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Overview of the Federal Income Tax: Would a ‘flatter’ income tax benefit every American?

What began as simply a percentage levy on income earned by individuals and businesses, easily understood by all citizens, has grown more and more complex.

The federal income tax is now comprised of a complex system with credits, deductions, regulations, and bracketing that no one person fully understands or could explain outright. Throughout recent history, the tax code has been the discussion of much debate. Many have questioned the effect industries have had in emerging to help people avoid paying taxes and allow special interest groups the ability to win concessions. At the same time, the government itself has turned to the tax code as a tool to redistribute income in order to increase social equity.

Economists suggest that the current federal income tax system is strangling our economic growth. Former President Jimmy Carter has called the progression of the federal income tax system “a disgrace to the human race,” in need of reform. The federal income tax is, in a general account, “a complete mess…not efficient…not fair…not simple.” Economists have mused about a wide variety of ideas that would help fix the concerns regarding income taxes and how to proportion taxes altogether, but a multitude of questions remain. One of the main objectives revolves around how to not only make the tax code fairer but designate the federal income tax for particular federal revenue spending every year as an asset, helping provide a basis for economic security, national security and defense, and eliminating the national debt.

While Republican and Democrats often disagree on how people and corporations should be taxed, they will generally agree on one thing—that the current tax system is simply unfair. The exact meaning of ‘fair’ is at the heart of that debate. In this context, does fair mean ‘impartial’? Does it mean ‘just’? Or does it imply ‘equitable’? Impartiality would suggest that everyone be taxed at the same rate, regardless of income or industry. A ‘just’ code might imply that the wealthier people in our society should bear a larger percentage of the tax burden, as they have a greater ability to pay. ‘Equitable’ implies the concept of the redistribution of income, or the use of the tax system to insure social equity—fairness.

Nearly 80% of federal revenue is through individual income taxes and a lot of this money goes towards defense spending. Significant portions of this money become unaccounted for and there is a pervasive sense of unequal distribution. The larger point, however, is that the modified or new version of the income tax rate has the potential to also reduce any increases in the federal deficit while increasing the federal revenue. A tax rate that reflects the country’s values and diplomacy would be an extreme benefit for the United States; its economic well-being and security, national defense and security, and the people. A hybrid flat income tax is a good, fair bargain for all parties involved. A hybrid flat tax holds citizens accountable and creates transparency between the government and the populous. The tax could ultimately make strides towards the objective of achieving a sense of social and economic equity, and by its influence and association, contribute as a solid foundational structure for national security.

The first income tax imposed on US citizens was in fact a flat tax. In 1861, President Lincoln imposed a 3% tax on all income above $800 in order to fund the Civil War. Rates increased to the range between 5% and 10% until the income tax was abolished in 1872, where it was viewed as having a “socialistic tendency.”  A 2% tax was imposed again in 1894, but was ultimately deemed unconstitutional by the Supreme Court. Determined to create a permanent and reliable source of revenue, in 1909 Congress passed the 16th Amendment, and it was ratified by the states in 1913.   The Amendment stated:

“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.”

While the first version of the official federal income tax ranged between 1% and 7% of income and exempted almost 99% of all individuals in the US from taxation, it was not long before a series of tax brackets emerged, ranging from 6% to 77%. Earlier versions of the income tax primarily impacted only the nation’s wealthiest families. But this new progressive tax was collected from both the rich and from the bourgeoisie middle class, feeding the government’s appetite for a sustainable revenue stream.

In 1920, Andrew Mellon, Secretary of the Treasury, reduced the top rate from 77% to 25%. Surprisingly, total revenues increased by 3%. This was the first indication that a more impartial tax system might eliminate avoidance and actually increase revenues altogether. However, by the 1930’s, the top marginal rate was again at 63% with fewer personal exemptions. In the 1930’s, the income tax became ‘everyone’s tax’ or the ‘everyman tax’, to some extent. The change to a reduction in personal exemptions provoked an ever-increasing share of the adult population finding themselves “caught in the tax net.” It was during this period that the income tax became more than just a worry of the wealthy—a majority of American citizens and businesses had now been gratuitously drawn into the system. During World War II, the top marginal rate of tax reached its highest level at 94%. Considered confiscatory by many, the rate was quickly reduced after the war, but rose again to 91% during the Korean War, its rate enduring until the early 1960’s.

