The Real Solution To Tax Reform

The Capitol Building from the East

The subject of income tax is as polarizing today as it has always been. Nobody disputes the need for tax revenues to fund the government, nor do many dispute the fact that our current income tax system is in desperate need of an overhaul. The problem comes when we try to find a solution to the problem.

The left promotes a “tax the rich”, class warfare philosophy and uses cute little talking points suggesting that the rich don’t “pay their fair share”. The right promotes a philosophy that tax cuts are the solution to every problem, whether it’s health care, the deficit or national defense.

Personally, I don’t subscribe to either philosophy.

The idea that tax cuts are always the answer is flawed. There are many more components that affect economic growth than just taxes. Historically speaking, however, the philosophy of lower taxes being beneficial is far more rooted in reality than the alternative. When the Bush tax cuts were implemented, federal income tax revenues did dip slightly for the first two years, but in the following three years, GDP growth accelerated significantly and tax revenues increased at an even faster rate.

During the Great Depression, FDR implemented massive increases in Government spending and taxes on the wealthy. This resulted in a short term boost of the economy. Within three years however, the economy stalled again and the stock market experienced a second crash in 1937. Even when the economy had started to improve, the unemployment rate never dropped below 17%. This can hardly be characterized as successful economic policy.

Some point to the Clinton-era tax increases to support the notion that higher taxes help the economy. The problem is that those same people tend to ignore the most important facts. After the Clinton tax increase, GDP and tax revenues both grew almost as much as after the Bush tax cuts, but there were two important differences. The first is that the economy was booming during the mid-90s due to the tech boom, which would have happened regardless of tax policy because it was created through technological innovation.

The second important fact is that most of the increases in revenues came from capital gains taxes, which were lowered, not raised. These revenues were disproportionately higher than the revenue from the marginal tax rates that were increased and were largely responsible for the significant increases in federal income tax revenues.

The mechanics behind this are simple. Consumer Spending is what drives the economy. Anytime you take less money from taxpayers, they will have more to spend. When Consumers spend money, it creates demand in the market, increasing revenues to businesses which provides them with the capital, and more importantly, the need to expand and hire more workers.

This is why our economy is still struggling today. Despite the American Recovery and Reinvestment Act, which was touted as the solution to our economic woes, Consumer Spending has stayed flat. The reason for this is also simple. Government spending does not drive the economy. It can provide a small and temporary boost, but it is exactly that. Small and temporary. This is because it is not sustainable economic activity. It is finite, and will not last. True economic growth comes when Consumers voluntarily spend their money on products and services that they want or need.

Now, the notion that tax increases are the answer is just absurd. First, we couldn’t raise taxes high enough to make a significant impact. Raising taxes on the wealthiest, even if all things were equal, would generate no more than $500-$700 billion in additional revenues over the next 10 years. That’s only about 1% of our spending over the same period.

Secondly, many seem to forget that the higher you raise taxes, the more taxpayers change their behavior to minimize the impact. The left assumes that economics is a zero sum game where raising taxes will result in an equal increase in revenue. This is absolute folly. Raising taxes never results in the amount of additional revenues that are forecast (the Clinton hikes only provided about 60% of the revenues that they claimed it would).

Raising taxes on the rich is a stupid idea for more reasons than that, but also not for the reasons that most Conservatives claim. It’s not that the rich go out and start or invest in businesses when their taxes are lower (although they do). It’s a stupid idea because rich people spend money, and generally in much larger quantities than the poor or middle-class. Once again, Consumer Spending.

It’s a universal truism that regardless of whether or not someone is rich or poor, the more money they have to spend, the more will be pumped into the economy, thereby creating jobs in the process. We may be able to get away with raising taxes a little in a good economy, but in a bad economy, it’s a disaster waiting to happen. Just ask FDR.

The only thing more absurd than the idea of raising taxes is the notion that the rich don’t “pay their fair share”. I’m sorry, but anyone that regurgitates this particular talking point is either a hardcore ideologue, just plain ignorant or both. I pulled the 2008 income tax data from the IRS and put it together in the table below to illustrate how absurd this notion is. This is only income tax data, so it does not include other taxes such as the payroll taxes for Social Security and Medicare, but those are separate issues. This chart shows the following data by income range:

  • Number of Tax Returns Filed (and percentage of total)
  • Adjusted Gross Income (and percentage of total)
  • Taxes Paid (and percentage of total)
  • Effective Tax Rate
  • Taxes Paid to Income Earned Ratio – This goes to the “fair share” claim. If someone is paying their fair share, the taxes paid would be equal to their income earned (meaning 100%). A ratio higher than 100% would mean they are paying more in taxes than their earnings and ratio of less than 100% would mean they are paying less.

