Tax Reform

Look at the conversation Jesus had with the man who came to him trying to trip him up. He looked at Jesus and he said to him. “Is it all right to pay taxes to Caesar?” I wish so much Jesus had answered that question differently. It would be absolutely wonderful on April 15th to be godly and rebellious at the same time. – Ravi Zacarias (2012)

People really hate taxes and are open to any argument purporting to reduce their personal tax burden even if it cuts into their personal wealth (e.g., deductibility of home mortgages). Politicians exploit this. They spin the illusion of you paying less; yet government spending keeps growing. Guess who’s going to pay?

Contents

  1. Tax Reform
  2. Stop the Game
  3. Economic Impacts
  4. Social Engineering
  5. Public Morality
  6. Business Taxes
  7. Design Criteria
  8. Proposal

Stop the Game

I get whizzed off when the person in front of me at the checkout line has a coupon I don’t have. Bad enough I’m forced to buy something I don’t want. It’s worse when I see other people paying less.

So I go out of my way to reduce my price. I spend time looking in the newspapers and mailers for coupons. I shop around. I go to group purchasing websites.

The better I get at lowering my price the more the manufacturer raises the base price to cover my savings. I feel better because I’m often paying much less than the sticker price. Manufacturers feel better because they see increased revenues.[1]

There’s a certain amount of money the government needs to collect and it’s coming out of your pocket by hook-or-crook: income taxes, inflation, property values, fees, import taxes, stamp taxes, etc. Politicians often do not hesitate to hand out favors to taxpayers who are most price sensitive, burdening everyone else to pay the difference.

Do we really want a coupon-clipping tax system?

Economic Impacts

Pick any tax option. Academics and lobbyists will trot out their econometric, statistical, multi-variant, monte-carlo, dynamic feed-back models and ‘prove’ certain groups will be more harmed than others. They’ll prove jobs will disappear, inflation will skyrocket or the most vulnerable will become destitute. The conviction in their voice makes them worthy of a guest appearance on Art Bell’s Coast-to-Coast AM.

Truth is these ‘experts’ haven’t a clue. Not even directionally. There are many more variables in this simple tax choice than in the consensus climate models; and look at the success rate we’ve had with those over the last decade and a half.

Tax an item and you get less of it ceteris paribus but there are so many other factors influencing these decisions which far outweigh the impact of taxes (as long as taxes are not confiscatory or zero).

You cannot design a tax code to achieve desired economic results a priori. Maybe you can guesstimate the impact of a new tax for a year or two after its enactment but beyond that you just can’t know.

How a tax affects individual wealth can only be known in practice or a posteriori. Only in practice can you see the responses of lobbyists, foreign manufacturers, foreign trade delegations, ambitious politicians, frugal consumers, real estate investors and others. Only in practice will you know if a tax burden will be offset by changes in wages, investments, prices, jobs, asset valuations, etc.

The single most important factor in the selection of a tax code is its impact on national wealth. The more wealth we generate the more we have as a tax base. But we can only know this when we know it.

Social Engineering

Social engineering of the tax code refers to tinkering with the tax bases or rates to achieve desired social or political outcomes. If you want more research in industry you give a tax break under the guise it will encourage further investment into research.[2]

What’s wrong with social engineering of the tax code? Same thing that’s wrong with modeling economic impacts. You can’t know its effects beforehand not even at the margin. Many factors much more important than taxes affect levels of research, poverty, oil & gas exploration, job creation, home ownership, etc.

Lobbyists and politicians use social engineering as unabashed give-aways to political supporters, payback to the wealthy for their help in hidden tax schemes, and bribes to key constituencies (e.g., home mortgage deductions).

The moment you manipulate the tax code for one worthy social goal is the moment other politically powerful players get the idea to manipulate the tax code for their own perhaps less worthy goals.

Objection! I reject the premise that tax collection is an end in itself. We set up our social policies (e.g., lift folks out of poverty) and use all the tools of government to achieve those policy goals, one of which is tax collection. I can’t get traction politically on the spending side so I’m going to push my pet ideas through on the collection side. I refuse to take this arrow out of my quiver!

