Taxes are a necessary nuisance, almost universal in any modern human society that has a government and currency system, as referenced by the phrase "Death and Taxes". But tax systems are not created equal; some work better than others, and most tax systems work better for some people than others.
In my opinion, the best tax system has the following attributes:
- Simplicity: The best tax system is as simple as possible.
- Good incentives: The best tax system is the one that creates the best incentives. To be more specific, the best tax system creates incentives for wealth creation and preservation, and disincentives for harmful or destructive activities and activities that use up wealth and resources.
- Fairness: People disagree, often strongly, about what constitutes "fairness" of a tax system. I believe that a tax system is fair only if people and businesses who are using no public resources pay no tax and if people who are living modestly and struggling to make ends meet pay no tax unless there are truly no other options for funding the government.
- Sustainability: A good tax system is one that has a sustainable stream of revenue. The incentives set up by a tax system are important in promoting or hindering sustainability, both of the tax system, and society as a whole. I also have a specific page on sustainable taxation.
As I will explain below, there is no perfect tax system. These goals described above are a "holy grail" of tax systems, but it is not possible to achieve them fully. Often, these goals will be in conflict with each other to a degree.
A good solution, as I see it, is one that avoids the worst problems or incentives/disincentives and balances simplicity against other goals. I would favor a system much simpler than the current federal income tax system in the U.S.
Taxes Create Incentives and Disincentives:
Any tax system sets up incentives and disincentives. Because people generally do not like paying taxes, taxing an activity usually provides a disincentive to engage in that activity. The higher the tax, the stronger the disincentive.
Taxes can also set up positive incentives, by creating incentives to engage activities which avoid or reduce the tax. For example, taxing the holding of money provides an incentive to spending cash, or taxing energy use provides incentives for conservation.
I have heard the argument from some conservatives and libertarians that it is not good, proper, or ideal to think about incentives when designing a tax system, and instead that tax systems should be based on some notion of "fairness". I see two problems with this argument: (1) the notion of "fairness", while important, is subject to a great deal of disagreement, and (2) all tax systems create incentives, and these incentives result in real changes in the structure of society, so any tax system that does not adequately take into account incentives is likely to have unintended negative consequences on society as a whole.
Simplicity is one of the key ideals of tax code that most people wish to achieve. A simpler tax code has numerous advantages:
- The simpler a tax system is, the harder it is to evade taxes.
- Simpler taxes require fewer resources in society to be dedicated to tax preparation, tax collection, and tax planning.
- The simpler a tax system is, the easier it is for people to clearly understand the implications of the tax system, and clearly see and understand the incentives and disincentives created by the system.
If simplicity of a tax system has so many advantages, then why is our tax code complex? Part of the problem is due to ineffective and short-sighted political decisions, which often make patchwork changes to the tax system to achieve various political goals. In some cases, the complexity is due to outright corruption, as money fuels outright bad tax policy which favors certain corporations or groups of individuals. But there are also a few more sincere motivations that create pressure for tax codes to become more complex.
There is, unfortunately, a tradeoff between simplicity and fairness of the tax code. The world is a complex place, and there will always be ways in which the tax code is somehow unfair. For example, it seems unfair to tax income at the same rate, when they are living in areas with a different cost of living, as a person with a certain income might be living very modestly in one area and yet still struggling to make ends meet, whereas the same income in another area might result in the person being able to live a rather luxurious lifestyle. But adjusting taxes for cost of living would not only make the tax code much more complex, but would greatly increase the possibilities for tax fraud and tax evasion.
People rarely talk or think about a tax system being robust, but the concept is simple. Some forms of revenue are more robust in the face of change, whereas others are not. For example, income tax and sales tax revenues fluctuate greatly as a function of how well an economy is doing, as both income and purchases of new goods are higher when the economy is booming. Accordingly, these are not very robust sources of tax as they tend to fall off when the economy takes a downturn. Property tax can be more or less robust, depending on whether or not property values are changing.
