Why Can't the Whole Tax Code Be More Like FICA?

The proposals for tax reform being considered by Congress just tinker around the edges. The Trump plan is quite good, about as good as a plan could be without changing the whole structure of income-based taxation. That structure consists of several tax brackets together with a myriad of deductions, phase-outs and arcane rules. And that is just the individual code; the corporate code is worse. Now is a rare moment in American history where we have an opportunity to rip up the old system and replace is with a simpler, fairer, more transparent tax code.

There are three main pillars to the federal income-based tax code.  Around 45% of federal revenue comes from the individual income tax. Some 10% comes from the corporate income tax. Another 35% comes from the FICA and SECA taxes, which directly fund OASDI --- Social Security retirement payments and disability insurance --- and, Medicare (HI). FICA stands for “Federal Insurance Contribution Act” and SECA stands for “Self Employment Contribution Act. Usually both are just referred to as FICA, and I will follow that convention.

Businesses, whether for profit or not, pay half of the FICA tax (7.65%). That is at least 50% more money than the corporate income tax. Suppose we eliminate the corporate income tax and replace it with a small increase in the corporate share of FICA (say, to between 11% and 12.5%). Pretty much a revenue wash, but a huge improvement in compliance costs and incentives. An equal increase in the individual share of FICA, coupled with an expansion of the FICA base, and elimination of tax loopholes might just make up for all the revenue currently raised.

The tax base for FICA and SECA is much simpler than for the individual income tax base. The main features that define this base are

  1. Earned (and only earned) incomes (essentially wages and salaries) are taxed, though some care must be taken by the self-employed to meet the criteria for earned income.
  2. Unearned incomes, especially, interest, dividends, capital gains, rents and royalties are not taxed by FICA.
  3. Employers and employees each pay 1.45% for HI and 6.2% for OASDI, but the self-employed pay both.
  4. There is no ceiling for Medicare taxes. The OASDI tax rate applies only to income up to a ceiling, currently set at $127,200.
  5. There is a 0.9% HI surtax on income above a certain threshold, currently $200,000 for single and $250,000 for married taxpayers. This surtax was a terrible idea which raises little revenue and should be repealed.

That is pretty much it. Very few rules. Very simple rules.  If only the rest of the tax code were that easy to understand. I have never heard objections to the fact that FICA (and SECA) payments permit no exemptions or deductions. Occasionally there are complaints that the regressive nature of the OASDI ceiling is unfair. There is a long dull history to this fact, having to do with the funding of essentially fictitious trust funds, which are little more than bookkeeping entries on the federal balance sheet.

Here is a proposed new set of rules:

  1. Define a new enhanced FICA tax base to include:
    1. All earned income with no ceiling.
    2. All employer provided benefits such as health insurance and pension plans.
    3. All unearned income.
  2. Set new rates for enhanced FICA:
    1. The employee’s share of the payroll tax.
    2. The employer’s share of the payroll tax.
    3. Self-employed pay both shares.
    4. Unearned income taxed as if it were self-employment income, so recipient pays both shares.
  3. The bookkeeping entries on the federal balance sheet known as the trust funds would continue to be funded by the part of the enhanced FICA base reflecting the old rules. It would be seamless to taxpayers.

That was the bad news. The good news is that the old income tax on individuals is gone. The old corporate income tax is gone. No longer will business decisions be income tax dependent. Compliance costs will plummet. The enhanced payroll tax is effectively a tax on the use of labor. Capital use is taxed via the tax on unearned income paid by businesses to taxpayers.

Here is a partial list of qualitative improvements.

  1. Business income tax code is repealed and abolished.
  2. Personal income tax code is repealed and abolished.
  3. Compliance costs near zero.
  4. No marriage penalty.
  5. No AMT (Alternative Minimum Tax).
  6. No Death Tax.
  7. No Gift Tax.
  8. No complex rules on eligibility for deductions.
  9. No distinction between employees and independent contractors.
  10. No distinction between for-profit and not-for-profit firms.
  11. No distinction between debt and equity capital.
  12. No arcane rules on corporate expenses and/or depreciation of capital assets.
  13. Fewer intrusive IRS investigations.
  14. Fewer tax-based investment decisions.

