Replacing The Income Tax With A Different Tax System That Is Fairer, Simpler & Less Painful — Revisited
By David Grace (www.DavidGraceAuthor.com)
I recently published the article “Should We Replace The Income Tax With An Entirely Different Tax System?” in which I outlined an alternative to the income tax. I’ve considered the feedback I received on that article and I’ve come up with a revised plan that avoids some of the original proposal’s drawbacks.
Basic Tax System Goals
In my opinion the allocation of taxes among citizens should be based on an underlying rational, reasonable and fair principle.
- Instead of arbitrary brackets there should be an objective, logical principle as to how taxes are allocated between different citizens.
- Paying taxes should not make any citizen relatively richer or poorer. Everyone’s share of the country’s wealth should be the same after they’ve paid their taxes as it was before they paid them.
Today, taxes are collected first, before the citizen even gets his paycheck.
- I think taxes should be collected last, meaning that taxes should be paid after citizens have purchased the more important things in their lives such as rent, food, clothing, and the other necessaries of life.
- I think everyone would like taxes to be as painless as possible.
- I think that we all want the tax system to be as simple as possible.
I think we can do a better job of achieving these goals by replacing the income tax with a completely different type of tax.
What Is A Fair Principle For Allocating The Tax Burden Among Citizens?
Suppose an isolated town has lost its principal source of water. There are two privately-owned nearby lakes and under its emergency powers the town passes a law requiring the lake owners to sell water to the town even though the lake owners don’t want to.
Jones Lake holds 9,000,000 gallons and Smith Lake holds 1,000,000 gallons. That is, 90% of the available water is held in Jones Lake and 10% of the available water is held in Smith Lake.
The town needs to buy 100,000 gallons/month.
How should the forced sale of 100,000 gallons of water be allocated between the two lakes?
The most reasonable, rational and fair way to allocate the water purchase between the two lakes is to buy the same percentage of the 100,000 gallons from each lake that each lake’s volume of water bears to the total supply of water in both lakes.
That is, buy 90% of the water, 90,000 gallons, from Jones Lake and 10% of the water, 10,000 gallons, from Smith Lake.
That way, no matter how much water the city buys, after every purchase Jones Lake will still hold 90% of the available water and Smith Lake will still hold 10% of the available water.
Under that formula each lake will be treated in the same way and each will maintain its original percentage share of the total water supply.
Substitute Wealth For Water
I would argue that we should use the same principle in allocating the tax burden between citizens as was used in the above example to allocate the obligation to sell water between the owners of the two lakes.
If you want to get water, you have to get it from the people who actually have it.
If you want to collect money, you have to get it from the people who actually have it.
Instead of a tax on income with arbitrary progressive brackets, I propose that instead we divide each person’s net wealth by the country’s total privately-held wealth and multiply each person’s percentage share of the country’s privately-held wealth times the total amount that is budgeted to be collected by the tax.
This is a wealth-neutral tax.
Paying this tax will not make any citizen either relatively richer or poorer.
Rather, everyone’s proportionate share of the country’s wealth will be the same after they’ve paid this tax as it was before they paid it.
Example Numbers
Here are some rough numbers. I emphasize the word “rough.” They are certainly not exact but they are close enough that they can be used as ballpark examples in order to get a general idea of how the system would work.
[Some sources:
Income Tax Illustrated by the Tax Foundation
Household Income by the Tax Policy Center
Current Population Survey Tables for Household Income by the Census Bureau
Household Income In The United States by Wikipedia]
Federal income taxes collected: about $1.5 Trillion
Total U.S. privately held wealth: about $80 Trillion
Number of Adults in the U.S.: about 250,000,000
TABLE COLUMN HEADINGS
1=Percentage Of Adult Population In This Group
2=Number Of People In This Group
3=Percentage Of Total Privately-Held Wealth In This Group
4=Share Of Total Tax Based On Their Share Of The Wealth
5=Average Amount of Tax Per Adult In This Group
1 — — — — 2 — — — —3 — — — —4 — — — — 5 — —
Top 1% — 2.5M — — 34.6% — $519B — —-$207,600
Next 4% — 10M — — 27.3% — -$410B — —- $41,000
Top 5% — 12.5M — -61.9% —-$929B
Next 5% — 12.5M — -11.2% — $168B — —- $13,440
Top 10% — 25M — — 73.1% — 1.097T
Next 10% — 25M —-12% — —- $180B — — — $7,200
Top 20% — -50M —- 85.1% — $1.28T
60%-80% — 50M —-10.9% —- $164B — — — $3,280
40%-60% — 50M — — 4% — — — $60B — —- $1,200
20%-40% — 50M — — .2% — — — $3B — — — —-$60
Bottom 20% 50M —Minus .2% —-$0 — — — — — 0
The striking aspect of this table is how relatively small the per capita tax amounts actually are.
Under a wealth-based tax system the people in the top 90% to 95% wealth ownership bracket would pay about $13,500 each ($27,000 for a household).
