Tax Inefficiencies and Alternative Solutions

Abdullahi Mohamud (12361802)

Benjamin Franklin was once quoted as saying, The only sure

things in life are death and taxes. With the advancement of medical
technology today, one could make a case for the latter being more
resolute than the former. The point being that taxes are a matter of
life, and one that impacts our standard of living arguably more than
any other financial variable. As such, its critical that were executing
taxation in the most prudent, efficient, and fair way that can possibly
be achieved. Is the United States Federal Government executing its tax
policies in this manner? If not, what can we do to improve our tax
policies? I intend to explore these topics in detail. I will examine some
of the major federal taxes we have in the United States today, namely:
individual income tax, payroll tax, and various wealth taxes. The
implementation and data collection required to enforce these taxes
also requires very large bureaucratic structures due to the sheer
complexity of the tax code and a the size of the tax base. There are
administrative costs resulting from this that I will also address. After
exploring some of the shortcomings of the U.S. federal tax structure, I
will look at two forms of alternative tax ideas: national consumption
taxes, and the flat tax. The culmination of these ideas will hopefully
paint an accurate picture of some of the problems facing our current

federal tax code, and perhaps shed some light on ways to tax
collection.

Part I. United States Federal Taxes

According to the Bureau of Economic Analysis, the federal
government collected over 80% of its revenue from taxes on
individuals income via the payroll tax and income tax. These two taxes
are extremely similar in terms of the revenue source they tax. Both are
taxes on income, but the payroll is restricted to workers while the
income tax is levied on all income not qualifying for the payroll tax. It is
probably most sensible to think of the payroll tax as a sub-category of
the income tax, even though theyre mutually exclusive. The income
tax is calculated starting with your annual gross income less any
applicable deductions, and exemptions. From that point you will be
assigned a tax rate based on the amount of your annual income. The
United States has a progressive system of marginal taxation. This
simply means that your applicable marginal tax rate continues to
increase as your earnings increase and you move into a higher tax
bracket. The difference between a pure income tax and a marginal
income tax is in how the tax is applied to your income. A marginal tax
works like a stepladder in the sense that you always pay the lowest
rate on your first dollars of income until you enter a new bracket, at

which point the tax rate goes up on those additional dollars and again
when you reach the next bracket. This process continues until youve
reached your level of income. On the last page I have a table that
identifies the marginal tax rates for individuals and married couples.
These are the up-to-date rates as of 2013. The primary difference
between these rates and past rates is the addition of an additional
bracket for those whose annual income exceeds $400,000, at which
point the marginal tax rate is 39.6%. There are a number of
implications inherent in this particular tax system. The first, and
perhaps most controversial, issue is that of equity. Designing a tax
system that appeals to everyones sense of fairness is a political
impossibility simply because of the variability in how one defines fair.
A large number, if not a majority, of people seem to favor a progressive
tax system (one that taxes more successful people at higher rates) as
being more fair because wealthy individuals have a lower marginal
utility associated with their consumption spending than does the poor.
This is true, but the fact that I dont agree with it being characterized
as fair only demonstrates the stratification of thought regarding the
matter. In order to determine the equitable nature of any tax, however,
would require us to define a fixed set of criteria as to what any
individuals fair share of taxes should be. Delineating what these
criteria are, or should be, is beyond the scope of this paper. The point
is that the lack of consensus on the matter is in part responsible for the

complexity that exists in the tax code today. If you printed the federal
tax code out on 8.5 x 11 inch paper, you would have 8,000 pages of
material to sift through. The result of this is a cost that all of us must
bear as consumers referred to as compliance costs. Compliance
costs are the costs of time and money that must be incurred by
individuals or businesses to insure their taxes are paid in the correct
amount and on time. The number of exemptions, deductions, credits,
and variable tax rates makes these costs quite substantial. According
to one estimate by the IRS Taxpayer Advocate, Americans aggregately
spent $163 billion (11% of tax receipts) complying with tax laws in
2008. The existence and impact of these costs is prevalent by simply
observing the number of companies available to help manage them
(i.e. H&R Block, Tax Resolution Services, Turbo Tax, etc). Of course,
these are not the only costs associated with the income tax. Perhaps
the most devastating cost, from an economic standpoint, is the
disincentives for work and the resulting dead-weight loss that they
cause. Any marginal tax on income is going to provide a disincentive to
work when a marginal increase in earnings would move one into a
higher tax bracket and thus increase their tax liability. This occurrence
can be noted when examining the demand and supply for labor in the
marketplace. The demand side of the equation is not impacted by a tax
on labor earnings, but the supply curve shifts to the left. The result is a
higher market wage, a reduced number of workers, and a dead-weight