Whenever anyone suggests a reform of the tax code, if it is taken seriously, the first thing that happens is that the various tax think tanks take a look at revenue projections.  Then, if it seems to pass muster enough to be considered by Congress, the CBO takes its own look. What can I say about the CBO that hasn’t been said before?  I like to call their projections the fool’s gold standard of economic predictions.  All I can do is test my proposal against actual tax data from past years. It turns out to be fairly consistent from year to year.

The spreadsheet presented here shows that the proposed unified tax system can be revenue neutral, if so desired. Today, corporations pay two main taxes---employer share of payroll tax and corporate income tax. It is the latter which takes center stage in liberal vs. conservative arguments about tax reform. But a better number to argue over is the sum of those two taxes. Abolishing the corporate income tax does not lower the total corporate tax liability, since the employer share of the payroll tax makes up for it.  Of course there will be individual firms which win or lose.

It may seem that the new payroll tax disproportionately taxes labor. But, through the tax on unearned income, capital-intensive firms still get dinged. The true corporate share of taxes is better represented by the sum of their share of the enhanced payroll tax and the unearned income tax payments from dividends, interest, capital gains, pension, and other corporate sources.

Minor rate adjustments have a significant impact. I urge interested readers to play around with the tax rate in the spreadsheet. Rates of 11% to 12.5% nearly duplicate current revenue in the years 2011 to 2015. I have retained the convention that the employees and employers each pay the same rate. But that is not necessary. A split of 14% employee/ 11% employer, for example, might make sense.

I am not recommending specific numbers for the employee/employer rates. I do have a suggestion for how to set them if the proposed new system is enacted. Set a permanent rate of 11% for each. Then, every two years, force Congress to vote on how much to add to that for the next two years, with a cap of a 3% add-on for each to expire with each current Congress.  Of course, any new Congress can undo the whole thing, but I think that would become politically difficult.

If some version of progressive taxation is still demanded, a surtax on high incomes could be added to the mix, but I hope that is not necessary for passage. At the other end of the income spectrum, there may be some low income earners penalized by the new rules. A simple non-refundable tax credit could easily make up for that.

Two parameters must be set. They are the employer’s rate and the employee’s rate. Under current law they are equal.  Total revenue collection only depends on the sum of the two rates.  I suggest not tinkering with the split for now, but that is a minor detail.

The spreadsheet compares revenue generated by the current tax code with the new proposal. These are not projections. These are the figures for the actual fiscal years 2011-2015. The cells shaded light green contain the new payroll tax rates.  These parameters should be editable, but there were publishing issues to prevent that. Instead, I am providing a static sheet here and a link to a live, editable version of the spreadsheet.  I don’t know how long that link will remain live, so download it or copy it to your own computer soon if you are interested in playing around with different rates to see their impact on tax revenue. You may have to click on an “enable editing” button.

Tax Base & Revenue Statistics

APPENDIX 1: Current Tax Preferences

No doubt powerful interest groups will miss the complex set of rules governing deductions. There are three major deductions which have always stood in the way of serious tax reform. They are the deductions for mortgage interest, charity, and state and local taxes. The first two are preserved in the Trump plan. The third is eliminated, though most observers think it will have to be retained to enable passage. In the tax plan proposed here, these deductions would disappear. If the behavior encouraged by those deductions must be subsidized, let it be with capped tax credits ---which amount to welfare without a means test.  Here is a brief discussion of why we should not care that the tax preferences are all gone.

Mortgage Interest: Of all the deductions this is probably the most popular and untouchable one. It is perceived as a bona fide middle class perquisite, even though it benefits high income taxpayers far more. It is kept intact under the Trump plan. Its claimed purpose is to encourage home ownership, which needs no further justification. But does it really accomplish that purpose? The answer is “Yes, but…” The more money you owe on your house and the higher the interest rate on that loan, the greater is your deduction. Since most buyers do borrow at least 80% of the cost of the home, this indirectly subsidizes home purchases. But responsible homeowners, who try to pay off their debt quickly are penalized by the loss of part of their deduction.

Thus, the deduction directly subsidizes indebtedness with one’s home as collateral. It discourages unencumbered home ownership.

