Reforming the Tax System

If there's one part of government which is overripe for explosive remodeling, it must be the tax system.

There's a problem, though. Reform is hard. Real reform--the kind which comes from starting over from a blank sheet of paper--is often politically impossible. Any overhaul creates both winners and losers, and the losers usually fight much harder against change than the winners fight for it.

I give Bush a lot of credit for putting the tax code at the top of his list of priorities for the next term. Tax code complexity costs me and my company thousands of dollars a year, and even then we're never certain that we've fully complied with the law.

But the winners under our current system (and presumed losers under a new tax code) represent some powerful interests. Payroll services, tax preparation services, accountants, and tax lawyers all stand to lose, since they're the recipients of most of the money my company spends on tax compliance. True tax reform would essentially put ADP and H&R Block out of business overnight. In addition, any industry which receives preferential treatment under our current system--and there are many, ranging from agriculture to manufacturing to oil--will oppose clean-slate reform.

As a result, I'm very skeptical of the Bush administration's ability to accomplish anything more than superficial tax reform (maybe limited to cutting taxes yet again, and eliminating a few egregious problems which mainly favor Democratic constituencies) despite its election victories.

But we can still dream, can't we?

Problems with Tax Reform

Before we can actually start reforming the tax code itself, we have to struggle with some weighty economic and philosophical questions. For example:

• Everyone agrees that our tax system should apportion taxes fairly. But what is fair? Is a flat tax (tax all income at the same rate) fair? Or does the tax code need to be progressive to be fair?

• The tax system should promote economic development (or at least get in the way as little as possible). But does this mean favoring certain industries over others, or giving tax breaks to the wealthy as an inducement to start or grow businesses?

• The tax code has often been used as a way to promote various kinds of social good. The most familiar example is promoting home ownership by making mortgage interest deductible, effectively subsidizing the cost of buying a house. Purists may argue that this isn't what the tax system should be for, but others can reasonably argue that this is a relatively clean way to create economic incentives for favored economic activity (cleaner than outright subsidies, for example).

• Who is responsible for paying the tax? Businesses are often better-equipped to deal with the paperwork and complexity of complying with the tax law, but they are also better able to find sneaky ways to avoid paying taxes (such as moving offshore). Individuals often find tax compliance a huge burden (especially the federal income tax).

There are no right or wrong answers to these questions (and many others). Reasonable people can (and will) have different answers, and there's no way to craft a tax code which will satisfy everyone. Part of the reason our system is so complex is that it has evolved over centuries out of a series of small compromises.

Types of Taxes

Another question is what types of taxes should be assessed. Any kind of tax will tend to discourage the particular economic activity it taxes, so the kinds of taxes imposed will make a big difference in the overall impact of the tax law.

Sales/Consumption Taxes: Most sales and consumption taxes are assessed at the state level, but there are some federal ones (i.e. the gas tax, telecommunications taxes). The burden of collecting these taxes usually falls on the companies selling goods and services, so they tend to be very simple from a consumer's perspective. Some kinds of sales and consumption taxes are targeted specifically towards particular government services (these are often called "user fees"), which makes them more politically palatable, even if calling it a "user fee" doesn't actually change the economic impact any.

Property/Ownership Taxes: Local governments and some states raise money by taxing real estate and (in some states) other personal property. This provides a very stable income stream for the government, since real estate values don't tend to vary dramatically from year to year, and the paperwork burden is low (the county sends you a bill, you pay it). The downside is that property taxes can be regressive if your property appreciates in value faster than inflation; and there's a limit to how much property tax you can impose before you start pushing down real estate prices.

Income/Payroll Taxes: The biggest and most-hated tax is the levy federal and state governments charge on personal income. Of course, any big tax will be unpopular, but part of the problem is the overwhelming complexity of the income and payroll taxes. Both individuals and employers have a significant burden in complying with the many different income taxes (state, federal, FICA, Medicare) and pseudo-taxes (unemployment insurance, workers' comp). When people talk about "tax reform" they usually mean reforming just the income and payroll taxes.

Corporate Taxes: The other biggie is the tax on corporate profits, along with various registration fees, franchise taxes, and so forth which corporations have to pay to maintain the legal right to exist. In theory, this is probably the simplest tax, since it is based on a flat tax on corporate taxes. In practice, however, alternate accounting rules, special deductions, obscure loopholes, and convoluted business practices have made the corporate profit tax as complex as any other.

Some Obvious Reforms

There are a few changes to the tax code which should be non-controversial (except for the people who will wind up paying more taxes as a result, but there's no way around that....):

Eliminate separate accounting rules for corporate taxes. Right now, companies effectively keep two sets of books under two sets of accounting rules: tax accounting, and GAAP (Generally Accepted Accounting Principles). The tax rules are used to calculate profitability solely for the purposes of paying taxes, while GAAP accounting is used for everything else (especially reported profits from public companies). Companies have an incentive to bend the rules one way (minimize profits) for tax purposes, and the other way (maximize profits) for public reports. By making the tax accounting rules the same as GAAP, and requiring that companies pay taxes on the actual profits they report to shareholders, you will accomplish two things:

1) Companies which "push the envelope" on their accounting in order to boost profits for Wall Street will have to pay more taxes as a result, reducing the incentive for abusive accounting; and

2) Companies will have less incentive to use loopholes or accounting tricks to reduce the taxes they pay, since that will also cut their reported profits.

In other words, less accounting fraud and more tax dollars collected. As a bonus, companies will only have to prepare one set of financial statements, reducing their legal and accounting expenses. What's not to like (unless you're an accountant or tax lawyer)?

Fold the federal payroll taxes into a single tax. Right now, there are several different federal payroll taxes: income tax, FICA, and Medicare. Worse, there's a "hidden" tax on payrolls, the "employer contribution" to Social Security (FICA) and Medicare, which equals the amount taken from your paycheck every month. These taxes are kept separate to maintain the political fiction that Social Security and Medicare are somehow separate accounts within the federal government (the truth is that all the money basically goes to reduce the federal deficit). By combining these taxes into a single tax, you will both increase the transparency of the tax system, and reduce the paperwork burden, especially on employers and the self-employed.

Balance the freakin' budget already! Is it really so much to ask that we actually ask our citizens to pay for the federal services they consume? Right now, our government is basically kept afloat because the Chinese and other governments choose to buy U.S. bonds at absurdly low interest rates. Someday, that will end, and the more debt we run up, the sooner that day will come.

The Not So Obvious Reform

Next article, my immodest proposal for reforming the payroll/income tax systems....