Counter to Objection. In a sense I too advocate a touch of social engineering in my design criteria; below (e.g., I make taxes more visible to reduce the temptation for politicians to get greedy). We shouldn’t completely rule out using the tax code for policy goals.

But mostly it doesn’t work. It’s counter-productive in that it reduces Federal tax revenues, now perhaps by as much as a third. It’s dominated by people who have the time and money to milk it for their own babies. It’s exploited by those looking to shrink Big Government by drying up its tax revenues. It’s often regressive: rich and poor alike get the same percentage tax breaks. Politicians cherish it as a covert slush fund to reward campaign donors.

Prima facie having social goals in the tax code should be viewed as gaming it for political purposes, unless clearly shown otherwise.

Collect taxes in a way that is as politically neutral as possible. Don’t manipulate the tax code for social goals. Instead design the code to create wealth. The more wealth a nation has the more is available to help the poor, clean up the environment, etc.

Social engineering provides the rationale to cheat for those left out. How would you feel if you worked at Ford and saw a bankrupted GM get special treatment allowing it to carry forward its tax losses into its restructured company, giving it a tax advantage over Ford almost in perpetuity? Ford played by the rules. GM cheated and won.

Game the tax code and you erode trust in the system which leads to greater tax avoidance and at times even evasion.

Public Morality

It would be nice if individuals felt it a patriotic duty to pay their Federal taxes. If I knew my tax dollars would go to feed a hungry child I would be less likely to cheat.[3] But today it’s just too easy to find Federal spending that insults one’s moral values (e.g., funding of abortion, oil & gas subsidies).

We can’t fix this nicety with a tax policy. But we can lessen other insults to our collective conscience inflicted simply by the way we collect taxes.

Public morality is the most precious commodity for a healthy democracy. Undermine that morality and you breed a culture of distrust, fear, selfishness and resentment. Corruption on Wall Street. Business fraud. Crooked politicians. Sound familiar?

Numb the public conscience and you start with a deficit the next time you’d like to tap into that conscience. We have neighbors who are truly suffering; who can really use a hand? Well I’ve learned to rationalize my concern away. I’ve come to believe you (and your allies) are using these unfortunates as a way to advance your personal agendas.

I imagine many of you … have received cash payments for things you’ve done which you didn’t report on your income taxes. You should only feel the tiniest bit of guilt on this because it’s a social norm. … You’re not allowed to mow somebody’s lawn and get paid without reporting it on your income taxes. That’s the law. But most people say it’s no big deal. And I don’t think you should feel miserable for having broken the law in this way. It’s the common practice in our society. – Erik Olin Wright, University of Wisconsin, Contemporary American Society (SOC 125, 2010)

Once you start down a questionable path it becomes harder to get back on the right path. I don’t want to cheat but I don’t want to be a chump by being honest![4] My competitors engage in these practices so I rationalize tax avoidance in my own mind in order to stay in business. And then tax evasion. And then fraud. You sent me straight to hell with your tax code and I hate both you and me for allowing it.

To reduce temptations keep tax rules few and simple. A simple tax basis is the best incentive for honesty. The fewer the moving parts in the tax basis the lesser the temptation to cheat.

Income as a tax basis is the devil’s playground.[5] It has many moving parts (revenue, costs, expenses, deductions, exemptions, contingencies and who knows what else). It’s a trivial task to avoid income taxes. I switch from income to capital gains and back. (e.g., pay myself more or less in stock options vs. wages). It’s even easier for businesses to cheat.[6]

Instead, we look to tax bases that limit the temptation to cheat: persons, extracted commodities or real property. They’re nailed to the ground. You know as a taxpayer you’ll get caught if you fudge on the amount of coal extracted from your land, as an example of a tax basis, and would not even give it a second thought. The below chart ranks the ‘temptation quotient’ for several common tax bases.

TemptationAcademics, community organizers, libertarians and lawyers pooh-pooh my belief about our utter dependency on public morals for our nation’s health and welfare. Doesn’t matter to them if tax avoidance escalates into greater misdeeds. Doesn’t matter if people would steal from their own grandmother if given Plato’s Ring of Gyges. As long as we go after my political or social ends, the greater good or the lesser evil, you should only feel the tiniest bit of guilt for cheating.