The people in the 60% to 80% top wealth bracket would only pay about $3,300 each in taxes ($6,600 for a husband and wife household).
If taxes that are now collected as income taxes (that is excluding payroll taxes used for social security and Medicare) were allocated in proportion to each citizen’s share of the country’s total wealth, 40% of the population would pay essentially no federal personal tax at all.
If taxes that are now collected as income taxes were allocated in proportion to each citizen’s share of the country’s total wealth the bottom 50% of the population would pay about $33 Billion of the $1.5 Trillion or about 2.2% of the money now collected by the income tax.
In 2013 the bottom half of the population by income (which probably correlates well with the bottom half of the population by wealth) paid about 2.8% of all income taxes or about $9 B more than they would have paid under a wealth-tax system.
If taxes that are now collected as income taxes were allocated in proportion to each citizen’s share of the country’s total wealth the top 10% of the population would pay about $1.097 Trillion or about 73.1% of the money now collected by the income tax.
In 2013 the top 10% of the population by income actually paid about 69.8% of all income taxes or about $50 Billion less than they would have paid under a wealth-based tax system.
No Tax Brackets
Unlike the income tax system, a wealth-based tax system would not have any arbitrary tax brackets.
Your tax return would report the net value of your assets (with a $10,000 exclusion for clothing, furniture, etc.). The Treasury would add up the reported net values of all privately held assets and compute your percentage share of that total.
The total budgeted personal tax to be collected would be multiplied by your percentage share of the total wealth and the result would be your share of the total tax.
For example, if your total net wealth was $10,000,000 and the total of all privately-held wealth was $80 Trillion and if the total tax to be collected was $1.5 Trillion then your tax would be
$10M/$80T = 1/8,000,000 X $1.5 Trillion = $187,500.
If your net wealth was $1M then your tax would be $18,750.
If your net wealth was $100,000 then your tax would be $1,875.
For a real-world example, in 2012 Mitt Romney’s wealth was about $250M. In 2011 his income was about $21M and he paid income taxes of about $3.2M or around 15%.
Under a wealth-based tax system Mitt Romney would have paid about $250M/$80 Trillion X $1.5 Trillion = about $4,700,000 in federal taxes instead of $3,200,000 or about 22.4% of his income instead of the approximately 15% he actually paid.
Taxes Paid Last Not First
Our current federal tax system is a Transfer Of Wealth tax system which is based how much net money a person receives in a year. The government dips its bucket into every income stream as the money flows by.
If we based your share of the tax burden on your net wealth, which is the money left over after you’ve first paid all your other bills, then your taxes would be collected last after all your other expenses had been paid.
When you tax income, to some degree you discourage work. If the citizen is free to keep what he earns without a tax based on income that deterrence to work goes away.
More Painless Taxes
Taxes are painful when we collect them in amounts and ways that materially, negatively impact the taxpayer’s enjoyment of life.
It’s not about the dollar amount of the tax. It’s about how much paying the tax has a real negative impact on the quality of life of the person paying it.
Under a wealth-based tax system taxes are less painful because
- Taxes are paid last and thus never impact a citizen’s ability to pay for the vital things in his/her life.
- Taxes are very small in proportion to the citizen’s total wealth.
- Taxes do not deter you from earning more money
Simplicity
An income tax system is inherently complicated. Different types of income are taxed at different rates and different types of expenditures have different tax consequences. Some spending is completely deductible. Some is partially deductible. Some is fully deductible up to a certain cap amount.
Because the taxation of both the type of income received and the type of payments made is used as an economic and social tool to both encourage and discourage certain activities any income tax system will inevitably become a nightmare of complicated rules, brackets and loopholes.
A wealth-based tax system is inherently simple.
Each year you’d file a tax return showing your net assets — bank accounts, stock holdings, gross and net real estate values, and physical assets (cars, boats, jewels, etc.) less a $10,000 exemption to cover things like clothing, furniture and other low-value personal items.
You add up your assets. You deduct your liabilities. You’re done.
No Gift Taxes
Because there is no tax on income you can give your money away without either you or the recipient paying a tax. If you want to give money to your children, you can do it tax free.
Also, forget the estate tax. Your assets will transfer to your heirs tax free upon your death. As those assets make your heirs richer then they will be included in the calculation of your children’s taxes next year.
Foundations, Trusts & Charities
In order to avoid massive transfers to and concentrations of wealth in untaxed trusts and foundations, both would have to also be subject to the wealth tax. If they weren’t then the trusts would quickly get very rich, their assets would be excluded from the calculation of total privately-held wealth and each individual’s percentage share of the total wealth used in the tax calculation would drastically increase, thus greatly increasing every citizen’s tax obligation.
Without including foundations and trusts we would have three classes of wealth: individuals, corporations and foundations, but with only individual wealth being used to compute the tax.
This would quickly wreck the system so we would have to include all foundations, trusts and charities in the wealth and tax calculation.
