Radical Reformation of Current Tax System

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“Nobody spends somebody else’s money as carefully as he spends his own…”, – Milton Friedman.

Taxation, a means by which governments finance their expenditures by imposing charges on citizens and corporate entities, is used according to the ACCA (2013) for one of three reasons: to raise revenue, to redistribute wealth, and to change behavior. This essay will focus on income and wealth taxation in the United States, which makes up 81% of the federal revenue (National Priorities Project, 2015). Most of the tax payer’s dollars are used for government programs that redistribute wealth. This happens through either Social Security (24%), Medicare and Medicaid (26%), or safety net programs (9%), which combined comes to a total amount of $2,282 trillion (Center on Budget and Policy Priorities, 2017). To fund these ever-expanding government programs, legislators have to constantly create new laws. Their main focus while doing so is to create a fair tax system. Meanwhile the main goal of these social welfare programs, to raise low-income households out of poverty, is not actually being achieved (Fontenot, K., Semega, J., and Kollar, M., 2018), rather it is making low-income households depended on the State (Sowell, 2012). The direct issue is that although these programs are not working, politicians do not repeal them (Friedman, 1993) even if it means bankrupting their country or state (Bandler, 2016). The goal of this research paper is to try and find a way, using scientific literature, to reform the income tax and social security system in such a way that it would work more efficiently without leaving the poor out in the cold. This paper is structured in the following way: first, it will describe and analyze the current income tax system. Secondly, it will explain and examine the welfare programs. Next, the essay will describe and study the negative income tax system, which is the first part of the tax proposal. Part four will go over and analyze the flat tax system, which is the second part of the proposal. The last part of the research paper will give the conclusion.

Currently the United States uses a progressive income tax system: as income rises, increasingly higher taxes are imposed. According to bankrate.com (2018) there are seven tax brackets: 10% (income up to $19,050), 12% ($19,051 to $77,400), 22% ($77,401 to $165,000), 24% ($165,001 to $315,000), 32% ($315,001 to $400,000), 35% ($400,001 to $600,000), and 37% ($600,001 or more). You can imagine this progressivity as a staircase. Every tax payer starts out at the bottom. When income reaches the maximum amount of a tax bracket, every dollar earned above that maximum is taxed in the new tax bracket (Shlaes, 2016). This concept means that the last dollar earned gets taxed more heavily than the first dollar. This system’s main goal is to redistribute wealth. Graphically income inequality can be shown by the Lorenz curve. This curve shows us where the wealth in a society is concentrated. This is done by splitting all income earners into ten groups. On the horizontal axis it shows the cumulated percentage of earners, and on the vertical axis it shows the cumulated percentage of their income. What the progressive tax tries to do is make the Gini-coefficient, a measure of statistical dispersion intended to represent the income or wealth distribution of a nation’s residents (0 means perfect equality, and 1 means perfect inequality), as close to zero as possible.

Welfare programs, a variety of governmental programs designed to protect citizens from the economic risks and insecurities of life, are created with the best intentions. But when government uses taxpayer’s money to help people, strange things happen according to Milton Friedman (1980). This notion that government had to protect its citizens came to be during the Great Depression. This is when FDR and some of his associates created government programs such as the social security act, unemployment benefits, and welfare payments. A side effect of these new programs was that they came with new rules and regulations. Bureaucracy started growing.

Nowadays, the Social Security Administration has almost 60,000 employees (ssa.gov, 2019), whom are dispensing other people’s money with the best possible intentions. However, these measures, made by government, often do not have the effect that was desired. In Milton Friedman’s ‘Free to Choose,’ he explains that the Welfare programs destroy people’s independence because a lot of the time a mother and her children would be financially better off on welfare programs and without a father in the house. Children whose family is on welfare will likely in their turn also live on welfare. These programs are so heavily regulated that government officials decide what the welfare recipient is allowed to do, to eat, etc. (Friedman, 1968). It also makes people afraid to apply for a job because if they were to lose the job it could take months before they are allegeable for welfare again.