(Please note: data totals do not equal the totals at the bottom due to overlapping income ranges.)

2008 Personal Income Tax Data
2008 Personal Income Tax Data - Source: IRS.gov

Look at the first line. Those evil, greedy rich folks that make $1 million per year or more earn 16.6% of the income, yet pay 23.6% of the taxes. Their tax to income ratio is 141.9%, meaning that they pay almost 42% more in taxes than the share of income that they earn. From a broader perspective, the 0.3% that are the highest income earners pay almost one quarter of the tax burden. Is that fair? It is if you’re a Liberal (or more accurately, not “fair enough”), but I suppose that’s because the rest of America has a different definition of the word “fair”.

Conversely, those that make less than $50,000 make up 54.7% of taxpayers, earn 14.4% of the income, but only pay 9.2% of the taxes. The ratio for this group is 64%, meaning that they pay about 36% less in taxes than their share of the income. The numbers only get worse if you look at the lower income ranges. Once again, is that fair?

Let’s make it really simple. If you earn $50,000 per year or more, you are paying not only your own taxes, but also a large portion of the taxes for the people that earn less than $50,000.

Perhaps I’m stupid, but I was under the impression that “fair” means that something is effectively the same for everyone. Our tax system is not fair. Our tax system is a convoluted, progressive system that punishes success and has so many loopholes that it cannot possibly put all taxpayers on a level playing field. I absolutely agree with the left that there are many that don’t pay their fair share. The problem is they have it backwards. If anyone is not paying their fair share, it’s the lower income earners, not the higher ones.

The Solution

The solution is simple. We need more tax revenues, but we don’t need higher taxes. We need more taxpayers. We also need to level the playing field so that everyone pays their fair share and doesn’t have to pay more than they should to support someone who pays less. How do we fix it? Simple. Abolish the current tax code and implement a new code that requires all taxpayers to pay the same rate with no deductions allowed. This is not something that can be accomplished overnight simply because it is a drastic change, so it would probably be more prudent to phase it in gradually over a couple of years.

To illustrate my point, I created a rough example. I had to estimate some of the income numbers because the IRS provides adjusted gross income (after deductions) but not the pre-deduction gross incomes. To do this, I used the mean income per income range. I know it’s not exact, but it should be close enough to show that after making small adjustments based on actual numbers, it would solve the problem.

The new, single page tax code would look like this: All personal income is taxed at a rate of 12.5%. There are no exceptions, deductions, loopholes or credits. If you make $10,000, you pay $1,250. If you make $100,000, you pay $12,500. If you make $1,000,000, you pay $125,000. The only way you get a credit is if you overpay. We’re not giving you money because you decided to have a kid this year, nor are we giving you money because you’re poor. Sorry, but welcome to the real world, where everyone is required to pull their own weight.

Using the rough calculations mentioned above, based on 2008 data, a 12.5% tax rate for all taxpayers, with no deductions would be almost exactly revenue neutral (it would actually generate about $6 billion more). As previously stated, it would also be a very small increase for the lower income folks (from 12.2% to 12.5%). By contrast, the $50k and up crowd would see a decrease from 20.3% to 12.5%.

Corporate taxes could and should be addressed in a similar manner, but that subject has its own eccentricities, so I’ll leave that discussion for another day.

Implementing this type of a tax code would benefit everybody. Done correctly, it would be revenue neutral so it wouldn’t negatively impact current government revenues, but it would ultimately result in future revenue increases by stimulating Consumer Spending. It would make our economy stronger by not artificially inflating certain economic activities through tax incentives (the home mortgage interest deduction is a factor that contributed to our financial crisis by making it easier for people to buy homes that they couldn’t afford).

It would create more taxpayers while lowering rates for a significant percentage of Americans. While it would raise taxes on many, it would also reduce taxes for many. Since there are far more taxpayers in the lower income brackets, the increases would be much smaller per taxpayer than the reductions would be for the higher income earners.

It would make the tax code simple and put everybody on a level playing field, where everyone pays the same percentage of their income, regardless of how much or little they make. It would save taxpayers money because they would no longer need to pay for tax preparation services to navigate the myriad regulations and rules.

It would also save taxpayers money by dramatically reducing the size and scope of the IRS. We would need far fewer IRS agents and could re-task many of them to chase down the $400 billion or so in taxes that are owed to the Government but have not been collected.

The biggest benefit is that would finally end the agonizing, painful, partisan debate in Washington over taxes. Our politicians could finally use a phrase that they have never been able to:

“Problem solved.”


+Kevin A. Nye

Comments are welcome. Please feel free to keep the stupid ones to yourself.