Should We Replace The Income Tax With An Entirely Different Tax System?
Instead Of Paying Taxes First, Why Not Pay Taxes Last?
By David Grace (www.DavidGraceAuthor.com)
We Didn’t Always Have An Income Tax
Many people assume that the income tax is how the federal government is supposed to be funded, but that’s not necessarily true. The constitution was adopted in 1788. The income tax wasn’t established until 1913.
The United States operated without an income tax for 125 years.
I asked myself if there might be a better way to fund the federal government than with an income tax.
My basic principles were that taxes:
- should be fairly allocated,
- should be as painless as possible and
- as much as possible they should not degrade the incentive to work.
I came up with the following idea. I’m not saying that it must be adopted. I’m saying that this is a topic that people should think about and I’m throwing this idea out there to ignite that discussion.
I believe that most societal problems are rooted in systems problems. Bad systems, not bad people, yield bad results.
You can’t fix people. You can fix the systems that people function under.
The purpose of this article is to encourage, incite, and inspire people to think about adopting a more efficient, less painful and more equitable federal tax system.
Drawbacks Of The Income Tax System
The income tax system has many drawbacks:
- We pay income taxes before we pay for food or rent or any other expenses of life. Our taxes are taken from us before we even get our wages, and we have to live on the money that is left over.
- The income tax is complicated to calculate, pay and collect.
- It’s full of loopholes that benefit special interest groups.
- At higher brackets it may discourage work.
- It rather quickly maxes out on the the amount of taxes the government can collect.
- And, I would argue, it doesn’t equitably allocate the cost of government among the population.
Taxes Should Be As Painless As Possible
We’d all be happier if taxes were less painful.
I want to propose a new tax system whose main goal is to make taxes as painless as possible. The less painful taxes are the happier the citizens are and the greater the amount of taxes that the government can collect.
Making Taxes Less Painful
Who Pays The Tax
Taxes are more or less painful depending on who pays them, so let begin by talking about how humans spend money.
We start out paying for the things we absolutely must have — food, rent, utilities, medical care, etc. If we have any money left over we may buy a car, a fancy phone and the like. If we still have any money left we may want to have some fun, so we go to a concert, have a few drinks, etc.
If we get even richer maybe we buy some expensive clothes and furniture, a nice vacation, a better house.
Now, if we’re even richer and we’ve got lots of “extra” money we buy a vacation home, a Porsche SUV to go with the Lexus sedan, maybe a boat.
But now we’re even richer. We’ve got so much money that it doesn’t even mean very much to us any more. We buy a $25,000 watch. No body needs a $25,000 watch but we’ve got so much money, who cares? Then we buy a half-million dollar Ferrari.
We don’t even drive the Ferrari very much but, we’ve got so much money we put a second floor on the garage and install an elevator to so it can hold the seven or eight different cars we’ve bought.
Then we get a 50 foot yacht, a million-dollar diamond necklace, yata, yata, yata, but who cares? We’re super-rich. It’s all Monopoly money to us.
The more dollars a person has, the less any one dollar means to them. Put another way, an expense is painless to a person when paying it will not materially impact the qualify of their life.
The first thing we think about if we want to make taxes more painless is to collect them in amounts and ways that won’t materially, negatively impact the enjoyment of life of the taxpayer. 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.
Yes, there’s always the odd millionaire who leaves a 5% tip because it kills him to spend any money, but that’s an emotional problem no one can solve.
The point is, if someone has so much money that giving them a million dollars or taking a million dollars from them will not affect their enjoyment of life in any material way, then their paying a million dollar in taxes is essentially painless to them.
So, first, we want to skew the tax system as much as possible to charge every taxpayer a relatively painless amount of taxes, “painless” meaning that their payment of that tax will not materially negatively affect their quality of life.
When Are Taxes Paid
The second way we make taxes less painful is that we delay when people have to pay them.
If you had the choice of paying a thousand dollar tax today or paying nothing today and having your estate pay a two-thousand dollar tax after you’re dead, which would you prefer?
Wouldn’t you rather live tax-free and enjoy your money while you’re alive and let your estate worry about paying your taxes after you’re gone? Especially since you could take a fraction of the tax money that you saved by not paying any taxes and use it to buy life insurance that would enrich your family tax-free upon your death.
So, the second way we can make taxes more painless is to give the taxpayer the option to delay paying some or all of his/her taxes until after they’re dead.
Those two things together — assessing an amount of tax that is relatively painless to the taxpayer and then not making them pay that tax until after they’re dead would make taxes far less painful, wouldn’t it?
