How to Junk the IRS

Corruption of the IRS cannot be denied now that the Fifth Amendment has been invoked. The most hated agency of the federal government could be nearly eliminated, its function radically simplified and its discretion drastically curtailed. A new approach, computed on a transparent base consisting of compensation to labor and capital, rather than on "taxable income," promises lower rates, clarity, and utter simplicity. 

For many years conservatives such as Art Laffer, Steve Forbes, Newt Gingrich, and many others have supported a flat tax of some sort or other. Most of the detailed proposals are not really flat. They carve out preferences for investment income or charitable deductions, and fail to integrate the FICA (Social Security and Medicare) taxes into their plans.

Currently, workers pay around 15% of their compensation up to a ceiling of $115,000 in FICA levies. Above that, a Medicare tax of some 4% still gets paid with no ceiling.  Technically, half of all that is paid by employers, but the full amount is generated by the workers' salary.  Interactions with the rest of the tax code may lower the effective rate a bit, but 15% is good enough for rough calculations.

Of the millions of words in the tax code only a couple of thousand words or fewer are needed to describe the FICA tax rules. The corporate and individual tax rates are easy enough to describe, but the rules for determining taxable income -- the tax base -- are impervious to rational thought. The FICA base is easy to describe. All "earned" incomes such as salaries, wages, bonuses, etc. are in the FICA base. All "unearned" incomes such as rents, royalties, interest, dividends, and capital gains are excluded.

The individual income tax code provides brackets from 10% to 40%. The 25% bracket begins at around $35,000. It ends a bit above the FICA ceiling. A first approximation is that everybody pays at least 25% plus 15%  --  a total rate of 40%  --  on all their income up to the ceiling. Then they pay a bit less up to around double the ceiling, rising to around 44% at the top. That is remarkably flat already. It is obfuscated by the complex web of deductions and exclusions in the income tax code. Those tend to flatten out the code even more, bringing top effective rates to below the 40% level.

The Core Tax     

Most observers say they favor simpler rules, with fewer deductions and lower marginal rates. That is a good description of the FICA tax. In My Fair Lady, Professor Higgins sings "Why can't a woman be more like a man?" I heartily disagree. Vive la difference!  My song is "Why can't the income tax be more like the FICA tax?" That is a slogan for real tax reform!

Suppose we start by removing the ceiling on FICA and applying it to all unearned income as well as earned income and all benefits, including health insurance. Then reduce all the brackets above the ceiling by around 15%. This immediately flattens the bracket structure to a top rate of 25% or less. That would still leave the deduction nightmare and the preferences for capital gains and dividends intact, but would still leave the true total tax rate between 35% and 40%.

Even the lowest income taxpayers face an income tax of 10% to 15% on top of FICA.  As we have seen, most taxpayers face 25%. Suppose we add between 5% and 10% to the new extended FICA tax. Then everyone will pay a flat tax of between 20% and 25% on the full current FICA base with the ceiling removed and unearned income included.

Before liberals jump on the bandwagon, we abolish the entire rest of the individual and corporate tax code.  Change the name of the tax from FICA to "Core Tax." Suppose we set the full rate at 20%, up from 15%. Incredibly, this brings in close to what all three taxes do at present.  At 25%, it would bring in hundreds of billions more.

Since there is no longer a corporate income tax, issues of double taxation disappear.  Instead each employee has (say) 11% withheld from each paycheck. The company matches that with 11% of their payroll. If individuals receive any unearned income, they pay the 11% themselves.  It could even be withheld by the payer of dividends or interest. That seems to give unearned income preferential treatment. To remedy that flaw, the company paying dividends or interest is assessed the same 11% on those payments. It is a direct tax on use of capital. Both capital and labor get taxed at a single rate by payers and recipients.  Corporations would be indifferent to whether they spent a dollar on interest, paying a dividend, or hiring a worker. There are no preferences or government attempts to bias the market with its tax code. Effectively the core tax is shared between payers and payees, so that an 11% rate amounts to a 22% assessment on the base itself. The one small exception may be on capital gains, where there is really no payee.

Here are the core tax calculations for individuals:

1.            Enter your total unearned income.

2.            Multiply line 1 by 0.11.

3.            Enter money withheld or prepayments on your behalf by the payers of line 1.

4.            Subtract line 3 from line 2.

5.            Send payment or request refund.

Note that just as FICA doesn't appear on form 1040, compensation (including benefits) and the core tax withheld by employers is not on the individual's tax form. You will still get an informational form from your employer verifying the tax withheld.

