES INCREASE! President Coolidge in the 1920s, President Kennedy in the early 1960s, President Reagan in the 1980s, and President Bush in the 2000s demonstrated this. The deficit problems following the more recent Kennedy, Reagan, and Bush tax cuts resulted from government spending that increased faster the increasing tax revenues. This provides further support to the original concern of our Founding Fathers that increased tax revenues lead to bigger government bureaucracy and control over economic and individual freedoms.

Our current and worsening fiscal and debt crises requires a comprehensive solution including significant reductions in government spending, major entitlement reform, and desperately needed tax reform to accomplish the goals above. Reform alternatives must consider sales (consumption) taxes, personal and business income taxes, social taxes (those designed to regulate behavior such as “sin” taxes and redistribution of income), “tax expenditures” (legal/loophole tax deductions for businesses and individuals), and government subsidies. The Congressional Democrats have no specific tax reform plan and Obama’s only consideration is raising taxes on the so-called “rich”, which is neither rational nor fair, will harm growth of our country, and cannot solve our deficit problem. Simply taxing business and the “rich” and giving revenues to the government to be redistributed is inefficient, wasteful, detrimental to job and economic growth, and encourages more companies and individuals to move offshore or find lawyers to “game” the system. Last year GE, with $14 Billion in worldwide profits, paid NO federal income tax, because of “tax expenditures” and government subsidies. This is crazy! Big businesses with big legal departments and lobbyists in Washington get tax relief and subsidies while the small businesses, which are the job creation engine of our country’s growth and future prosperity, are stuck with the high tax rates and no funding (unless you have friends in government or are part of stimulus plan).

Overly simplified, there are three basic reform alternatives to consider.

1) Retain but simplify our current “Progressive” tax system (the more you make, the higher the tax rate), eliminate or significantly reduce the deductions and government subsidies (thereby broadening the tax base), significantly reduce all the tax rates for both individuals and business, and eliminate the Alternative Minimum Tax (AMT). Our current system with extensive and complicated deductions also represents a “double taxation” on income, first at business level and again at personal level when profits or gains are distributed. It is important to realize that the US business tax rate is currently the highest in the developed world at 35% (China is 25%, Russia is 20%, Germany is 15%, Ireland is 12.5%) and foreign profits repatriated back to the US are penalized by being taxed at the higher US rate. The current system encourages businesses to move offshore where taxes are lower and to retain profits abroad rather than returning them to America for investment or distribution. This is a job killer not a job creator and leads to wealth creation abroad not in the US. Frankly, I believe business “income (profit)” taxes should be abolished or at minimum reduced to levels consistent with those countries with whom we compete. Reform of the current “Progressive” tax system is the basis for alternatives in the Bowles-Simpson Deficit Reduction Commission Report, “The Moment of Truth”, and ignored to date by President Obama and the Democrats (see Bowles-Simpson Have it Right!). Republican Paul Ryan’s House of Representatives’ approved 2012 Budget Plan, “The Path to Prosperity”, is also based on this approach. (My reservations with the Ryan budget are that it does not address Social Security reform and does not adequately address Defense spending.)

2) Adopt a “Flat Tax” (one low tax rate paid by all) combined with the elimination or significant reduction of deductions and government subsidies above and the establishment of a single low tax rate for individuals and business. It is neither “Progressive” nor “Regressive” based on income and does not penalize one class of citizens over another. Steve Forbes, Arthur Laffer, and Stephen Moore, among others, have proposed a “Flat Tax”. A low “Flat Tax” could accomplish all the goals above and reduce costs and increase compliance with the tax code by significantly simplifying both tax filing and administration. The tax reform in The Heritage Foundation comprehensive proposal “Saving the American Dream” is essentially a “Flat Tax” system based on income sources spent on consumption with an initial single low rate of 18.5% and deductions limited to education, charitable donations, and mortgage interest protection plus protection for low-income earners.

3) Adopt the “Fair Tax” (a tax on sales or consumption, not income), which abolishes income taxes on business and individuals and eliminates the need for the Internal Revenue Service (IRS). The US is the only developed country in the world without a broad national sales tax, usually called VAT. Currently a “Fair Tax” proposal in Congress would replace all federal income taxes on individuals and businesses, the Internal Revenue Service (IRS) would be abolished (a huge saving in administration expenses), and income tax withholding from wages would be eliminated. The new “Fair Tax” would be collected at the point of purchase like the current state and local sales tax. A “prebate” (advance monthly tax rebate) would be given to households on purchases up to the poverty level. Initially the tax would be levied at 23%. A “Fair Tax” treats everyone equally, would substantially reduce administration and compliance costs, greatly simplify the tax process, and allow more freedom of choice for consumers in purchasing and saving decisions. Equally important is the fact that a federal sales tax broadens the taxpayer base to include federal tax revenues from all non-citizens (including illegal immigrants) as well as US citizens making purchases within the country. A “Fair Tax” also encourages savings rather than consumption. “Americans for Fair Taxation” and Republican Presidential Candidate Herman Cain support this proposal.

Any of these proposals or a rational combination of them will accomplish the goals for tax reform stated above and stimulate economic and job growth for our country. Fortunately as noted above, there are several specific proposals available to accomplish this and adoption of any of them would be an improvement over the current system. I personally prefer alternative 3), the “Fair Tax”, followed closely by alternative 2), the “Flat Tax”, but neither may be politically viable. The “Fair Tax” in combination with either alternatives 1) or 2) is also a preferred option.

Tax reform is a vital part of any successful comprehensive plan to resolve our fiscal and debt problems. Let’s encourage our government to stop political bickering, get back to work, adopt one of the above, and get job growth and our economy back on track!

The Old Guy PhD