The IRS Scandal and Tax Reform

Of the three big scandals currently roiling DC -- the Benghazi terrorist attack, the seizing of phone records from the Associated Press, and the Internal Revenue Service's targeting of conservative groups seeking tax exempt status -- the IRS scandal may alarm the most Americans. That's because the IRS is the most hated and feared outfit in government.

In the disaster film The Day After Tomorrow (2004), a new Ice Age descends on America in a matter of hours. A group of young people take refuge in the main branch of the New York City Public Library, and to keep from freezing to death, they start burning books. Three of the youngsters have this exchange:

JEREMY: Friedrich Nietzsche! We cannot burn Friedrich Nietzsche; he was the most important thinker of the 19th Century!

ELSA: Oh, please! Nietzsche was a chauvinist pig, who was in love with his sister.

JEREMY: He was not a chauvinist pig.

ELSA: But he was in love with his sister.

BRIAN PARKS: Uh... 'scuse me? You guys? Yeah... there's a whole section on tax law down here that we can burn.

Brian Parks has the right idea, but rather than just "a whole section," I say burn down the entire infernal tax code and throw its ashes to the four winds. In "The Autocrat Accountants" at National Review last Friday, Mark Steyn writes:

A civil "civil service" requires small government. Once government is ensnared in every aspect of life a bureaucracy grows increasingly capricious. The U.S. tax code ought to be an abomination to any free society, but the American people have become reconciled to it because of a complex web of so-called exemptions that massively empower the vast shadow state of the permanent bureaucracy.

This IRS scandal is an excellent moment to push for comprehensive tax reform. Tax reform could be much simpler than the professional politicians would have us believe. The scandal helps us see the simplicity of reform because it involves the very thing that has so complicated taxes, and that's exemptions -- the scandal involves the denial or delay of exemptions. What we should do is get rid of all exemptions. But would Americans still be able to make their house payments if they don't have their mortgage deductions?

Yes. In 2011, I showed how we can throw out all the exemptions in the tax code, and keep people paying roughly the same in personal income taxes as they have been. For example, were my reform in effect, everyone earning the median income in 2000 ($51,700) would pay 5 percent on every dollar of their income, rather than paying zero percent on their first dollar and 28 percent on their last dollar. (This assumes that the median income would be a break between brackets.)

If you have doubts, check out "Summary of Latest Federal Income Tax Data" at the Tax Foundation right here and scroll down to Table 8. Table 8 details average tax rates, that is, the percent of adjusted gross income (AGI) paid as income taxes, i.e. effective rates. In the last year listed, 2010, we see an average tax rate of 2.37 percent for the bottom half and for the next to highest quartile an average tax rate of 6.01 percent. This data tells me that by using the latest effective rates, my method would set the statutory rate for the current median income at less than the 5 percent paid in 2000.

On the left side of Table 8, however, is a disturbing discontinuity: Every year from 2004 through 2010 except one, the average tax rate for the top 0.1 percent was lower than that of the top 1 percent. Table 7 tells us that in 2010 it took an income of $369K to get into the top 1 percent, and an income of $1.634M to get into the top 0.1 percent. Since all of them have the same statutory rate, the reason for this difference in effective rates must surely be exemptions -- the very thing at the heart of the current IRS scandal.

My idea for reforming the individual income tax involves setting the statutory tax rates to the effective tax rates and eliminating all exemptions, which account for the difference between the statutory and the effective. But we need one more thing, which is to set up smaller tax brackets, which means more tax brackets. This simple little device of using more tax brackets, each with its own tax rate, is how to eliminate exemptions while keeping taxpayers paying about the same as they have been.

The Tax Table in the instructions for the 2012 Form 1040 requires 12 pages (p. 79-90) and only handles taxable incomes up to $100,000. With my reform, we could have a hundred brackets covering all incomes and get it all on one page. If you refer to page 90 in the instructions above, you'll see that an unmarried person with a taxable income of $99,999.99 would have a tax rate on that income of 21.45 percent. But according to Table 8 at the Tax Foundation, those making incomes in the millions, the top 0.1 percent, had an effective rate of 22.84 percent in 2010. And some of those top earners paid at a rate less than 20 percent -- and all because of exemptions.

The current IRS scandal throws light on thugs in the executive branch. But it was Congress that created the IRS. And it's Congress that created all the myriad exemptions that have complicated our lives and made possible the shenanigans at the IRS. Congress uses exemptions to control us. Do we really want the current crop of clowns in Congress deciding what's exempt and what's nonexempt?

Congress has neither the competence nor the intellectual heft for such decisions. By eliminating exemptions, we make it more difficult for the IRS to abuse us in the future. If America can't get real tax reform now, after this outrageous IRS scandal, then we may have to wait for it until the next Ice Age.

NOTE: Watch this segment from last Monday's "The Kudlow Report" for a spirited debate on the IRS scandal. (The first four minutes deal with the Oklahoma tornado, but you can position the video to begin at the 4-minute mark.) Former Special Counsel Joe diGenova is in rare form and Larry, as always, is on the mark in questioning the involvement of the NTEU, the National Treasury Employees Union.

Jon N. Hall is a programmer/analyst from Kansas City.

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