In general I think the best way to have a robust tax system is to tax in such a way that stabilizes, rather than destabilizes the economy. It is difficult to find taxes that are not dependent to a degree on economic activity, but it is certainly possible to find ones that change more or less. This is part of my argument for sustainable taxation, whereby a tax system only raises revenue from economically healthy, thriving businesses and individuals, and does not touch those who are merely starting out or who are struggling.
My Ideal Tax System:
I would support a radical restructuring of the tax code in the United States, leading to a complete elimination of all income tax and payroll tax. I support elimination of both individual and corporate income tax. Why?
Income tax disincentivizes work, a productive activity which creates wealth in society. I believe that, rather than tax productive activities, it would create better incentives to tax only destructive activities. Here are some ideas of types of taxes I would support:
- A carbon tax or tax on fossil fuel use, ideally by taxing them at the point of extraction - Fossil fuels are a limited resource; when they are used up, they are permanently destroyed. Their use also has negative environmental consequences. Taxing fossil fuels at the point of extraction would be important, as it would create the greatest incentive to capture the full amount of fuel, rather than wasting the fuel (such as by burning natural gas off on an oil rig). However, this may be more difficult to implement so the relative benefits of taxing extraction vs. taxing other stages in the process must be weighed.
- Tax pollution. Examples could be taxing agricultural operations based on their generation of nutrient pollution in runoff, or taxing emissions of various pollutants. The largest barrier to taxing pollution is that pollution can be difficult to measure, so such taxes are not always realistic to implement.
- Tax disposal of resources - when resources are disposed of, they are permanently destroyed. It thus makes sense to tax waste disposal at a high rate. However, the feasibility of this type of tax is limited because if the tax rate is too high, it can lead to illegal dumping or illegal disposal of goods.
- Tax holding of cash, but at a low rate. If the rate were too high, it would encourage individuals to take large amounts of cash out of their bank accounts and hold them as hard cash; it would thus make the most sense to keep this tax rate well below the typical interest rate of an interest-bearing savings account. A holding tax on large cash deposits could provide a strong pro-business tax, in that it would create an incentive for spending the cash, much in the same way that a modest, stable rate of inflation creates a strongly pro-business economic climate.
- Tax political contributions - It is generally agreed upon that political contributions have a negative impact on society. Rather than make them outright illegal, or restrict them with a complex system of regulations, it seems more effective to just tax them. This tax could be made progressive, in order to enable large numbers of individuals to exert a greater influence over politics than a single wealthy party.
- In addition to taxes, use fines and penalties to ensure that illegal activities do not result in losses to the public budget--for any offense that results in a cost to public funds, make the fine slightly higher than the total cost incurred (including the cost of enforcement, prosecution, etc.).
These proposed taxes are a radical departure from the current tax system. Are there smaller changes that could be made immediately that would still have a substantial positive effect? Yes!
A less radical proposal:
I propose to begin tax reform by the following changes:
- Eliminate the payroll tax (social security + medicare tax).
- Make up for the lost revenue from the payroll tax by an across-the-board increase in income tax. Because payroll tax taxes only about the first $100K in wage income, and income tax taxes all income with no cap, a flat income tax of a much lower rate could raise the same amount of revenue.
This change to the tax system could be implemented without making any changes to the payouts of social security and medicare. I understand and agree with the need to reform the social security and medicare systems, but I also believe in tackling problems one step at a time. This single step could be a revenue-neutral reform to the tax system that would carry several benefits:
- This change would simplify the tax system.
- This change would lighten recordkeeping requirements for businesses and self-employed individuals, as businesses would no longer need to separately calculate and pay their share of the payroll tax, and self-employed individuals would no longer need to calculate the separate self-employment tax.
- By shifting the burden away from wage earners and the businesses employing them, this change would eliminate a major barrier to employment, and have the effect of spurring job creation across the board in the economy. This could have the effect of increasing economic activity and thus indirectly raising tax revenues in the long-run.
- This change would actually produce a substantial reduction in the size of the government's budget. Why? A huge portion of total government expenditures are in the form of payroll and contractors; by reducing the costs of payroll and contracting, total government spending would be substantially cut across-the-board.
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