We all know that the federal income tax, Social Security tax, and Medicare tax need fundamental reforms. But what reforms, and why?
I have chosen these short essays to help voters, including members of the media, consider the answers they would offer. I’m confident, from years of teaching undergraduates at a liberal arts college, that readers can understand the essays without having any background in tax policy or economics and without a talent for numbers. I also believe the essays will interest anyone who cares about public policy and is tired of empty promises of politicians to fix our tax system.
In the case of the income tax, what would a fairer, simpler, and more economically sound tax system look like? And why do so many tax breaks satisfy none of these values. What reforms of Social Security and Medicare are necessary and appropriate to make the programs financially sound over the long run?
Once you have read these essays, you will have the tools to identify which tax laws--not just the 10 questions posed here--make sense to you, and to consider workable reforms when they do not. You might even ask candidates from your district and state to answer these questions. Their answers may help you decide how to vote.
Finally, “5 Common Myths and Misunderstandings” follow Question 10. They might surprise you.
What This Book Can Do for You
There are two days this year when millions of people like you play pivotal roles as Americans. The first is April 15, when you pay your taxes. The second is November 6, when you vote for the candidates who will decide what taxes you are to pay and how to spend them.
Most of us care a lot about how much we like and trust the candidates--their smiles, their voices, our sense of their integrity and capacity to lead. But policy issues also should affect our choices. We’ll want to know where they stand on ending the war in Afghanistan, on terrorism, immigration, policies to strengthen the economy and reduce unemployment, and on federal deficits. And on lots of social issues--involving housing, education, marriage, health care, Social Security, Medicare and much more.
All of which means you’d better remember April 15 when November 6 comes around. Why? Because federal tax laws are increasingly relevant. Except for the U.S. Constitution, they represent the most comprehensive expression of our nation’s official values. The choices Congress makes about our tax policies crucially shape who we are as a nation and what we will become.
The leaders we elect write these laws, and rewrite them, in every session of Congress. Rarely have the stakes been as high as they are this November. As you know, Democratic and Republican candidates for the presidency and Congress have profoundly different views of the government they favor and the tax policies to support it. The tax issues are particular urgent: A Congress dangerously divided has left itself only a few months to determine the destiny of the Bush tax cuts, which automatically expire this January 1 if there is no new legislation.
To borrow from Abraham Lincoln, our nation is engaged in a great civil war. The Obama/Biden team proposes to retain the Bush tax cuts for all but about the top 3% of taxpayers, whose tax rates would rise to where they were at the end of the Clinton administration. The Reagan/Ryan team not only would retain the Bush tax cuts for everyone; they would drastically cut all our tax rates even further. Beyond that, they would exempt the vast majority of taxpayers (Romney) or all taxpayers (Ryan) from tax on their passive income—capital gains, dividends, and interest. That would place most (Romney) or all (Ryan) of the tax burden on the wages of working Americans.
Both sides agree, however, that to move in the direction of a balanced budget, Congress must eliminate or modify lots of tax breaks. There’s just one problem: The candidates promise to identify which tax breaks only after the election. That’s hardly reassuring. How can we trust their tax cuts if they won’t show their hand on the painful part—cuts in tax breaks that are likely to be politically unpopular and difficult to enact yet are essential to make sense of their budget proposals?
As Flaubert warned, “Le bon Dieu est dans le detail”(God is in the details). Or is it the “Devil?” So, if we can get candidates to address well-designed questions on the subject, we can learn more than their position on taxes. Their answers will expose their broader values.
Few candidates will welcome this challenge. Incumbents won’t want to explain their failure to tackle the shortcomings of our tax laws because so many special tax breaks benefit their constituents. And challengers who need to raise outrageous sums of money for their campaigns, aren’t about to outrage potential donors. Alternatively, candidates might have to admit that they had no idea that particular laws were so unfair and wasteful.
No, the candidates really don’t want to hear these questions. And that’s all the more reason to ask them.
The Way the System Works Now (and it ain’t pretty)
Albert Einstein is reputed to have said, “The hardest thing in the world to understand is the income tax.”
A dizzying smorgasbord of exclusions, exemptions, deferrals, deductions and credits shelters nearly half of all income from tax, giving our revenue system a distinctly split personality--half tax collection, half tax avoidance. Think of it this way: Congress combines progressive tax rates—currently rising from 10% to 35% as taxable income rises--with regressive tax breaks that protect a whole lot of income of high income taxpayers from being taxed at any rate. Last year alone, about $6 trillion-- I said Six Trillion Dollars--of individual income legitimately avoided tax, thanks to hundreds of rules Congress has fashioned.
Paul O’Neill, President George W. Bush’s first Secretary of the Treasury, observed: “The [tax] code today encompasses 9,500 pages of very small print. While every word…has some justification, in its entirety it is an abomination.”
