Funneling revenue to the government to support its various functions is a necessary bane to our form of society. There are legitimate political questions on how large or small, intrusive or essential the government has become, a discussion for another day. The issue here is what kind of changes can be made to the tax system to make it better?
Generally, taxes alter decisions about how to use resources, creating economic inefficiencies. By changing the relative attractiveness of highly taxed and lightly taxed activities, taxes impact decisions such as what to consume, how much to work, and how to invest. In some cases this is the intention of Congress and in others, it is the unintended results of their action.
The current Federal tax system has four main elements: (1) income tax on individuals and corporations (which consist of both a “regular” income tax and an alternative minimum tax); (2) payroll taxes on wages and self-employment income; (3) taxes on estates and gifts, and (4) excise taxes on certain goods and activities.
The Federal income tax, the most important revenue source, is based on an individual’s taxable income. An individual computes taxable income by reducing gross income by deductions allowable in computing adjusted gross income (AGI), and then uses a standard deduction or itemized deductions, and the deduction for personal exemptions.
Graduated tax rates are applied to a taxpayer’s taxable income to determine the income tax liability. Lower rates apply to net capital gains and dividends. A taxpayer may also be subject to an alternative minimum tax and may be able to reduce income tax liability by certain tax credits. Seems complicated?
It is no surprise the tax law takes a very expansive view on what is income. Gross income includes "all income from whatever source derived”. How is that for legislative drafting? There is quite a list of enumerated income items in the Tax Code as illustration, and courts have consistently given a very broad meaning to the definition of income, interpreting it to include all income unless a specific exclusion applies.
The starting point for a better system is to do away with all the items excluded from gross income.
The list of income exclusions is long and expensive to the Treasury, but I suggest no more excluding: gifts and inheritances, life insurance proceeds, sale of a residence, interest on state obligations, group-term life insurance, adoption expenses, compensation for injuries, health plans, meals and lodging, cafeteria plans, educational assistance plans, dependent care assistance programs, income earned abroad and my favorite-- the parsonage allowance.
Make it simple. If it looks like income, it is. I know, some of these exclusions are sacred, but they are all measures of income - a benefit to the person. The only exception to be made involves the receipt of retirement, annuity, and social security payments. Plus, there needs to be some more thought on the inheritance and gift exclusion or at least a special way to pay any tax to prevent forced asset liquidation.
With gross income in hand, the concept of adjusted gross income, a contrived notion, is the next to go. These are the so-called “above the line” deductions. Get rid of them all! No more IRA deductions, student loan interest, tuition and fees, educator expenses, expenses for performing artists, health savings accounts, moving expenses related to a new job and alimony. Gone into the dustbin.
The new tax code is already now simpler, and we can make some adjustments later on to accommodate a few of these matters.
Before we get to the most important part, let’s dispose of a few more items in a kind of housecleaning.
The Alternative Minimum Tax (AMT) requires taxpayers to compute their taxes twice and pay the higher of the two amounts. The AMT affects about 33 million taxpayers, but its impact is forgiven every year for the most part by a “patch” raising the threshold limit. Although the AMT was enacted to prevent high-income taxpayers from escaping tax liability through tax preferences, its applicability now is gone. Repeal it. Save the time, effort and complication and the budget hypocrisy.
The Tax Code has multiple provisions regarding savings for retirement. There are different sets of rules governing eligibility, contribution limits, taxation of contributions and distributions, withdrawals, availability of loans, and portability. Simplify it; make it one-size-fits-all.
More than half of all individual income tax returns are affected by the phase-out of certain tax benefits as a taxpayer’s income increases. Phase-outs are simply back door tax increases and are burdensome as well as deceptive. Get rid of all of them. A relic of the past tax games played.
Finally, individuals may reduce their tax liability by certain tax credits. Tax credits are allowed for certain business expenditures, foreign income taxes, dependent children and child care expenditures. In addition, there is a refundable earned income tax credit, which is an income transfer program for lower income taxpayers akin to a quasi-welfare program. If government wants to provide for lower income assistance, do it outside the tax system. Get rid of them all and while at it get rid of all personal exemptions, child exemptions, and additional exemptions based on age. The new system makes all of this unnecessary.
People hold different opinions as to whether the current rate structure is equitable. Some believe the rate structure should be more progressive, and effective tax rates should rise with income more rapidly than they do under the current system. The next installment, will discuss equity, fairness, distribution and characterization of different sources of income.
Jack. O. Nutter is a partner in the Washington DC firm of Nutter & Harris. Mr. Nutter is former tax counsel to the U.S. Senate Finance Committee. His further comments on tax, economic and political issues can be found at jacknutter.com and can be reached by e-mail at jack.o.nutter@gmail.com
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