Alternatives To Paying Income Tax

73,608

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

tax returns, tax refund, tax preparing, tax return, federal taxes, irsA 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

Pros:

  • 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.

Cons:

  • 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

Pros

  • 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.

Cons

  • 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.

Final Thoughts

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?

 

Thanks for reading! If you enjoyed this post be sure to subscribe by email or RSS to keep up with all the latest posts! 

 

 

Tagged , . Bookmark the permalink.

17 Responses to Alternatives To Paying Income Tax

  1. I have a soft spot for a consumption tax. I live on the cheap and would probably save a bundle of money with that system in place.

    And it would be a powerful incentive to recycle, reuse, and re-purpose rather than buying new every time. Eco-aware types can rejoice at the sustainability.

    • I’d save a bunch of money with the consumption tax as well. I like that it would reward people for saving, Americans really need a kick in the a** to start living within their means.

  2. One pro of the Fair Tax is that it would capture existing black market , or unreported income at the cash register. There’s also a rebate back to everyone to cover up to the established” poverty level so that the low income aren’t repressively taxed. At the end of the day, anything has got to be better than our current tax code!

    • There would have to be some form or rebate to help the lowest income earners in any system. I think everyone can agree our current system needs a change. Let’s just hope somebody actually does something about it one of these years.

  3. Savvy Scot says:

    The UK need to cut their income tax rates and make up for it by chasing corporations who are paying zero corporation tax!!! Rant over

  4. Give me the consumption tax! The government would finally be rewarding saving. Of course, the economy would probably suffer and I do feel it would hurt low income people a little unjustly, but I’d settle for the consumption tax with a few deductions to help the poor out.

  5. A flat 15% tax rate would hurt a lot more than just the poor. Switching from marginal rates to a flat rate would mean a tax increase for all single filers earning under $65,000, all joint filers with no dependents under $130,000. A family of 5 would need to earn $160,000 per year before coming out ahead with a flat tax.
    A flat tax really only benefits the wealthiest 10% or so of the country.
    The tax code got to be so big by decades of special interests lobbying for preferential treatment. At the end of the day, I don’t think it’s overly complex for the vast majority of filers. Anyone eligible for the 1040EZ can be done in 15 minutes.

  6. Good breakdown of the flat vs. consumption. I also agree that a modified version of the consumption tax will be a superior alternative than the system we have now.

  7. I was going to have a post soon about this question – what if there were no taxes, and everything was pay as you go/tolls.

    For example, you only pay for the road you drive on. The government builds it, then uses a digital odometer to track your mileage, and you pay a tax concurrent with your driving.

    Or, if we want to go to war, we have to vote on paying the bills – like the Revolutionary War times. Or, if you have a child in school, you pay the teacher’s salary that year.

    It would be an interesting premise, because so many people say they don’t get benefits for their taxes, when they really probably reap much more in benefits than they pay.

    • Only having parents of schoolchildren paying for the teacher’s salary would lead to primary education becoming prohibitively expensive. Do you want to be paying $30,000 per year to send your kid through 13 years of schooling?
      Besides, an educated populace benefits more than just the kids and their parents.

    • I think the time it would take to accomplish anything that way, not to mention the debates that would arise over every decision would outweigh any potential benefits. I think we do need to start thinking outside of the box like that to find a better solution though.

  8. Flat tax with a substantial allowance so that you only pay tax on the element above the allowance would be good. But you have to recognise that many of the absurdly high salaries paid are exactly because of high rates of tax. At one time in the UK the income tax rate was 83% with a further 15% on unearned income (dividend, interest etc). Then there was a period with pay restraint (annual 4% increase only) which led to the expenses scam – being given an upmarket company car was one. If we were to start from square one again, the flat tax would be better. Mortgage interest relief was abolished some years ago here anyway.

  9. Justin@TheFrugalPath says:

    I can see pros and cons to both sides and either way there will be winners and losers.
    On major issue I have with the tax code is with CEOs who earn a majority of their income through stock. Our system should treat any stocks obtained through benefit packages as income as soon as it is earned rather than capital gains when it’s cashed.

  10. Martin says:

    I lean toward the flat tax although I cannot predict all possible outcomes positive or negative. As far as the statement of hurting poor people, I might add one exemption, people making less than $15,000 annually gross income would pay no tax, anything above it: flat rate. It is hard to live on 15 k annually it would be even harder to live on 12,750 annually if tax is imposed.

  11. A flat, uniform tax seems quite fair overall. Regardless of other factors, everyone is treated the same way. Fair, right?

    Of course, taxes are such a massive industry these days that I see things getting more complicated going forward than the other direction

  12. Integrator says:

    There is a consumption tax in Australia which is used as a supplement to an income tax. These are typically more regressive taxes (as you point out ) that tend to hit lower income folks harder.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>