Real Tax Reform
It's tax time again. Although many Americans will have to work beyond April 15 just to make enough to pay their taxes (Tax Freedom Day falls on April 30 this year), the income tax is the tax that infuriates Americans the most. And rightly so, since it is the primary means of funding the interventionist-welfare state.
According to the Congressional Budget Office, the total revenue of the federal government during its most recently completed fiscal year (FY 2006) was $2.406 trillion. Individual income taxes accounted for $1.043 trillion of the government's total take. Besides individual income taxes, the government's revenue also comes from corporate income taxes, social insurance taxes, excise taxes, estate and gift taxes, customs duties, and miscellaneous receipts.
Individual income taxes could painlessly be eliminated if federal spending was simply reduced to about the level it was at the beginning of the previous administration. Unfortunately, however, no recent tax reform proposal even addresses the issue of giving the federal government less money to spend.
There is no shortage of tax reform proposals currently being promoted. Although they are all quite dissimilar, there are some common themes that proponents of these plans emphasize: the complexity of the current tax code, the abuses of the IRS, loopholes that allow some individuals to avoid paying their fair share, and the millions of dollars and hours wasted on compliance and enforcement costs. Advocates of the various tax reform proposals not only promise that their plans will reduce complexity, tame the IRS, close loopholes, improve fairness, and reduce compliance and enforcement costs, they will also make us more prosperous, invigorate the economy, create jobs, reduce the tax burden on the middle class, promote economic growth, and make us more competitive overseas.
Yet all of these plans are doomed from the beginning as a solution to the wealth-destroying, redistributionist, success-punishing, social engineering, welfare state-funding tax code because they ignore the real problem.
The Flat Tax
An income tax with a flat rate, such as that advocated by Steve Forbes in his book Flat Tax Revolution (Regnery, 2005), is one proposed alternative to our current income tax system with six brackets (10, 15, 25, 28, 33, and 35%). Under Forbes's flat tax plan, there would be a flat rate of 17 percent with "generous exemptions for adults and children" that can be filed on a form about the size of a postcard. The Forbes plan would eliminate the estate tax and the Alternative Minimum tax, as well as taxes on capital gains, Social Security benefits, interest earned, and dividends received; it would not eliminate Social Security taxes, Medicare taxes, or federal excise taxes.
But rather than being a real flat tax, like the Medicare tax of 2.9 percent that everyone pays, Forbes's flat tax is a highly progressive tax that shifts the tax burden to the middle and upper classes that have earned income. Because of its "generous exemptions for adults and children," it ends up having tax brackets like the current system. And with its refundable tax credit of $1,000 per child and its refundable Earned Income Tax Credit, the flat tax perpetuates a welfare scheme.
I have critiqued Forbes's Flat Tax Plan in detail here.
Another proposed tax reform measure is a consumption tax in the form of a national retail sales tax (NRST) called the FairTax. Legislation to this effect has been introduced in Congress by John Linder (R-GA). The most prominent advocate of the FairTax has been syndicated radio talk show host Neal Boortz. Linder and Boortz are the authors of The FairTax Book (Regan Books, 2005). The FairTax would replace income taxes, capital gains taxes, social insurance taxes, excise taxes, estate taxes, gift taxes, Social Security taxes, and Medicare taxes with a NRST of 23 percent on all new goods and services. In addition, every family in America would receive a monthly "prebate" check from the federal government to be reimbursed for the taxes paid on "the basic necessities of life."
The rate of the FairTax is actually 30 percent, not 23 percent. FairTax advocates obtain the number of 23 percent because they figure the rate inclusively (the tax is included in the price of the product) rather than exclusively (the tax is added to the price of the product). Although proponents of the FairTax talk about how it would eliminate the IRS, it would do nothing but change its name and function. The FairTax plan creates new taxes, new taxpayers, and new tax collectors. Because it makes it easier for the federal government to raise taxes, institutes universal welfare with its prebate check, is even more progressive than our current system, and has unknown and potentially huge transition costs, the FairTax should not be considered an incremental step toward more liberty and less government.
I have critiqued Linder and Boortz's FairTax Plan in detail here.
