Fundamental Tax Reform - The 15% Solution

Jeb Bradley call for tax reform via a flatter income tax reminded me that I agree on the need for tax reform and have some ideas on the matter. We need to start laying out what principles we should have behind our tax policy. Moving to a 3 tiered rate is better, but is not enough of a change and does not take away the problems of complexity in the current system.

How about this for a radical idea: Abolish the income tax for everyone making under $100,000 and have a simple 15% flat tax for everyone above that. Impossible? No, very possible.

The flat tax is a good idea. The FAIR tax is a good idea. But both ideas are getting picked apart because the current complex web of taxes is hidden and obscure enough, and the proposals, ironically, dont attack the core issues: It's both the complexity and the cost of taxes (ie quantity) that drags us down.

So let us start with 5 principles for fundamental tax reform:
1. The Federal Government Costs too much, spends too much and taxes too much. Tax reform should include tax reductions.
2. We need a simpler, flatter, lower rate tax system.
3. We need to shift taxes to tax production less and consumption more
4. We need to fix entitlements through choice
5. We need legislative and constitutional protections for taxpayers to limit tax hikes, spending hikes and runaway deficits.

Let's look at these 5 Fundamentals of Fundamental tax reform

1) The Federal Government Costs too much and the burden of Government should be limited.
We can implement this by limiting Government Spending to 15% of GDP as long-term goal. Since WWII, the Federal Government burden has been between 18% and 23% of GDP. It has not shrunk even as Defense spending fell in the post-Cold War era. There is a simple way to cap the burden of Government spending: keep spending, including entitlements, at inflation rate plus population growth. Limit Government spending to that rate, and the Federal Government will shrink relative to the economy, until we reach 15% of GDP as long-term goal.

Without a long-term overarching goal of lessened burden of Government, tax reform is doomed to be ineffective, as the cost of Government pushes tax rates up.

2) We need a simpler, flatter, lower rate tax system.
The tax system needs to go in the direction of BROADER BASE and LOWER RATES. Our current system includes billions in compliance costs; people filling out forms, collecting income tax information, paying accountants, etc. A tax system with lower rates mean less tax avoidance and economic distortion; this maximizes economic efficiency and minimizes. An economist put it this way before Congress:
"the theoretical case remains valid for a tax system with a broad and clean base which minimizes the reward to tax-driven economic activity."

In other words, the broadest tax base with the lowest rates possible has the lowest economic drag. We don't do that because the Congress and politicians want to use the tax system to reward and punish behavior. However, that is not a valid purpose for the tax system. It should be used for revenue collection, not social engineering.

The solution the FAIR Tax proposes is to abolish and replace the income tax.

Out solution is less drastic, and it takes us in the direction of a "the rich pay 100%" simple, flat income tax. Abolish the income tax for all but 15% of Americans. The top 10% income tax payers would pay about 95% of the income tax (people making $100,000 or above). the next 5% would pay a fraction of the income tax. The remaining 85% of americans should pay NO income tax. With a simple flat 15% rate there would be a radically simplified income tax. We would have the same simple flat rate for corporate taxes, cap gains, income: 15%. This has huge benefits for the tax system in that it does not reward one type of income over another, making tax avoidance by shifting types of income a thing of the past. In this system, long-term gains over 4 years could be indexed to inflation if that is desired/useful.

The estate tax could also be abolished and/or replaced with a mechanism to shift capital gains from one generation to the next. Ie, heirs would pay adjusted basis for their inheritance, or may defer that until they sell assets acquired in inheritance, again at the 15% rate.

One simple flat rate of 15% that leaves most people alone to pay nothing would also enable the abolition of tax breaks, complicated tax rules and classification, complex depreciation and depletion rules. In short, the system could be massively simplified. We would allow expensing of items that today are under complex capital rules (it would not harm tax collections, as they would be paying BTT on purchases).

3) We need to tax production less and consumption more
There are many reasons why we must most to tax consumption instead of production. Our country is consuming its seed corn and diminishing its base of wealth by running very unhealthy and large trade deficits. These deficits are not a function of sloth, but rather a function of our tax system, which disfavors production and favors consumption. The trade deficit is an $800 billion gap of economic activity (consumption) that is taxed at a We need to fix the trade deficit over the long term; this is due to tax policy; shift taxation to include imports.

Solution: As we lower the corporate and personal income tax rates to 15% maximum, have imports and energy (oil,gas, coal) taxed at 15% flat rate. The 15% import tariff is not a protectionist tariff but a money-raising tariff on 20% of the economy. Free trade agreements might impinge on the tariff for goods from some countries. Then add a 5% Federal BTT/VAT (business transfer tax/value added tax), akin to the FAIR Tax NRST, but at a much lower rate. All goods bought and sold are subject to 5% Federal sales/value-added tax.

The FAIR tax shifts the tax code 100% to consumption, replacing all other taxes. In doing so creates its own issues: First, the rate is very high, as high as 30% sales tax (or 23% when viewed as portion of final price); to avoid having this tax be viewed as regressive, there is a need for a rebate, but this rebate becomes the equivalent of a universal subsidy payment to every family in America, thus requiring some interaction with the taxing authority. (In our plan there would still be a limited EITC program to rebate for social security and sales taxes, but it would be for a limited section, the low income households.) Last, the FAIR Tax has to consider whether to tax capital good sales, like houses (only if new), and in that dividing like is possible mischief with the tax code or some possible economic distortions. In the housing example, new home sales would be taxes but not existing home sales. Renovations would be rewarded over new construction.

No tax system can avoid the distortions, and it may be that the culprit is not what is taxes, but the rate itself. Would it stay simply and clean when the rate is so high? Consider excise taxes: they can and are different on different types of goods. The FAIR Tax could fall prey to that complexification if interest groups beg for 'relief' of the high rate.