How about a tax credit of 2% of the current appraised value of the property, or $20,000, whichever is smaller? The need for the value is unfortunate, so some thought should go into a rule which captures it without an expensive appraisal. The big advantage over the current deduction is that it encourages home ownership without encouraging debt. No doubt, this would cost the Treasury some revenue. However the upside is that the less money involved in leveraging home ownership, the safer that ownership is. When recessions hit, or when involuntary loss of jobs occurs, the outright home owner can more easily ride out the storm without fear of losing his or her home.  That would provide a huge bulwark against the nasty feedback loops that cause downturns to feed on themselves. This reform alone should be adopted even if the main proposal of this article is not.

Charitable Contributions:  To begin with, this is really a strange deduction. It subsidizes a wide variety of not-for-profit organizations, with no value judgment as to their merit. Many of these entities, spend 80% or more of their budgets on fundraising costs alone. Much of the rest goes to administrative costs, especially six and seven figure salaries for various people. If politicians simply cannot bear to eliminate this subsidy entirely, replace it with a tax credit. A non-refundable tax credit of say, 10% of contributions, with a maximum credit of $10,000 would be an adequate level for most taxpayers. Million dollar donors don’t need their pet projects subsidized by ordinary taxpayers. The Trump plan keeps the charitable deduction as is. But that is a bad idea.

State and Local Taxes:  Obviously, this subsidizes the state budgets of high tax states. I agree with Trump that it should be dropped all together. If politically it must be retained, replace it with a non-refundable tax credit of say, 2% of income or $20,000, whichever is lower. If it is kept as a deduction it should be capped at say, $50,000 of state and local taxes to deduct.

APPENDIX 2: Current True Brackets

Next time, you hear a politician bloviate on the topic of tax brackets, consult the following chart. It combines the FICA tax rates with the income tax brackets. Nearly everyone with any significant income pays a high marginal total rate of around 35% - 40%. The so-called progressive income tax is just another government lie, albeit a clever lie. It is actually worse than it looks since most deductions benefit higher income taxpayers. It was actually these observations that led to the design of the unified tax code proposed in this article.

The proposals for tax reform being considered by Congress just tinker around the edges. The Trump plan is quite good, about as good as a plan could be without changing the whole structure of income-based taxation. That structure consists of several tax brackets together with a myriad of deductions, phase-outs and arcane rules. And that is just the individual code; the corporate code is worse. Now is a rare moment in American history where we have an opportunity to rip up the old system and replace is with a simpler, fairer, more transparent tax code.

There are three main pillars to the federal income-based tax code.  Around 45% of federal revenue comes from the individual income tax. Some 10% comes from the corporate income tax. Another 35% comes from the FICA and SECA taxes, which directly fund OASDI --- Social Security retirement payments and disability insurance --- and, Medicare (HI). FICA stands for “Federal Insurance Contribution Act” and SECA stands for “Self Employment Contribution Act. Usually both are just referred to as FICA, and I will follow that convention.

Businesses, whether for profit or not, pay half of the FICA tax (7.65%). That is at least 50% more money than the corporate income tax. Suppose we eliminate the corporate income tax and replace it with a small increase in the corporate share of FICA (say, to between 11% and 12.5%). Pretty much a revenue wash, but a huge improvement in compliance costs and incentives. An equal increase in the individual share of FICA, coupled with an expansion of the FICA base, and elimination of tax loopholes might just make up for all the revenue currently raised.

The tax base for FICA and SECA is much simpler than for the individual income tax base. The main features that define this base are

  1. Earned (and only earned) incomes (essentially wages and salaries) are taxed, though some care must be taken by the self-employed to meet the criteria for earned income.
  2. Unearned incomes, especially, interest, dividends, capital gains, rents and royalties are not taxed by FICA.
  3. Employers and employees each pay 1.45% for HI and 6.2% for OASDI, but the self-employed pay both.
  4. There is no ceiling for Medicare taxes. The OASDI tax rate applies only to income up to a ceiling, currently set at $127,200.
  5. There is a 0.9% HI surtax on income above a certain threshold, currently $200,000 for single and $250,000 for married taxpayers. This surtax was a terrible idea which raises little revenue and should be repealed.

