Federal individual income tax

[Updated the implementation plan on August 17, 2009.]

When I started this blog it was partly because I believed I had some good ideas about various issues. Now that the excitement of the election is behind us and the initial Obama administration flurry is subsiding, I’m going to tackle some of those issues. First up: the Federal Individual Income Tax.

All tax policy is based on beliefs about what is right and fair and how things should work. There is no value-free tax policy. Here are the beliefs behind my tax policy:

1) Everyone should pay taxes. I don't care how little you make or where your money comes from - you pay taxes on it. There must never be a time when some people pay taxes and some people do not - we're all in this together.*

2) Income tax rates should be progressive. I'm utterly opposed to a flat-rate tax. Although I'm not at all religious I did spend a lot of years in Sunday School and the Parable of the Widow's Mite has stayed with me ever since.

3) People shouldn’t be making life decisions based on the tax implications. For example, a house is a huge responsibility and - as we‘ve just seen quite clearly - can be a world of trouble. But because avoiding taxes is seem as a universal good, people apparently do actually say to themselves, “What the heck! I’ll buy a house. It’s just like paying rent but I get to deduct the mortgage insurance.” This deforms rational decision-making.

4) The tax code is not the place for social engineering (beyond that already implicit in a progressive tax code). In order for a tax system to work, the system must be perceived as fair and clear. The more the tax code is used to promote desired outcomes the more people argue it’s not fair. Remember the fights over the “marriage tax” and now over the “death tax”? I could get a whole post out of the whole "charitable deductions aren’t fair" quarrel. Most destructive, of course, is the chronic suspicion that the rich can somehow use “tricks” that aren’t available to those less well off. Make the tax code simple and clear and many of those complaints disappear.

What does this mean in practice for my tax policy? First, no one is in a 0% tax bracket. This is not a change from recent tax policy. The 2008 and 2009 Federal Individual Tax Rates define the Marginal Tax Rate for people making from $0 to whatever as 10%.** In other words, based on current tax policy, if you make $100, you owe the government $10.

It doesn’t actually work that way, of course. To start with everyone gets a standard deduction: $5,450 on the 2008 1040A for people filing single, more if you’re a head of household ($8,000) or married filing jointly ($10,900). If you have children, you get a $3,500 credit for each child. So if you’re married and you have 2 children, you don’t pay any tax unless you make more than $17,900. And you only pay then if you do not qualify for any of the other deductions and tax credits listed on Form 1040A (pdf). Plus you can qualify for even more deductions which means a Form 1040 and Schedules.

So under my plan, no deductions. You pay taxes on whatever you make. I don’t care if you have 10 children or no children; if you contribute to an IRA or give to charity; if you’re paying off student loans, pay interest on your mortgage, or have medical bills out the wazoo. None of that is the concern of the IRS and so none of that is deductible.

There is one and only one exception to the “No deductibles” rule: Any money the Federal government is already withholding from your paycheck does get deducted from your income before you calculate your taxes. This means whatever is withheld for Social Security, Medicare, etc., does not get taxed. This includes your employer’s matching Social Security amount.

If the country wants to continue to encourage certain choices such as having children or taking on a mortgage or wants to ameliorate bad fortune like incurring huge medical expenses or becoming disabled, that’s fine. The government can fund programs to provide financial help to people who meet certain criteria and mail those people checks. Whatever situation the government wants to reward or ease it can do so, just not in the tax code.

Which brings me to the next rule of my plan: all of your income is taxable and - with a few exceptions I’ll note in a minute - it’s all taxable at the same rate. If you get a check from one of the programs I discussed in the last paragraph to encourage you to have children or to lessen the blow of huge medical expenses, that’s taxable income. If you get money from Social Security or welfare, from a job or a trust fund, it’s all taxable. Income “in kind” is taxable, too. Yes, this means the use of a car and driver but it also means food stamps and public housing. If you’re the CEO of a huge megacorp and the company provides you with an apartment, that’s taxable income. If your company pays for part of your medical insurance; puts matching funds into a retirement account for you; puts money into a pension fund for you - it’s all taxable income. (Medicare is a huge knot to wrestle with. I’ve solved Social Security - except for one small glitch - but I haven’t solved Medicare. Until I know more, I don’t know whether the Medicare “premiums” the government is essentially paying for the elderly should be taxed as income.)

Furthermore, all of an individual’s income counts the same. Salary, savings account interest, stock dividends, stock sales, Social Security, welfare, income “in kind”, whatever. It all goes into the same pot, gets added up, and that’s the income you pay taxes on. No special rates for capital gains and stuff like that.

While you’re recovering from the shock, let’s talk about those exceptions. All but one have to do with selling stuff you own:

1) When you sell stock, you count as income the difference between what you paid for the stock and what you sold it for. If you lost money on the stock you can count that as a loss. However, you must (not may, must) income average any profit or loss across the years you owned the stock. This means filing amended tax returns for those years if necessary.

2) When you sell your house you count as income the difference between what you paid for the house and what you sold it for. If you lose money on your house that does NOT count as a loss - after all, you had the use of the house for however long you owned it so you don't get any better deal than someone who has paid rent all those years. If you want, you may income average any profit across the years you owned your house. This means filing amended tax returns for those years if necessary.

3) Selling any other real property - a car, unused clothes, old gold jewelry, the china you inherited from your grandmother - works just like selling your house. The profit is the difference between what you paid for the item and what you sold it for; you cannot deduct losses from your income; if you want you may income average any profit across the years you owned the item (and file any necessary amended tax returns). If you cannot prove how much you paid for the item or if you did not pay anything for the item, the profit is whatever you sell it for. In the case of inherited items, the price at which you “bought” is the value on which you paid income tax when you inherited the property. Which brings me to :

4) Yes, inherited property is just another form of income, treated the same as all the rest except that I would allow income averaging over some number of years into the future to reduce the tax burden of inheriting, say, your parent’s paid-off home or your aunt’s thriving accounting business. We could set a fixed number of years - say five or ten - or we could get into calculating the number of years to income average based on the size of your inheritance vis-a-vis your income before the inheritance. The latter is much more fun.