Let’s be clear about the meaning of a tax break. I’m not talking about provisions in the tax laws that help measure your gain from a trade or business or investment. For example, it is not a tax break to deduct health insurance premiums you pay for your employees or to deduct property taxes you pay on the building you use in connection with your business. Only after deducting such expenses can we know the real economic gain from your business, and it is your gain, not your gross income or sales, that should be taxed.
But if your employer pays health insurance premiums for you and your family, and the premiums are excluded from your income, you have enjoyed a “tax break”: Your family health insurance costs are your personal, not a business, expense. Similarly, if you and your family use a residence solely for personal purposes, the right to deduct property taxes on your residence is a tax break: The taxes are not related to any trade or business income generated at your residence.
Tax breaks may not have grandiose names like “No Child Left Behind,” but they are, nevertheless, de facto social and economic programs. Most are equivalent to a tax-free grant of money from the government. For example, the tax savings someone realizes from a deduction for property taxes on her vacation homes or her right to defer taxes for decades on pension plan contributions and accumulations is just as much a helping hand from the government as if the government actually gave her the equivalent dollars in tax-free grants.
Either way, through tax breaks and tax-free grants, the government has less money and certain taxpayers have more. The cumulative number and size of all tax breaks is nothing other than “Big Government.”
“A tax loophole is something that benefits the other guy. If it benefits you, it is tax reform.” —Russell B. Long, former U.S. senator
Equally important, tax breaks serve some people and not others, and some people more than others. They create winners and losers.Often, theycreatedouble losers. As discussed in some of the following questions, the tax break itself often drives up the price of what is being subsidized, such as college or child care; so you become a double loser if you don’t get the tax break and have to pay more for college or child care than you would if the tax break didn’t exist in the first place.
While tax breaks may be necessary at times to promote fairness, resolve technical problems, or stimulate growth, they are far out of control. The result today is a tax system so complex, arbitrary and wasteful that the public can’t trust it to be fair.
It seems obvious that the guiding principle of a fair income tax system should be that equals pay equally. But today, if you and I have comparable incomes and the same household size, it is unlikely that we will pay comparable taxes. The odds further decline as our income rises. I may pay less taxes than you because my mortgage is bigger than yours, or my employer offers more tax-free fringe benefits than yours, or my income is from investments and yours is from wages, or my accountant is cleverer than yours,or you may not have an accountant at all. Whatever you think about these outcomes, you can see why some people become winners, and others losers.
In fact, most tax breaks are actually upside down: They perversely provide larger tax savings as you become more successful by sheltering your rising income from higher tax brackets. In short, the greatest savings are for taxpayers in the highest tax brackets who need government assistance least, and the least savings are for taxpayers in the lowest tax brackets who need government assistance most. Here’s a simple example:
Mr. CEO and Ms. Secretary elect to have their employer subtract $1,000 from their wages to purchase disability income insurance on their behalf. Because this is part of the company’s tax-free fringe benefit plan, each saves the tax on $1,000.
If we assume that Mr. CEO would have paid a tax on the $1,000 at the top rate of 35%, that tax break saved him $350. Ms. Secretary, meanwhile, makes a fraction of his salary and would have paid only a 15% tax on the $1,000--so she saved only $150. Put another way, Congress subsidized $350 of Mr. CEO’s insurance costs, which means the insurance effectively cost him only $650, but it subsidized only $150 of Ms. Secretary’s, which means the insurance effectively cost her $850.
The disparity worsens in the real world. The typical executive will purchase a larger disability income policy than will his secretary. If he elects to buy a policy that costs $6,000 a year, and his secretary can afford only the $1,000 premium, she still saves only $150 while he saves $2,100 (35% of $6,000).
Who thinks that makes sense? If paying taxes were a sport, we could say: OK. Each of us will play the tax avoidance game as cleverly as we can. Most Americans, though, want a tax system that fairly distributes tax burdens among us. Yet politicians’ main response is to couple promises of more tax breaks with disingenuous laments that the system is unfair and incomprehensible.
All of which confuses us. On one hand, we expect government to solve countless problems—from the BP oil spill, to the Katrina disaster, to crop relief, to unemployment insurance, to prescription drugs for seniors, to securities fraud, to abusive bank lending practices, to unsafe toys for children, to terrorist threats. Yet we have heard endlessly over the past decades that federal income taxes, which pay for these interventions, are “bad.” As linguist George Lakoff has written, “When the word tax is added to relief, the result is a metaphor. Taxation is an affliction. And the person who takes it away is a hero.”
Of the world’s 28 developed countries, only two or three collect less tax revenue as a share of their economy than does the U.S.