On the positive side, this would encourage charities to quickly distribute their assets to their beneficiaries.
While there would not be a tax-deduction incentive to give money to a charity, any money given to a charity would cease to be included in the donor’s net assets which would therefore decrease the donor’s taxes.
Depending on how the numbers worked there might be some tax relief that could be extended to some high-standard, qualifying charities. Maybe they could pay a tax equal to three-quarters or one-half of what an individual with the same amount of assets would have paid.
Non-Liquid Assets
What about those relatively few people who own very valuable assets but have a relatively low income? Of course they could always sell the asset tax free because under a wealth-based tax system there would be no capital gains taxes.
They could also borrow against the asset, thus decreasing its net value which would decrease their taxes.
But suppose they didn’t want to do either.
The system could provide that if the wealth tax exceeded some percentage of your adjusted gross income, e.g. 40%, that you could elect to treat the excess tax as lien on your assets with interest accruing at twice the then current T-Bill rate.
So, if you had a family farm that had a high value but your net income from the farm was relatively low, you could elect to cap your due and payable tax at 40% of your adjusted gross income and the government would get a tax lien on that asset for the unpaid balance which debt would not be due until you sold the farm or you died, whichever happened first.
If you wanted to reduce the sting of paying this tax debt upon your death you could purchase a term life insurance policy in an amount equal to the lien so that when you died your heirs could either use the tax-free life insurance proceeds to pay off the lien and retain the farm free of estate taxes or they could sell the farm, pay the lien through escrow and keep the balance of the sale price plus keep all the tax-free life insurance money.
The Corporate Income Tax
While this principle could also applied to the corporate income tax I’m not sure how the valuation process would work for large business entities because so much of the value of many corporations resides in their intellectual property, trade name and good will. The mechanics of valuing corporate assets would require substantial study.
Since corporation taxes only generate about one-fourth as much revenue as the personal income tax, completely replacing the corporate income tax with a wealth-based tax is a far less pressing issue.
A Variation On The Plan With Regard To Corporate Dividends
What if we left the corporate income tax in place?
The official U.S. corporate tax rate is 35% but because of how the tax code is designed, today the top 500 corporations pay an average of about 17% of profits in federal corporate income taxes.
Corporate pre-tax profits are about $2.1 Trillion and federal corporate income tax revenues are about $350B.
After deducting federal and state taxes, corporate profits are about $1.65 Trillion.
About one-third of after-tax corporate profits, about $530 Billion, are distributed as dividends.
If the corporate tax loopholes were eliminated and the tax rate was set approximately halfway between the formal rate and today’s actual rate the corporate tax rate would be about 25%.
$2.1 Trillion X 25% = $525 Billion in corporate income taxes or an increase of approximately $175 Billion over the taxes that are paid now.
$2.1 Trillion — $525 Billion Federal tax — $100 Billion state taxes = $1.475 Trillion or a $175 billion decrease in after-tax corporate profits, which is equal to the increase in federal corporate tax revenues under this plan.
The more taxes paid by corporations the less taxes will need to be paid by individuals.
Today, corporate dividends are double taxed, that is, the profits are taxed when earned by the corporation and the dividends are taxed a second time when received by the shareholders.
Without a personal income tax, if we allowed corporations to deduct dividends from profits before calculating corporate income taxes, corporations could distribute those dividends tax-free which would substantially reduce the amount of corporate taxes collected.
This, in turn would force us to similarly increase the amount of taxes collected from individuals under a wealth-based tax in order to make up for the reduction in corporate income tax receipts.
To avoid this problem we could treat corporate dividends as a special “hybrid” case, part corporation-related and part individual-related because they would be deducted by the corporation under the corporate income-tax system but be subject to a relatively very small tax under the individual wealth-tax system.
In order to both eliminate double taxation of dividends and keep the distribution of dividends tax neutral, we would need to have a special rule that would tax dividends upon their receipt by shareholders at the same percentage as the corporate income tax rate they were deducted against.
For example, if corporate taxes were reduced to 25% and corporations could deduct dividends from profits we would similarly tax the shareholders’ receipt of corporate dividends at 25% making a corporation’s payment of dividends tax neutral.
That way, if the corporation elected to keep its profits it would pay a 25% corporate income tax. On the other hand, if the corporation elected to distribute its profits it would avoid a tax on the money so distributed but the shareholders would pay an identical rate of tax upon the receipt of the dividends.
This rule would neither increase nor decrease tax revenues but it would give corporations the flexibility to either retain profits or distribute them as dividends in a tax-neutral manner.
Food For Thought
I’m not claiming that this should absolutely be enacted tomorrow as the solution to all our tax problems, nor am I suggesting that this is a perfect system without its own drawbacks. It’s not perfect. It does have drawbacks.
I’m suggesting that we reconsider the basic income-tax system we’re using today to collect and allocate taxes.
I’m suggesting that there is a better way to do things.
I’m suggesting that we seriously think about making changes.
– David Grace (www.DavidGraceAuthor.com)
