The Hybrid Tax Reform Plan

The personal Tax Code contains both Payroll Tax (FICA) and Income Tax components. Based on the fiction that FICA somehow funds a pension plan and a medical insurance plan, discussions of the share of total tax paid by various groups of taxpayers usually ignore FICA. One hears misleading statements like "The top 10% of taxpayers pay 70% of all income tax."  But FICA is every bit as much a tax as income tax.  It currently accounts for more than a third of annual federal revenue. That it is somehow earmarked for Social Security benefits does not negate the fact that it is a tax. Avoid it and you can go to jail.

FICA is a regressive flat tax.  Income tax is a progressive graduated tax.  Chart 1 shows the combined effect in each bracket for single self-employed taxpayers.  Having different rules for the same total earnings causes justifiable resentment. The deduction for mortgage interest deters people from having high equity in their homes, which would tend to stabilize the economy in downturns. The corporate income tax slows economic growth and sends companies overseas looking for better deals.

A new system dubbed The Hybrid Tax solves all those problems. The whole thing can be summarized in a few lines:

• 1. Hybrid Vigor: Replace the current tax code with a mixture of a flat part and a progressive part. Exact marginal rates and bracket lines should be set after suitable analysis of expected revenue.
• 2. Level Playing Field: Eliminate differences based on type of income or loss, family structure, or type of employment.
• 3. Bulwark Against Recession: Create a tax credit based on home equity instead of interest deductions to encourage people to owe less on primary residences.
• 4. Pro-Growth: Eliminate the corporate income tax for American firms.

 Technical notes:

Tax rates used for the combined FICA and Medicare payroll tax, respectively the Medicare tax alone, are 14.13%, instead of 15.30%, and respectively, 2.68%, instead of 2.90%, which reflects the fact that half of these are deductible from taxable income above the line. (14.13% = 15.3% x (1-7.65%); 2.68% = 2.9% x (1- 1.45%)). Upper bracket self-employed taxpayers may pay $2000 or so less in total dollars because they get to deduct $7630.

 Is the Current System Fair?

The most striking thing about Chart 1 is the bulge between $34,000 and $106,800, which affects most middle class taxpayers. This flies in the face of fairness in a supposedly "progressive" tax code.  Sometimes liberal critics do point out that the payroll tax falls most heavily on low income taxpayers but they seem not to get just how bad it is. Perhaps it is because those same critics cling to the myth that Social Security is some kind of pension plan which you pay into when you are young and withdraw from when you are old.

The injustice of the bulge in the bracket structure is even worse than it looks. Since FICA and Medicare are payroll taxes, few deductions apply, so that the deductions which reduce the impact of the higher brackets do little for lower bracket taxpayers.

The unfairness of the tax system and much of its complexity come from a combination of a few things:

1. The bracket structure is based on what kind of family one belongs to, and includes the much reviled marriage penalty.
2. Some important deductions are not available to self-employed individuals. Being self-employed is part of the American Dream. Yet the tax code penalizes that as compared to being an employee.
3. The rules governing the "phase-out" of certain deductions as income rises are confusing and seem arbitrary and capricious. Their complexity gets in the way of sensible financial planning.
4. The Alternative Minimum Tax is an abomination. It is a particularly nasty way to deny deductions to successful people.
5. FICA has a ceiling and most deductions don't apply to FICA.
6. Earned Income and Investment Income are treated differently.

These can be categorized politically quite easily. The first four are hated by conservatives and loved by liberals. The last two are just the opposite. Naturally, there is some crossover due to individuals being particularly impacted by one or more of these issues.

It would be helpful if liberals and conservatives could agree on some general principles by which to measure fairness. Here are a few suggestions.

