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Note that this page has not been updated in over eight years while the federal Internal Revenue Code seems to be changed every year. Thus, examples below will seem strange.
There is strong sentiment in Congress and the White House to reform the Internal Revenue Code yet again. I will wait until I can determine what is actually implemented before updating this page. In the meantime, my proposals remain valid.
29 December 2012
While often criticized as confiscating what a person works hard to earn, income taxes more accurately reflect the taxpayer's ability to pay taxes than sales taxes (which are levied on the need to provide clothing and — in some jurisdictions — food for the taxpayer's family) and property taxes (which are levied on shelter).
Nevertheless, since the great effort (not entirely successful) to simplify personal income taxes in the 1980s, they have become ever more complicated. Many of these complications were intended to make income taxes more palatable, especially for the affluent. However, they actually make the personal income tax less palatable. Further, various quirks intended to broaden the base for levying personal income taxes have had inequitable results.
All this — complications and inequities — makes this the least popular tax of all. However, there is no real consensus on an alternative.
Yet some change is desperately necessary in the structure of personal income taxes. Here are some suggestions.
Distinctions between earned and unearned income should be eliminated. Income is income and all forms should be taxed equally. This includes dividend income; however, corporations would receive a tax benefit when they share their profits with their owners through dividends.
Since there is disagreement whether a capital gain is really income or merely a reflection of inflation, that should be treated separately. Also, removing the tax-exemption from interest on municipal bonds would merely mean states and local governments would have to increase taxes to pay higher interest on their bonds; since this would not reduce the overall tax burden, that exemption would remain in effect with a modification.
Someone living below the poverty threshold should not be paying income taxes. Take the income level below which a married couple without children is deemed to be living in poverty. The personal exemption for a taxpayer should be half that amount.
Then take the additional income level below which a family of four — two adults and two children — is deemed to be living in poverty. The dependent's exemption should be half that additional amount.
For example, according to the U.S. Census Bureau, the income threshold for a married couple without children was $12,321 in 2003, below which the couple was in poverty. This would make the personal exemption $6,160. The Census Bureau also declared a family of four as living in poverty with an income below $18,660, the additional amount being $6,339. That would make the dependent's exemption $3,170. Yes, the dependent's exemption is less than the taxpayer's exemption, reflecting the fact that — with shared expenses for shelter, utilities, and other items — the costs for a family are less than the costs for the same number of individuals living separately.
While poverty thresholds differ depending on whether dependents are children or adults, the computation outlined here — starting with two adults and then adding two children — should be used as the standard for determining the exemptions. The Census Bureau recomputes the poverty threshold at least annually, and the exemptions should be changed annually.
Note: These personal and dependent's exemptions would apply without regard for adjusted gross income. Since the personal exemption would be twice the current amount, the doubling of the exemption for the elderly and blind would be eliminated.
The standard deduction should be eliminated. Every taxpayer should itemize, but itemized deductions should be fewer and more simple.
*** Begin Right Sidebar ***State income taxes: $2,100
Federal taxes: $5,500
*** End Right Sidebar ***
Using the example in the box at the right, a taxpayer would receive a credit of $2,600 against his federal income taxes, thus paying $2,100; his overall tax burden would then be $7,300. Another taxpayer with the same taxable income paying only $3,500 in state and local taxes would receive a credit of $1,750, thus paying $3,750 in federal income tax; her overall tax burden would then be $7,250. The latter would pay more in federal income taxes (because of a smaller credit for lower state and local taxes) but have an overall lower tax burden.
However, today there is one aspect of charitable contributions that appears abusive. If I donate a non-cash asset to a charity, my deduction is based on its value at the time of the donation, not what I paid for it. If I bought stock for $5,000 and donate it when it is worth $10,000, I get a $10,000 deduction for something that cost me $5,000. The same step-up that is proposed for gifts and inheritances involving non-cash assets should also apply to donations. That means, the charitable deduction should be the average between the original cost and the value at the time of the donation ($7,500 in the example).
