Your 'Fair Share' in the New Tax Rate RegimeBy Jon N. Hall
The ongoing stir over the rich paying their "fair share" of the tax burden is associated with investor Warren Buffett's claim to have a lower effective tax rate than his secretary. In an opinion for The New York Times last summer, Buffett claimed to have a tax rate of 17.4 percent while the underlings in his office averaged 36 percent. Naturally, it'll strike a lot of folks as unfair if billionaires like Buffett pay at a lower real rate than average working stiffs.
But besides the unfairness between the titans at the top, like Buffett, and everyone else, there's another type of unfairness in the federal Individual Income Tax that should also rankle folks, and that's the unfairness seen among folks in the same income bracket. Taxpayers may be covered by the same statutory tax rate, but it's what they pay that matters. Here's an example of this second kind of unfairness:
In a 2004 CBO report, the second section of Table 1A shows that the effective tax rate on individual income for the Middle Quintile was 5 percent for tax year 2000. Further down, the second section of Table 1C shows that average pretax income for that Middle Quintile in 2000 was $51,700. For that income, an unmarried person who doesn't itemize nor take advantage of any exotic exemptions could, in 2000, have paid a personal income tax of $9,055. That amounts to an effective rate of 17.5 percent, which is exactly 3.5 times the average effective rate of his compatriots in the Middle Quintile. That's far more of a difference in tax rates than that between Mr. Buffett and his secretary, and it's between folks whose income can put them -- in the same bracket!
So, we have vertical unfairness, as seen between Buffett and his secretary, and we have horizontal unfairness, as seen among taxpayers in the same income bracket. Inasmuch as the top 1 percent continues to pay around 40 percent of the federal Individual Income Tax and the bottom 50 percent pay less than 3 percent, which type of unfairness is worse: that between the mega-rich and the peons, or that among the peons themselves? (Can we still say "peons" in America?)
President Jimmy Carter said that the U.S. tax system was a "disgrace to the human race." It's only gotten worse since Carter's day. There are two big factors that account for the unfairness, complexity, compliance cost and general aggravation of the federal government's personal income tax system. These two big factors also account for the differences in effective tax rates and what one actually pays the I.R.S.
The first factor concerns income sources. Some sources of income are taxed at different rates than regular income, which has a top statutory rate of 35 percent. In the case of the wealthy, like Buffett, some of their income is from long-term capital gains, which are taxed at 15 percent. Other sources of income aren't taxed at all, such as tax-exempt municipal bonds. And some sources of income, such as social security benefits, aren't fully taxable, unless one's income is high. So, when one reports one's "total income" on line 22 of our beloved Form 1040, one might not be reporting all of one's income.
The taxpayer might like to think that after he's listed all his income that he'd be close to being done preparing his taxes. But he'd be wrong, as his ordeal may be just beginning. Which brings us to our second factor -- exemptions.
Exemptions are just unfair: Someone has to make up for the lost revenue that exemptions account for. And these folks are not only those with the highest incomes; they are also folks in the middle (as shown above) who don't, or can't, take advantage of exemptions. And because the feds are borrowing so many trillions of dollars, some of those who will make up for the lost revenue due to exemptions haven't even been born.
In the lame duck session last year, Congress extended the "Bush tax rates" for another two years; they are due to expire January 1, 2013. What "tax rate regime" will follow? Will Congress extend the Bush rates yet again, so that the Warren Buffetts of America can continue paying less than their secretaries? Or will Congress, at long last, devise a tax system that is fair? Since everyone else is floating a tax reform plan, here's my plan for reforming the federal Individual Income Tax:
Several of the tax reform proposals now being discussed feature a single tax rate. They are variations of the so-called "flat tax." The simplicity of the flat tax may be appealing, but what America really needs is many more rates.
So, my plan sets up an expanded set of new income brackets (see note below). Then, we ascertain the effective tax rates for these new brackets for the latest year. Next, we set the new statutory rates for these new brackets to their old effective rates that we just discovered. Finally, we eliminate every exemption in the U.S. tax code for personal income.
Why more brackets? Currently, the personal income tax has 6 brackets with 6 rates. But by employing much smaller brackets the new statutory rates can be kept much closer to what the most recent effective rates were for far more taxpayers. This is vital for the middle class.
By eliminating all exemptions, this plan should appeal to those who cry out for radical simplification. In fact, all 33 lines on Form 1040 from line 23 through line 55 would be deleted (along with all their supporting forms and instruction booklets) and replaced with a single line where the taxpayer listed his tax, which all taxpayers will derive from a new tax table. This plan is so simple that it's difficult to imagine that others haven't already thought of it, but I don't know if that's the case. In any event, I have christened my plan the "Multi-bracket Flat Tax."