loss. A dead-weight loss, by definition, results from a sub-Pareto

optimal allocation of resources (in this case labor), and indicates a loss
of surplus that both consumers and producers share. The degree of
severity of the dead-weight loss is determined by the elasticity of the
labor supply. This is where the progressive nature the United States
income tax becomes problematic. According to the website
JustFacts.Com, the highest quintile of earners pays approximately an
8% higher effective tax rate than the next highest quintile, and the
discrepancies between rates are smaller for all other quintiles (see
graph on the last page). Individuals in the bottom tax brackets are
much less elastic than individuals in the upper income tax brackets.
This means that the reduced incentive to work is much stronger for
wealthier individuals than poorer individuals, resulting in the largest
dead-weight loss for those who are the most productive. An alternative
way to look at it is that upper income individuals have an increased
incentive to avoid taxes via tax sheltered accounts, offshore accounts,
and illegally evading taxes, all of which would deprive the federal
government of some of the revenue they had intended to collect. I
dont mean to imply that any and all individual income tax structures
are subject to these problems, but the one we have in the United
States today is.
Now, the focus of my discussion will concentrate on taxes on
changes in asset values, or wealth taxes. One of these taxes is the

capital gains tax. A capital gain is any appreciation of value that is

realized by the seller upon the sale of an asset. This includes gains
made upon the sale of securities and physical assets, excluding real
estate. This is one of two primary forms of asset taxation: accrual, and
realization. Bank accounts and bonds that earn interest in given
periods of time are taxed on that interest at the end of each fiscal
period. In contrast, a tax on realization is one that is only applicable in
the event the asset is sold. For example, I could have a $2 million
appreciation in my stock portfolio (which would drastically reduce my
incentive to complete college, but thats another story), but it would
not be taxable income until I liquidated my holdings. This is the
advantage of saving or investing in assets that produce capital gains
rather than accrue interest. It wouldnt be feasible to attempt to
measure unrealized capital gains at the end of each period so that they
may be subject to tax, and in some cases, the gain might be large
enough that an individual would be required to divest himself in order
to pay the tax. The economic effects of the capital gains arent as
obvious as the income tax, but two things are clear: they
disproportionately affect high income earners more heavily, and they
slow down asset liquidations. The first effect is both intuitively and
empirically verifiable when you take into account the income effect. A
positive correlation between investment levels and income indicates
that wealthier individuals invest more than less wealthy individuals.

Not only this, but like the income tax, the capital gains tax is
progressive. As for the pace of asset-liquidation, the capital gains tax
has two categories: short term (1 year), and long term (greater than 1
year). The capital gains rate changes frequently, the most recent being
2013. For the current fiscal year, short-term capital gains are taxed as
ordinary income and long-term capital gains will qualify for either a 0%,
15%, or 20% rate, depending upon your income. The difference in tax
rates between the short-term and long-term, and the fact that gains
are taxed only on realization creates what is referred to as the lock-in
effect. Basically, it pays off to defer your asset sales as far into the
future as possible in order to minimize the present value of future tax
liabilities. This slows down asset sales, which may have negative
implications regarding the efficiency of asset price-adjustments.
The other wealth tax that I will comment on briefly is the estate
tax. The estate tax, sometimes referred to as the death tax, is a tax
on remaining assets that are passed on to ones heirs when they die.
The estate tax ranges from 15-45% on estates valued at $3.5 million or
higher making it, once again, a highly progressive tax. The applicable
tax base for this tax is fairly small, and it thus not a large source of
revenue for the federal government. However, 2008 statistics reveal
that the estate tax raised about $18 billion in tax receipts. Considering
the limited nature of the tax, most arguments in favor of it are
normative ones centering on the issues of fairness and wealth

