73,608…what is the significance of that number? If you answered “the number of pages in the 2012 US federal tax code” congratulations, you win!
The federal tax code is bloated and over complicated. Every election it seems a new set of politicians from each party pledge to make simplifying the tax code a top priority, yet it never happens. Judging from the feedback on my post about preparing your own taxes it seems more and more people are opting to have a professional do their taxes for them. Really, who can blame them? Its gotten to the point where even those of us that do prepare our own tax returns can’t do it without the aid of complex tax software.
Instead of tinkering with our current system and making it even more complex as we strive for fairness, why not throw the entire thing out the window and explore a better option?
Before you think I’ve gone completely off the deep end, let’s explore two possible alternatives to our current “progressive” income tax system.
Option #1: The Flat Tax
A flat tax is just what it sounds like: A single, uniform tax levied on every taxpayer. A flat tax doesn’t treat people differently depending on their income and it is devoid of all the confusing deductions and exploitable loopholes found in our current system.
If a flat tax of 15% was instituted, everyone would pay 15% of whatever income they made.
A person making $40,000/year would pay: $40,000 * .15 = $6000
A person making $500,000/year would pay: $500,000 *.15 = $75,000
Simple enough, right? The rich person still pays more in overall dollars, yet everyone is “pulling their own weight” by paying the same percentage of income.
Pros & Cons of the Flat Tax System
- It’s simple. Add up your income earned in the prior year and cut Uncle Sam a check for 15% and get on with your day. Less hassle, less bureaucracy, what’s not to love?
- No loopholes. Rich people and corporations with teams of expensive CPA’s can’t game the system like they can now. No more debates on how Warren Buffett or Mitt Romney pay a lower tax rate than their middle class employees.
- No “penalty” for success. Some would argue that entrepreneurship and investment is stifled under our current tax system. With a flat tax this disappears as the tax rate remains constant no matter your income.
- The tax industry would be destroyed. There would be no need for all the tax preparation services we have today. Thousands at the IRS and CPA’s across the country would be put out of work. The ripple effect could have a significant effect on our economy and job market.
- It hurts the poor. Yes, I know I said everyone pays the same percentage. But our current system has a lot of breaks and deductions built-in that help the elderly and poor often reduce their tax burden to zero. In a true flat tax system these people living at or below the poverty line would be forced to pay the government money that they probably can’t afford to live without.
- No refunds. Without deductions for charitable giving, mortgage interest, children or the earned income credit everyone would have to pay up come tax time. This could burden those families that rely on their yearly tax refund check.
- Decrease in retirement savings and charitable giving? There is a worry that people will give less to charity if there is no tax benefit to doing so. I think only a horrible person would give to charity solely for the tax breaks, but I’m sure it happens. There is also a worry that retirement savings would shrink without the tax benefit of doing so. This would put even more of a reliance on our dysfunctional social security system for retirees.
On the surface a flat tax system sounds like the perfect fix. It’s simple and everyone pays their fair share. However as you dig into the realities of a flat tax, it becomes clear that if it was ever to be adopted in the United States it would have to be a modified version. One that allows exemptions for the poor and certain other deductions that Americans just can’t live without.
So if a flat tax isn’t our silver bullet, what else is there?
Option #2: The Consumption Tax
The consumption tax, often called the “fair” tax, wipes out income taxes altogether. With a consumption tax, all tax revenues are generated via a national sales tax. People would only be taxed when they spent money, not when they earned money.
Many states, such as my state of New York, have statewide sales taxes. A national consumption tax would resemble these taxes but would most likely be more comprehensive than the state sales taxes (some states don’t tax food, or clothing etc…).
Pros & Cons of the Consumption Tax System
- It encourages saving. Savings rates for Americans are embarrassingly low. With a national consumption tax people would be encouraged to save more of their money because buying more needless crap would mean paying more in taxes! You’d see far fewer people living above their means as an over sized “McMansion”, the newest BMW, or buying a new iPad every other year would no longer be seen as “needs”.
- It expands the tax base. Because spending, and not income is taxed it would collect taxes from everyone living in or visiting the country. People working “under the table”, illegal immigrants, and even drug dealers now become contributing tax payers.
- Increased productivity. Instead of taxing productivity as we now do, we would be taxing consumption. This would further increase the incentive to work harder, be more productive and earn more money.
- The stock market would benefit. With no tax on investments, new money would come pouring into Wall St. sending the markets higher. Businesses would also save money which could lead to more businesses paying out more dividends to investors or even resulting in greater job creation.
- A consumption tax is regressive. – Lower income families spend a higher percentage of their income on just the things they need to survive. A consumption tax would result in the poor paying a higher percentage of their income in tax than the rest of the population which results in a widening of the gap between rich and poor in the US.
- Retiree’s get screwed. – Imagine paying tax on income your whole life, saving up, calculating your expenses and then having the price of everything you buy be x% higher than you planned on due to a change to the consumption tax.
- The economy will be hit hard in the short-term. – Our economy is very dependent on consumer spending. With a consumption tax people will be encouraged to spend less, save more and pay off debt. While these are obviously all long-term pros, in the short-term our economy will suffer transitioning to what will be come the “new normal” for spending levels.
- A rise in black markets? People don’t want to pay taxes no matter how you asses them. Paying a tax on everything you buy could lead to more people turning to the black market to buy goods as a way to avoid paying the tax.
As you can see, there is no perfect system of taxation. Both of the alternative options discussed above hit the poor harder than our current progressive income tax system does. If either option was implemented there would need to be provisions built-in to try and lessen the burden on low-income families. One other problem of both the flat tax and the consumption tax is that it’s unlikely that either one could supply the government with the same amount of tax revenue that our current system generates. You can bet that no change will ever happen as long as that’s the case!
I think that a modified version of either of these options would be better than the mess of a system we have now. Maybe even a hybrid between the two would be a more realistic scenario. Realistically it’s probably a pipe dream that any major change will come to our tax system anytime soon. As I mentioned in a bullet above, the tax industry stands to take a major hit from a change to a “simple” tax system. You can bet that they’ll spend a ton of money fighting to put a stop to any of these changes if they ever start to gain serious momentum. So for now, the best we can do is let H&R Block to understand the tax code for us and trust them to get us the best refund possible.
What changes to the current tax system would you like to see? Can you think of any other pros or cons that we’d see from a switch to either of the systems above?