The Tax Code and Wishful Thinking

(Doug Keegan’s Making Cents reports on personal finance air on Lincoln Radio Journal. www.lincolnradiojournal.com.)

Its tax time again. And for some of us, that means hours spent pouring over statements and filling out confusing forms. The process can be, well, less than pleasant. So what can be done to improve our income tax system? Doug Keegan of Harris SBSB is here to explain.

Doug, before we get your thoughts on improving the income tax system, you wanted discuss its history.

Yes, I do because I think it’s fascinating. You know, back in the good old days, that is, after we won the Revolutionary War, did you know our federal government didn’t tax people’s labor. Instead, it taxed things like alcohol and tobacco. So, essentially, it was more of a consumption tax. And it was like that up until the Civil War. But when the Civil War erupted, Congress needed money. So out of desperation they enacted our country’s first income tax law and set up the Office of Internal Revenue, known today as the IRS. However, the income tax was not meant to be permanent and was abolished in 1872.

Everything was fine again for many years up until 1894, when a flat tax was enacted. But the flat tax was challenged and ruled unconstitutional by the U.S. Supreme Court because at that time all federal taxes had to be based on state population. So, in order to create a permanent income tax, the Constitution had to be changed. By 1913, there was enough political will and support to amend the constitution to grant Congress the power to collect income taxes. And that amendment, the Sixteenth Amendment, changed taxation in America forever.

But Lowman, it really wasn’t until WWII before the income tax affected most Americans. Prior to WWII, very few Americans paid income taxes because the tax targeted high income earners. For example, in 1939, just before the war started, the marginal tax rate was 4% if you made less than $4,000 a year, no matter you filing status. To put that into perspective, more than half of American households in the 1930s earned less than $1,500. So, most Americans paid little to no income taxes prior to WWII. But starting in 1941, because of the war and the need to fund the war effort, the federal government had no choice but to extend the income tax to virtually all Americans and increase marginal tax rates. They also began collecting income tax through payroll withholding. By 1945, some 43 million taxpayers paid into the system compared to just 4 million in 1939. And the lowest marginal tax rate jumped from 4% to 23%. Now of course, Lowman, the rate increase, collected through payroll withholding, was sold to Americans as a wartime emergency necessity. It was supposed to go away after we won the war. But, like most expansions of government, it didn’t and the marginal tax rate for those in the lowest tax bracket remained around 20% up until the mid 1960s. And that tax structure, including payroll withholding, remains with us today.

What is your point of view when it comes to income taxes?
I think income taxes should exist solely to pay for appropriate functions of government. Now I know we can debate all day what that means, but in my opinion, when the tax code is used to reward or penalize particular behaviors or groups, it becomes the tangled mess we have today.

Lowman, almost half of US households pay no income tax. And for those that do, according to the Tax Foundation, their tax bill averages 3 months pay when you factor in state and local taxes, Social Security and Medicare. Now, I understand that in order for our society to function, we need centralized services and government plays an important role in delivering those services. But why should someone have to wait 3 months before enjoying the fruits of their labor while others don’t have to wait at all.

I think all tax professionals would agree that good tax policy should include equity and fairness, certainty, simplicity, and transparency. I’ll leave it to your listeners to judge if they think we have that.

So what are some areas in the tax code you would like to see improved?
Let me give you few examples. I think almost everyone should have some "skin in the game". Why does Congress get to pick who pays and who doesn’t pay? Why shouldn’t we all pay our fair share?

I also think that taxes should be paid directly by each individual so that each person is aware of their true tax burden. Taxes like corporate taxes and tariffs actually disguise the actual burden of the tax. For example, when a corporation is taxed, there are only three possible sources for those funds: a stockholder receives lower dividends, an employee receives lower wages, or a consumer pays higher prices. Also, the current tax code encourages corporations to incur debt by making debt tax deductible, while dividends are not tax deductible. Eliminating corporate taxes removes this disparity in treatment.

Now let’s talk about itemized deductions. I think mortgage interest deductions should be eliminated. Why should the government favor buying over renting? Renting is better for lower income people. Plus, the deduction is only available for those who incur debt. Why should the tax code irrationally encourage debt?

Next, I think deductions for state and local taxes should be eliminated. Why should taxpayers in states with lower taxes subsidize taxpayers in states with higher taxes? Here’s how it works. Imagine two taxpayers in two states. Each one makes $100,000 and to make the math simple each has a tax bracket of 20%. So each pays $20,000 and each pays equally for the cost of government given their income. But, if there is a 5% state tax in one of the states, the state takes $5,000 from that taxpayer, but the taxpayer gets $1,000 back on their federal taxes. That’s how taxpayers in states with lower taxes are subsidizing taxpayers in states with higher taxes.

Finally, let’s talk about capital gains rates. Capital gains are taxed at different rates from ordinary income. This causes gaming of the system and should be eliminated. Why? A business owner can do three things with profit: they can take it out as salary, they can take it out as dividends, or they can allow it to grow the value of their company, selling it later as a capital gain. Having unequal tax treatments for those three items provides incentives to structure things differently. Having the same rates for everything removes the incentives completely. It then doesn’t matter how the individual is paid.

What would you propose?
First of all, I have no clue how to fix the current system. It’s such a mess. But if there’s an overhaul, I want it to be fair and transparent. But the likelihood of that ever happening in Congress seems very remote. However, if I had a choice, I would prefer the flat tax. Now we can debate percentages, but I think in principle the flat tax is simple and straightforward. I also think there should be a few non-refundable credits for items such as medical expenses, charitable contributions, education expenses or savings into retirement accounts. These credits would be available to anyone and could be carried back 5 years or forward indefinitely. Again, we can debate the percentages, but I think you would have broad public support for those types of credits. In the end, whatever is proposed, I just want it to fair and transparent.