Forgive me Father for I have sinned. I stole from my wealthy neighbor to pay the Peter’s Pence.

Business Taxes

Often academics and economists simply assume reducing business taxes will increase national wealth. You get more investment when you tax less, ceteris paribus. But as a corollary to the futility of economic modeling (above) no one can tell you what a business will do with new-found wealth from a favorable change to the tax code. Sure there are theories, anecdotes and purported examples from third world countries. But we have no clear evidence as to how a change as disruptive, for example, as moving the U.S. to a Capitation Tax would get reflected in business use of tax windfalls.[7]

When a business makes more money than it needs to continue making money we do not decide collectively as a society how to distribute that excess money. Individuals who contribute however remotely to running the business compete among themselves for that decision: management, stockholders, labor, financiers, suppliers, consumers, patent holders, mobsters, hucksters, politicians, etc.

In the absence of a concerted effort by other contributors management will first funnel excess money to family, friends and themselves; then perhaps to shareholders.

The government contributes limited liability protection and demands, like any other self-respecting mobster, as much of the excess money as its clients can bear. As long as businessmen make money they want the government out of their hair. When things go south they want the protection of limited liability. As a society we collect this protection money.

We collect protection money with something called taxes. You don’t want to pay business taxes? Then we abolish limited liability protection. …more

Design Criteria

Below are the only criteria you need to choose (or to design) a tax option. These are high level and open to interpretation. But follow the intent of these criteria and you’ll come up with tax solutions that are comprehensive, robust and unambiguous. Other commonly proposed criteria like ‘lowering tax burdens’ or ‘sharing tax burdens’ inevitably lead to our current tax mess, which I hope we all find quite unacceptable.[8]

1. Reduce temptations for politicians to covertly increase taxes or game the tax code.

Keep taxes front-of-mind for the taxpayer. “Pay Taxes on Election Day!” A tax option scores higher when it involves a deliberative tax outlay, is a substantial amount and is in-your-face (e.g., a stamp tax). We use a gut check when scoring this criterion: which tax option most feels like a burning coal in the pit of your stomach when you pay. When you run your monthly Quicken™ budgets I want you to see taxes showing up as a reduction to your wealth reminding you to find out why they jumped up last April.[9]

Enfranchise as many taxpayers as possible. An option scores higher the fewer the taxpayers we exempt from paying. We want every resident to pay even if just a little; or even if they later get a rebate. We want every voter to go through the mental deliberation of making a tax-specific payment.

Make highly visible uses of the tax code to hand out political favors. An option scores lower the easier it is to tweak the tax base or tax rates. Deductions and exemptions lower the score. Multiple tiers or progressivity lowers the score. Complexity lowers the score. An option that per se undermines the political or social rationale for social engineering scores the highest (e.g., the Confederated Tax).

Empower competing taxpayer interest groups. Set up the tax bases and rates so powerful interest groups compete with each other to reduce their tax burdens; where one group’s gain is another’s loss. Special interests tinkering with the tax code for their own gain face powerful opposition. One way this can be achieved is to set a fixed tax contribution across overlapping payers (e.g., A+B=100, B+C=100, C+D=100 for a total of 200).

2. Reduce temptations for taxpayers to cheat.

Make tax evasion patently high-risk and high-pain. Use a tax basis highly resistant to tinkering (e.g., persons). Have a tax option that takes two or more persons conspiring in order to cheat (e.g., a sales tax). Use rebates instead of deductions. Have an option tied to licensing or inspection actions (e.g., automotive property tax in NJ). Have an option tied to publicly available data (e.g., census data). Make it so even the dumbest criminals will see how easy it is for them to get caught and punished.

Prefer tax options where enforcement costs are practical for punishing both small & large cheats. Make it worth the effort to go after smaller infractions (e.g. Chrysler Building). Collect taxes and penalties from many millions of small cheats and you end up with far greater revenue than just catching a few large cheats.[10] Have tax bases that are open to public scrutiny (e.g., commodity taxes). Have taxes where neighbors report unfair differentials (e.g., property taxes). Have taxes where the value of the tax bases fall within a narrow range (i.e., outliers become obvious).

