Ask tax reformers what they most want from the tax code and you invariably get one answer. It doesn’t matter whether they’re liberal or conservative, progressive or libertarian. Everyone wants taxes to be simple and fair.
It’s a beguiling mantra. Unfortunately, it means radically different things to different people. As Congress gears up to tackle tax reform this fall, Americans will have to watch carefully. True tax simplification would broaden the income base, increase the number of people and corporations who actually pay into the system, demand more of high-income earners than low-income earners, and make filing simpler. Often, however, proposed tax reforms are simplistic – and unfair.
For example: Some in Congress argue that to be both simple and fair the income tax must be a flat tax. It’s an attractive idea: one simple form and one tax rate for everybody. Unfortunately, many flat-tax proposals presented in the past decade eliminated taxes on investment income altogether, which effectively shields a big source of income for the richest taxpayers. If Americans are worried today about millionaires and billionaires paying income taxes at rates effectively lower that the tax rates paid by their secretaries, what would they say when a flat tax kicks in and the disparity becomes even larger?
Other members of Congress are once again pushing the “fair tax,” which would simplify taxes by scrapping the current system entirely. Instead of federal income, payroll, and estate taxes, Americans would pay a national sales tax. This proposal does not consider how such a drastic change will accommodate other tax systems used by the United States and its international partners. States, most of which define income using federal standards, would have to institute new tax codes and tax return filing procedures, which would be even more complex for businesses and individuals dealing with multistate income and taxes.
Also, although the original Fair Tax legislation included a provision to preserve our tax treaty network (now over 60 countries), these countries would nevertheless terminate their US tax treaties for lack of a quid pro quo. People and companies with cross-border investments and business would be paying other countries’ taxes with no treaty relief. More complexity at the state level and higher taxes from other countries are too high a price for simplification.
Let’s hope that Congress doesn’t look to its last major overhaul of the tax code as the model for tax simplification. Although the 1986 Tax Reform Act was billed as simplification at the beginning, it turned out to be anything but. “The ’86 Act was not simplicity,” William Archer, former House Ways and Means chairman and an architect of the ’86 act, stated in a 2001 interview. “It created more complexities and more work for people who represent clients who have problems with the Tax Code.” Erwin Griswold, former solicitor general of the United States and dean of Harvard Law School, was even more succinct. He called the tax reform “a monstrosity.”
Proponents for the ’86 Act argue that it was simplification because over 6 million lower income taxpayers were dropped from the income tax rolls. This method of “simplification” has continued, due to the ever-increasing standard deduction and family deductions combined with stagnating wages, which has resulted in millions more dropping off the tax rolls. Today, 43 percent of US household units pay no federal income tax, allowing anti-tax proponents to claim, with some justification, that high-income taxpayers already pay most US income taxes.
But that claim is form over substance. In fact, America’s wage earners pay most of the income taxes (because US Social Security and Medicare taxes are also income taxes calculated on and deducted from employee wages). Added to these direct taxes on employees’ income are their employers’ share of Social Security and Medicare taxes and other employment taxes considered by most economists to be borne indirectly by employees through lower wages. And payroll taxes on wages have become the primary revenue source for the United States, as payroll taxes increased while other taxes have been reduced – and as multinational corporations maneuvered to legally avoid US income taxes. According to IRS revenue statistics, wage withholding (less refunded taxes) plus other payroll taxes exceeded 70 percent of the revenue collected in 2012, while for over a decade, corporate revenues have hovered around 10 percent.
The ’86 Act did create a fairer income tax by taxing investment income at the same ordinary income tax rates as wages. No tax professional expected these fairer tax rates to last long, however, because Congress didn’t delete from the tax code all of the provisions related to capital gains. Sure enough, lower capital gains rates crept back into the tax code. Then President George W. Bush pushed for and got a lower rate for dividends as well.
If Congress is really interested in simplifying taxes, it will reduce the multiple rate structure for individuals from four – single, married filing jointly, married filing separately, and head-of-household – to one, the norm in most countries with advanced economies. Just such a (revenue neutral) proposal was presented by conservative economist Milton Friedman to President Bush’s tax reform panel in 2005. Even National Taxpayer Advocate Nina Olson has pointed out in her report to Congress that a family-based system always fosters complexities.
Then Congress should adopt the unique “blank slate” tax reform approach outlined by Senate Finance Committee Chairman Max Baucus (D) of Montana and Ranking Member Orrin Hatch (R) of Utah. Under this approach, all tax expenditures (subsidies) would be eliminated from the draft reform bill and tax rates would be lowered accordingly. In order to be added back into the draft legislation, the deductions or credits would have to 1) help grow the economy, 2) make the tax code fairer, and/or 3) effectively promote other important policy objectives. Each permanent provision added back would result in measurable higher tax rates.
Finally, it should ensure that the tax structure is progressive, so that higher-income people pay a higher rate than lower-income people. There is nothing inherently complicated or new about this. When the income tax was instituted exactly one century ago, there were six tax rates. Over the next decade, that number grew to 54 plus a schedule of surtaxes (to fund World War I) – all done, incidentally, without the aid of computers, which weren’t introduced for tax return preparation until the early 1970s. The tax rates remained progressive for decades until Social Security taxes and the later addition of Medicare taxes became an increasingly important source of revenue making our tax system more and more regressive for wage-earning Americans. It is time to get back to a truly progressive tax system for America’s taxpayers.
As thousands of lobbyists begin to descend on Congress to protect their clients’ tax subsidies, we can remind our congressmen and congresswomen that they also represent the people who are already bearing most of the income tax burden, America’s wage earners, and that a truly fair and simple tax code should benefit them, too.
– Paula N. Singer is a tax attorney with Vacovec, Mayotte & Singer LLP and author of many articles in tax journals and 11 tax guidebooks published by Windstar Publishing (now Thomson Reuters).