(Note that proposed changes in capital gains taxes mean that, for an asset held more than ten years, the taxpayer would be able to sell it tax-free and then get the full deduction for donating the cash. This would simplify matters for both the donor and the charity.)
The problem is that all interest income is taxable unless earned on municipal bonds while no interest expense is deductible except for interest on mortgage and investment loans. Even then, not all interest expenses for mortgage loans are deductible. For example, if the money borrowed was not used to buy or improve your home, it is not deductible. And interest expenses for investment loans is not deductible if the investment yields non-taxable income (e.g., municipal bonds). In an audit, there can be convoluted tracing of when the loans were made and how the money was used.
Rather than reporting interest income on Schedule B and deducting only certain interest expenses on Schedule A, all interest income and expenses should be reported together as a net amount.
|Item||Example 1||Example 2||Example 3|
|taxable interest income||$1,000||$1,000||$1,000|
|non-taxable interest income||$500||$500||$4,000|
|reported on Form 1040||+$500||-$500||$0|
Not only does this restore equity between income and expense. It also eliminates any questions whether interest expense on an investment loan was used to buy municipal bonds or what the purpose was of a mortgage loan.
Note: Deductions would apply without regard for adjusted gross income.
The AMT is a response to the fact that some very wealthy individuals paid almost no federal income taxes because of very clever tax shelters. Today, even a person with a moderate income must at least go through the process of computing the AMT, even if the result is that the AMT does not apply. Eliminate the AMT! There are indeed abusive tax shelters; and they must be eliminated, too.
Much of what follows is in terms of a husband earning a income and supporting his wife. This is not sexist; this merely reflects the social environment during the relevant time period among those whose economic status made this happen.
In the first half of the 20th century, an interesting combination of federal income taxes and state family law benefited residents of community property states (e.g., California). Residents of states without a community property law (e.g., New York) could not get this tax benefit.
Under community property laws, a wife was automatically entitled to half her husband's income. Thus, in a community-property state, a married couple would file two tax returns — one for the husband and one for the wife — each as the taxpayer and each reporting half the income and half the deductions. In a state without community property, the couple could file only one tax return, with the husband as the taxpayer and the wife as his dependent. Using today's tax rates on a $70,000 taxable income, a California couple would pay $11,120 in federal taxes while a New York couple would pay $14,346. To eliminate this inequity, the Internal Revenue Code was changed to allow joint returns, allowing married couples in all states to split their incomes and pay taxes accordingly.
In the 1970s and 1980s, as gender equality became a major political and economic issue, more and more women found they did not need husbands to support them. There was a significant increase in single taxpayers. They saw joint returns as a tax shelter for the married and began to clamor for elimination of the singles penalty. Again using today's tax rates on a $60,000 taxable income, a married couple was paying $11,120 in federal taxes while a single person with that income was paying $14,346.
Heeding the demands of voters who were single, Congress again modified the Internal Revenue Code (as they seem to do annually). Giving a partial break to single taxpayers, Congress created the marriage penalty. At one time, my wife and I could have saved over $2,000 per year in federal income taxes by divorcing (and our taxable income was well below $70,000).
There is flawed logic in complaints about the singles penalty. For a married couple, their income is indeed shared. The comparison should be between two unmarried individuals whose combined income equals that of a couple. In California, both the couple and the combination of two singles pay the same state income taxes. That is the way it should be for federal income taxes.
While the tax rates were recently modified to reduce the marriage penalty, some inequities still exist. For example, a husband might not be able deduct what he puts into an IRA if his wife's job is covered by a pension plan, even if the pension plan provides no added benefit for married couples.
The Internal Revenue Code should not discourage marriage or encourage divorce. Thresholds, criteria, and limits expressed in dollars should be set so that a married couple sharing an income pay the same taxes as an unmarried couple sharing the same income.