Avoid taxes that fall too heavily on single factions. We seek Goldilocks sizing in each individual’s tax bill: not too high as to invite lobbying, not too low as to make enforcement impractical. Spread tax burdens across interest groups, industries, geographies and classes of people. Spread tax burdens across several tax bases. Avoid one-size-fits-all tax options.

3. Select tax options that most increase (or least decrease) national wealth (discussed in the proposal below)

DesignCriteriaThe above chart ranks illustrative tax options in order of preference (descriptions of these options are found here: Fair Tax II, Capitation Tax, Confederated Tax). Ideally we would have a mix of tax options. I use stand-alone options merely to illustrate the mechanics of the comparison.

I describe below some of the thinking used to score these alternatives.

Fair Tax II uses economic transactions (e.g., purchase transactions) as its basis. These are easier for politicians to game. It has moderate collection costs. Once in place, it’s hard for individuals to avoid or evade.

Capitation Tax, a fixed amount per person, is very hard to evade (you are the person) and is very in-your-face. It has low collection costs. It’s hard to game. It can be harder to enforce on indigent taxpayers.

Confederated Tax, having states collect a Federal tax on behalf of their residents, ranks higher or lower in each criterion depending on the tax code selected by the states. The Confederated Tax stops social engineering of the tax code but only at the Federal level, hence the question mark. If our scoring criteria indeed contribute to the greater public good we should see states gradually incorporating them into their alternate tax codes (e.g., states should be seen moving toward the Capitated Tax).

In the chart, the alternative tax options seem to beat the current tax code hands-down. But recall the chart only gives half the equation. Equally important is how well a tax option increases national wealth, to which I now turn.

Proposal

The devil you know (today’s income tax) is often better than the devil hidden in the details of new tax proposals. One big advantage of today’s income tax is the fact that individuals have already incorporated their expectations of it into their plans. Often this greatly outweighs proposed advantages of alternative tax options in public opinion.

People will simplistically look at their 1040 from last year and compare it to projected taxes for any new tax proposal. Taxes are immediate. Benefits always seem to be way off in the future. Many U.S. taxpayers today believe they pay no Federal taxes (e.g., they falsely believe payroll taxes go into their personal account). Any thought of moving toward a new tax option must first unmask this deception.

The Tax Reform Act of 2014. A 12-16 year experiment to see which tax options really are the best.

Get input across the ideologies and design a set of alternative tax proposals. Use mixtures of Fair Tax II, Capitation Tax, Confederated Tax, Sales Tax, Property Tax, Commodity Tax, Payroll Tax, etc.[11] Hell you can even throw in a bit of progressive income tax. Who knows?

Then use the design criteria to prioritize the top three or four tax proposals. Design criteria only give half the picture but half is better than none. We agree up-front not to presuppose economic or social impacts for any of the proposals.

Pick one of the proposals and try it out nationwide.

Fix the amount of revenues to be collected ($3 trillion in 2012) and collect those revenues using each proposal in turn (3-4 years each). Each proposal automatically expires at the end of its turn and the next in line kicks in.

We freeze Federal revenues to inflation-adjusted increases for the duration of the experiment. We don’t freeze the political process (e.g., lobbyist pushing for tax breaks). We don’t freeze international trade negotiations. We don’t adjust for inflation, recession, debt ceiling stalemates, foreign investments, tax treaties or other exogenous factors.

Collect real data on winners and losers. Randomly select 250,000 households (~.25%) and track changes to their socio-economic status (e.g., wages, savings, asset valuations, prices and baskets of goods purchased).[12]

Look at qualitative improvements to the fortunes of the 250,000 households regardless of address changes, health events, job changes, etc. Are they much better off, better off, just the same, worse off or much worse off? Then do a simple count. Under which tax proposal did the most households fare better over the 3-4 year trial period?[13]

How did our design criteria really score in the experiment? Remember we only guessed at these scores during the prioritization. Which tax proposal leads to greater control of tax loopholes? Which leads to greater taxpayer honesty?

