Better Taxes for Business and the Middle Class Now

and Better Spending Later

by Eugene Patrick Devany

[DRAFT May 18, 2012, IN PROGRESS, COMMENTS ENCOURAGED]

Lower the individual and corporate income tax rate to 8% (with no deductions, credits or loopholes), tax individual net wealth at 2% (excluding $15,000 cash and retirement funds) and tax sales at 4% via a Value Added Sales Tax (VAT) on business.

This blend of taxes would generate at least $500 billion more than current revenue (about 18.5% of GDP). Regressive payroll, AMT, estate, gift, capital gains taxes as well as deferral of US taxes on foreign income would not be necessary. A little background can be helpful to appreciate why:

1. individual and business tax reform is needed

2. income as a tax base is overtaxed

3. low flat rates can build political consensus for reform

4. consumers create jobs and will restore the economy

Does Fairness Matter?

Tax Rate unfairness can be illustrated by the fact that Mr. Romney pays the federal government 15% of his $20,908,880 gross income and Mr. Obama pays 20% of $844.585. Citizens for Tax Justice computed that an upper middle class family earning $68,700 pays 28% in combined federal, state and local taxes (including 19% in federal taxes when you consider the payroll tax that does not apply to most of the Obama or Romney income). There may be a little misguided envy of the elite who are asked to pay the Alternative Minimum Tax (AMT) – not because of their success but rather do to their payroll tax holiday above $110,000. Mr. Obama reportedly is worth $5,000,000 and Mr. Romney at least $200,000,000. Under the 2-4-8 Tax Blend everyone pays the same rates - 8% of income plus 2% of net wealth over $15,000 per person (and on equity in a house but not retirement funds). Mr. Obama would pay $5,000 more in taxes and Mr. Romney would pay about $2,500,000 more. [For comparison, under the proposed Buffett Rule, Mr. Obama would not pay any more in taxes because his income is below $1,000,000 and Mr. Romney would pay a 30% income tax rate and $3,000,000 more in federal taxes].

Tax Delay is another form of tax unfairness. The investment class does not rely on earned income and uses capital gains to grow their wealth. The appreciation of certain assets (i.e. stock, real estate, gold, etc.) is taxed only when the assets are sold (and at low tax rates). The taxation of capital gains began as an effort to have the investment class pay a fair share because their wealth was high but their earned income was low. If assets are not sold for 10, 20 or more years the tax is deferred and often never paid at all. Documents showing the cost (basis) of items many years earlier are often (and conveniently) unavailable. The tax avoidance is unfair to those that have to pay each year (and at higher rates). The investors have the advantage of wealth and can borrow against the assets without paying any taxes. Where a decedent dies without cashing in his chips and the estate is large the taxes can be a substantial burden for the heirs. Tax avoidance also occurs when US corporations own foreign subsidiary corporations which are permitted to delay the 35% corporate tax rate until the money is brought back into the country. The 2-4-8 Tax Blend resolves all deferral issues. By taxing all individual net wealth gradually at 2% per year there is no need to tax certain capital items when sold or at death. By lowering the corporate tax rate from 35% to 8% there is no need to continue the corporate deferral because the foreign subsidiary (except in a few tax haven countries) will have already paid the foreign country more than an 8% tax and the parent company gets full credit for it.

Tax loopholes are called tax expenditures in the tax code and include any exemption, deduction or credit that reduces tax revenue. The 2-4-8 Tax Blend eliminates tax expenditures except for a modest tax exempt retirement savings plan. Some tax expenditures are temporary and these are called tax extenders because congress often extends the expiration dates after some political horse trading. For example, Mr. Romney was reportedly overheard speculating that he might support elimination of the mortgage interest deduction for second homes. With the 2-4-8 Tax Blend the mortgage principal is deducted from the market value of the home when computing net wealth so there is no need to deduct mortgage interest. The ability to deduct student loan principal works the same way and the ability to deduct credit card debt would provide a big break for those most in need of help. Other tax deductions and credits such as the standard deduction, state and local taxes, dependents, etc. would be lost but it is a small price to pay for an 8% income tax rate versus a 19% income tax rate. The business tax expenditures are a hodgepodge of giveaways for certain kinds of business. Nevertheless, most business CEO’s would trade all the tax loopholes for an 8% income tax, a 4% VAT and much needed tax certainty. A level playing field is worth something and you will not find an oil tycoon, farmer or manufacturer who will let go of their tax advantage unless all other business are willing to do the same. That’s why incremental reform won’t work and that’s why there is hope for bold do-it-all-at-once reform.

