"As Washington scrambles to find the 'just right' package that will allow enough of Congress to vote for an increase in the debt ceiling, some leaders have asked those Americans who make more money to be willing to pay more taxes, calling for fairness to be reflected in the tax code. However, new research from Bruce Yandle finds that from 1979 to 2007 the individual income tax burden on the...
Can the Tax Code Be Less Taxing?
In 1913, United States Federal Income Tax laws filled four hundred pages. By 2013, they numbered 73,954, a sign of increasing complexity. At fault: numerous deductions, credits, exemptions, special interest loopholes, and tax laws that change almost daily.
Many agree that the tax code is a mess and needs fixing, even as far as completely scrapping the system for something simpler. The question also arises of how to make taxes more "fair," whether by making the rich pay the most, or by having everyone pay the same rate, for instance. The difficulty comes in agreeing on the best plan and finding enough support to implement a change so large, it would inevitably cross special interests no matter what the proposal.
U.S. income taxes date back to the Civil War. In order to pay expenses, the Lincoln administration imposed a graduated income tax: three percent on those making $600 to $10,000 and five percent for those making more than $10,000. The income tax fell out of favor after several years, with a brief reintroduction in 1894 before being declared unconstitutional in 1895. Until 1913, ninety percent of tax revenue came from alcohol and tobacco sales.
Enter Form 1040. The passage of the 16th Amendment in 1913 allowed the federal government to directly tax income without dividing revenue equally amongst the states or referencing population size. Rates were low, with one percent levied on earnings over $3,000 and a six percent surtax on earnings over $500,000. Later, the expenses of World War I spurred Congress to lay a progressive tax going up to seventy-seven percent. Still, the proportion of American income taxpayers was small.
The Revenue Act of 1942 broadened the scope of who was taxed and introduced medical and investment deductions. Due to needed revenue for World War II, the Current Tax Payment Act of 1943 forgave a portion of taxes from the previous year and made employers withhold income taxes to pay quarterly. This way, the federal government could collect revenue throughout the year rather than waiting. By 1945, over twelve times as many income tax returns were filed as five years earlier.
According to a past U.S. Department of the Treasury Facts Sheet, withholding "also greatly reduced the taxpayer's awareness of the amount of tax being collected, i.e. it reduced the transparency of the tax, which made it easier to raise taxes in the future." One reason for this, as some point out, is that paying smaller portions throughout the year and getting a refund is less painful than writing one big check at tax time. New York Fed chairman Beardsley Ruml had similar thoughts when he suggested his withholding plan during the war.
In the 1980s, President Ronald Reagan made a big push for tax reform, uniting Congress to pass the Tax Reform Act of 1986. This lowered the income tax and raised the capital gains tax so that both equaled twenty-eight percent. This attempt at fairness closed loopholes for the rich and eased taxes for lower income earners.
Rates have fluctuated since, with an overall drop in the percentage paid. At the same time, complexity has proliferated, and complaints continue about the richest not paying their fair share. For example, the Buffett Rule (so-named because Warren Buffett said he paid a lower tax rate than his secretary) targets top earners who lower their rates below the national average by hiring experts to find tax loopholes.
Aside from policy issues, simply reducing tax code complexity would save valuable resources and increase tax revenue. Yearly costs of income tax preparation have been estimated at $107 billion, or one percent of GDP, and time required for paperwork equal to 3.19 million full-time jobs. Cutting these administration costs would mean money to spend elsewhere in more productive activities than paperwork. It also appears that more people comply with a tax code that is less complex.
Perhaps the simplest proposal for change is an across-the-board flat tax. Robert Hall and Alvin Rabushka made the idea popular in their 1982 book, The Flat Tax. They proposed to replace the progressive income tax with a nineteen percent flat tax across all income levels except the poor's. There would be no loopholes or deductions, and a tax return could be filed on a postcard.
Such a tax removes the problem of double taxation and penalties on saving. Proponents believe incentives like these change economic behavior and encourage greater production. The flat tax also ends special-interest favoritism by taxing everyone at the same rate. However, this would mean a new pinch for close to half of Americans, who pay little or no income tax under a progressive tax system. It would also increase income inequality.
Eastern Europe became a testing ground for the flat tax in 1994, first with Estonia, followed by Latvia and Lithuania. Countries making these reforms had initially good results. Russia's low flat tax coincided with better compliance and significantly higher revenue, which led to a boom of other countries adopting the flat tax. However, some say it is hard to tell if European improvements resulted from the flat tax or other, simultaneous tax reforms.
As time went on, the excitement about the flat tax declined. Slovakia, a poster-child for low flat rates, replaced them with a progressive structure during its 2013 austerity measures. This was despite experiencing stable tax revenues, lower unemployment, and higher economic growth. The change signaled a push for income equality.
A national sales tax, or Fair Tax, is similar to a flat tax, but takes revenue from a different source—the point of purchase rather than of income. Therefore, those who buy more items pay more taxes; those who save money pay fewer. One popular proposal has been a twenty-three percent sales tax on the price of goods. These proposals typically include a "prebate" based on the poverty level to make allowance for buying food and necessities.
While some see a national sales tax as an interchangeable alternative to the flat tax, others believe it would result in tax evasion because of the high sticker price. Reformers also warn that, without first repealing the 16th Amendment, a national sales tax could easily turn into an additional tax on top of the current income tax. A national sales tax would force the government to pay taxes on the products it buys, as well, which can be seen as either a positive or negative.
The value-added tax, or VAT, is supposedly easier to collect than a sales tax. The VAT adds a percentage of tax along each stage of production rather than sticking a full tax on the final price. While some would say this hides the sticker shock of a one-lump sales tax, others point out that the tax goes into the final purchase price and costs the same as a sales tax in the end.
Because of its efficiency, the VAT encourages more government spending. In Europe, a VAT usually exists alongside the income tax, making it an extra tax. VAT and sales taxes are also criticized for their regressive nature. Because the rich can spend a smaller proportion of their income, they would theoretically pay a smaller percentage of their income than the poor in taxes.
An alternative to flat, sales, or VAT taxes is the semi-progressive but relatively simple and successful tax code of Hong Kong, which one researcher points to as a model poorly understood by Americans. Beginning in about 1955, the region employed a system of basic deductions and exemptions. It included four tax brackets based on wage level and a flat rate for corporate profits. The government kept filing down to a one-page online return while maintaining a healthy economy.
Despite discontent with the current tax code, garnering enough support for fundamental reform has proved challenging. However, proposals will likely continue to be made as taxpayers look for new solutions and reassert old ones.
This topic surveys the basic history and problems of the current tax code and explores some of the major proposals for reform.
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