Beyond Repair

Tuesday, July 30, 2002

Enron, political campaign contributions, and April 15 all have one thing in common: the Federal Income Tax Code.

Enron allegedly engaged in accounting shenanigans to circumvent the tax code as well as to mislead the investment community. Encouraged by the complexity of the tax code, the company used arcane accounting practices that inflated reported earnings to shareholders while at the same time hiding income from the Internal Revenue Service (IRS). Virtually all corporations employ a battery of attorneys and accountants to figure out how they can legally circumvent the tax code. This is a burden to the corporation as well as the economy.

Campaign contributions flow from special-interest groups to political candidates so that they will provide the special-interest group with favored treatment under the tax code. There are more than 100 exemptions, credits, and deductions under the tax code. Each exemption, credit, or deduction represents a special-interest group. This is a corruption of the political process as well as a burden to the economy.

April 15 is the most infamous day of the year. This year some 130 million individuals filed federal income tax returns and in the process became reacquainted with the monstrosity known as the Federal Income Tax Code. This is a burden not only to the tax return filer but also to the economy.

The negative common thread between misleading or fraudulent accounting, campaign finances, and the income tax filer can be eliminated by reforming the tax code.

The Tax Burden

The tax code is designed by Congress to (1) raise enough revenue to pay for its own activities (the bureaucracy of the three branches of government, defense, infrastructure development, etc.); (2) redistribute income from those who have it to those who do not (entitlement programs); and (3) reward special-interest groups through deductions, credits, and other loopholes. To accomplish this agenda, the tax code has evolved into an incomprehensible and impenetrable collection of jargon that impedes incentives, resourcefulness, and risk taking.

The Federal Income Tax Code comprises a whopping 6,000 pages. The instructions for filing Form 1040 (and related schedules) alone come to more than 100 pages. All told, each year the American people spend more than 2 billion hours preparing their tax returns and corporations devote about 3.5 billion hours to tax-related paperwork. The IRS estimates that each tax filer using Form 1040 and related schedules (about half of all taxpayers) spent on average more than 20 hours preparing his or her 2001 return, up 25 percent from three years ago. (This does not include the time spent by hired accountants.) According to the Tax Foundation, individuals and corporations spend more than $224 billion a year to measure, track, document, shelter, prepare, and file tax returns. The Citizens for an Alternative Tax System estimates the cost of compliance to the economy at more than $600 billion annually—almost twice the defense budget and more than the revenues gained last year from Social Security taxes. Indeed, we could save Social Security by simplifying the tax code.

Tax code changes enacted by Congress in 1997, 2001, and 2002 have added more pages, schedules, and forms to the code. Recent changes have increased the complexity of the code, which in turn has increased the cost of compliance and the burden to the economy. We are going in the wrong direction.

The tax code is economically destructive because it taxes savings and investment at the expense of consumption. Wages are taxed once, interest income and capital gains twice, dividends three times, and finally the estate (the accumulation of one’s life total of wages, savings, and investment returns) is taxed again at death. The very nature of this multiple taxation of income discourages savings and investment, not to mention work itself. Although the target of this multiple taxation of income and savings is the rich, the burden of these taxes falls on the middle class and poor because the taxes stifle investment, new business creation, and employment formation.

The tax code fosters political corruption through the bribing of public officials by special-interest groups in the form of campaign contributions (despite the enactment of the McCain-Feingold campaign finance reform bill).

Finally, the tax code fosters corporate corruption when companies like Enron use it to manipulate and misrepresent revenue, income, assets, and liabilities.

In 1996 the National Commission on Economic Growth and Tax Reform concluded after an extensive study that “the present tax system is beyond repair. It is impossibly complex, outrageously expensive, overly intrusive, economically destructive, and manifestly unfair.” The commission observed that “the current tax code cannot be revised, should not be reinvented, and must not be retained.” If Martians were to land in Washington, D.C., and, as their first act, read the tax code, they would conclude that there is no intelligent life on earth.

The Solution

How best to fix the tax system? The following ideas should be implemented in reformulating the tax code:

Tax all income once and at its source. This would shift the burden of taxation from savings and investment to consumption. This would eliminate the multiple taxation of interest, dividends, capital gains, and inheritance. Market forces would then dictate that resources be allocated to their highest and most productive use without the distortions created by taxes.