The United States government is trying to find a solution to this problem. Using taxpayer’s dollars, they have created training programs. These programs that run under the governments Comprehensive Education and Training Act, have a high dropout rate (Friedman, 1980).

The motives of these government programs are good but their achievements are not. According to Milton Friedman (1980) the reason for this is because the means we have been using are bad in two respects: firstly, all these programs use one group of people to spend other people’s money on objectives created by a third group of people. Nobody has the same dedication for achieving someone else’s goals, then he has for his own objectives. Secondly, these programs have a negative moral effect on both the program’s administrators and the supposed benefactors. It gives the administrators a feeling of power while giving the benefactors a feeling of almost childlike dependence. As a result, these programs misuse money, while not achieving their objectives. Without these programs the situation would not be ideal either. Poor people would have to rely on private charity. But those people would still have their sense of self dignity, and maybe more important is the fact that we would not take away their initiatives. They themselves know better what they need than the people in Washington D.C., whom are regulating their lives right now. A community grown out of self-help is healthier than a community created by bureaucrats (Friedman, 1980).

The solution to the current welfare situation might be the negative income tax. Linke (2018) defines the negative income tax as follows: the negative income tax is a way to provide people below a certain income level with money. This would require poor people to file income tax returns just like everybody else (Friedman, 1968). In theory, this system would give people a percentage of the difference between their income and an income cutoff, or at the point where people have to start paying income taxes. Say the income cutoff is $30,000 and the negative income tax is set to 50%, then someone who makes $20,000 would receive $5,000 from the government. If a person were to make $28,000, they would receive $1,000 from the government (Linke, 2018). This concept is different from a universal basic income, which is a system where all citizens would receive a set amount of money from the government no matter what their income is (Winick, 2018). This tax system is structured in such a way that people who work will always make more money than people who do not. It is true that a person who does not make any money will receive more from the government than somebody who does, overall, the working person will have more (Linke, 2018). The negative income tax would give poor people money instead of welfare benefits. This would allow people to use the money the way they felt they had to. These payments would be distributed either weekly or monthly as to protect the poor from spending all their money instantly (Friedman, 1968).

Currently, most states have laws that dictate that if someone’s income is inadequate, they are entitled to have it supplemented and brought up to an adequate level. What is considered adequate or not is judged by the welfare agencies themselves. But more important are the effects this has on incentives. By bringing all income up to this adequate level it destroys poor people’s incentive to work. Even worse: if a law-abiding person on relief earns a dollar, his or her relief gets reduced by a dollar (Friedman, 1968). Instead, under the negative income tax there is an incentive for poor people to work and the more they made the better off they would be. According to Milton Friedman, this new tax system would be much simpler than the current system. The IRS would administer the negative income tax instead of many different organizations (Linke, 2018). In 1968, the government was spending roughly $50 billion/year on welfare programs. The negative income tax would have been superior to the welfare programs in two ways: firstly, it would use the public funds on supplementing income – not distribute the funds to various organizations and hope that it would trickle down. Secondly, it would cost far less than the current system. Christopher Green carefully estimated that the negative income tax, using the 50% tax rate, would have cost somewhere between seven and nine billion dollars (Friedman, 1968). Making it much cheaper than the current system.