Simplicity in the tax code is a virtue, and there needs to be some way of locking down the simplicity. Our approach is simply to point out that simplicity, a wide base, and low rates are three aspects that go hand-in-hand. A wide base means to exempt as little as possible. Simplicity likewise means few or no exceptions and treat as many things alike as possible. Thus we believe the FAIR Tax rate itself is the flaw

But a lower FAIR Tax rate won't raise enough revenues by itself. So we fall back on a combination of a very scale-down, stripped-down flat fair income tax that only the rich pay, combined with a reduced social security wage tax rate, and a stripped-down BTT tax rate and income/energy excise tax. These four taxes, combined, can raise 15% of GDP at low rates. A maximum rate of 15% on all taxation.

This proposal is more balanced; it shifts us about 40% of revenue in the consumption tax direction. There are equity or "fairness" objections to flat taxes and the FAIR tax. This proposal keeps the good ideas of the FAIR and flat tax, but provides it in a more balanced way of achieving it and does it in a way where working and middle class families have a very reduced tax rate.
The rich pay a lower rate overall, but pay a great share of total taxes.

THE NEW TAX SYSTEM
15% - personal income ($100,000 exemption level for family of 4, so only top 15-20% pay); corporate income; cap gains
15% - import tariff; energy excise taxes
5% - BTT/VAT/Federal sales tax
10% - soc insurance tax; all visible to wage payer

4. We need to fix entitlements through choice
Part of the impediment to tax reform politically is that the majority of workers are now actually paying more into social security tax rate than income tax, thanks to prior efforts to cut the income tax rates for middle income payers; the social security tax, if left alone, is too high and too regressive. Alas, flat tax attempts on the income tax leave this behemoth alone. But to attack the social security tax rate, we have to answer the questions about addressing social securities' future.

One fundamental is this: We need to lower the Social Security tax rate. And we can do this, if we raise the limit on contributions: Set the rate to 10% from current 15%; increase contribution limit to $1 million or even make it unlimited so this is a real flat wage tax. What this does is shift a lot of the taxes that the rich were paying into income taxes at the 28-35% rate into social security. The benefit of this shift is that this enables keeping the fundamental tax reform from resulting in an overall regressive tax system.

This would be a dramatic tax reduction for working class and middle class, but will beg the question: How to keep social security afloat? The answer is simple. Get people who have their own means to fund retirement to opt out, while they continue to pay some contribution to the system.
Have Choice in social insurance - #1 opt-out options for all programs.

Solution: Reduce from 10% to 7.5% for those who choose to opt-out of social security. Opt-out means that they are deciding they will not partake of the benefits of social security when they retire. We will require a 401(k) plan for those who do. With no cap on social security tax, there will be a big incentive for high income people to opt out, and thereby have zero reliance on the govt for their retirement security. we can evolve social security to be a safety net program.

Solution: Have Choice in social insurance - #2 medicare choice. By letting people opt out, we encourage less Government dependency.

The tax proposals I outline above are NOT regressive, while at the same time providing lower tax rates at all income levels. A low flat tax plus a regressive social security tax equates to a regressive tax scheme wherein the tax rate on millionaires could be less than on someone making $50,000, and has been opposed by liberals on those grounds. The problem has been that social security has been this hybrid tax and retirement scheme. What we need to do to ultimately reform social security is to separate out the portion of social security that is a redistribution/safety net and the portion that is a retirement security mechanism. A personal account based on individual contributions can be and should be the method. That can be based on the 2.5% add on to the 7.5% tax on wages. Such a scheme will be fair and workable.

The 15% solution tax system is based on four key taxes: Income tax, wage tax, sales tax, import/energy tax. The virtue of the system is that all rates are low. One objection to a proposal that adds one more tax but does not abolish another is that all tax rates can become greater,
getting raised by tax-hikers incrementally without great injury all at once, but a drip-drip of accumulated burden. We must avoid creating a powerful mechanism for large Government. We must instead restrain the tax rates and the tax system so it cannot simply grow back. This is one reason why we cannot do the above scheme without taxpayer protections ...

5. We need constitutional protections for taxpayers
We need a Taxpayer Bill of Rights
- repeal and replace 16th amendment with a constitutional limit on tax rates, putting in a constitutional maximum of 15-25%. Similar limit of 7.5-10% on BTT/VAT could be put into the amendment
- 2/3rds vote in both Houses of Congress required for tax increases
- spending limitation, tax limitation
- line-item veto
- balanced budget amendment

If these items cannot be made into constitutional amendments, they can be made into law or as Seante and House rules in such a way that Congress will be constrained in spending and in new taxes. Just as today there is a point-of-order on budget-busting, a similar point-of-order on any tax increase, or a House and Senate rule that requires 2/3rds approval for tax increases is required.

In summary, tax reform is vital for America and it needs to start by agreeing to the basic principles for tax reform: Less taxation overall; simpler, flatter tax code; tax production less; address entitlements; put in taxpayer protections. These principles are satisfied with a balanced "15% solution" package that brings the best of the Flat Tax and FAIR Tax ideas. The 15% solution package that would be harder for liberals to demagogue, since it lowers taxes for the working class and maintains the 'equity' of having those who make more to pay more. At the same time, in shifts taxation towards consumption to a signficant degree, enabling America to level the competitiveness playing field.

Most importantly, if we went in this direction, our economy would take off like a rocket. The tax rates would encourage production and investment at much higher levels, and the economic boom would lead to higher revenues that would enable us to reach the goal of a Government that could live on 15% of the nation's total GDP.