Qualities of an Excellent Tax System

Noting at the start of this project that our tax system has no defined goal and grows ever more bewildering – the Federal tax code alone grew in the past 10 years from 1.4M to 3.8M words – I asked: “What if we had a tax goal and a budget management plan?”  The posts summarized below explore results of the current system to identify what should change.

What We Tax shows how much of what kinds of tax is collected at each level of government.  Federal revenue is chiefly from income and social insurance taxes.  State and Local governments rely mainly on property, sales and inheritance taxes.  Total tax revenue grew steadily as a % of GDP to a peak in 2000 and has since dropped very sharply on two occasions although government spending has not.  Federal taxes are half the total.  Personal income tax is 30% of the total and social insurance 20%.

Who We Tax shows how much tax is paid by each income group.  The lowest fifth whose income averages $12,400 pays 16% of that in sales and other such taxes.  They do not earn enough to pay income tax.  The middle 20% who average about $33,400 pay 25% in taxes overall.  The topmost 1% who average $1.3 million pay 31%.  Tax paid relative to income is similar for all income groups – the top fifth gets 59% of all income and pays 64% of all taxes, the bottom fifth gets 3.5% of all income and pays 2% of all taxes.

The Dept of Health and Human Services judging who has “insufficient income to provide the food, shelter and clothing needed to preserve health” determines that the entire bottom fifth has insufficient income, as does a family of four in the next fifth, and even a family of five in the middle income group.  The bottom fifth, after subtracting the 16% they pay in taxes has $10,400 to support themselves.

What We Do Not Tax examines why our system is so complicated.  Nobody fully understands all the provisions that exclude some income from taxation.  These deductions and payments made via the tax system total almost a third of overall Federal spending, more than $800B in 2012.  That is more than our spending on our three most costly programs, Social Security, defense, and Medicare.

Tax exemptions are popular with politicians because they are less visible than spending programs and generally do not need annual funding decisions.  All the big exceptions have a lot of support with the possible exception of the Earned Income Tax Credit, which benefits only the bottom fifth.  Although the other exemptions are imagined to benefit society in general, they primarily benefit the top 20% and some disproportionately benefit the top 1% income group.

Business Tax explores how our taxes on corporate and other businesses compare to other nations.   Although our top corporate tax rate is among the world’s highest, many of our largest corporations use tax exemptions to pay much lower rates.  GE paid none at all in 2010.  Multinationals manage their accounts to show profits in tax haven countries to avoid US taxes.  All large ones have the advantage of tax deductible debt financing.  What our corporations pay is half the OECD average.

An exceptionally high percentage of our businesses that together produce half of all business net income is not incorporated, which blurs the distinction between business and personal taxes and facilitates legal tax avoidance.

Purpose and Performance of Our Tax System examines its effectiveness, overhead, fairness and clarity.  The system is ineffective, failing by a wide margin to fully fund government activities and allowing illegal evasion on almost a fifth of taxable income.  Its overhead at 30% on income tax is much too high.  It is unfair, only two of five considering it even moderately fair.  Finally, it fails utterly on clarity.

Our current tax and budget management system allows 61% of us to believe the federal deficit can be cut substantially without raising taxes while at the same time opposing cuts to programs that account for 62% of all spending.   Social security cuts are opposed by 79%, Medicare by 76% and defense by 58%.  While opposing cuts to any programs with significant costs, three in four believes almost half of government spending is wasted and imagines cutting programs with relatively tiny costs would be a solution.

That huge compendium of public opinion research confirms in more detail what we in fact already know: we hate taxes, we love benefits.   Home owners hate property taxes but love the mortgage interest deduction.  Almost everyone hates inheritance taxes although hardly anyone has to pay any.  And so on.  What this means is a better tax system will be impossible unless we first agree how we want the tax revenue to be spent.  We will get nowhere considering changes in isolation and make progress only by assessing the impact of potential changes on the outcome we want.

Taxes, Wealth and Fairness explores the outcome we want.  The previous post explored public opinion about fairness and noted, for example, that 66% of us believes “everyone should pay some minimum amount of tax to help fund government”, the implication being that some do not, e.g., the 47% Romney noted who pay no income tax, although as we saw above, the bottom fifth in fact pays 16% of their income in taxes.  This post turns from exploring mechanisms to results, what we mean by saying our tax system should have a fair outcome.

Nine out of ten Americans want a society with a relatively equal distribution of wealth.  The average of our opinions is that the top fifth should have 32% of the total wealth.  What we think they have is close to twice that percentage (59%).  In fact, they have 25% more even than we imagine, a full 84% of our society’s total wealth, and their share is growing fast at the expense of every other group.  Despite great disagreements over policies that affect wealth distribution, e.g., tax and welfare, a great majority of us appears to believe that wealth should be distributed far more equally than we imagine it is, and we imagine it to be distributed much more equally than the reality.

In the next post I will begin exploring different tax approaches to get the system we appear to want, a system that:

  • Fully funds all authorized government activities, not necessarily every year, but on average
  • Makes it easy to understand the impact of proposed tax and spending changes
  • Leads toward the distribution of wealth we democratically choose
  • Has a low collection cost and allows minimal illegal evasion
  • Does not disadvantage US business in the global economy

My biggest surprise from the research is the relatively equal distribution of wealth nine out of ten of us appear to want.  I interpret that to mean we want relatively equal opportunities to become wealthy, which would include relatively equal access to high quality education and health care, for example, as well as relatively little unfair opportunity based on parental wealth.

I began this research because year after year we keep borrowing, not to fund investments for our future, but to keep consuming, and that’s unsustainable.  Better we work our way out of this downward spiral than be forced to when it is more painful.  That motive is the origin of the first bullet point above.  But I now see the deeper problem.  The tax and budget management system we have is not at all what we want.  That’s the origin of the remaining bullet points.

It will be extremely hard to get the tax system nine out of ten of us appears to want.  Inequality as extreme and fast growing as we have (net worth of the wealthiest 7% grew 28% in the past three years while the lower 93% lost an additional 4%) results only when political power based on wealth is shaping government policy.  When we see our tax system’s enormous and confusing volume of laws, we imagine its apparent chaos to have grown randomly.  It can be no accident, however, that it results in wealth flowing always and only to the top.

I will be grateful for any comments about the research, analysis and conclusions so far.  Have I failed to research anything essential, made any flawed analyses, or come to any unwarranted conclusions?

One comment on “Qualities of an Excellent Tax System

  1. John wrote: “Martin, I’ve been following your blogs on taxes with interest. Just a couple of comments at this stage:

    1. I always grind my teeth when I see social security benefits lumped in as part of our federal budget. For instance, under your “The Purpose and Performance of Our Tax System” blog, you have a pie chart showing Social Security benefits as 22% of the federal budget. That amount, and others like it, should be lumped under something like “Repayment of Borrowed Money” (yes, I know you “borrowed” someone else’s pie chart and you’ve indicated elsewhere that you are aware SS is outside the budget).

    2. Regarding your Estate Taxes blog, I would add that, while the best argument against this tax is the double-taxation argument, another purported problem is that some small family-owned farms and businesses might have to be liquidated to pay estate taxes when the progenitor dies leaving the children to find some other line of work.”

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