Schansberg: Middle Class Forgotten in Tax Law

October 4, 2017

by Eric Schansberg, Ph.D.

Death and taxes may be inevitable, but there’s no need to make them any more painful and unjust than necessary.

Taxes are required to finance government spending. (The types and the extent of government spending are important too, but those are topics for another day.) Revenues can come through various taxes. The winds of change are blowing for federal income tax reform, so let’s focus our attention there. (Corporate income taxes are high, compared with other countries, but that’s a more complicated topic.)

We can all agree that income taxes should be collected in an equitable (“fair”) and efficient manner. Of course, fairness is in the eyes of the beholder, so we may not see eye-to-eye on the particulars. But we can still offer a few observations there. And economists have much to say, far more objectively, about the efficiency of tax collection.

To be efficient, a tax code should be simple, have few if any loopholes, a broad base, and relatively low tax rates. Loopholes encourage inefficient resource allocation, as people choose behaviors made artificially attractive by the subsidies. Higher tax rates discourage productive behavior. They also encourage tax avoidance and tax evasion. A broad tax base is implied by few loopholes and would allow us to have lower tax rates while raising similar tax revenues.

To fit most people’s ideas about fairness, income taxes should be “progressive”: higher average tax rates paid by those with higher incomes. Loopholes should be limited since they allow people to shelter their income if they’re politically connected. And we should be wary of tax burdens imposed on the more vulnerable in society—here, the working poor and those in the middle class.

The current system clearly falls far short in terms of both equity and efficiency. So there is potential for popular tax reform.

To me, the worst thing about federal income taxes is something that is rarely discussed: FICA’s 15.3 percent tax on every dollar earned by the working poor and middle class — to finance Social Security and Medicare. Unfortunately, this is not part of the current discussion. Nobody cares enough about the working poor and middle class to raise the issue. So, that’s also another topic for a different day.

The next worst thing also doesn’t get enough attention. According to the IRS and the Tax Foundation, Americans spent $34 billion and 9 billion hours to fill out our income tax forms in 2016. The former is about $440 from the average family of four — money that could be spent elsewhere. The latter is equivalent to 4.5 million full-time workers digging holes in the ground and filling them up all year long. Neither is good for productivity and prosperity.

Tax reform ought to be easy. The tax code’s complexity is ridiculously inefficient. Its loopholes for corporations and individuals are obviously unjust. At least on the surface, there is something significant in tax reform for politicians in both major political parties. Democrats would presumably oppose loopholes for individuals and corporations. Republicans would prefer lower rates and shouldn’t defend loopholes or complexity.

The problem is that politicians don’t really care all that much about loopholes. In fact, they often prefer a complicated system with loopholes to make special interest groups happy.

An efficient and equitable tax reform? No income taxes on dollars earned below the poverty lines. A flat income tax on income above the poverty lines. And no deductions, except perhaps for charitable contributions.

The working poor would continue to pay no federal income taxes (except the staggering burden of the 15.3 percent FICA income taxes on every dollar they earn). Those with higher incomes would have more income exposed to taxation, resulting in higher average tax rates.

A few easy examples illustrate this last point. Assume a 20 percent marginal tax rate on all income earned above $30,000. If you earn $30,000, you pay no income taxes. If you earn $40,000, then $10,000 would be exposed to the 20 percent tax rate — for $2,000 in taxes and a 5 percent average tax rate. If you earned $100,000, then $30,000 would be exempt and $70,000 would be taxed at 20 percent. This would result in a $14,000 tax bill and a 14 percent average tax rate. As income rises, the average tax rate would rise.

Tax forms would be simple, saving billions of dollars and billions of hours. Interest groups would not have access to loopholes. Corporations would not be able to avoid taxes. What’s not to like? In the coming months, we’ll see if the general public has the knowledge and if politicians have the courage to overcome the preferences of interest groups.

Eric Schansberg, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is professor of economics at Indiana University Southeast.



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