• Recognize that FICA taxes are part of the overall income tax burden. There is no reason to change anything else about how Social Security and Medicare are financed.
• Treat all taxpayers equally with respect to marital or family differences, source of income, and employment status. All disparate treatments come with a set of justifications. Every ox should be gored equally. The ability to deduct the cost of health insurance is the most important form of discrimination based on employment status. The impact of itemized deductions is diminished once the bracket structure and FICA treatment are fixed.
• The deduction for home mortgage interest has always had the perverse effect of incenting people at all income levels to owe money on their homes. Typically, the tax code should not be used for social engineering. In this case however, encouraging people own their homes outright (or have high equity) is important enough for an exception. It may even prevent or soften some economic downturns. A tax credit based on home equity would probably be a fair way to accomplish this.
• The preferential treatment accorded capital gains is a source of resentment among working people. There are many good arguments for this preference, but it smacks of welfare for the rich. To avoid that rancorous argument, eliminate the special treatment of gains. In return, allow unlimited deductions of capital losses from ordinary income in any year they occur. Positive and negative income should be treated symmetrically.

The Corporate Income Tax 

The current code is more than 10,000 pages long. Its very length and complexity makes compliance and enforcement difficult and expensive. It is easy to see the revenue raised by the major sections of the tax code. The figures below are for fiscal year 2010 from the OMB website.

Personal Income Tax                                                  $956B                         44%

Payroll Taxes (Social Security, Medicare)                     $746B                         34%

Corporate Income Tax                                                $198B                         9%

Other                                                                        $273B                         13%

Total Receipts                                                            $2.174T                       100%

Projections are not the subject of this article. But it is stunning that the OMB projects personal and corporate income tax revenue (in constant dollars) to increase by a factor of more than 2.5 in the next decade. How can anyone believe that prediction given today's economic conditions? Supposedly, that rapid growth will keep the debt from exploding even more than it already is. But it is no more than a wish and a prayer.

Look at the Corporate Tax. Nominally, it is set at 35% of corporate profits, but in 2010 amounted to around 11% of reported profits. As a share of tax revenue, it raised a mere 9% of the total.  Costs of compliance are enormous. It is hard to know which estimates to trust, but surely the many billions of dollars spent on compliance could be put to more productive uses. Shareholders can be taxed on dividends and gains. There is no reason to tax corporate profits too. Just eliminate the corporate tax entirely. All the associated record keeping, tax planning, foreign relocation, and other bad side effects will disappear. The benefit to the economy is hard to quantify precisely, but it would give GDP a much needed multi trillion dollar shot in the arm.

The Hybrid Tax 

Flat tax advocates seek improved fairness and simplicity. Impose a single rate on all brackets, while curtailing or eliminating most deductions and adjustments. But the major cause of unfairness today come from the payroll tax and the distinctions based on the source of income. Most flat tax proposals fail to address this problem. Liberal critics say that its supporters are just shilling for the rich, but more likely, it is the inane and dangerous myth that Social Security is a funded retirement system, rather than a politically untouchable pay-as-you-go system that blinds them to reality.  Many taxpayers favor a progressive system out of a sense of fairness. They oppose a flat tax for that reason. However, nobody on either side of the aisle seems offended by the current code wherein income up to $34,000 is taxed at the same rate as income from roughly $100,000 to $170,000.

Fact: The tax code is already essentially flat with a highly regressive bump in the middle caused by the payroll tax and a milder progressive bump above $170,000.

Chart 2 depicts an example of the Hybrid Tax, with a 15% base tax, an additional 8% up to some income level 1, 15% from level 1 to level 2, and 20% above level 2.

These rates seem to conform pretty well to a smoothed out Chart 1. The exact bracket levels and the marginal rates should be set after calculating the impact on total revenue. If these rates and boundaries are set properly, none of the features of the new plan cause revenue loss.

The purpose of the Alternative Minimum Tax (AMT) is to make sure that everybody pays at least some minimal percentage of total taxable income. The Hybrid Tax takes care of that without the complexity. Everybody has to pay a base tax of around 15% with no deductions. All FICA payments are credited in full to the taxpayer's total bill. This does not change the employer's contribution. That too would be credited in full to the taxpayer's bill. No more AMT.

Deductions would only be applied to the progressive brackets but not to the base tax, making it possible to eliminate the crazy-quilt of phase-outs in the current code. Perhaps some tax credits would remain, subject to the whims of Congress.

A rough calculation suggests that the proposed example of the Hybrid Tax in Chart 2 would yield approximately 5% more than the current revenue from FICA, income tax, and corporate tax combined.