The current federal income tax code is almost 10 million words and rising. This shows how complicated the current system is. The annual cost of compliance – the money, effort, and time it takes for people to prepare their taxes – is estimated by researchers at the George Mason University to be $378 billion (Forbes, 2016). Now the essay will talk about a system that would be simpler and fairer than the progressive tax system: the flat tax system. A flat tax applies a single tax rate to all levels of income. The most fundamental reason for this proposal is to simplify the system. Proponents of the flat tax even go as far as saying that the tax form could fit on the back of a postcard (Gale, 1998). The framework created by Hall and Rabushka would split the income structure into two categories: individuals and businesses. Both groups would be taxed at 19% and structuring the tax code so that each dollar of income can only be taxed once. The argument for these two groups is simple: when different forms of income are taxed at different rates, people will figure out how to take advantage of this (take deductions to the highest available rate and reporting income at the lowest available rate). Businesses will have to pay tax on all income earned, less wages paid. Under the flat tax, there is no deduction for interest paid out, meaning that investment is taxed through the operating income of a firm. The result of this is that taxing interest earned from return on investment is unnecessary. Because investment is taxed through a firm’s operating flow, an important part of the Hall-Rabushka proposal is the elimination of capital gains taxation (Teller). According to the ACCA (2013), simplicity in the tax system will produce the following benefits: lower administration costs, higher accountability, and higher stability.

“Taxation may be so high as to defeat its object… a reduction of taxation will run a better chance, than an increase, of balancing the budget”, – John Maynard Keynes.

A poll from the 1980 by Karlyn Keene, showed that the vast majority of Americans thought that flat proportional taxes were fair taxes (Shlaes, 2016). The reason for this is that the equal proportionality that comes with a single tax rate feels fairer than the progressive tax which penalizes earning more. However, it does not only feel fair it actually increases fairness. The flat tax eliminates loopholes created for special interests (Teller) and end favor seeking, special treatments, and tax breaks. This would take power away from lobbyists and big corporations (Forbes, 2016). Since economic growth appears to be more strongly linked with reducing the administrative burden on business than with cutting the taxes (ACCA, 2013), the enormous cut in compliance costs would help stimulate the economy. Investment and job creation would grow (Forbes, 2016). This tax system makes high earners have lower taxes, which will raise more revenue. Tax cuts bring back money that corporations have put overseas for example after Reagan’s tax cuts the tax revenue that was coming from the richest 1% grew 10%. A more current example is the Trump tax cut after which corporations returned $465 billion to the United States (Forbes, 2016) (Bartash, 2018). The reason behind this can be explained using the Laffer Curve: the theory that if a country’s tax rates are low, the amount of money collected by the government will increase. The idea of a flat tax rate is unpopular because when you cut taxes in a progressive tax system this necessarily means that those who are currently paying the highest taxes, the rich, will also get the largest tax cuts (Shlaes, 2016). Advocating these breaks is not a popular political move, but is our current system, in which the top 5% of income earners pays 59.58% of the total amount of income tax while the bottom 50% pays only 2.83% (York, 2017).

This research paper’s tax proposal is a combination of both the negative income tax and the flat tax. It would change the redistribution of wealth to be more effective while at the same time raise more revenue. The negative income tax part of the tax reform would get rid of the big social welfare programs, thus giving poor people more power over their own lives while at the meantime costing far less than the current welfare programs. It would ensure that every person has a basic income, while give incentive to people who want to work and earn more. Those people would no longer have to worry that they would lose their welfare benefits by getting a job. The people who are currently stuck in the welfare trap would be able to go out and contribute to society. Since this system gives people cash, instead of welfare benefits, poor people would have the opportunity to decide for themselves what they need most. The big bureaucracy in Washington D.C. would no longer be able to dictate their lives. They would have the opportunity to follow their goals. If a person were to spend their money recklessly, they would have to rely on their community or private charity. This is important because if communities are able to help their own members, since government would no longer have to step in, it would also mean a freer society. Because this system is setup in such a way as to stimulate poor people to get a job, it will also help bring people above the poverty line, which is something the current system is failing to do. The flat tax component of this proposal would simplify our income tax system: it would bring down the cost of compliance and administrative burden on people. It would increase fairness by eliminating loopholes, special interests, favor seeking, and tax breaks. Because the flat tax taxes all people that earn an amount above the income cutoff equally, this incentivizes people into earning more. They would no longer feel like the government is penalizing them for working hard. The lower tax rate would also mean, as shown by the Laffer curve, that government would receive more income from tax revenue. This system would have lower costs than the current system while at the same time generating more revenue. The government would be able to shrink down its massive debt. The negative flat income tax system is a pro-growth, business friendly tax system that provides a minimum income in a free market and for the average American it would also lower the tax burden. This tax proposal should have support from both parties. The proposal has the flat tax rate, high work incentives, and a very free market approach – which republicans want – while also providing middle- and low-income families with a tax break and giving a minimum income to all citizens, which is favored by democrats.

