What This Book Can Do for You
"If you know the position a person takes on taxes, you can tell their whole philosophy. The tax code,
once you get to know it, embodies all the essence of life: greed, politics, power, goodness, charity."
—Sheldon Cohen, former IRS commissioner
Albert Einstein is reputed to have said, "The hardest thing in the world to understand is the income tax." Paul O'Neill, President Bush's controversial first secretary of the treasury, got at least this right: "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."
"[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
"The income tax has made more liars out of the American people than golf has."
—Will Rogers
"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, professor, Yale Law School
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 4, when you vote for the candidates you want to spend them.
If you're like most of us, you'll pick candidates mainly by how much you like and trust them-their smiles, their voices, your sense of their integrity and capacity to lead. But policy issues also affect your choice. You'll want to know where they stand on Iraq, terrorism, unemployment, Social Security, federal deficits. And on lots of social issues--involving housing, health care, education, marriage, and much more.
All of which means you'd better remember April 15 when November 4 comes around. Why? Because federal tax laws are increasingly relevant. Except for the U.S. Constitution, they represent the most comprehensive expression of our government'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 every other November write these laws, and rewrite them, in every session of Congress. 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 are not going to want to explain their failure to tackle the shortcomings of our tax laws or, perhaps worse, admit that they had no idea that particular laws were so inequitable. And challengers are going to be wary of offending some of their supporters by proposing sensible and responsible policies that help people who really need it and require others to pay more.
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)
A dazzling (or 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 with regressive tax breaks. Higher rates are imposed on higher levels of taxable income, but regressive tax breaks keep a whole lot of income from reaching those higher rates. Last year alone, about $5 trillion--I said Five Trillion Dollars--of individual income legitimately avoided tax thanks to rules Congress has fashioned
Let's be clear about the meaning of a tax break. I am not referring to provisions in the tax laws that help measure your gain from a trade or business or investment income accurately. 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 such deductions can we know the 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 unrelated to any trade or business income conducted 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. Offering taxpayers a deduction for giving to charity, an exemption for selling a home, or a complete pass on paying taxes on a Roth IRA is just as much a helping hand from the government as it would be if the U.S. government were actually paying their bills. Tax breaks serve some people and not others. They create winners and losers.
While necessary at times to promote fairness, resolve technical problems, or stimulate growth, tax breaks have gotten out of control. The result we see today is a tax system so complex, arbitrary and wasteful that the public no longer trusts it to be, simply, fair.
It seems obvious that the guiding principle of any income tax system should be that equals pay equally. But it is unlikely that if you and I have comparable incomes and the same household size, we will pay comparable taxes. The odds decline further as our income rises. I might pay fewer taxes than you because my mortgage is bigger than yours or because my accountant is cleverer than yours or you might not have an accountant at all or because my employer offers more tax-free fringe benefits than yours or because my income is from investments and yours is from wages. Whatever you think about these outcomes, you can see why some people become winners, and some losers.
In fact, most tax breaks are actually upside down: They perversely provide the greatest tax savings for taxpayers in the highest tax brackets, who need the savings least. 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 at the top rate of 35% on the $1,000, that tax break saved him $350. Ms. Secretary, meanwhile, makes a fraction of his salary and would have paid a tax of only 15% on the $1,000 - so she saved only $150. Or, put another way, Congress subsidized $350 of Mr. CEO's insurance costs, but only $150 of Ms. Secretary's.
The disparity worsens in the real world. The typical executive will benefit from a larger disability income policy than will his secretary. If his policy costs $6,000 a year and his secretary's costs only $1,000, 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 incomprehensible.
All of which confuses the electorate. While we expect government to solve countless problems-such as addressing the damage from Hurricane Katrina and the subprime mortgage mess--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."[1] 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.
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 than you have, I should pay 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.
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.
We would begin our efforts at reform by aligning everyone by the size of their income. We're not just talking about their wages, bonuses, pensions, partnership profits, interest, dividends, and capital gains that count as income today. We're also talking about income now excluded 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, 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 $50,000 would pay less tax than a single, childless person who has the same income. We might also want to adjust for certain hardships, such as extraordinary 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. But we would proceed cautiously, keeping tax breaks to a minimum--knowing all too well that one tax break begets another. Whenever possible, we'd try to achieve goals (previously addressed in the tax laws) through explicit budgetary allocations that the public, and press, can more readily understand and evaluate.
Fewer tax breaks also would allow us to set significantly lower tax rates because of the relationship between tax breaks for certain people and tax rates on everyone. The government needs a certain amount of revenue to function. Therefore, the more tax breaks, the higher the tax rate must be to generate that revenue. For example:
Assume that you have $50,000 of income, and that the government needs $10,000 in taxes from you. That need 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. For example:
If you and I each have $50,000 of income (for a total of $100,000), and the government needs $20,000 in taxes, a 20% tax rate will suffice if all $50,000 that we each have is taxed. If exemptions and deductions reduce my taxable income to $30,000, while yours stays at $50,000, the tax rate 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. As conservative and liberal economists agree, 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.
Another benefit would be transparency. Rather than embedding social programs in little-understood tax laws, Congress would have to fund them directly. Let's say that Congress wants to help some of us with our housing costs. Instead of offering mortgage interest deductions and exclusions from capital gains when a house is sold, it would hold open hearings about the best and fairest way to achieve that objective. Any legislation that emerged would establish a budget and eligibility rules, consistent with the direct budget process generally, all of which would increase the odds that people who need the help most would get the most help.
To sum up: Our ideal world would have a stripped-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 1040s by ourselves, in an afternoon or less.
But you probably wouldn'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 flag-waving, 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 owning a home 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 achieve the community-supporting benefits of subsidizing mortgage interest payments or any other cause, 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. Sometimes there's a smarter way to offer the same break. 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 would then 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%. That would mean both of them could take $150 directly off 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 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 focus relief more on people who need it.
To help you, and 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. Two questions address the financial stresses of Social Security and Medicare, which should concern us all.
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 will have the power to insist on answers, and actions, from candidates to questions you have about the tax laws, in exchange for your vote.
It's easy to shrug and say it's all over your head. And you can go on doing just that--shutting your eyes, paying your taxes, and watching how they're spent.
Or you can demand that that the people who get your vote for federal office--for the presidency, the Senate, and the House of Representatives--begin making our tax laws more sensible and sound.
Now to the questions!
[1] Lakoff, George, Don't Think of an Elephant! White River Junction: Chelsea Green Publishing, 2004, 4.