We step back from the data à la John Tukey and see what patterns emerge.

My guess is certain proposals will jump out as obviously better or worse than others regardless the underlying economic or social climate changes. And, surprise, we’ll ask study participants what they think. This will be the official report.

Release the survey data to the interest groups and let the number games begin. Statisticians and academics will dive in with their quantitative models showing how one proposal is best (or unfair) for their pet interest groups.[14] Public relations firms will engage in merciless spin. Trot out the suffering children and lonely old women with their cats! Many will argue the results were swamped by uncontrolled exogenous factors.

We have the official report side-by-side with the special interest reports. Dueling spreadsheets. The devils are now fully exposed. Let the voters decide.


2. Today we disguise social policy by passing it through the tax code. For example, we have a European-style child allowance in the U.S. It’s called the Child Tax Credit. We have riddled the tax code with thousands of these tax breaks as an alternative to honestly and openly enacting public spending programs. The complexity makes people hostile to paying taxes. It promotes the idea I’m paying more in taxes than someone who can afford to hire a tax attorney.

3. Politicians have mastered the legerdemain of swapping earmarked funds for general funds, so a new tax enacted to feed the hungry, for example, merely leads to an increase in unrestricted general funds and no further food for the hungry. Money laundering. In the private sector folks would go to jail for this. See why taxpayers feel cheated at every turn?

4. Before I worked at a CPA firm. I was at happy hour with co-workers and I picked up the tab. I was asked “Where are you going to charge it?” And I said “Charge it? We didn’t talk client business.” I had a colleague say “Oh Sherron. Stop being so naïve. The partner’s can’t pay us what we’re really worth. They expect us to pad our expense reports to get us up to a market rate of compensation.” That’s the rationalization. That it’s okay to cheat or game.” – Sherron Watkins, Whistleblower, former Vice President of Corporate Development, Enron (2009).

5. Income taxation of corporations is extremely damaging to jobs, local economic development and local investments. Global corporations gifted in the art of the tax dodge purchase well-run local businesses, and finance the purchase solely on the basis of the tax dodges they expect from the acquired company. Look at the tax bill of a target acquisition. If it pays high taxes (or has a high tax-loss carry forward) then acquire the company and capture those tax benefits in order to finance the acquisition.

6. Make high interest loans from a low tax country into a subsidiary located in a high tax country.

7. What Do Firms Do With Cash Windfalls? They waste them on ill-advised investments with family and friends.

8. I have little sympathy for simplicity of filing (e.g., postcard-sized 1040’s) as a criterion. A horrible tax code can still be simple. I want transparency not simplicity, though the two often are found together. Having 6-9 tax tiers is trivial from the standpoint of filing or tax planning in this computer age, but it’s mortal in its temptation to cheat.

9. Yes I know progressive academics want taxpayers to feel they are investing (a debit accounting entry) and not expensing (also a debit). Depends on how my money is spent.

10. …the land must be literally covered with assessors and collectors, going forth like swarms of Egyptian locusts, devouring every blade of grass and other green thing. – Abraham Lincoln (1843)

11. None of the listed tax options work very well alone. You’ll need two to four tax options in each experimental proposal, though any single taxpayer should only be subjected to one or two standalone taxes (i.e., only be subject to one or two of the tax bases). For example, individuals may pay Federal taxes using both the Confederated and the Capitation tax options; corporations using a property and income tax, etc.

12. You randomize selection of participants for each new run of the trial. If individual fortunes go horribly south then, just like in a clinical trial, we either halt the experiment or enact emergency protections for those few unduly harmed.

13. My measure of success is the wealth of the nation as calculated by improvements to the wealth of the greatest number of taxpayers. It will be very unlikely Bill Gates will be ‘much better off’ under any proposal.

14. I like Stanley Young’s idea from Everything Is Dangerous. A Controversy (1:10:10) Blind ½ the underlying data from public view as a threat to embarrass ‘scientists’ who skew or cherry-pick the public data to sell their desired results.

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