Not only can we do that, we can collect more taxes by doing that.
The Features Of The New Tax System
- Pay taxes last after we’ve paid all our other bills
- Defer tax payments for years or for life at low interest
- Make the tax less complex to calculate and pay
- Have fewer loopholes
- Increase tax receipts in comparison to those collected with today’s income tax system
- Abolish gift, estate, capital gains, corporate and individual income taxes
- Provide an incentive for wealthy people to earn more compared to a high-bracket income tax system
- Taxes that are less painful to every taxpayer
No, it’s not impossible to do this.
The Philosophy Behind The Plan
Let’s start with the idea that everyone needs to be able to pay for their basic expenses of modern life: food, rent, clothing, medical insurance, phone, Internet, electricity, water, transportation, child care, education, etc.
After people have paid for the things they need in order to have a decent life and when they have money left over, then they can afford to pay taxes.
Pay taxes last, not first.
Today taxes are collected upon the transfer of wealth. The government dips its bucket into every income stream as the money flows by. Call them income taxes, gift taxes, capital gains taxes, corporate taxes, estate taxes — they’re all taxes charged on the transfer of wealth.
Today our federal tax system is a Transfer Of Wealth tax system.
But there’s an entirely different way we could structure taxes.
Instead of charging a percentage of every dollar that you receive and collecting the tax before you pay your bills, we could tax the amount of wealth you have left over after you’ve paid all your bills.
We don’t have to tax income — the money coming in before you pay your bills.
We can tax net wealth — the money left over after you’ve paid your bills.
The philosophy here is that taxes should be based on what you have, not what you get.
That means there would be no gift taxes. No estate taxes. No corporate income taxes. No capital gains taxes. No taxes on dividend income. No taxes on interest income. No taxes on income, period.
Who Would Be Taxed
The term “taxpayer” would exclude governmental entities and educational institutions. It would include everyone else — individuals, corporations, foundations, and charities, though the tax rate on nonprofits would be less than that on individuals.
Since income, gift, capital gains, and estate taxes will all be abolished and replaced by a tax on net wealth, people will have an incentive to give money away. If your net wealth decreases then your taxes decrease with it.
Instead of waiting until they die to give money to their children, wealthy people will have an incentive to give money to their children today, thus decreasing their own taxes without generating any gift taxes or income taxes for their children.
The same reasoning applies to gifts to charity. You don’t get taxed on wealth you’ve given away and that you no longer have.
Replace A Wealth Transfer Tax With A Wealth Ownership Tax
Basically, we would be taxed on the value of the hard assets we had left over, our net wealth, after we’ve spent all the money we want to spend.
Wealth would be defined as the net value of our tangible assets: bank accounts, stock portfolios, real estate, high-value physical items such as jewelry, fine art, automobiles, etc.
How would this work?
We Start With A Basic $50,000 Exemption
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.) above a basic exemption floor of $50,000 per person.
For many people, clothing, jewelry, furniture and automobiles would have a total net value of less than $50,000 and those people would owe no tax at all. Why? Because they’re struggling to survive and they can least afford to pay taxes.
If You Do Owe A Tax, Its Payment Can Be Deferred
The tax would be a percentage of your net worth over $50,000 but you wouldn’t have to pay it now if you didn’t want to.
Let’s say that you had a lot of assets and that your tax obligation was $20,000. You could pay part or all of it now if you wanted, or you could check a box on the tax return that said: “I Want Defer Payment Of This Tax.”
Upon filing your return the government would have a lien on all of your assets in the amount of your unpaid $20,000 tax debt.
The lien would bear simple interest at the then current T-bill rate plus one percent. So, if the interest rate the government paid on a $20,000 T-bill was 1% you would owe the government interest on your $20,000 tax bill at 2% per year simple interest. No compounding.
Your net wealth might be totally comprised of stock or land that you never want to sell. No problem. You would simply owe the tax without paying it.
Each year the amount of the tax lien would reduce your net worth so that when you calculated next year’s taxes your net worth would be less and next year’s taxes would be less.
The less you have, the less you pay. Eventually, you will die and any unpaid tax debt would be paid out of the sale of some of your assets by your estate.
Since there would be no estate taxes your heirs would get your entire remaining estate tax free no matter how big that estate was, which should make them happy. And since you’re dead, you don’t care.
Remember that you’re not paying any income tax so you’re saving lots of money over what you would have in your pocket under an income tax system. If you like, you can take part of the money you didn’t pay in income taxes and buy term life insurance. That way, part or all of the reduction in the value of your estate from paying your deferred taxes would be offset by those tax-free life insurance proceeds.
