A modest proposal for individual tax reform

I talk a lot about simplifying the tax code, for two big reasons. First, the complexity of the tax code leads to absurd economic outcomes, like arbitrary cutoffs between eligibility and ineligibility for benefits like the Retirement Savings Contribution Credit. Lest you think my concern is exclusively for the poor, I’m equally infuriated by things like the personal exemption phase-out for high-income tax filers and income-testing for retirement accounts like Roth IRA’s.

Whether you think a progressive income tax or a flat tax is the best way to finance the government, there’s no reason to believe that a tax code with marginal tax rates that simply bounce up and down all over the place is the best way to finance the government.

The second reason tax simplification is one of the defining issues of our era is that the complexity of the tax code is harmful in its own right. You could imagine a tax code as complex as ours that nevertheless resulted in smoothly rising marginal tax rates. That tax code would still be a crisis, because it would demand the time and attention of taxpayers that could instead be used doing something, anything, besides filling out IRS worksheets.

With that in mind, here is my three-part plan to simplify the tax code. Feel free to share it with your friends, neighbors, and legislators.

1. Tax all income in the year it’s earned.
2. Tax capital gains as ordinary income.
3. Lift the cap on income subject to Social Security taxes.

I call this a three-part plan, but that’s mostly a function of how our income tax code is currently constructed, and where the complexities are hiding to be rooted out. It’s really a one-part plan: count up all the income you receive each year, look it up in the tax table, and write a check. Let’s take a look at each part in turn.

Tax all income in the year it’s earned

This part of the plan ends all tax-deferred and tax-free savings vehicles. I have written before that I don’t have any objection to a Roth-like savings vehicle that would allow people to save a fixed amount of money that could compound and be withdrawn tax-free. Such accounts don’t create any kind of complexity, since they don’t require any adjustments to income in the year it’s earned. My objection is to any and all programs that allow people to defer present year income, because such programs create harmful complexity.

This would mean the end of 401(k)’s, HSA’s, FSA’s, traditional IRA’s, dependent care savings accounts and any other vehicle that allows people to avoid paying taxes on the income they receive each year.

The reason to do this is not to punish people who save for retirement, or save to pay medical bills, or save to pay for dependent care. The reason to do this is to simplify the tax code.

Tax capital gains as ordinary income

I’ve written on this before so I can be brief: the reason to tax capital gains and dividends as ordinary income is not to punish the owners of capital, or to discourage capital formation, or to combat income inequality. The reason to tax capital gains and dividends as ordinary income is to simplify the tax code.

No more tracking the purchase date for each lot of shares you buy, no more 60/40 splitting of profit from futures contracts, no more deducting long-term losses against short-term gains. Your capital gain is the amount you received in excess of what you paid — that’s the amount you pay taxes on.

Lift the cap on income subject to Social Security taxes

Each year the “wage cap” on Social Security earnings is adjusted to reflect wage inflation. In 2017, it’s $127,200. That means if you have multiple jobs, or a job and a small business, or multiple small businesses, you have to calculate how much of your income from each source on which to pay the full 15.3% FICA tax and how much to pay the lower 2.9% Medicare tax on. Higher-income earners then also have to decide how much income to pay the so-called “Additional Medicare Tax” on.

Lift the cap and levy a flat tax on all the income people earn each year. Again, the reason to do this is not to punish high-income individuals. The reason to do this is to simplify the tax code.

Here you might be tempted to stop me and say, “but Indy, if we already have a progressive income tax levied on all income in the year it’s earned, why do we even need a separate Social Security tax?” That is an excellent question. The answer is that things should be made as simple as possible, but no simpler. I don’t believe Social Security needs a “separate funding stream” in order to be protected from political meddling. However, I do believe Social Security benefits should be earned and paid out based on income from work and not from capital. It would be curious indeed to calculate the government pension of a capitalist based on the amount of dividends they’d received over the years! A separate Social Security tax levied exclusively on earned income is a simple, rather than complex, way to track people’s earned income throughout their working life.

The advantages of this plan

After implementing these three policies, tax preparation would consist of adding up all your income from all sources during the calendar year, subtracting the standard deduction and any personal exemptions, and looking up the resulting number in a tax table. A simple online calculator would do 90% of the work.

The disadvantages of this plan

The biggest disadvantage of this plan is that it would raise a phenomenal amount of money, and close 76% of the Social Security “funding gap” (click on Revenues, then “Subject All Wages to Payroll Tax”). Since the Republican Party has used the federal deficit as a policy bludgeon for 40 years, reducing the deficit through tax simplification would create an enormous amount of pressure to cut tax rates in order to increase the deficit back to “crisis” territory in order to justify cuts to the welfare state. You saw this strategy at work back in 2001 when Federal Reserve Chairman and Ayn Rand apostle Alan Greenspan testified that federal budget surpluses created the risk of the federal government having to accumulate private assets, potentially destabilizing the capital markets. His solution? Tax cuts, and the federal deficits of the 2000’s.

But besides the purely partisan challenges this plan would create, it’s important to keep in mind what this plan would not do:

• it would not remediate lead contamination in residential areas, playgrounds, or parks;
• it would not repair or replace any roads or bridges;
• it would not modernize the electrical grid to address the challenges of intermittent energy sources like wind and solar;
• it would not make higher education more affordable;
• it would not subject banks to sufficient regulatory scrutiny to prevent another global financial catastrophe;
• it would not increase the density of expensive coastal cities where high-paying jobs are increasingly concentrated.

These are all serious problems in American life that need to be addressed, and my tax simplification plan doesn’t address any of them.

That’s because we need to stop asking the tax code to solve all our problems. The tax code should raise the money we need to finance the state as painlessly as possible.

Once the tax code is simplified, we should welcome fights over what tax rates are appropriate and what activities the federal government should spend our tax dollars on. We should have vigorous disagreements about the appropriate size and scope of government activity. But every year we make tax simplification a hostage in those fights is another year we go without tax simplification.