Americans overwhelmingly want their tax system to be fair. This means, for most, a system, which is the same for everybody. That is, it should not be rigged in favor of high-income earners who can hire accountants and tax lawyers to find ways not to pay taxes. Similarly, most agree that having half the population pay no income taxes at all to support government programs is not healthy. The claim that every worker pays Social Security and Medicare taxes, while true, does not address this issue because both programs are designed so that, if there are no changes, these same lower income workers will receive back far more in benefits than they will pay in payroll taxes. Thus, any money they pay in payroll taxes will come back to them and none will go to support the rest of government. These individuals have no incentive to oppose additional government spending and tax increases because they only benefit from bigger government at no cost to themselves. This is not healthy for them because it fosters a culture of dependency, or for the broader nation.
Gov. Romney should propose a flat tax applicable to all income, including capital gains and dividends, and the elimination of all personal deductions except the charitable deduction (at every income level) and, for people conducting businesses as individuals and not through a corporation, partnership or other business organization, the same deductions to which the business organization would be entitled. More on the charitable deduction below, but the business deductions are necessary to equalize treatment between taxpayers who do business as individuals and those who use a business organization. The standard deduction would be replaced by an individual, refundable credit equal to the flat tax on an income equal to the highest average income of people who today pay no income tax. I would index the credit to overall per capita personal income so that as the economy grows, and high-income individuals earn more, the credit becomes larger.
Under this system, people who pay no income taxes today would still pay no income taxes, but if the flat rate increased, or they earned more income, any refund they received would become smaller. Eventually, they would start paying taxes. The economic incentives would thus be similar to people who are paying taxes, even if lower income individuals are receiving a net benefit from the government.
I suspect that higher income individuals will end up paying more (and higher effective rates) than today, but have a lower marginal rate, which is the rate that most affects incentives to work, save and invest. Overall, the distribution of taxes through society will still end up with high-income earners paying the lion’s share of income taxes.
This is simple to describe, easy to understand, obviously fair and economically beneficial. It also has other benefits. First, simply eliminating “many” deductions, but not virtually all, will not, in the long run, be a lasting reform. As long as a substantial number of special deductions are there, there will be lobbyists waiting to ask for just one more for their special interest. The only way to do reform, and keep reform, is to establish the principle of no special provisions for anyone. Let economic incentives, not tax breaks, drive economic decisions. Second, the cost of compliance will go down, and voluntary compliance will go way up because people will perceive the system as fairer, correct tax treatment will be easier to determine, and compliance will be easier and less expensive. Third, it will provide equal treatment among taxpayers no matter the source of their income, and to married and unmarried individuals and couples, and those married individuals who file separately.
But why keep the charitable deduction? Some conservatives and libertarians would prefer the government, and particularly the federal government, stay out of doing charity altogether. That is unlikely to be a majority opinion. There are strong political interests in favor of the charitable deduction, and most Americans think that supporting education, the arts, religious organizations, help for the poor, and so on are worthy causes and should get some government support. If we can eliminate, or substantially reduce, direct government support for many of these causes, and instead spur private support through the charitable deduction, it will be far preferable as public policy.
The charitable deduction is far better than direct government support for charitable causes for a number of reasons. First, a dollar given to a charitable cause only costs the government that dollar multiplied by the flat tax rate, while direct support costs the government 100% of that dollar. That is, if the flat tax rate is 20%, each dollar of charitable giving only costs 20 cents while direct government support costs $1.00. Thus, charitable giving is highly leveraged. Second, taxpayers can decide where their charitable dollars are going rather than having someone else decide. This will be popular, and will avoid the problems of taxpayers objecting to certain charitable programs by government which they do not like. Let those who like pictures of Christ dipped into urine support that kind of “art” but leave the rest of us out of it. Similarly, lobbyists will have less to do because the charitable dollars will be allocated by individual dollars not be special earmarks and other budget provisions. Third, private charities can administer their charitable programs far more efficiently and effectively than the government, thus providing more bang for the buck. Fourth, because every government program becomes, in some sense, an entitlement, it is far more difficult for government programs to cut off undeserving recipients than it is for a private charity.
For those who object to higher taxes on capital gains and dividends because they will reduce needed investment, there need to be two other wrinkles in the system. First, capital gains should be considered income only to the extent they are actually based upon an increase in the value of an asset sold. That is, to the extent a sales price higher than the purchase price is due, in part, to inflation, no capital gains tax should be due. This will encourage long term investing while still keeping a fair and simple system. In addition, to keep equal treatment among business entities, dividends paid should be deductible to the corporation. Thus, there will be no double tax on dividends, dividends will be encouraged, and there will be equal treatment of equity capital and debt which will encourage equity investing.
This system is simple, understandable, fair, and can be designed to provide the same revenue as is being provided under the current system while reducing the marginal rate for high-income taxpayers and the effective rate for low-income taxpayers. That sounds like a win, win, win to me.