Here are the core calculations for corporations:

1.            Enter your total payroll, including all benefits.

2.            Enter all dividends and interest paid to shareholders and creditors.

3.            Add lines 1 and 2.

4.            Multiply line 3 by 0.11.

5.            Enter any prepayments.

6.            Subtract line 5 from line 4.

7.            Send payment or request refund.

Analysis and Objections

The first serious objection might be that this is just another regressive flat tax, favoring the rich.  In fact the analysis so far confirms that it actually fixes the regressive parts of the FICA tax. True, in return, it eliminates other taxes. Undoubtedly, there will be individual winners or losers, but nobody should experience a large tax increase or cut.

The most important reason that this is not just another flat tax is that it is computed on a base consisting of compensation to labor and capital, rather than on "taxable income."  The definition of taxable income is and has always been the cause of all the complexity. Instead, the core tax is levied on a base that is transparent for all to see. Every company or sole proprietor knows its payroll including benefits and surely knows the cost of its capital.

Conservatives probably gasped when it was proposed to extend FICA to all income with no ceiling. But before liberals could smile, they realized that the entire income tax code for individuals and corporations was gone. True enough, all deductions vanished with it, along with marriage penalties, alternate minimum taxes (AMT), and billions of dollars in lobbyist income and campaign donations. The hundreds of billions of dollars spent annually to comply with the tax code would be available for more productive uses.

Since the core tax base does not depend on profitability, there would be no need for the complex rules defining legitimate non-profit organizations.  Just as for FICA today, they would be responsible for withholding a payroll-based tax. The difference is that it would capture more revenue from highly paid employees and the higher core rate.

The recent abuses by the IRS involving the classification of conservative political advocacy groups would no longer be possible. The need for all tax audits would be drastically reduced.

Simple objective rules require little enforcement. Less enforcement means less abuse by entrenched bureaucracies. Less abuse means less expense to taxpayers to fight abuse and more confidence in the system. All conservatives should favor this change.

Comparisons of the core tax to various flat tax proposals are inevitable. This totally misses the point. It is the core base that is the key to the core tax. Flat tax proposals only speak to the final calculation of tax liability.  The FAIR tax, a 23% sales tax, that some say is really a 30% sales tax, avoids some of the rules for income calculation, but requires extensive records and special income rules for rebates. The Heritage Foundation tax reform proposal is just an attempt to replace liberal social engineering with conservative social engineering. It is no simpler than the current system.

A mild objection occurs to me. Only outgoing cash flows get taxed. Salaries, benefits, interest, and dividends can't be sheltered. Only retained earnings could escape taxation.  It turns every firm into a potential 401K or IRA.  Given the low core tax rate, it seems unlikely to be abused. It could even be a real boon to the economy by leaving firms with internal capital to invest. If it does become a problem, laws "encouraging" firms to disgorge excess retained earnings to its owners could be passed.

Any proposed tax reforms which fail to address the complexity of the calculation of the tax base will fail to address the real problem. That is one of the selling points of the Fair Tax. The Core Tax Base is simpler, more transparent and incredibly efficient.

Current Tax Revenue

-             FICA Tax ......................................................................................................... $950

-             Individual Income Tax ................................................................................. $1350

-             Corporate Income Tax ................................................................................. $350

-             Excise Taxes, Tariffs, Interest Receipts, Estate and Gift Taxes, etc........ $250

-             Total ............................................................................................................... $2900

Other than the excise tax line, all the revenue is derived as a percent of income bases, where the definition of "income" is critical but subjective and unstable. The core tax base is simple and transparent. Because of overlapping categories, it is hard to glean precise figures from the various governmental sources, but as best as I can determine, the total core base for individuals and firms is around $12T. The 11% rate would raise around $2.6T (22% of $12T), matching current revenue  --  less the $250B from excise and other non-income-based taxes.

The core tax can be a double-edged sword.  After all, what is a mere 1% change? It sounds so small, but it means around a quarter of a trillion dollars in annual revenue. If the 11% rate went to 15%, it would balance the budget!  Can Congress be trusted with such power? My own simplistic view is to lock in a core rate of 10% or 11% in permanent law. Rates above that would always expire half way between Congressional elections. Each new Congress would have to deal with it.

There is still the issue of progressive rates. Nothing in the core tax base prevents it from supporting multiple brackets. My own preference is to keep it flat. But after the core tax rate, which everybody pays, a higher bracket (or more) could be added, as a percent surtax on the core tax base. As long as Congress stands firm against deductions and preferences, the core tax approach works well.