redistribution that I touched on previously. The primary argument in

favor of the estate tax maintains that it helps prevent the
concentration of wealth in the hands of a few families, and assures that
those individuals dont acquire too much financial power. Up until this
point, I have done my best to refrain from making value judgments on
the information I have presented, but I will make one comment on this
argument and allow the reader to judge the validity of it. If the concern
that motivates the estate tax is that the extremely wealthy individuals
will acquire too much power and threaten the freedoms of others, isnt
it a threat to the freedom of those individuals to not allow them the
choice of how to distribute their wealth? Is the only splendor of work
the income that is received, or does it also include the freedom to use
that wealth in a manner that brings them happiness? I will leave those
questions for your consideration.

Part II. Tax Reform Ideas Worth Considering

As I made abundantly clear in the beginning, taxes are
unavoidable and no one enjoys paying them. As a result, the concept
of the perfect tax is nothing more than a pipe dream. However, I will
briefly detail two tax plans that are worth taking a look at, namely: the
flat tax, and a national consumption tax.
The flat tax is denominated flat because it taxes all individuals
the same percentage on their annual earnings. There are several

advantages to this proposal. First, the economic distortions caused by

the ordinary income tax will be eliminated because all sources of
income are taxed equally, allowing resources to flow to the most highly
valued uses without having to attempt to minimize tax liabilities. For
example, the disincentives to work that the marginal progressive
income tax creates will be non-existent. Second, savings will be
exempted from taxation. I particularly like this aspect of the tax,
because it allows capital to accumulate unencumbered and could
potentially boost investment in the long run. Last, the flat tax would be
extremely simple to put into place, administer, and understand. As a
result, transparency would be increased, and administrative and
compliance costs would be greatly reduced. The primary downside to
the flat tax resides again on the judgment of equity. The flat tax would
be far less progressive, and this endangers the political viability of the
option.
The tax scheme that I favor most is probably even less likely to
be implemented in the United States than the flat tax, and that is the
national consumption tax. More specifically, I favor a national sales tax.
Similar to the flat tax, a national sales tax is not biased in favor of
those who choose saving over consumption, because it does not tax
savings. The implications behind this are identical to the ones
described above. In addition to this, the tax base will be broadened to
include revenue from sources that werent formerly taxed, such as:

illegal immigrants, tourists, and criminals (who make their money on

the black market, or evade taxes). The reasoning behind this is simple:
the tax is levied on all products, and everyone consumes; thus, there is
no escaping it. Several possible issues exist with a national sales tax.
First, and most obviously, inflation will be severe and high priced
goods/assets will be become outrageously expensive. However, in the
absence of an income, capital gains, savings, and payroll taxes,
incomes would be high enough to offset this if the sales tax rate was
set at the correct level. It is critical to understand that the price of
anything you purchase in a competitive market already has the costs
of the taxes they paid embedded in it. Given the removal of these
costs, and the imposition of an exclusive, final stage tax would simply
offset these price reductions. One downside to this tax proposal is that
it is more regressive, because poorer individuals spend a larger
proportion of their income on consumptions expenditures. One possible
solution to this problem is proposed by the Fair Tax plan, which
suggests a rebate that would be offered to impoverished individuals on
necessary expenses, such as food, clothing, and other items.
Hopefully, this paper has been enlightening as to some of the
problems and criticisms regarding our existing federal tax code, and
proposed solutions. I attempted to present them in the fairest manner I
am able to, while also providing some insight into which ideas I prefer,
and which I do not. These ideas may never be realized, or they could

be the next big idea to rescue the United States from fiscal disaster,
only time will tell. If Ive been able to contribute to the tax policy
debate in any way, however minuscule, then this paper has
accomplished its objective.

Relevant Figures and Sources

Public Finance and Public Policy

Author: Jonathan Gruber

JustFacts.Com
http://www.justfacts.com/taxes.asp#distribution

About.com
http://taxes.about.com/od/capitalgains/a/CapitalGainsTax_4.htm

FairTax.org
http://www.fairtax.org/site/PageServer

Wikipedia.org