That is pretty much it. Very few rules. Very simple rules.  If only the rest of the tax code were that easy to understand. I have never heard objections to the fact that FICA (and SECA) payments permit no exemptions or deductions. Occasionally there are complaints that the regressive nature of the OASDI ceiling is unfair. There is a long dull history to this fact, having to do with the funding of essentially fictitious trust funds, which are little more than bookkeeping entries on the federal balance sheet.

Here is a proposed new set of rules:

  1. Define a new enhanced FICA tax base to include:
    1. All earned income with no ceiling.
    2. All employer provided benefits such as health insurance and pension plans.
    3. All unearned income.
  2. Set new rates for enhanced FICA:
    1. The employee’s share of the payroll tax.
    2. The employer’s share of the payroll tax.
    3. Self-employed pay both shares.
    4. Unearned income taxed as if it were self-employment income, so recipient pays both shares.
  3. The bookkeeping entries on the federal balance sheet known as the trust funds would continue to be funded by the part of the enhanced FICA base reflecting the old rules. It would be seamless to taxpayers.

That was the bad news. The good news is that the old income tax on individuals is gone. The old corporate income tax is gone. No longer will business decisions be income tax dependent. Compliance costs will plummet. The enhanced payroll tax is effectively a tax on the use of labor. Capital use is taxed via the tax on unearned income paid by businesses to taxpayers.

Here is a partial list of qualitative improvements.

  1. Business income tax code is repealed and abolished.
  2. Personal income tax code is repealed and abolished.
  3. Compliance costs near zero.
  4. No marriage penalty.
  5. No AMT (Alternative Minimum Tax).
  6. No Death Tax.
  7. No Gift Tax.
  8. No complex rules on eligibility for deductions.
  9. No distinction between employees and independent contractors.
  10. No distinction between for-profit and not-for-profit firms.
  11. No distinction between debt and equity capital.
  12. No arcane rules on corporate expenses and/or depreciation of capital assets.
  13. Fewer intrusive IRS investigations.
  14. Fewer tax-based investment decisions.

Whenever anyone suggests a reform of the tax code, if it is taken seriously, the first thing that happens is that the various tax think tanks take a look at revenue projections.  Then, if it seems to pass muster enough to be considered by Congress, the CBO takes its own look. What can I say about the CBO that hasn’t been said before?  I like to call their projections the fool’s gold standard of economic predictions.  All I can do is test my proposal against actual tax data from past years. It turns out to be fairly consistent from year to year.

The spreadsheet presented here shows that the proposed unified tax system can be revenue neutral, if so desired. Today, corporations pay two main taxes---employer share of payroll tax and corporate income tax. It is the latter which takes center stage in liberal vs. conservative arguments about tax reform. But a better number to argue over is the sum of those two taxes. Abolishing the corporate income tax does not lower the total corporate tax liability, since the employer share of the payroll tax makes up for it.  Of course there will be individual firms which win or lose.

It may seem that the new payroll tax disproportionately taxes labor. But, through the tax on unearned income, capital-intensive firms still get dinged. The true corporate share of taxes is better represented by the sum of their share of the enhanced payroll tax and the unearned income tax payments from dividends, interest, capital gains, pension, and other corporate sources.

Minor rate adjustments have a significant impact. I urge interested readers to play around with the tax rate in the spreadsheet. Rates of 11% to 12.5% nearly duplicate current revenue in the years 2011 to 2015. I have retained the convention that the employees and employers each pay the same rate. But that is not necessary. A split of 14% employee/ 11% employer, for example, might make sense.

I am not recommending specific numbers for the employee/employer rates. I do have a suggestion for how to set them if the proposed new system is enacted. Set a permanent rate of 11% for each. Then, every two years, force Congress to vote on how much to add to that for the next two years, with a cap of a 3% add-on for each to expire with each current Congress.  Of course, any new Congress can undo the whole thing, but I think that would become politically difficult.

If some version of progressive taxation is still demanded, a surtax on high incomes could be added to the mix, but I hope that is not necessary for passage. At the other end of the income spectrum, there may be some low income earners penalized by the new rules. A simple non-refundable tax credit could easily make up for that.

