Tax Reform

I preface by noting both that I realize that there is no such thing as fairness in taxation, that taxation is  theft governed by the law of the jungle, and that government is a necessary evil that should be kept as small as possible. The best taxation policy would be to shrink government to its proper functions and then argue about what sort of taxes should support that much smaller entity. However, I also realize that most of my countrymen disagree with me, and that such a large shrinkage is not likely to happen anytime soon. (We may get lucky and get back to something like the situation in the Clinton administration after the next election, but anything better seems a long way off.)  That being so, it might be a good idea to look at the present tax code and see what could be done to make it a bit simpler and less crippling and perverse.  

The personal income tax is usually the first one people think about. Here simplification has potential benefits apart from removing perverse incentives and economic distortions in reducing the money and man hours spent annually on tax preparation and compliance, money and time that almost no one outside the accounting business would see as productively spent. A significant  simplification would be to have a system treating all sorts of income as nearly equally as politically possible  with as few brackets as politically possible.  

In the line of treating all income equally, it would make sense to tax dividends and capital gains at the same rate as other income.  Leftist critics of the present system are right about this. However it also makes sense to tax only real capital gains, not phantom ones due purely to inflation. A solution would be to convert the purchase basis of sold assets to an equivalent value in present dollars using a table of inflation rates and pay tax at one’s full rate on the difference between that more nearly accurate basis and the selling price.  There is also a problem in terms of equal treatment with dividends – the problem of double taxation. The corporation pays taxes on the earnings it distributes in dividends, and then the recipient pays income taxes on those dividends.  A solution here would be either not to tax the corporation on dividends (since the corporation does not keep the money but merely passes it through to stockholders)  or to tax both the corporation and the recipient on half of the dividend at the full tax rate (which would deal with the supposed problem of the money being completely untaxed if the recipient were tax exempt).

Then  there are the deductions, most of which would be good targets for elimination if one’s goal were simplicity and equal treatment. The deduction for state and local income taxes is an obvious one to kill. It is hard to see anything particular about that  tax that should earn  it special treatment not given to other taxes collected by states, counties, and cities. The deduction  serves chiefly to make the state and local bite a bit less burdensome for rich people living in California,  New York City, and a few other high  tax locales.  That also may explain why it has never been touched. On the surface there is more to support the deduction for property  taxes on homes, since having  a higher proportion of property owners in the population  is generally a good thing, and this deduction is supposed to make buying a house easier.  The same arguments support the deduction for interest paid on mortgages.  However, given the fairly high present standard deduction, both seem in practice  to be more tax breaks for wealthier people buying expensive houses than help for middle income people to afford a house. This is also the case for the deduction for vacation homes. Besides it is not  easy to find reasons  that a renter should necessarily pay more taxes than a mortgagor with the same income. A portion of his rent certainly goes to cover the interest and property tax expenses of the landlord.

The present exemption for the employee for health insurance paid by the employer is one that never should have existed in the first place, since its unintended consequence of  tying health coverage to one’s job is one of the main  causes of the present mess in health care in the country.  The same goes to a lesser extent for the various other types of insurance offered in company’s cafeteria plans. 

IRA’s, 401’s, and their various cousins present an interesting problem. The simplest course would be to eliminate their tax benefits since they seem to serve mainly as benefits for savings by prudent people who would have saved anyway.  It is not clear  that very many irresponsible people  are persuaded to save by the tax breaks. A  counter argument is that even the careless get old, and that at least the mandatory and company funded plans should keep their favored treatment. This would make more people less dependent on social security, which would have benefits. Either way  there would need to be a transition period when money already in these plans was treated as promised.

Ending deductions for charitable contributions would be controversial, but there are good reasons for doing so, starting with the fact that the organized charities and non-profit organizations are already advantaged in the tax code by being tax exempt themselves. Additionally, given the large standard deduction, the biggest benefits from the deduction go to wealthier people. Also from the viewpoint of equal  treatment and effectiveness, it is hard to see why the tax code should disfavor a direct donation to poor or needy people in comparison  to one funneled through a organization that takes its own cut before the recipient of the charity sees anything. (Right now, for example, if someone buys an impoverished  single mother a presentable outfit to wear to a job interview or gives a poor college freshman a few hundred bucks to help with the cost of books, it is certainly a charitable contribution, but not a deductable one.)

Doing all this would lead to a simpler income tax for individuals and to some quite low yet revenue neutral  tax rates. I think it would also be less distortive and deliver fewer unintended consequences. The next step would be to hack into the jungle that is business and corporate accounting and tax law. That’s where it would get really complicated.  However simplifications and benefits could  be had there as well, over time.

Of course none of this is likely. Politicians seem to like the present mess and enjoy both the present tax code and offering favored constituents ways to finesse it .