In 1964, the “Kennedy Tax Cuts” were pushed through congress by President Lyndon Johnson, reducing all marginal corporate and individual rates—where the most effective were seen reducing by as much as 20%. The result was lower unemployment, stronger economic growth, and increased government revenues. This was the first real proof of the theory supporting what later became known as the ‘Laffer curve.’ Economist Arthur Laffer, drawing on work by John Maynard Keynes, suggested that increasing tax rates beyond a certain rate would be counterproductive to raising revenues. In this scenario where the increased tax rates would produce counterproductive revenues, individuals would choose other activities over earning more, companies would invest less, and avoidance and cheating would run rampant throughout the economy. The Laffer curve suggests that a flatter version of the income tax might benefit the government and the people. The curve contends that:

“…cutting income taxes at the same time that public investment falls and government consumption rises, as occurred in the 1980’s…increases the likelihood that the government loses tax revenues. In this case, a revenue increasing strategy would have consisted in the idea of lowering income tax rates but increasing public investment at the expense of government consumption. As a general rule, raising public investment relative to public consumption will tend to add to tax revenues.”

The Laffer curve believes that lowering taxes to the peak of the curve, or what is referenced as a ‘revenue maximizing point’, would yield the greatest revenues for both taxpayers and government. There are many parallels between the ‘revenue maximizing point’ and rates President Ronald Reagan alluded to in 1981, passing an across-the-board, all-encompassing reduction rate of 25% for all kinds of income. During his second term, President Reagan passed what could be seen as the closest version of a flat tax that the U.S. had seen since 1861. Reagan instituted just two marginal rates, 15% for about 4/5ths of the population and 28% for the rest—eliminating over $100 billion dollars in tax loopholes and what would eventually become exemptions. These are the kinds of steps that need to be taken today in order for the U.S. government to account for all kinds of income and provide more federal revenue.

The results under Reagan were dramatic. Federal receipts grew from $618 billion to $991 billion (an increase of 60%). At the same time, the top 10% of taxpayers paid an increased share of income taxes to the Federal government, while the lowest 50% of taxpayers paid a reduced share of income tax revenue. Personal income tax revenues declined from 9.4% of GDP to 8.3% GDP, while payroll tax revenues increased from 6.0% GDP to 6.7% GDP during the same period.

Despite Reagan’s ‘flatter’ tax resulting in a huge windfall to the nation’s wealthiest families, widening the income gap between the very rich elite and everyone else. In spite of the fact that the 1986 tax act dramatically assisted in reducing marginal tax rates, especially on the top tax bracket, it did not cut all total taxes. Almost instantly, Congress sought to increase taxes. It wasn’t long before Reagan’s successors, Republican and Democrat alike, diluted the simplicity of Reagan’s plan by adding loopholes, exemptions, and new tiers of rates.

Most recently, President Obama made what was idyllically thought to be a more  ‘just’ tax structure the centerpiece of his 2012 Presidential campaign. The picture painted by President Obama was that the tax code favored the rich at the expense of the middle class. Voters agreed with this belief. As a result, the code was revised in January 2013 to include higher payroll taxes, higher taxes on investment income, limitations on corporate income tax deductions for Medicare costs, an increase in the tax on investment income, a new top marginal rate of 39.6%, and a host of income and investment related taxes to fund the 2009 Affordable Health Care for America Act. The National Tax Journal proposes that the question is not whether or not the federal income tax code needs changing, but how best to do so. A flatter tax would reverse inequity and benefit the great majority of Americans, whose income comes almost entirely in the form of wages.

In looking at rough numbers, the total Adjusted Gross Income of the United States Economy in 2010 was approximately $8.089 trillion. Deductions totaled 1.955 trillion, and exemptions about $1 trillion, so the total income was approximately $11 trillion. Total tax collected in that year was $857 billion, or about 9% of total income. Currently, 47% of Americans pay no income tax due to evasions and avoidance. Herein, if the highest income taxpayers continue to pay progressively, and deductions and exemptions are eliminated, some combination of rates should emit sufficient revenue and tax accountability for an overall adequate economic return.

