Tax Reform: Broaden the Base and Ditch the Credits

This is the second of three articles on how to revamp the tax code

 

Funneling revenue to the government to support its various functions is a necessary bane to our form of society. There are legitimate political questions and differences on how large or small, intrusive or essential the government has become. However, we can all agree, government does need some money to move around and redistribute. 

Congress has been discussing reforming the tax system for years. Now with the expiration of the so-called Bush tax cuts, payroll employee tax reduction and much more scheduled for next year, Congress will have to make major decisions regarding the tax code. It is likely to be after the election at the earliest and at the latest after the time a new Congress and perhaps a new Administration is installed.

The issue here is what kind of changes can be made to the tax system to make it better? There are fundamental differences between Democrats and Republican on what defines tax reform and where the tax burden should be imposed. However, it is generally assumed that both sides may be receptive to the concept of broadening the tax base by elimination tax preferences and lowering rates. For the time being, let’s leave rates out of the equation.

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 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”. 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.

A starting point not usually discussed, as part of tax reform 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.

With gross income in hand, the concept of adjusted gross income, a contrived notion, should 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.

The new tax code is already now simpler more fair and broad based but in the final details some adjustments may be needed to accommodate a few of these matters.

A few more items need 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.

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.

In addition, repeal all notions of personal exemptions, child exemptions, and additional exemptions based on age. A truly reformed broad based, low rate system makes all of this unnecessary.

Of course, this radical approach would be almost impossible to enact. However, the concept of base broadening and simplification should be imbedded in the process and the results