None of that is to say that you couldn’t elect to pay part or all of your taxes as they accrued if you wanted to. It would be your choice: pay the tax and escape the interest charge or check the box and let the government collect the tax and the interest when you sell your assets or when you die, whichever happens first.
Isn’t that a lot less painful than giving the government 20% or 30% of every dollar you earn before you even receive the money?
How Would Various Types Of Assets Be Taxed?
Real Estate Assets
Let’s assume you owe $20,000 in deferred taxes and that you own some land with $100,000 in equity. The government would have a tax lien on that land for that $20,000 tax bill.
If some day you elected to sell that property the tax lien would be paid out of escrow like any other lien.
If the equity was insufficient to pay the entire lien then the sale would still close but with only a portion of the lien being paid and the balance of the tax obligation remaining as a lien on your other assets. The lien would never put your property “under water.”
Of course you could always borrow against your real property, but those new loans would be junior to the existing tax liens and the tax liens would be paid through escrow before any sale proceeds would go the holders of any junior mortgages.
The new loans would decrease your equity in the property, decreasing your net wealth, and thus decreasing your taxes next year.
You could receive and spend those loan proceeds any way you liked, tax free.
Cash & Stock Assets
If you listed $400,000 worth of stock as one of your assets and you decided to sell stocks whose value was $100,000 only a portion of the sale proceeds would be paid against the $20,000 tax lien.
$20,000 lien/$100,000 sale proceeds = 20% X 3 = 60% X $20,000 lien = a $12,000 payment to the government thus reducing the balance of the tax lien to $8,000. You would receive $100,000 — $12,000 = $88,000 from the sale of the $100,000 in stock.
Remember that capital gains taxes would be abolished so you would get the $88,000 tax free whereas if you were a top-rate taxpayer under the current income tax system you would get $100,000 — $20,000 in capital gains taxes = $80,000 instead of $88,000 under the net wealth tax system.
The same partial payment mechanism would be applied to withdrawals from money-market accounts, CDs and other cash accounts.
Intangible Assets
Your net worth calculation would not include many classes of intangible assets such as goodwill and intellectual property rights because (1) they are extremely difficult to accurately value and (2) they are subject to large swings in value.
For example, you might own a patent that today is worth $1M but which could be worthless two years from now. The real value of the patent or trade name or goodwill is the cash flow those assets generate. That cash flow would increase your net worth and since your tax obligation is computed based on your net worth, the tax will be captured as that intangible asset generates actual money that increases your net worth.
So, no tax on those kinds of intangible assets.
Corporations
Corporations would be taxed the same way that individuals would, on their net wealth. Because there would be no corporate income tax, profits could be retained or distributed to shareholders without any tax consequences to the shareholders.
Because, unlike individuals, corporations are immortal, they would be required to pay off at least half of each deferred tax obligation no later than ten years after the tax accrued and pay off the entire deferred tax obligation no later than twenty years after the date it was incurred.
Again, intellectual property rights and goodwill value would be excluded from the calculation of a corporation’s net worth.
What About Charities?
Of course, a major tax avoidance strategy would be to set up a foundation which you directly or indirectly control and give that foundation all your money. You might do a “chris-cross” where your foundation spends its money for the benefit of your friend Robert and Robert’s foundation spends its money for your family’s benefit. We don’t want that.
To avoid this (1) no foundation or charity could directly or indirectly spend any money for the benefit of any donor or the family of any donor or for anyone whose foundation gives benefits to this foundation’s founders or their family, and (2) charitable foundations would also be subject to a net wealth tax.
Charities that actually give money away wouldn’t owe much tax because by the end of the year their net wealth would be very low; they would have given the money away.
Charities that retained donations instead of spending them to fulfil their charitable purpose would be subject to the net wealth tax, but their tax rate could be a less, perhaps 50% to 75% of the normal net-wealth tax rate.
A net wealth tax system would thus encourage wealthy individuals to give money to charity and it would also encourage charities to spend the contributions.
Because universities’ net wealth is tied up in land and buildings which the university cannot do without, universities would be exempt from the tax, as would municipalities and government entities such as transit or harbor authorities.
Net Wealth Tax Rates
Because we don’t want to try to appraise every single little thing everyone owns we would exclude the first $50,000 dollars of everyone’s wealth. So, for most individuals who don’t have substantial real estate equity, their car, their furniture, their jewelry, clothing, etc. would all be worth less than $50,000 and they would pay no tax at all.
