Reforming the Income Tax

In my prior article, I outlined the difficulties in trying to pass any real reform of our tax system, and proposed a couple of obvious fixes to current problems (which don't have a snowball's chance of passing).

Now, as long as I'm dreaming about remaking the tax code, I'd like to offer a more radical vision of a simpler, fairer income tax system which doesn't have a snowball's chance of even being considered:

The Household Profit Tax

The Household Profit Tax is conceptually based on the Corporate Profit Tax, which (before being spoiled by weird accounting rules, strange deductions, and special loopholes) is very simple: companies pay a flat percentage of their profits.

A household (or individual) is very similar to a corporation from a financial perspective. Each person has income (for example, salary, pension, interest and investment income, etc.), and expenses (food, clothing, shelter, business expenses, etc.). What's left over after subtracting expenses from income is the Household Profit, which goes either into savings or discretionary spending.

Households would pay a flat percentage of their "profits" as taxes, after deducting a broad category of expenses. The tax rate on the "profits" would be relatively high, since most households would have little (or no) profits.

In essence, the Household Profit Tax is A flat tax with many deductions and a high tax rate.

The advantages of this system come from (a) using a high standard deduction so that many households don't have to pay any tax at all (and may not even have to file income taxes); (b) the elimination of multiple brackets; and (c) simplifying the rules about what's deductible and what isn't.

Household Profit Tax In Practice

In practice, the Household Profit Tax boils down the these simple rules:

1) Any group of people living in the same household (and their dependents) can file jointly or separately as they choose. So if Grandma is living with you, you can file a joint tax return with yourself, your spouse, your kids, and grandma all on the same return. Or, your spouse can file a separate return if she chooses. Or one of the kids.

2) Add up all income from all sources for everyone filing on the return, including salary, pension, business income, interest and dividends, capital gains, etc.

3a) Calculate a large standard deduction of $10,000 per person on the return (i.e. a family with mom, dad, and two kids claims a standard deduction of $40,000).

3b) Alternatively, for households with lots of expenses, add up all household expenses. This would be any expense needed to live a reasonably comfortable middle-class life or generate personal income: rent, interest, food, clothing, car, insurance, charitable contributions, childcare, educational expenses, legal fees, taxes paid to other jurisdictions, business expenses, medical expenses, capital losses, etc. The only things which wouldn't be considered "household expenses" would be truly discretionary spending (artwork, nonbusiness-related travel, restaurant meals, etc.) and "investments" to be resold at a future date (stocks, bonds, a house, gold coins, etc.).

4) Subtract the expenses (3) from the income (4). This is the Household Profit. This is taxed at a 50% rate.

[Note: I haven't run the numbers on this, so I don't know if a 50% profit tax and a $10,000/person standard deduction would be revenue-positive, -negative, or -neutral.]

Advantages of the Household Profits Tax

1) Simple in concept, and simple in execution. Many people would not have to file tax returns at all, or could file a simple three-line return. Even those people who itemize their expenses could do so in a very short form of only 2-3 pages. All the oddball schedules and calculations (not to mention the dreaded AMT) go away.

2) Simple to enforce. The IRS already gets reports of income for most people in the U.S., and the only avenues for tax cheaters would be (a) unreported income, which is hard to get away with these days; (b) claiming nonexistent expenses (save those receipts!); and (c) deducting a nondeductible expense, which would be harder to do with simpler rules about what's deductible. Plus, a 2-3 page return is much easier to audit than a 10-20 page return [my taxes last year were over 50 pages].

3) Fair for everyone. The only way for the wealthy to avoid paying their fair share would be to spend more money. But spending money helps the economy, and shows up as someone else's household or corporate profits.

Objections to the Household Profits Tax

Let's be fair, this idea is never going to get a serious hearing anywhere. Real reform is just too politically difficult. But if it was seriously proposed, I can anticipate these objections:

1) The 50% tax rate is higher than today's highest marginal tax rate. True, though I don't know if 50% is the right number to raise the revenue needed to balance the federal budget. The real number might be 30% or it might be 60%.

In any event, it isn't an apples-to-apples comparison, since so many things are deductible under this plan. For example, take a wealthy family of four which spends $50,000/year in mortgage interest (on a million-dollar home), $20,000 on clothing, $30,000 on car expenses, etc., for $150,000 in total household expenses. At a 50% Household Profit Tax, they'd have to have household income of $300,000 per year in order to pay 25% of total income in taxes.

Stated differently, because households which earn more also tend to spend more, and most expenses are deductible, the effective tax rate should be similar to our current system (but much simpler to calculate).

2) This is effectively just a 50% tax on savings and luxury goods. That's no more true than saying that our present income tax system is effectively a 10% to 35% tax on savings and all spending except mortgage interest, childcare, and out-of-pocket medical expenses. But if you insist on looking at it through that particular prism, I think it is much fairer to allow people to deduct all the necessities of life, instead of just a chosen few. Why should a $10,000 operation be deductible when $10,000 in groceries isn't?

3) It'll never get passed. Radical reform like this is just too hard. Yeah, you got me there.