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Personal Income Taxes

Copyright © 2004 by David E. Ross

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.

• A flat income tax without any deductions, exemptions, or credits and with only a single tax-rate would be a boon to the wealthy and fall most heavily on the middle class. This is politically impossible.
• A value-added tax is actually a national sales tax and would require amending the Constitution. Experience in other nations that use this is that it is very inflationary by raising the costs of goods and services. As indicated before, this is a tax on the need to provide the materials for living without any regard for a person's ability to pay the tax. As the government discovered in the 19th century, any general tax other than a head tax or an income tax would require amending the Constitution.
• A head tax would mean that every person would pay a fixed number of dollars each year. Can you really believe that the dishwasher in the local restaurant should pay the same in taxes as Bill Gates?
• Some think that a severe cut in government services would allow all personal taxes to be eliminated. Sorry, but the remaining revenues — mostly corporate taxes and customs duties — would not support the Department of Defense, let alone pay to operate federal prisons, pay salaries to immigration officers, or ensure that the appropriate flu vaccine is available each year.

Yet some change is desperately necessary in the structure of personal income taxes. Here are some suggestions.

Income

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.

Personal and Dependent Exemptions

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.

Deductions

The standard deduction should be eliminated. Every taxpayer should itemize, but itemized deductions should be fewer and more simple.

• The deduction for health expenses should be eliminated. The threshold of 7.5% of income eliminates this deduction for most taxpayers in high income levels while Medicaid eliminates the health costs for most taxpayers in low income levels. In any case, if the U.S. had a system of delivering and paying for health care similar to most other industrialized nations, this deduction would be meaningless.
• The deduction for state and local taxes should include sales taxes in order to equalize the overall tax burden between residents of high-tax states and low-tax states. Actually, it should include any state or local tax that is generally applied across the taxing jurisdiction. However, instead of taking this as a deduction against income, it should be a credit against the federal income tax itself. Perhaps the credit should be only half the amount of state and local taxes, leaving some incentive for keeping those taxes within some bounds.

  *** Begin Right Sidebar ***

  State income taxes: $2,100
  Property taxes: $1,300
  Sales taxes: $1,800
  Total: $5,200
  

  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.

• With one exception, no change is needed for charitable contributions. It must be noted that each dollar of contribution deducted from income results in a loss of at most 35¢ in taxes while prudent selection of charities means that a dollar of services is obtained, services chosen by the taxpayer.

  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 mean of 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 deduction for casualty and theft losses should be eliminated for any insurable loss, even if the taxpayer failed to have insurance. The rest of us should not subsidize faulty decision-making by others, and a failure to obtain available insurance is indeed a faulty decision.
• Job expenses and other expenses incurred to create taxable income should be fully deductible. The threshold of 2% income should be eliminated. This deduction should include all such expenses, including the commuting to and from work. Allowing a deduction for commuting would equalize the situation between two taxpayers, one who drives to a local office and then drives to an actual remote place of work and claims a deduction for business travel and the other who drives directly to an actual remote place of work. The IRS should provide schedules for each metropolitan area showing the allowed deduction based on miles commuted and the cost of public transit; costs beyond using public transit should not be allowed for the commuting deduction. Given the problem of finding affordable housing near work in many areas, a deduction for commuting expenses is very appropriate.
• Deductions under other miscellaneous should be eliminated.
• The most troublesome deduction is interest. If I have both a Visa card and a CD at my bank, I must pay taxes on the interest earned by the CD but I cannot deduct the interest I pay on my Visa card. With today's low interest rates, the effect is not really noticeable. When interest rates rise (and they surely will), the unfairness of this will be quite clear. It will then create an incentive for me to liquidate my CD (long-term money) to payoff my Visa card (short-term debt). Magnified by the number of individuals in a similar situation, the result would reduce bank liquidity and curtail funds available for business loans and capital expansion. It is just unsound economics.

  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.

  • First, itemize all taxable interest income (all interest except "municipal" bonds).
  • Then, itemize all non-taxable interest income.
  • Finally, itemize all interest expenses.
  The amount reported on Form 1040 would be the net of taxable interest income and interest expense. If, however, the result is a net expense, it would be offset by non-taxable interest income. The following table gives some examples.

  Item	Example 1	Example 2	Example 3
  taxable interest income	$1,000	$1,000	$1,000
  interest expense	$500	$2,000	$2,000
  net	+$500	-$1,000	-$1,000
  non-taxable interest income	$500	$500	$4,000
  reported on Form 1040	+$500	-$500	$0

  • In Example 1, since the net is taxable income, the non-taxable income is ignored. It is not taxed.
  • In Example 2, the net deduction is reduced — but not eliminated — by the non-taxable income.
  • In Example 3, the amount reported on Form 1040 is $0. Part of the non-taxable income eliminates the entire deduction. However, the remainder of the non-taxable income remains non-taxable.
  Note that the offset using non-taxable interest income occurs only after the expense is netted against taxable interest income.

  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.

Alternative Minimum Tax

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.

The Marriage Penalty versus the Singles Penalty

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.

Tax Rates

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!

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.

The use of Census Bureau data has several problems.

• The Bureau estimates household income. This lumps together single and married taxpayers. Further, some members of a household might be dependents and not taxpayers.
• The Bureau's estimates reflect gross income before capital gains. The brackets should instead be determined by net taxable income, including the taxable portion of capital gains.
• The Bureau's latest estimate is for two years ago. The brackets to be used when filing 2003 income tax returns (in 2004) should reflect data from the 2002 tax returns (filed in 2003) — data that are only one year old.

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:

Here are some examples:

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.

• During an expanding economy, rising incomes will cause the brackets to rise but with a lag. The resulting "bracket creep" will tend to cause more taxes to be paid, thereby moderating the expansion and possibly preventing or at least delaying a bubble.
• Nevertheless, a contraction will eventually occur. Falling incomes will then cause the brackets to fall but again with a lag. Negative "bracket creep" will tend to provide tax relief and moderate the contraction.

In both cases, the effect will occur more quickly than could be obtained by Congressional action since it will occur automatically.

Earned Income Credit

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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