Reform the Code or Accept the Consequences

Toxic taxes fairly describes a tax code that prevents a balanced budget and encourages the growth of income and wealth at the top at the expense of consumer power and jobs at the bottom. At the risk of political incorrectness, the assimilation of women into the workforce and the loss of 50,000,000 potential customers through abortion are important demographic factors that have impacted the economy in ways not fully appreciated. Unintended consequences include legitimate demands for government benefits and services that are no longer common in private business. The recent fight for national health insurance illustrated the self-destructive economy-be-dammed attitude that attempts major spending and entitlement reform without first reforming the tax code and getting the economy on a path to sustainable growth. Health care is too expensive to be funded from just the income tax base and the middle class can not afford to pay for it with typical take-home pay.

Tax cures abound and it is worth considering some of the suggestions by experts dedicated to burning the current tax code. To illustrate (with admitted oversimplification) assume the value of the major FY 2010 tax bases were: $12,500 billion for individual income, $1,100 billion for corporate income, $10,300 billion for consumption and $53,100 for net wealth. To illustrate the range of flat tax rates needed to generate $2.6 trillion in federal revenue (about 18% of GDP) consider some different combinations of one, two or three tax bases (The 2-4-8 Tax Blend is the last example):

• 4.9% of individual net wealth [very progressive], or
• 25.2% of retail sales [very regressive, similar to FairTax which would tax additional $500 billion and give monthly refund to low income families], or
• 28% of withdrawals from savings or money borrowed (for consumption) [like Heritage Foundation’s New Flat Tax, very regressive], or
• 19.1% of personal and corporate income (above $13,000 individual exemption), [like Steve Forbes flat tax, optional elimination of corporate taxes, regressive], or
• 14% payroll taxes and 25% Income Tax (over $100,000 deduction) and 15% Corporate Income Tax and 12.5% VAT [like Competitive Tax Plan, retains many tax loopholes for business and high earners, and similar to Smart Tax Plan with 9% VAT but only $50,000 income tax deduction and 20 to 36% rates, regressive], or
• 9.5% of personal and corporate income and 12.5% VAT [like Herman Cane’s 9-9-9 plan, replaces payroll taxes, somewhat regressive], or
• 8% income tax and 2% of net wealth tax (excluding $15,000 cash and retirement funds) for individuals; and 8% Corporate Income tax and 4% VAT tax for business [2-4-8 Tax Blend, balanced]

The Right Blend of taxes is needed and the other approaches fall short. There are some who think congress might eliminate all or most tax expenditures and sufficiently expand the income/payroll tax base to enable a one flat rate tax code (like the Forbes Flat Tax) or fewer and fairer tax brackets. Most agree there is no political way forward because there would be too many influential losers and too much pain for the middle class. Continued patches to some of the over 200 tax expenditures is likely (with specifics to abide the winners in the November elections) but these changes will not be mistaken for true tax reform and will likely be temporary measures. Creative minds and think tanks have sought to walk around the political stalemate of income taxation by looking to consumption. Both Paul Ryan and Herman Cane have suggested using a Value Added Tax to supplement the tax base and lower the income tax rates. Consumption taxes are regressive especially when added to an income/payroll structure that weighs heavily on the middle class and the poor (on on top of state sales taxes). At least the expanded consumption-income tax base would enable congress to keep more income tax loopholes in place and ease the pressure for political compromise. Attempts to bypass the income tax altogether and to fully rely on a consumption tax such as the FairTax are very appealing because it avoids the counterproductive income tax expenditures and replaces the regressive payroll taxes. Unfortunately, the FairTax is so regressive that a half trillion dollar pre-bate program is needed for low earners and the redistribution of both income and wealth to the top will accelerate. The New Flat Tax supports the accumulation of wealth (i.e. savings) at the expense of everything and everyone. The 2-4-8 Tax Blend takes the opposing view by putting wealth in the service of people - and focusing on middle class savings. From an economic health viewpoint it is far better to have 100 families put $50,000 in the bank than to have one person save $5,000,000. The 100 families become financially resilient and able to handle most crises without government support and at great savings to the rest of us. The bank aggregates the funds and will lend or invest the money in either case.

