Our Income Tax System

There has been much discussion recently regarding income tax rates and the rate structure. Overhauling the income tax system is a popular promise our politicians are now making due to demand from their constituents. We will no doubt hear dueling overhauling ideas over the next few months until November 6 (which, apropos of nothing, is my 60th  birthday).  Citizens seem to believe that the system needs to be simplified because they are certain, or at least fear, that the current complexities result in their individually paying more tax than they would pay under a simpler system. Or that they are paying an unfair portion of the total taxes collected under the current system.  Or even that the government is hiding in this cloud of complexity, some dark deceptive secret that is sucking their soul out.  The last one is not as popular as the other 2 but it's going around.   There is no question in my mind that our income tax system is extremely complex. 

Probably the radical overhaul that I hear favored by most people who button hole me at various occasions is the Flat Tax.  The description of the flat tax system I hear most is "you just take one single rate for everyone and multiply it times your income".  When I ask about deductions they say that there should be no deductions.  The rates I hear favored are normally a rate less than the person I am talking to is currently paying, all the way down to 10%.

Arguing against the Flat Tax--
1.  This country decided a long long time ago that it favored a progressive tax system; the highest marginal rates are levied on the higher income earners (a marginal rate being what rate you pay on the last dollar of income you make that year, so that if you made $200,000 your marginal rate would be the rate you paid on the 200,000th dollar).  Right now our rate structure generally has six rates, 10, 15, 25, 28, 33 and 35.  If your "TAXABLE INCOME" is $200,000 you are in the 33% tax bracket which means that the first $8,700 is taxed at 10%, the next $26,650 is taxed at 15%.  The next $50,300 is taxed at 25% with the next $90,800 taxed at 28%.  Finally the last $23,550 is taxed at 33% (though I don't intend to discuss this in this piece, note that though the taxpayer is said to be in the 33% bracket, only $23,550, about 10% of their TAXABLE INCOME, is actually taxed at 33%.  This, I believe, is greatly misunderstood by the taxpaying public in general).  In this example the taxpayer is single and has no income from stock ownership.  I think when discussing the progressive tax rate, it is not enough to simply say "that's how we've always done it so we must keep doing it that way".  The question is begged, do we believe that a progressive tax rate structure is desirable over a more regressive income tax, like the sales tax, or, like some countries have, a VAT (a single rate value added tax), or in this case a flat tax, and if so, why?

The desired result of a progressive income tax rate structure is to have the higher income earners pay a higher percentage of their income than lower income earners.  Here is a link to a paper by Cornell's Robert H. Frank, The Progressive Income Tax, which speaks at great length about practical benefits of a progressive income tax rate structure from one economist's point of view.  I found it to be very interesting and persuasive on the whole.  But I don't think that the average citizen will give 2 hoots and a holler about what Robert H. Frank thinks.  Many will be distrustful of him just because of his status in the academic world.  And many will be distrustful because his conclusions are, to many, counter intuitive and therefore not "common sense".

I suspect that the reason we have had a progressive income tax from 1913 on is that it maximizes the revenues a government can collect while minimizing the amount of political protest.  After all wealthy citizens have much more of what is called discretionary income and will feel the pinch of income taxes, if they feel it at all, to a much lesser extent. 

And maybe, from an emotional, moral and ethical standpoint, Americans have had, throughout most of this country's history, a soft spot for the hard working but down trodden poor and "soon to be poor" and even the almost poor, all the way up to "I can see the almost poor from here".  And so perhaps the progressive income tax rate structure appealed on that basis also.  Placing all other matters aside, perhaps we felt that if the government needs to take revenue from its citizens, perhaps they should stay out of the pockets of "the little guy".  The rich won't miss it near as much.  No rich person will do without because they pay a heftier portion of the income tax.

I believe that there are good reasons to keep the progressive rate structure.  Mr. Frank lays out a persuasive technical argument for it. 

However, there are those that would say that the progressive rate structure is now a myth anyway, due to allowing differing rate structures for differing kinds of income.  The 15% top rate on dividends and capital gains is the quintessential example that we have currently.  When our R Presidential candidate is paying a14% effective rate, Warren Buffet, one of the richest people in the world is paying a 15% effective rate and our President is paying a 20% effective rate then one must question whether we have a progressive income tax system at this point.  Many of us, with much less, pay a higher effective rate (an effective rate being the percentage of your taxable income being paid in taxes). If we take that as a sign that the progressive tax rate system is already gone anyway, then it is hard to use it as an argument against the flat tax.  However, there are still a lot of wealthy people that derive their income from sources that are not capped at 15%.  So, they are paying in the top marginal rate, now 35%. While not pure, we still maintain a progressive rate system.  I would still maintain that, in spite of its impurity, there is still plenty of reason that the progressive rate system that we have is still superior to a flat tax system.