Tax relief, then, becomes a fitting, if addictive, antidote. In turn, our opportunity to enjoy so many forms of tax relief becomes a major obstacle to fundamental reform, let alone our capacity to pay our government’s bills. The Congressional Budget Office recently reported that, for 2009 (the most recent year for which complete data is available) the “average federal tax rate for all households reached the lowest level seen in the 1979 - 2009 period.”
An Ideal Income Tax
So, what is to be done, apart from persuading the public that taxes are necessary to provide the services they expect and need from the federal government? In the ideal world none of us is lucky enough to live in, we’d simply redraft the income tax laws from scratch. Just for the moment, let’s pretend we can do that.
We would have five goals. First, and foremost, we’d be as fair as possible--we’d base tax burdens primarily on people’s ability to pay taxes rather than on their ability to avoid them. In other words, if you and I have equal abilities to pay, we should pay equally; if I have greater ability to pay, I should pay more. We then can debate how much more.
Second, an ideal income tax would be as economically sound as possible. Taxes usually slow economic growth to some extent by taking money away from individuals and businesses. But we would minimize that negative impact: While raising the necessary revenue, the tax would distort as little as possible our desire to work, to be entrepreneurial, to save and invest.
Third, we would make our tax laws relatively simple and understandable. Most people would be able to prepare their own tax returns, which would save them time and money. A far simpler system would offer fewer opportunities for less honorable types to cheat, which would make government oversight easier and give all of us far more confidence that if we paid our fair share, others would too.
“The income tax has made more liars out of the American people than golf has.” —Will Rogers
Fourth, we would make the laws stable, so that people could count on them year after year and plan accordingly.
Fifth, we would want the laws to raise sufficient revenue to pay the government’s bills.
How to Achieve those Goals. We would begin efforts at reform by aligning everyone by the size of their income. We’re not just talking about wages, bonuses, pensions, partnership profits, interest, dividends, and capital gains that count as taxable incometoday. We’re also talking about income nowexcluded from tax because of tax breaks—fringe benefits at work, contributions to retirement plans, gains on the sale of a principal residence, interest on state and local bonds, gains when stocks are swapped in mergers and acquisitions and when one piece of real estate is swapped for another, and wages earned abroad. And much more.
Next we would decide how much of that income should be taxed, and at what rate. We’d make sure that we didn’t tax the truly poor, and that we didn’t tax households into poverty. We would adjust tax burdens for household size: A married couple with two kids who earns $75,000 would pay less tax than a single, childless person who has the same income, although we’re likely to debate how much less. We might alsowant to adjust for certain hardships, such as extraordinary uninsured medical expenses, or for particularly generous charitable behavior. We might choose to help parents who, despite working full time, can’t earn enough to pay basic living expenses, including those nasty childcare costs.
But we would proceed cautiously, keeping tax breaks to a minimum – knowing all too well that one tax break begets another. Whenever possible and practical, we’d try to achieve goals previously addressed in the tax laws through explicit allocations in the federal budget that the public and media can more readily understand and evaluate.
Fewer tax breaks also would allow us to set significantly lower tax rates because far more income would become taxable—we would “expand the tax base.” In this way, we address the crucial relationship between tax breaks for certain people and tax rates on everyone. The more tax breaks we have—that is, the “shorter the tax base”—the higher the tax rate must be on income that remains taxable in order to generate the revenue needed. For example:
Assume that you have $50,000 of income, and that the government needs $10,000 in taxes from you to pay for government services. That sum would be met by a 20% tax rate. If exemptions and deductions reduce your taxable income to $40,000, a tax rate of 25% would be needed. And if additional tax breaks reduce your income to $30,000, the tax rate must be 33% for you to pay $10,000.
Tax breaks also allow some of us to pay less taxes on the same income than is paid by others, which means that equals may not pay equally. For example:
Assume that you and I are each single, each of us has $50,000 of income (for a total of $100,000), and $20,000 of that is needed to pay for government services. A 20% tax rate will suffice if all $100,000 is taxed. But if tax breaks reduce my taxable income to $30,000, while yours stays at $50,000, then, to generate the same $20,000 of taxes, the tax rate on that $80,000 would need to be 25%--$7,500 from me, and $12,500 from you.
One important benefit of our ideal system would be a stronger economy. Conservative and liberal economists agree that an income tax system that taxes our earnings and investments consistently and at lower rates would encourage Americans to make decisions about work, spending and investing based upon what makes the best economic sense instead of what reduces their tax exposure.
The definition of a corporate tax shelter: “A deal done by very smart people that, absent tax considerations, would be very stupid.” —Michael J. Graetz, while a professor at Yale Law School
Another benefit would be transparency. Rather than embedding social programs in little-understood tax laws, Congress would fund them directly. For example, Congress today allows deductions for property taxes on our family home and on an unlimited number of vacation homes. The deductions produce the largest tax savings for households with the highest incomes. Moreover, Congress never has established a budget capping the amount of tax revenue it is prepared to lose because of these deductions.