Some would say that that term is self-contradictory, an oxymoron. On the contrary, it's the other flat tax plans that aren't flat. Because other flat tax plans retain some exemptions, they will still have a multiplicity of effective rates. Under the other flat tax plans, even taxpayers with the very same incomes can still pay at different effective rates, just as they can under the current system.
With my plan, however, everyone in each of the new brackets pays at the same rate; the statutory rate is the effective rate; within each bracket the rate is flat. This flatness is only possible because I retain no exemptions.
Some taxpayers will squawk at losing their exemptions, especially the home mortgage write-off. But they should consider that by using current effective rates, this method incorporates all the current exemptions into the new statutory rates. Within each new bracket, the average taxpayer will be paying at the same rate that he used to pay at. Yes, some in each new bracket will pay more, but others will pay less.
Besides fairness and simplification, the reason to delete all exemptions is that the retention of any exemption opens the door for Congress to introduce new exemptions on down the road. By going surgical, root and branch, we make it politically more difficult for Congress to lard up the tax code again with new exemptions.
But there are those who resist radical simplification of the tax code -- they want to keep exemptions on the books. Which necessitates keeping tax rates high, as we can't have both lower rates and exemptions. The resisters include K Street lobbyists, and the tax preparation and tax avoidance industries. But exemptions are fundamentally unfair. They make it possible for individuals with the same incomes to have different tax liabilities.
Do you really want to pay at the same rate as billionaires? That's what the other flat tax plans propose. The main flaw of an income tax system that has just one rate is that folks at the bottom suffer big rate hikes. But if we try to ameliorate that problem by exempting more taxpayers from paying any income tax, that's also unfair. Already nearly half of Americans pay no personal income tax. Exempting more and more folks from paying anything just to create some spurious "flatness" can't be good for the republic.
So it's the other flat tax plans that are oxymoronic. What they actually should be called is the "single statutory rate tax."
Whether one is married or single, a parent or childless, a college student or a teenage worker, buying a home or renting, this proposal treats everyone the same. And you won't be lumped in with Warren Buffett, bless his philanthropic heart and more power to him.
By having a set of graduated tax rates, this plan should appeal to those who want the tax system to remain progressive. In the current system there are only 5 rates before the top rate kicks in at $388,351. In an era of 8 and 9 figure incomes, this is not really the cutoff level for "rich." (By the way, the word "progressive" as applied to tax rates has nothing to do with progressivism. It merely means that rates increase, or progress, in tandem with incomes.)
My proposal can only work if Congress strips all exemptions out of the tax code. But there's another big issue -- how do we calculate effective rates? That depends on what we use as total income. In the report cited above, the CBO calculated effective rates by using "adjusted pretax comprehensive household income," which "includes all cash income (both taxable and tax-exempt)." That suggests that the CBO added up all sources of income, including capital gains and tax-free bonds. If our tax reform were to figure effective rates like the CBO, then we'd need to start treating all sources of income the same; there would be no preference given to cap gains, et al. Such a change might trigger a revolt in some quarters. In which case, we'd calculate effective rates by keying off of the "total income" on line 22 of the 1040. Which would allow different income sources, like capital gains, to continue to be treated just as they are today.
Using the "total income" on line 22, however, will produce higher effective rates than using the "comprehensive" income the CBO used. It would be interesting to figure the effective rates for our expanded set of brackets both ways, and compare the resulting rates. It would highlight the effect of giving preferences to different income sources.
Because my plan mirrors the progressivity of the current tax system, it will also mirror any lack of it. So if the current tax system does indeed allow some higher income earners to pay at lower effective rates than lower income earners, then that could be reflected in my system. In a system with no exemptions, each bracket must have a higher rate than the bracket below it. Otherwise, it won't be fair. The solution is simply to adjust rates.
My main goal in drafting this tax reform plan was radical simplification of the tax code. By eliminating all exemptions, the plan succeeds on that count. But I also wanted the plan to be revenue-neutral, so I substituted the old real rates (i.e., the effective rates) to be the new statutory rates. Finally, I wanted folks to be paying the I.R.S. close to what they're currently paying. That's where all the brackets come in. Folks will be paying at the average rate that their (much smaller) bracket currently pays at. Fair enough?
Jon N. Hall is a programmer/analyst from Kansas City.
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