2. When people talk to me about the flat tax, as I said earlier, I always ask about the fate of deductions in their flat tax plan.  Most say "no deductions".  I usually counter "even for self employed people...no deductions for the costs and expenses incurred in earning the revenue?  I would not be able to deduct my office expenses, computers and telephones and scanners and wages paid to employees and the cost of taking on extra contract labor when needed, office supplies, etc. etc.?  Some say "well of course you could deduct those".  Others actually say "no, no deductions of any kind."  But either way you go there are huge pitfalls and unintended results.

If a business owner (and for purposes of this discussion I am leaving out businesses that must file a return of their own such as partnerships S Corporations and C Corporation) can't deduct the costs and expenses of doing business then, even if the rate is very low, there will be situations that will arise where a business has very large revenue, but for whatever reason, that particular year they lost money on a cash basis or some other generally accepted accounting method.  That business would be hit with a large tax even though it lost money. 

So let's say that we DO allow businesses to take deductions for their "ordinary and necessary" business expenses.  The door is now open.  We CPAs and the tax lawyers and just plain ol' smart people will be burning the midnight oil, and making lots and lots of money, figuring out schemes (tax planning) whereby a taxpayer can have a new business and deduct expenditures that would otherwise be considered personal expenses under the law.  After all, they are now ordinary and necessary business expenses.  TA DA!  Maybe the schemes won't be allowed, so we'll think of some more and the government will have to expend a bunch of resources in policing and litigating tax law compliance.  Well, there goes one of the strongest arguments in favor of the flat tax, ease of and less costly administration.  To a great extent that kind of thing goes on under the current system.  You can't take a tax deduction for a hobby loss.  So my rich clients that want to play gentleman farmer have to tread very lightly because...NEWS FLASH...gentleman farmers lose a LOT of money.  Over the years there has been developed through court rulings and Tax Regulations some safe harbors that these people can use.  As long as they meet certain measurable criteria they can play gnetleman farmer and deduct the 1 or 2 or three hundred grand it costs per year.  THAT is why I know what would happen even if you allow business deductions.  Suddenly with a shift here and move over there those expenses are business expense.  Again, TA DA!

3.  Lastly, I would argue in favor of our current system, that as flawed as some of the laws are, at least we have flexibility in our ability to change it.  I think we have changed it too much since 2000.  Practically every year there has been major tax legislation.  But sometimes change is very helpful, even necessary.  And I see the inflexibility of  the flat tax as a bad thing, even if there were nothing else wrong with it.  With a flat tax where do you go from there but back to where we are now? 

And I think there is no argument that tax law is a vital and powerful component in fiscal policy.  The flexibility of having that powerful tool in the fiscal policy tool kit could make or break the country in some circumstances.  It's a complex world we live in...even moreso than I can fathom.  It's not 1780 anymore.  We are not an agrarian society.  Our government is not made up of a few slave owning gentleman farmers. We are the most powerful nation on Earth and in many ways that makes the world a lot smaller for us and a lot more complex than for most of the rest of the world (except in Alaska.  That place is like brand new).  Economics is more complex than ever in history.  We are juggling a heck of a lot of balls in the air.

The Bankers and Fiduciary Club of Houston has a lunch every month that I used to go to.  I hate stuff like that but business is business.  They always have a speaker and sometime they even have one that is interesting.  Dick Armey used to come and speak to us every now and then when he was a big shot in Washington in the 90s.  I was a serious Republican back then so I was pretty impressed.  Anyway, he would always harp on the flat tax and how it would solve all of our problems.  There are a LOT of CPAs and tax lawyers in the organization who knew more about taxation then Dick Armey ever even dreamed of.  And it was fun when one of them would take Armey on on this subject.  It would get really tense because he was passionate about it...probably because he had invested so much of his time in speaking about it that he had kind of become synonomous with the subject.  But after the first time he came and spoke about it I spent some time reflecting on the whole concept and what I would do as a tax professional if the country decided to go down that road.  I told Marhsi, my wife, that if the country could ever come up with a better tax system that would do everything we need it to do, whether it was a flat tax or some other kind of tax, if it resulted in me having to change my work focus I would do it and be happy to do it.  I never want to be one of those people that always "kicks against the pricks".

I have included a link below for a website which shows the income tax rate structure since 1913.

http://www.taxfoundation.org/files/fed_individual_rate_history_nominal&adjusted-20110909.pdf .