In a direct budget process, Congress would hold public hearings annually to decide, first, whether the federal government should give money to households to help them pay local taxes on one or more homes. If so, Congress then would establish a budget for the program and decide who should receive the money and how much they should receive. While we know the process would be imperfect, it likely would increase the odds that people who need the help most would get the most help.
“Government should do what people cannot do by individual effort.” —Abraham Lincoln
To sum up: Our ideal world would have astripped-down system that taxes nearly all income but at much lower tax rates than we have now. For the most part, we wouldn’t worry much about tax breaks the guy next door gets because there would be few to worry about. Most of us could fill out our Form 1040s by ourselves, in an afternoon or less.
But you probablywouldn’t get that deduction for your home mortgage interest.
Fixing the System in the Real World
What? He can’t be serious, you say. The American dream is not just to own a home; it’s to claim a mortgage interest deduction, as a community-supporting, inalienable right. The fact that this deduction gives whopping savings to people who buy McMansions or second homes, and chump change to working stiffs in two-bedroom bungalows, doesn’t mean we have to get rid of tax breaks for homeownership altogether.
Relax! Here in the real world we can use the tax system to advance a number of social or economic policies while eliminating altogether those so unjustified that they deserve to be trashed. We can modify those that we retain so that they more likely accomplish what politicians have led us to think they already do. We can minimize their excesses and allocate the savings more equitably.
To decide which tax breaks are worthy of support, we need answers to some basic questions. Why do we have the tax break in the first place? What does it cost the government in lost revenue? Who should benefit from it? Who actually does benefit? What economic effect does it have?
We also want to think about what form the tax break should take, because different forms produce very different outcomes. For example:
Let’s return to Mr. CEO and Ms. Secretary, who excluded $1,000 from their income on their tax returns to purchase disability insurance. This saved Mr. CEO $350 in taxes, because he would have been taxed on the $1,000 in his 35% bracket. It saved Ms. Secretary only $150 in her 15% tax bracket.
If we thought that, to be fair, the savings for Mr. CEO should be no greater than the savings for Ms. Secretary, we might change this break from an exclusion to a credit. Mr. CEO and Ms. Secretary wouldthen include the $1,000 as income on their tax returns, but they would claim a credit against their actual income taxes. The credit could be set at any rate – let’s make it 15% of $1,000. That would mean both of them could subtract $150 directly from their taxes.
In the earlier example, the executive magnified his tax savings by acquiring a policy that cost $6,000. We might limit the tax break for everyone to a basic policy, which we will assume for this example to cost $1,000. If the executive wants the more expensive one, we wouldn’t object. He would just have to pay the additional cost without the government’s help.
Finally, if you think Ms. Secretary deserves more help than does Mr. CEO to acquire a basic disability policy, you might make the credit higher for her (say, 30%). You might even eliminate the credit altogether for high-income CEOs.
Of course, any credit complicates the tax laws, and a credit that varies with one’s income complicates them further. This demonstrates an obvious dilemma of conducting social or economic policy through the tax laws: The goals of simplicity and transparency always are sacrificed. Alternatively, you might believe, as I do, that if (and I emphasize “if”) it makes sense for Congress to subsidize the purchase of disability insurance, it usually should provide the funding through the direct budget process. Nonetheless, you see in the example of Mr. CEO and Ms. Secretary how Congress can flush out excesses in tax breaks, replacing most tax deductions and exclusions with tax credits that make sure that, at a minimum, people get it who need it.
The 10 Tax Questions
To help you and the candidates sort through a wide range of possible reforms, here are ten short, representative questions and straight-forward analyses, on a variety of subjects. Eight of the questions relate to the income tax. The other two address the financial stresses of Social Security and Medicare.
Once you have read the ten questions, you will have the tools to identify which tax laws--not just the ones posed here--make sense to you, and to consider workable reforms when they do not. You also will be equipped, if you wish, to ask candidates from your state and district to answer some of the questions. .
It’s easy to shrug and say it’s allover your head. And you can go on doing just that—shutting your eyes, paying your taxes, and accepting a system so fundamentally flawed.
Or you can demand that that the people who get your vote for the presidency, the U.S. Senate, and the U.S. House of Representatives begin to make our tax laws more sensible and sound.
Now to the questions!
 See Marron, Donald B, “How Large are Tax Expenditures? A 2012 Update,” Tax Policy Center, April 9, 2012.
 Lakoff, George, Don’t Think of an Elephant! White River Junction: Chelsea Green Publishing, 2004, 4.
 Congressional Budget Office, “The Distribution of Household Income and Federal Taxes, 2008 – 2009,” July 10, 2012.