Tax technology has come a long way with the IRS and Treasury able to easily collect and update digital data. This year foreign assets over $10,000 were reported and an expanded inventory of domestic assets and liabilities would be a no-brainer. With flat rates and basic digital reporting (and withholding from employers and financial institutions), the IRS would be in a position to generate the tax returns of most non-business tax filers (as was learned from an experiential program a couple of years ago). Digital filing of all returns and public filing of business returns should be the norm. Tax accountants would still find work in the computation of business income and valuation of unusual assets.

The Way Forward: The 2-4-8 Tax Blend

For business the combined 8% income rates and 4% VAT would be the lowest and most competitive business taxes of all the developed countries. [The U.S. is the only developed country without a VAT]. The 8% income tax rate also resolves the significant problem in the deferral of taxes on foreign profits caused by imposing a 35% tax (less credit for foreign taxes paid) when the money is brought back into the U.S. It is also worth noting that the type of VAT urged is similar to a tax on the gross sales of each business except that the seller gets full credit for all VAT taxes previously paid by suppliers.

For investors the net wealth tax might seem revolutionary by U.S. standards, but most high earners would willingly pay a 2% net wealth tax in exchange for eliminating the capital gains and estate taxes and keeping 92% of taxable earnings. The ability to buy and sell assets without being taxed on the gains would spur a new era of investment freedom. The increased after tax income would also create wealth much faster than a 2% net wealth tax could diminish it.

For workers the elimination of the payroll tax and reduction of the income tax rate creates an immediate boost in take home pay. For example, a young family earning $70,000 currently pays combined federal taxes of 19% but would take home $7,700 more with an 8% income tax (assuming net wealth of under $30,000). This additional $641 per month represents an enormous opportunity for both savings and consumption. The $15,000 per person cash wealth tax exemption also encourages a responsible level of liquidity. The retention of tax exempt retirement savings programs recognizes the need for the elderly to have sufficient assets to supplement social security. Current interest tax deductions for mortgages and student loans are replaced by the ability to deduct the loan principal in computing net wealth. This is the equivalent of a 2% reduction in the interest rate and is arguably a better incentive for both home ownership and higher education.

Only the 2-4-8 Tax Blend accomplishes:

• The lowest possible rates (because it has the broadest tax base)

• The same tax rates for rich and poor (without being regressive)

• A net wealth tax for everyone (as opposed to an unfair tax only on the rich used in many countries)

• The ability to target government spending programs to need based on both income and net wealth.

• Increased economic mobility and lower taxes (until substantial wealth has been accumulated)

• Elimination of all business tax code distortions

• Equalization of C corporation and private "pass-through" business taxation

• Retention of modest tax exempt retirement savings (based on need)

• Wealth tax cash exemption of $15,000 encourages minimum liquidity

• With a business VAT the US would no longer be the only developed nation not to have a VAT and would still have the lowest business tax rates in the developed world

• A tax plan that can be described in one sentence

Better Spending can be addressed after tax reform is in place (and not vice versa Mr. Grover Norquist). Tax Reform is needed to reverse our economic decline and taxes are needed to improve our quality of life and pay for some very large debt. For example, health care reform is needed but Obama care was premature and ill considered. A Volunteer Corp of persons willing to take part time jobs in government and at not-for-profit entities at just below minimum wage would be a lot better than most government handouts. In education, digital copyright free books, master class videos and tests could be posted for all at a small fraction of the amount the federal government spends subsidizing teachers and buildings (which is the job of the state and local government). I suppose we all have out our spending peeves … and don’t even ask me about the military or why the feds still maintain highways. The point is that major tax reform must be the priority after this November and spending reform as soon as the economy permits.