Other Tax Reform Proposals
Although the Flat Tax and the FairTax plans usually take center stage, there are some other tax reform proposals out there. Dale Jorgenson, an economist at Harvard University, advocates an income tax plan called the Efficient Taxation of Income. It would tax earned income at a flat rate of 10 percent and property-type income at a rate of 30 percent. Another proposal is the Business Transfer Tax. This is a value-added tax based on the difference between revenues and purchases for all enterprises and employers. It substitutes rebates for exemptions, deductions, and credits.
Government Tax Reform
Ever wanting to increase its revenue while making people feel better about paying their taxes, the federal government has also gotten in on the tax reform racket. The President's Advisory Panel on Federal Tax Reform has recommended two tax reform proposals. The Simplified Income Tax Plan would create four tax brackets. Although it would still tax interest received at regular income tax rates, it would exclude from taxation 100 percent of dividends and 75 percent of corporate-stock capital gains. The Growth and Investment Tax Plan would create three tax brackets and tax dividends, capital gains, and interest received at a rate of 15 percent. Both plans would replace the personal exemption, standard deduction, and child tax credit with a family credit. The earned income tax credit and home mortgage interest deduction would be replaced with different programs.
The problem with every one of these tax reform plans is a simple one: they are designed to be revenue neutral. Every federal agency, every federal program, every pound of federal pork — will be funded exactly as it is now. But funding Bush's new $3 trillion budget is not "fair" to American taxpayers no matter how the money is taken from them.
The concept of "revenue neutrality" is one that all advocates of liberty and limited government should be suspicious of. All revenue-neutral tax reform proposals allow Congress to maintain its spending orgy while appearing to lower taxes. The federal government is always the winner under any tax reform plan that is revenue neutral. These proposals merely shift the debate from how much wealth the federal government confiscates from its citizens to the manner in which it is done. The real problem is the bloated, profligate monstrosity that the federal government has become.
Those of us who believe that taxation is theft, and that there is nothing "fair" about the federal government seizing a portion of its citizens' income or confiscating 23 or 30 percent of the value of every new good or service, are often told that we support the current tax system with its 54,000 pages of Internal Revenue Code because we don't jump for joy over any of the abovementioned tax reform plans.
Nothing could be further from the truth.
We just believe that a tax plan that perpetuates the welfare state and pays for the warfare state is not the solution. Obviously, the "best" tax reform plan, from the standpoint of liberty and less government, would be to eliminate taxes entirely. None of us are naïve enough to think that will ever happen as long as we have the state to deal with. However, in the mean time, the next best type of tax reform is one that results in a substantial lowering of the amount of taxes collected. If taxes are cut by a large enough amount, then no one will be too concerned about how the government collects its taxes. Real tax reform begins with the drastic reduction of taxes and tax rates.
Critics of real tax reform (those who espouse "revenue neutral" tax reform plans) have been quick to criticize the rest of us because (so they say) all we do is shoot down their tax reform proposals and never offer any of our own. Therefore, as a first step toward real tax reform, I would like to show, in very simple terms, how individual income taxes could painlessly be eliminated: reduce federal spending to the level it was at the beginning of the previous administration.
At the beginning of this article I said that the total revenue of the federal government during its most recently completely fiscal year was $2.406 trillion and that individual income taxes collected during this period were $1.043 trillion. This means that if you subtract the income taxes collected from total revenue you end up with $1.363 trillion for the federal government to spend. That is just a little less than the government spent during the fiscal year in which Clinton began his first term.
Are income taxes evil? Yes. Should they be eliminated? Yes. Would it be a terrible thing if the federal government still spent over $1 trillion? Yes. But it is a start. It is real tax reform. With no income tax, there will be no capital gains tax, no withholding tax, no EITC welfare program, and no refundable child credit welfare program — all without a NRST.
All of this, of course, depends on Congress. Although it is true that the president submits a budget to Congress, it is Congress that ultimately decides on the amount of federal spending. It is only because we have a monstrous welfare/warfare state that the government "needs" to collect an income tax. The beginning of Clinton's presidency was not that long ago. The income tax can be abolished. It can be done quickly; it can be done painlessly — and it can be done for the benefit of the American taxpayer instead of the federal leviathan. Now that is real tax reform.
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.