Two parameters must be set. They are the employer’s rate and the employee’s rate. Under current law they are equal.  Total revenue collection only depends on the sum of the two rates.  I suggest not tinkering with the split for now, but that is a minor detail.

The spreadsheet compares revenue generated by the current tax code with the new proposal. These are not projections. These are the figures for the actual fiscal years 2011-2015. The cells shaded light green contain the new payroll tax rates.  These parameters should be editable, but there were publishing issues to prevent that. Instead, I am providing a static sheet here and a link to a live, editable version of the spreadsheet.  I don’t know how long that link will remain live, so download it or copy it to your own computer soon if you are interested in playing around with different rates to see their impact on tax revenue. You may have to click on an “enable editing” button.

Tax Base & Revenue Statistics

APPENDIX 1: Current Tax Preferences

No doubt powerful interest groups will miss the complex set of rules governing deductions. There are three major deductions which have always stood in the way of serious tax reform. They are the deductions for mortgage interest, charity, and state and local taxes. The first two are preserved in the Trump plan. The third is eliminated, though most observers think it will have to be retained to enable passage. In the tax plan proposed here, these deductions would disappear. If the behavior encouraged by those deductions must be subsidized, let it be with capped tax credits ---which amount to welfare without a means test.  Here is a brief discussion of why we should not care that the tax preferences are all gone.

Mortgage Interest: Of all the deductions this is probably the most popular and untouchable one. It is perceived as a bona fide middle class perquisite, even though it benefits high income taxpayers far more. It is kept intact under the Trump plan. Its claimed purpose is to encourage home ownership, which needs no further justification. But does it really accomplish that purpose? The answer is “Yes, but…” The more money you owe on your house and the higher the interest rate on that loan, the greater is your deduction. Since most buyers do borrow at least 80% of the cost of the home, this indirectly subsidizes home purchases. But responsible homeowners, who try to pay off their debt quickly are penalized by the loss of part of their deduction.

Thus, the deduction directly subsidizes indebtedness with one’s home as collateral. It discourages unencumbered home ownership.

How about a tax credit of 2% of the current appraised value of the property, or $20,000, whichever is smaller? The need for the value is unfortunate, so some thought should go into a rule which captures it without an expensive appraisal. The big advantage over the current deduction is that it encourages home ownership without encouraging debt. No doubt, this would cost the Treasury some revenue. However the upside is that the less money involved in leveraging home ownership, the safer that ownership is. When recessions hit, or when involuntary loss of jobs occurs, the outright home owner can more easily ride out the storm without fear of losing his or her home.  That would provide a huge bulwark against the nasty feedback loops that cause downturns to feed on themselves. This reform alone should be adopted even if the main proposal of this article is not.

Charitable Contributions:  To begin with, this is really a strange deduction. It subsidizes a wide variety of not-for-profit organizations, with no value judgment as to their merit. Many of these entities, spend 80% or more of their budgets on fundraising costs alone. Much of the rest goes to administrative costs, especially six and seven figure salaries for various people. If politicians simply cannot bear to eliminate this subsidy entirely, replace it with a tax credit. A non-refundable tax credit of say, 10% of contributions, with a maximum credit of $10,000 would be an adequate level for most taxpayers. Million dollar donors don’t need their pet projects subsidized by ordinary taxpayers. The Trump plan keeps the charitable deduction as is. But that is a bad idea.

State and Local Taxes:  Obviously, this subsidizes the state budgets of high tax states. I agree with Trump that it should be dropped all together. If politically it must be retained, replace it with a non-refundable tax credit of say, 2% of income or $20,000, whichever is lower. If it is kept as a deduction it should be capped at say, $50,000 of state and local taxes to deduct.

APPENDIX 2: Current True Brackets

Next time, you hear a politician bloviate on the topic of tax brackets, consult the following chart. It combines the FICA tax rates with the income tax brackets. Nearly everyone with any significant income pays a high marginal total rate of around 35% - 40%. The so-called progressive income tax is just another government lie, albeit a clever lie. It is actually worse than it looks since most deductions benefit higher income taxpayers. It was actually these observations that led to the design of the unified tax code proposed in this article.

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