Dear to the hearts of many conservatives is the idea of a single tax rate for all incomes. Bill Gates should pay the same proportion of his income in taxes as the janitor who cleans his office. Wrong!
Those who benefit from the economic system fostered by our government should pay taxes to support that government. Those who benefit disproportionately should pay disproportionately. Those who disproportionately benefit the greatest should disproportionately pay the greatest.
… the man of great wealth owes a peculiar obligation to the State, because he derives special advantages from the mere existence of government.
Theodore Roosevelt, 1906
And those who argue that graduated tax rates are confusing and thus we should have fewer brackets are also wrong. With tax tables, you can easily find the amount of tax merely by looking at the row for your income. To make it even easier, the IRS should do what California does for state income taxes: On a Web page, you enter your income and status (single, married filing jointly, etc); your exact tax is computed for you.
*** Begin Left Sidebar ***
|lowest 20%||$0 - $17,916|
|2nd 20%||$17,916 - $33,377|
|3rd 20%||$33,377 - $53,162|
|4th 20%||$53,162 - $84,016|
|highest 20%||$84,016 - up|
|highest 5%||$150,002 - up|
*** End Left Sidebar ***
The use of Census Bureau data has several problems.
These problems could be solved by having the IRS compute the brackets from the actual returns. A joint-return would count as two taxpayers; its net taxable income would then be half the amount reported on the return, taken twice. Brackets for joint returns would then be exactly twice the brackets for single returns.
The tax rates should start at 10% and increase in 5% increments. Just as today, a person in a bracket would not pay the rate on his or her entire income. Instead, the 10% rate would apply to income up to the bracket limit, with the 15% rate applying to income within the next bracket, et cetera to a maximum rate of 35% on the highest bracket. From this, we get the following tax-rate schedules, roughly estimating the brackets based on the Census data in the box above:
|$0-$11,900||10% of net taxable income|
|$11,900-$22,250||$1,190 + 15% of amount over $11,900|
|$22,250-$35,450||$2,743 + 20% of amount over $22,250|
|$35,450-$56,000||$5,383 + 25% of amount over $35,450|
|$56,000-$100,000||$11,575 + 30% of amount over $56,000|
|over $100,000||$24,775 + 35% of amount over $100,000|
|$0-$23,800||10% of net taxable income|
|$23,800-$44,500||$2,380 + 15% of amount over $23,800|
|$44,500-$70,900||$5,485 + 20% of amount over $44,500|
|$70,900-$112,000||$10,765 + 25% of amount over $70,900|
|$112,000-$200,000||$21,040 + 30% of amount over $112,000|
|over $200,000||$47,440 + 35% of amount over $200,000|
Here are some examples:
|Single, no dependents||Today||Proposed||Today||Proposed|
|Income after deductions||$35,000||$50,000|
|Net taxable income||$31,950||$28,840||$46,950||$43,840|
|Single, one dependent||Today||Proposed||Today||Proposed|
|Income after deductions||$50,000||$75,000|
|Net taxable income||$43,900||$40,670||$68,900||$65,670|
|Married, no dependents||Today||Proposed||Today||Proposed|
|Income after deductions||$45,000||$60,000|
|Net taxable income||$38,900||$32,680||$53,900||$47,680|
|Married, two dependents||Today||Proposed||Today||Proposed|
|Income after deductions||$80,000||$175,000|
|Net taxable income||$67,800||$61,340||$162,800||$156,340|
Yes, those with low or moderate incomes would see a tax cut while those with high incomes (well over $100,000 for a married couple with two children) would see a tax increase. Note that, for 2002, the Census Bureau reported the median household income was $57,852.
Determining the brackets by dividing the population into fifths and using year-old data can have a beneficial result relative to cycles in the economy.
In both cases, the effect will occur more quickly than could be obtained by Congressional action since it will occur automatically.
The revised personal and dependent exemptions mean most of the beneficiaries of the EIC will pay no taxes at all. This credit should be eliminated.
31 March 2004
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