After the first $50,000 in net assets, the tax would be 1% on net wealth between $50,000 and $500,000.
If you had a few thousand dollars in savings, some equity in your house and a couple of used cars, maybe your net wealth would be $150,000 and your tax would $1,000. Great for the middle class which needs all the help it can get.
The next bracket would be $500,000 to $5,000,000 taxed at the 2% rate. So, if your net worth was $2,000,000 then your tax would be
- 0 — $50,000 = $0
- $50,000 — $500,000 X 1% = $4,500
- $500,000 — $2,000,000 X 2% = $30,000
- Total: $34,500.
The next bracket would be $5,000,000 — $50,000,000 at 3% and then above $50,000,000 the rate would be 4%.
Isn’t A Graduated Rate Unfair?
No.
Fair is not about everyone paying the same percentage tax. Fair is everyone experiencing the same level of pain when paying their tax.
If I work all day and I earn $100 then the pain of my paying a $20 parking ticket is huge. If I work all day and I earn $5,000 the pain of my paying a $20 parking ticket is zero because that $20 payment is negligible to me.
Crucial to the principle of fairly allocating taxes is the principle of equalizing the pain of the tax.
If I have $100M and I pay a tax of $4M then I have $96M left over and that $4M tax payment does not negatively impact the quality of my life at all. Hell, that’s a diamond necklace and a new Ferrari.
If I have $50,000 and I pay $2,000, that payment will significantly, negatively impact the quality of my life. The pain of someone with $50,000 paying $2,000 is tremendously higher than the pain of someone with $100M paying $4M.
Example Tax Numbers
Let’s look at a simplified example.
My net worth is $2,000,000 comprised exclusively of the home that I inherited from my parents. I’m forty-five years old, male, a non-smoker, in good health and I’m going to live for another thirty years. I earn $100,000 a year. I’ve got one adult child. The T-Bill rate is 1% and the interest rate I will pay on my unpaid taxes is therefore 2%/year over the entire remaining 30 years of my life. My land will appreciate at an average rate of 2%/year over the remaining 30 years of my life.
Under The Present Income Tax System
Today, I will pay about $17,000/year income taxes on my $100,000 income. Ignoring the interest I might make on that money if I kept it instead of paying it in taxes and ignoring increases in my income over time, over the remaining thirty years of my life I would pay about $510,000 in income taxes.
When I die my land will have increased in value to $3.2M and will be transferred to my son estate-tax free assuming that the current $5M estate exemption remains in place.
Me: Negative $510,000. My son: Positive $3.2M.
Under A Net Wealth Tax System
The first year I will owe $34,500 in taxes. My house will increase in value next year by 2% to $2,040,000 but I will have a tax lien of $34,500 principal and $690 in interest which will almost balance the increase in value. To keep the calculations simple we will act as if the two, the increase in the land’s value and the amount of the annual tax lien, cancel each other out so that my net wealth will remain at $2M over the next thirty years.
When I die thirty years from now, the tax lien will total about $1,035,000 principal and about $321,000 in interest for a total of $1,356,000.
- $3.2M value — $1,356,000 taxes = $1,844,000 net to my son.
- Me: No Taxes (I saved $510K); My son: inherits $1.844M
So, I’m going to get an extra half a million dollars to enjoy during my lifetime and my son will inherit almost one million eight-hundred fifty thousand dollars when I die.
But wait — a forty-five year old nonsmoker can buy a $1M thirty-year term life insurance policy for about $3,250/year.
$3,250 X 30 = $97,500
So, if I’m concerned about increasing my son’s inheritance I could take less than 20% of the over half a million dollars I’ll save by not paying income taxes and buy a life insurance policy that will pay my son another $1M tax free at the time of my death.
So, what happened here?
The benefit I got was that I saved over half a million dollars that I was able to enjoy while I was alive and my son got only about $1.84M when I died, but I could have increased my son’s inheritance by $1M by spending $97,500 of my saved $510,000 on a million dollar life insurance policy thus leaving my son a total of about $2.84M in land and life insurance when I died.
The government also benefited from this system.
Instead of collecting about half a million dollars in income taxes from me while I was alive, it got $1.035M in net wealth taxes from me plus about $321,000 in interest at the time of my death.
So, the government got about twice as much in net wealth taxes exclusive of interest as it would have gotten in income taxes but it collected the money in a way that was far less painful to me and more beneficial to society because this tax plan reduced the taxes on the working class and much of the middle class to close to zero.