Broaden the tax base by eliminating all deductions, credits, and exemptions. The government calls these reductions in the tax base “tax expenditures.” The revenue loss to the federal government resulting from deductions, credits, and exemptions is more than $400 billion annually (or about 4 percent of GDP).

The reduction in the tax base resulting from deductions and other tax expenditures results in higher tax rates to raise the same amount of total tax revenue. However, higher tax rates encourage the shifting, hiding, sheltering, and underreporting of income. High marginal tax rates also reduce the incentives to work, produce, save, and invest, thereby dampening overall economic activity and job creation.

Tax expenditures are Congress’s response to the pressure of lobbies and special-interest groups. By their very nature they are unfair because one wage earner is treated differently than another. Deductions and tax credits are designed to encourage one activity over another. This is called social engineering: a group of bureaucrats deciding what is best for the economy. Under socialist and communist governments we call this central planning. Targeted tax credits and other special-interest loopholes cause a misallocation of labor and capital resources because they inhibit the free forces of the marketplace. If we believe in free markets, we should let them work without the distortions imposed by social engineers.

Create one tax bracket with a large front-end standard deduction. A standard deduction in the range of $30,000 would remove more than 5 million low-income families from the tax rolls. The standard deduction makes the tax structure progressive (that is, those with higher incomes pay a higher percentage of their income in taxes than do those with lower incomes). A large front-end standard deduction would eliminate the need for multiple tax brackets and their concurrent complexity.

Eliminate payroll (Social Security and Medicare) taxes. Payroll taxes total 15.3 percent on incomes up to $84,900, with the cost of the tax split evenly between employee and employer. Above this income cap, Social Security taxes stop, but the Medicare tax (2.9 percent for employees and employers combined) continues to the last dollar earned. The Social Security part of the payroll tax is highly regressive (a regressive tax system places a higher rate of taxation, as a percentage of total income, on lower incomes). Social Security taxes are particularly regressive in that all earned income above the cap ($84,900) is not taxed at all. The payroll tax burden falls almost entirely on the middle class. Total payroll taxes exceed income taxes for 80 percent of wage earners; 90 percent of workers have all of their earned income subject to the payroll tax. Unlike income taxes, the payroll tax cannot be reduced through a standard deduction, itemized deductions, or other loopholes. Only low-income earners are able to seek relief through the Earned Income Tax Credit, which has its own complexity and is subject to increasing abuse. Eliminating the payroll tax reduces the tax burden on the middle class and restores fairness to the tax system.

The tax code structure outlined above is often referred to as the flat tax. However, prior proposals have not addressed the payroll tax. Thus prior flat tax proposals are justly criticized because the middle class has to absorb the relief in tax burden that the flat tax provides to lower- and upper-income groups. Eliminating deductions will pay for eliminating the payroll tax. A flat tax rate of 22–24 percent will raise the same amount of revenue as is currently collected. This model is static in that it assumes no behavioral change resulting from the incentives unleashed by a lowering of tax rates and the redirection of labor and capital to productive investment. Under a dynamic analysis it is likely that a flat tax would increase government tax receipts, as the behavioral response to the increased incentives to work, produce, save, and invest would enhance overall economic activity. The tax rate could then be lowered to a point of equilibrium.

In 1986, Congress, in an unusual display of bipartisanship, passed a tax bill that reduced loopholes and lowered marginal tax rates. Special interests took a back seat to the national interest. The top marginal income tax rate was lowered to 28 percent from a rate that had been as high as 70 percent in 1980. But the reforms of 1986 were dismantled in the tax bills of 1990, 1993, and 1997. The 2001 tax bill initiated a modest and gradual reduction in marginal rates but added complexity, as did the 2002 tax legislation. As a result the tax code is lengthier and more complex than ever.

“Taxation without representation” became the rallying cry for the American Revolution. The Boston Tea Party in 1773 was one of a long series of protests against British taxation. Colonists boarded British ships and threw tea into Boston Harbor. I suspect that if the colonists were to review the current tax code they would chuck it overboard too.