Making Cents: A Tax Philosophy

To be sound, a tax system must be economically efficient, inflicting as little damage as possible on the economy.

Every tax system distorts economic decisions and leads to less economic activity than otherwise would occur, resulting in what economists call “deadweight loss.” These are the costs caused by distortion to working, investment, entrepreneurship, and other productive activities. The CBO says that “typical estimates of the economic cost of a dollar of tax revenue range from 20 cents to 60 cents over and above the revenue raised.” Harvard’s Martin Feldstein has gone so far as to conclude that the deadweight burden caused by incremental taxation “may exceed one dollar per dollar of revenue raised, making the cost of incremental government spending more than two dollars for each dollar of government spending” (National Tax Journal, June 1997)

What is more, applying different tax rates to different activities or to different producers exacerbates the distortion of economic decisions and increases the deadweight losses due to the tax system.

A sound tax system should be designed to minimize these losses.

Less Fuss:

A sound tax system should be logistically economical. It should impose the smallest possible compliance costs on taxpayers, and should minimize any extraneous administrative bureaucracies.

Every tax system imposes direct costs on taxpayers in terms of time devoted to tax preparation or money to buy the services of CPA’s. Ultimately, every tax system diverts a portion of tax revenues raised by the tax to pay the cost of administering and collecting the tax and enforcing its provisions. A sound tax system would minimize these costs.

What it takes:

Pay what you owe: An economically neutral tax is unbiased across the spectrum of economic activities.

Removing complexity and limiting the collection points for taxation also makes the system more transparent, making the public more certain that everyone is paying what they owe, and more comfortable with the fairness of the system.

Transparency: A tax system is transparent to the taxpayers if it is clear how much the government is costing them (and who is paying for what). Without transparency, the public isn’t able to accurately asses how their money is being spent and thus isn’t able to hold their representatives appropriately responsible.

14th Amendment Redux: Equal treatment under the law. Equality of opportunity should be the linchpin to our tax system, not equality of outcomes. The tax system shouldn’t be manipulated into an instrument of wealth redistribution or social engineering.

Simplicity: A tax system shouldn’t be gratuitously complicated beyond what is required Simplicity is the best sort of medicine for the tax-inflicted headache.

To be sure, the most visible, fluid tax systems are the most neutral and simple. Just a little bit effort by the citizens should be required in paying taxes. This is a necessary evil. Otherwise, the government could do and take whatever it wanted. Citizen-voters have a minimal responsibility, if not civic duty, to participate in this, a fundamental component of democratic society.

So, how’d they do?

The president's tax-reform panel submitted its two long awaited final proposals November 1st to the Treasury Department. Both plans offer changes to the tax breaks people have come to expect -- as well as to the complexity and costs of filing that many have come to loathe.

The panel's task was not to reduce taxes, but to make the tax code simpler, fairer and better equipped to promote economic growth. The president also told panel members that any proposal would have to be revenue neutral.

Plan A works with the current income tax system to:

Summarized by the Tax Foundation

  • Simplify the current tax code from six tax brackets to four (15%, 25%, 30% and 33%);
  • Replace the current low-income tax credits with a family credit and a work credit;
  • Fold the individual Alternative Minimum Tax into the current system by repealing the AMT, while repealing the deduction for state and local taxes;
  • Replacing the home mortgage interest deduction with a limited credit;
  • Limit the tax exclusion for employer-provided health insurance to $11,500 for families and $5000 for singles;
  • Consolidate the various savings vehicles into three simple savings plans while eliminating the tax on dividends paid by corporations from domestic profits and providing a 75 percent exclusion for capital gains; and
  • Cut the top corporate income tax rates to 31.5 percent from 35 percent, move to a territorial tax system, and repeal the corporate AMT.

Plan B follows A’s suggestions, but with these additions:

  • Move toward a progressive “hybrid” income-consumption tax with three individual rates (15%, 25% and 30%);
  • Tax all capital income (dividends, capital gains, and interest) at a uniform 15 percent;
  • Replace the corporate income tax system with a “cash-flow” tax at a rate of 30 percent;
  • Allowing full expensing of capital investments; and
  • Eliminate the deduction for interest payments for businesses.

Hopefully these recommendations will get the ball rolling on fundamental tax reform in the very near future.

By Julie Kesselman