In short, I had more money to enjoy during my life and the government got more tax money to use to run the country after I was dead and the middle class and working class citizens got a huge decrease in the amount of taxes they had to pay.
I call that a win-win-win.
What About Really Rich People?
Let’s run some more numbers. Mitt Romney’s net worth is about $250 million. At the time he ran for President his annual income was about $21M and he paid about 15.24% in income taxes or about $3.2M in income taxes. (Source: CNN Money).
Under a Net Wealth Tax he would owe:
- $50K — $500K X 1% = $4,500
- $500K — $5M X 2% = $90,000
- $5M — $50M X 3% = $1,350,000
- $50M — $250M X 4% = $8,000,000
- Total: $9,444,500
So, under this system Mitt Romney’s taxes would have increased from about $3.2M to about $9.5M, which is a big win for the government and for the middle class whose taxes would be vastly reduced by this system.
But, it’s also a win for Romney because he actually pays ZERO taxes while he’s alive instead of paying $3.2M in taxes while he’s alive, and his huge estate won’t pay any inheritance taxes when he dies.
And note that the amount of his tax bill is still more than four million dollars less than his income and the tax doesn’t even touch the quarter of a billion dollars he has in principal.
In short, his balance sheet shows a $9.5M debit but he’s got $21M cash income to spend and use to increase his assets even further. He doesn’t even feel that negative deferred balance-sheet entry.
High marginal income-tax rates can decrease the incentive to make more money. Since a net wealth tax is disconnected from income, the net wealth tax does not decrease the incentive to earn more money.
And note that the Net Wealth Tax will bring in much more money than the current income tax does. In Romney’s case, $9.5M instead of only $3.2M, but that’s an increase that still gives someone like Romney lots of benefits — no income tax, no estate tax no matter how huge his estate, and all his tax payments can be deferred until he dies.
If No One’s Paying Taxes Today How Do We Run The Government?
Actually, from an accounting standpoint taxes are being paid. It’s as if you paid the government your $20,000 tax bill now and then the government gave you that money back as a secured loan. The government has, in essence, a secured promissory note from you which goes on the asset side of the government’s balance sheet.
The government can then issue a T-bill against that secured note at and pay interest on that T-bill at a rate that is one percent lower than you’re paying on your loan, so the government makes one percentage point profit on the spread.
The government can use the proceeds of its new T-bill sales to fund its operation in the period between the date that it loans you the money to pay your taxes and the date that you either cash in some assets or you die and your estate sells some of your assets to pay back the loan.
It’s like filling up a pipeline. Over a period of twenty or thirty years people will die and assets will be sold and the notes will be paid. After that twenty or thirty years, as new taxes are incurred old taxes and interest are being paid. In the interim the government will have secured notes as assets against which it can borrow operating capital at a rate lower than the rate taxpayers are paying to it on their loans.
Potential Problems
- Someone would have run the numbers to calculate the total amount of taxes this system would generate to confirm that it would produce the same or a greater total amount of taxes as the total that taxes that the income tax and estate tax systems do today.
- The second unknown is if the government can actually sell enough T-bills to run the country until the pipeline fills up and the tax liens are being paid at substantial levels. If it can’t then a fix would need to be found. Maybe the tax liens would have to be paid within some set number of years, ten, fifteen, whatever.
- The third variable is the rates themselves. Obviously, they are arbitrary. Should they be higher or lower? Should there be more or few brackets? Different brackets? Should the base exemption be higher or lower?
- Fourth, should there be a base tax on people whose assets are less than the $50,000 exemption and who thus would thus pay no tax under this system? Should everyone who pays no net wealth tax instead pay a flat percentage tax of 10% or some other share of their net income in excess of $50,000 (or some other number) per year as an alternative minimum tax?
For example, if you had $100,000 in net income but you paid nothing in net wealth taxes should you pay $100,000 — $50,000 = $50,00 X 10% = $5,000 as an alternative minimum tax?
- Fifth, the paperwork would still be complicated. Valuation companies would spring up which would annually value your real property assets, compute your recorded liens and certify your land’s net equity. Similarly, other companies would prepare valuations for rare coins, art work, etc.
- Sixth, some people would hide cash or other assets. The tax would have to double on all deliberately undervalued or hidden assets.
A Thought Experiment
Do I think the country will actually scrap the current transfer tax system in favor of a net wealth tax system? No.
But I do think we should start thinking outside the box about taxes.
What do you think?
–David Grace (www.DavidGraceAuthor.com)