References

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Bankrate. (2018). 2018-2019 Tax Brackets. Bankrate.com. URL: https://www.bankrate.com/finance/taxes/tax-brackets.aspx
Bartash, J. (2018) Repatriated Profits Total $465 Billion after Trump Tax Cuts – Leaving $2.5 Trillion Overseas. MarketWatch. URL: https://www.marketwatch.com/story/repatriated-profits-total-nearly-500-billion-after-trump-tax-cuts-2018-09-19
Center on Budget and Policy Priorities. (2017). Policy Basics: Where Do Our Federal Tax Dollars Go? Center on Budget and Policy Priorities. URL: https://www.cbpp.org/research/federal-budget/policy-basics-where-do-our-federal-tax-dollars-go
Fontenot, K., Semega, J., & Kollar, M. (2018). Income and Poverty in the United States: 2017. United States Census Bureau. URL: https://www.census.gov/content/dam/Census/library/publications/2018/demo/p60-263.pdf
Forbes, S. (2016) Would a Flat Tax Be More Fair? PragerU. URL: https://www.youtube.com/watch?v=dGnFcmHH7t4
Friedman, M. (1968). The Negative Income Tax. LibertyPen. URL: https://www.youtube.com/watch?v=xtpgkX588nM
Friedman, M. (1980) From Cradle to Grave. Free to Chose. Volume 4. Public Broadcasting Service. URL: https://www.youtube.com/watch?v=eJFSLACxFkk
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Friedman, M. (2013). The Case for a Negative Income Tax: A View from the Right. Basic Income: An Anthology of Contemporary Research. p11-16. URL: https://s3.amazonaws.com/academia.edu.documents/51515984/BI_ANTHOLOGY_-_UNCORRECTED_PROOFS.pdf?AWSAccessKeyId=AKIAIWOWYYGZ2Y53UL3A&Expires=1548689876&Signature=L%2FDEy43tk0JI3c41R%2FJehhyKfEA%3D&response-content-disposition=inline%3B%20filename%3DBASIC_INCOME_AN_ANTHOLOGY_OF_CONTEMPORAR.pdf#page=35
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Keynes, J.M. Keynes and the Laffer Curve. Adam Smith Institute. URL: https://www.adamsmith.org/blog/tax-spending/keynes-and-the-laffer-curve
Linke, R. (2018) Negative income tax, explained. MIT Management Sloan School. URL: https://mitsloan.mit.edu/ideas-made-to-matter/negative-income-tax-explained
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Sowell, T. (1981) Poverty and Dependence. Firing Line. URL: https://www.youtube.com/watch?v=ZlsHNzp5SoM
Teller, L.B. The Flat Tax: An Analysis of America’s Most Controversial Tax Reform Idea. p146-155. URL: https://www.american.edu/spa/publicpurpose/upload/2011-Public-Purpose-Flat-Tax.pdf
The Social Security Administration. (2019) Organizational Structure of the Social Security Administration. Social Security Administration. URL: https://www.ssa.gov/org/
Winick, E. (2018). Universal Basic Income Had a Rough 2018. MIT Technology Review. URL: https://www.technologyreview.com/s/612640/universal-basic-income-had-a-rough-2018/
York, E. (2018) Summary of the Latest Federal Income Tax Data, 2017 Update. Tax Foundation. URL: https://taxfoundation.org/summary-federal-income-tax-data-2017/

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Radical Reformation of Current Tax System

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