One more rule: You pay taxes on your own income. That means if two people are married they don’t “File jointly” and pay taxes based on their joint income. Each spouse files a tax return and pays taxes on whatever income he or she makes. There is only one type of filing: Single.

So what should the tax rates be? Well, first, if you’re screaming in outrage because some poor person who makes $1,000 a year has to pay the government $100 of that, don’t. The lowest tax bracket shouldn’t be 10%; it should be 1/10th of 1%. Someone who makes $1000 has to pay the government $1. For the rest of the brackets, I want to replicate the current effective tax rates. This will make the change revenue-neutral for the government and - on average - tax neutral for taxpayers. The lowest bracket will, of course, now be paying taxes but the amounts are nominal ($40 on an annual income of $40,000).

The effective tax rate is the percent of total income (before deductions) paid in individual Federal income taxes. The Congressional Budget Office (CBO) has kindly put together this data although the most recent year I can find is 2005. (Information on earlier years is here.) The CBO gives effective tax rates broken down by quintiles along with average income for each quintile. It also gives the same figures for the top 10%, 5%, and 1%. This data isn’t perfect. In the incredibly unlikely event we ever decide to adopt my plan someone should spend a lot of time slicing and dicing the income tax data to determine effective tax rates for a variety of income groupings. However, it will do to go on with.

The average incomes for each quintile and then for the top percent groups become my tax brackets. My marginal tax rates are set up so that someone making what the CBO gives as average income will pay about what his effective tax rate was. Since the Lowest and Second Quintiles both have negative effective tax rates, I’ve set my tax rate for those two groups at 0.1%.

Here is my tax table with an additional column to show the effective tax rate for those making the top end of each bracket under my proposal. ((For the highest bracket I calculated Effective Tax Rate for someone making $1,500,000 since that was the average pretax income for the Top 1% in 2005.):

Over	But not over	Marginal Tax Rate	Effective Tax Rate
0	40,000	00.1%	00.1%
40,000	60,000	09.0%	03.0%
60,000	85,000	13.0%	06.0%
85,000	230,000	19.0%	14.0%
230,000	340,000	20.0%	16.0%
340,000	520,000	21.0%	18.0%
520,000		22.0%	20.5%

There’s one more element I want in this plan: The highest marginal tax rate will never exceed 25%. I’ll have more to say about this when I do my Position Paper on shrinking the Federal government. And at this point, I’d be quite happy if this plan was implemented even without such a cap.***

[Updated, August 17, 2009: Unfortunately, I had a lapse of logic when I originally described how I would phase in my new tax plan so I'm striking out the old implementation and putting in the new.]

Speaking of which, how would I implement it? I’d allow some fixed amount of time for switch-over, say five years. For those five years each taxpayer can elect to use either the old method of calculating taxes (complete with deductions and the old tax tables) or the new method of calculating taxes. That lets people who made major decisions based on the tax code adjust those decisions accordingly. After that five-year period, everyone follows the new rules.

[Um, no. If the government has to convert programs from relying on forgiving taxes to relying on distributing payments then people can’t pick whether to follow the new tax structure or the old one. In order to do so, the government would have to know to mail checks only to people following the new tax structure. So here’s my new implementation plan:

Speaking of which, how would I implement it? I don’t think there’s any way to phase it in gradually. We could manage a gradual phasing out of deductions and tax credits while phasing in the corresponding replacement government payments without too much trouble. However, adjusting the tax rates in step with these partial changes would be so complex as to be almost impossible to do at all and completely impossible to do in any way that convinces people it’s rational and fair. So we’ll simply have to set a date some number of years after passage - I’d prefer no more than two but could live with anything up to five - at which point the new structure kicks in. This means, of course, we’ll need to find a way to make sure the new tax structure isn’t un-legislated in the meantime. If legally possible - and I do not know if it is - the legislation creating the new tax structure should contain a provision that means it can only be modified or overturned by a super majority for, say, ten years after it’s passed.

There. All better.]

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* Yes, I am explicitly arguing that everyone should have to face the fact that the government does not pay for anything. Individuals pay for everything and I think it’s important that everyone who can vote both understand that intellectually and see the reality in terms of diverted income. A character in one of Rumer Godden’s books explains quite clearly why this sort of understanding is important (emphasis mine):

Faced with a most un-monastic need for a vast sum of money to pay for a building project that was committed to under the belief someone else would pay for it, the cellarer of Brede Abbey cuts back on a hundred small expenses. The Abbess tells her, “Dame, you are saving shillings and pennies when we need thousands of pounds.”

The cellarer replies, “I am aware of that but shillings will help. Besides, it brings home that buildings have to be paid for.”


** From 1916 to 2009 the bottom tax rate has been greater than 0% except for the period between 1977 and 1987.


*** This doesn’t address all the issues with individual taxpayers, of course. People who work at home and file as individuals will need some thought. Yes, some of their income is simply passthrough (billing clients for business expenses, for example) and some of their expenses are legitimate (a hairdresser who buys a hair dryer, for example). But can someone who works at home but must visit his clients once a week write travel off as an expense even though someone who commutes to work every day cannot do so. Obviously this will get very complicated very fast.

Also, as part of the quarrel over defining the rich as those making more than $250,000 a year, there have been claims that some people run small businesses - with employees - yet file individual income tax forms. I don’t understand how this works so that’s an area I will have to leave to those who are more knowledgeable than I.