The hybrid flat tax proposed would provide the fairness desired by taxpayers while also generating equity for the top 1/5th of the population. Just as Reagan’s tax plan eliminated millions of dollars in tax loopholes; a flat tax rate system on income could spark a sense of accountability, fairness, and prosperity in the American society and economy. The transparency between the populous and government could pay vast dividends in reaching and resolving bipartisan issues. The proposal identified is not one of a pure flat tax system; but rather, a modified version that includes “progressivity by offering allowances that mitigate the burden on the low levels of in­come,” while ensuring “income is taxed just once.”—as you think it maybe should have been all along. This positive aspect of the flat tax is “probably the strongest argument in defense of its equity consideration” and ability to help economically secure the nation, aiding federal revenue. Another benefit of the hybrid flat income tax lies in the ability that which the flat tax grants in increasing fairness by “eliminating loopholes created by special interests, particularly business interests,” allowing the government to account for a  lot more of the money that is being invested, circulated, and taxed. One of the main objectives revolves around how to not only make the tax code fairer but designate the federal income tax for particular federal revenue spending every year as an asset, helping provide a basis for economic security, national security and defense, and eliminating the national debt.

The income tax provides an abundance of federal revenue and ultimately translates back into how the government chooses to go about spending. Overall, the income taxing spectrum is simplified through a hybrid version of a flat tax, a tax concept that is simple enough to be put onto a notecard—according to some of the most contemporary formal proponents and authors of a flatter income tax. Despite the potential for mishaps within how a tax rate policy should operate, there are a few certainties about the American tax system identified throughout this analysis. First, because the federal tax system is extremely complicated and next, the idea of a hybrid flat tax on income provides great insight as to how the government can lower tax burdens on citizens while still allowing the economy in its entirety to flourish.

A hybrid flat tax on income would add a definite stability to the economy in the sense that it works towards balancing out tax burdens so that the government can account for all the different ranges of income more effectively. The possibility of the highest income taxpayers paying progressively, deductions and exemptions are eliminated, revenue and tax accountability cause the rate lie at the forefront of adequate economic return. Money directly from the federal revenue can be appropriately allocated to national security and defense when there is transparency and accountability within the tax code system and especially so when dealing with ‘everyman’s tax’ element of federal income taxes.

One potential proposal that mimics Reaganomics, includes a hybrid system that includes a flat rate for 4/5ths of the population and a progressive rate for the top 1/5th of the population. A policy could achieve fairness, simplicity, and social equity without imposing a hardship on the middle class. Specifically, the policy would entertain the following concepts:

  1. Anyone earning less than 150% of the Federal Poverty Guidelines would receive a refundable tax credit of 15% of Adjusted Gross  Income (AGI) at 100%, 10% of AGI at 133%, and 5% of AGI at 150%.
  2. Anyone earning between 150% of the Federal Poverty Guidelines and $450,000 would pay 20% of income
  3. Above $450,000 there would be a series of marginal rates ranging from 20% to 30%. Corporations would follow these guidelines as well.
  4. All other exemptions would be eliminated
  5. Taxes on interest and dividends would be eliminated (eliminating double taxation)

A flatter income tax system is simple and understandable. In a compromise, it addresses the standards of fairness endorsed by both Republicans and Democrats. The nation’s most needy families would receive aid from the federal tax system, in a manner that makes the redistribution of income very visible and understandable, and therefore acceptable. It would be acceptable because it satisfies most people’s sense of societal equity, where both the utility of the least well off people is maximized and all citizens are, more or less, receiving nearly the same or equal amount of goods.

This hypothetical federal income tax proposal simplifies the system enough for the bulk of American citizens and small businesses so that the “compliance economy” is reduced. Government gets to save in that regards, while the private sector can put millions of people to more productive use. It is simple enough to reduce cheating and avoidance, thereby naturally increasing revenues. It is flat for the middle class and small business, but progressive for the nation’s wealthiest taxpayers. A proposal of this mold addresses the issue of everyone paying their fair share, while at the same time ensuring that this portion of the population is not granted a windfall from the transition.

Naturally, any tax structure also needs to pass the ‘math test’–a question of whether or not the proposed plan will make the numbers work. It usually comes down to the question of, ‘will the policy generate enough revenue to cover government spending?’ In the preceding exploration of the tax system, the spending side of the tax equation has been ignored. Nonetheless, it is safe to conclude that under some set of assumptions, there is a function that would allow proposed tax revenues under a progressive tax system to equal current tax revenues under a flat tax system. In the hypothesized plan, assume that this function has been solved. So suggested rates should be viewed as relative, rather than absolute.

As a concept, the flat tax is impressive in the social equity it attempts to achieve. As practical policy, however, it leaves much to be desired in the fact that its proposed simplicity is met with great scrutiny. It remains to be seen whether such an untried system can function exactly as theorized.




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