To really “start over,” the Rand Paul Tax Plan must “blow up” the universal requirement that taxpayers must file with the IRS a personal return reporting all their income and paying the tax as a personal tax. And, it must “blow up” the misguided design of the present system for people and income to be taxed differently. These two pillars – the universal filing requirement and the misguided design – are the source of the income-tax mess today. And, so long as they are viewed as off-the-table for any tax reform, they stand as mountains blocking the road to real tax reform.
By James K. Jeanblanc | September 22, 2015
In June, Senator Rand Paul announced his plan to reform the income tax, boasting that it would “blow up the Tax Code and start over.” In addition to repeal of the income tax, he claimed it would eliminate the payroll taxes on worker salaries and wages.
He presented his plan not as a white-paper proposal, but sketched out in speeches, interviews, and short op-ed pieces. It was a quick response to the earlier reform plan of Senator Marco Rubio, also running for President. Both proposals seem tailored more to the candidates’ campaigns than to meet the goals of the most serious income-tax reformers.
Senator Paul calls his plan, “The Fair and Flat Tax,” a title obviously intended to capture the favor of both those supporting the Fair Tax, and those favoring a Flat Tax on income. Like Senator Paul’s Plan, the Fair Tax proposal would also replace the income taxes, estate and gift taxes, and payroll taxes, but instead with a 23% sales tax imposed on all domestic retail sales and imports. The Flat Tax proposal of Steve Forbes, however, would tax all income of individuals and businesses at a 17% flat rate, but would make no change in worker payroll taxes. Senator Paul’s plan would seem the more attractive with its proposed across-the-board tax rate of 14-1/2% on income.
Not a “Blow-Up” of the Tax Code
The Senator claims his proposal would repeal “the entire Internal Revenue Code” and “start over.” But, looking through all the smoke from the proposed demolition, it’s easy to see that many elements of the Tax Code would remain (not repealed) and even to be used as building blocks for the supposed “start over.” Most significant is that the Plan would not “blow-up” key elements of the Tax Code. It would continue them in the foundation of the new income tax system. The end result will be the same as building a new house on an old foundation infested with termites. More about this below.
Taxation of Personal Income
Indeed, as advertised, the proposal would replace the personal income tax, doing so with a 14-1/2% flat-tax on all “personal income” (i.e., wages and salaries, including dividends, interest, capital gains, and rent). Unclear is how the new tax would be applied to now-untaxed employee fringe benefits, municipal bond interest income, and tax-advantaged investment plans. Perhaps, these income exclusions are to remain, not to be “blown-up” for a real “start-over.”
Regardless, the proposed flat tax would not be a true flat tax on all income. The Plan would end most all deductions and tax credits (steps in the right direction), but the deductions formortgage-interest and charitable-contributions would be retained (two steps backwards). Most damaging to the promise of a flat tax is the Plan’s addition of a new tax break. The first $50,000 of income for a family of four is to be exempted from taxation. Also, not all of the tax credits would be “blown-up.” The earned-income-tax-credit, a popular but very costly and inefficient tax break, would be retained.
Worrisome in the hands of a future Congress is the plan’s exemption layer of the first $50,000 of taxable income. This amounts to a preservation of the concept of tax-bracket taxation (where extra dollars earned are taxed more heavily than the first dollars earned). By not “blowing up” this concept, not only does this prevent the proposal from being a true flat tax, but it leaves in place a mechanism for Congress to easily add more tax-brackets later, with the public more in acceptance (with the Plan enacted) that higher-income people should be taxed at higher rates.
Taxation of Business Income
The Plan would replace the corporate income tax with a new tax, the “business-activity tax.” This new tax would have the same 14-1/2% rate as the personal income tax. Evidently, it would be a separate tax and also be made applicable to the business income earned by partnerships, LLCs, and individuals carrying on proprietorships. Unclear is whether dividend, interest, and rent income earned in a proprietorship or other entity would be “personal income.” If “business-activity income,” it would not be eligible for the $50,000 family exemption. Also unclear is whether a proprietor’s business losses would be deductible against his “personal income.”
The drawing of income distinctions is sure to create complications for the tax system. A true flat tax requires no income distinctions because all income is taxed the same. But, significant for the future, the Plan’s establishment in the Tax Code of an income distinction would create an open door for Congress to decide to tax “business-activity income” at a higher “flat-tax” rate, and to even decide upon bracketed-taxation of “personal income.”
Under the “business-activity tax,” all special business tax breaks would be ended, except for a new one. Not true to the flat-tax concept, the Plan would allow businesses to deduct the cost of all their new capital investments as an expense (in lieu of being required to capitalize that cost and depreciating it over the life of the investment). All tax breaks have come with good purpose, and this one is intended to spur new investment. So much for the notion that a flat tax is supposed to be tax-neutral and not designed to influence business decision-making. Not to be overlooked is that generally-accepted accounting principles, used to match expense with revenue, do not accept the expensing of capital assets to the measure of income. So, the flat tax as proposed by the Plan would not be taxing all the “income” of businesses.
Any tax break, even nestled in the most pristine tax system, will serve as a beacon for the addition of more tax breaks. The irony in the Plan is that, by reducing the tax rate from the top corporate rate of 35% to 14-1/2%, much of the “juice” in this new tax break for the expensing of capital investments would not arise. So, why have the break? But, the juices will surge should Congress decide to raise the business tax rate, fostering a climate for more business tax breaks on the precedent of this new tax break having been endorsed by the Plan.
Elimination of Worker Payroll Taxes
A key part of the Plan is its proposed elimination of payroll taxes deducted from worker salaries and wages. Senator Paul claims this elimination would boost the incentive for employers to hire more workers. Whether this would be true is unclear, unless the employer-paid portion of these taxes also is to be eliminated.
Often overlooked is the fact that these taxes are not true income taxes, but are structured only as taxes for collection purposes. They are measured employee/employer contributions paid into the Social Security and Medicare Programs to accrue specific benefits for the workers under the Programs. These “taxes” stand in sharp contrast from true income taxes, payment of which do not accrue any program benefits for the income-taxpayers.
Elimination of the payroll taxes will leave these Programs with a huge revenue shortfall. The Plan is unclear how that shortfall is to be made up. Senator Paul has suggested that the “business-activity tax” would make up the funding, with the first dollars from that tax to be “ear-marked” for the Programs. This “ear-marking” is mere gimmickry to hide the reality that henceforth these Programs would be funded from the general revenues (and not from worker-payroll contributions). With payroll contributions no longer collected from workers, these Programs are likely to evolve into pure welfare programs, unfettered by having to increase the dedicated payroll taxes in order to expand their coverage.
A well thought-out proposal would contain a discussion of how the change in funding would, or would not, change the nature of these Programs. Short of that, one is left to speculation. If the Social Security Program were to be regarded as a pure welfare program (no longer to be an earned-retirement program), there will arise political pressure to curtail its benefits except for the very needy. And, Medicare, also funded from the general revenues, may be pushed in the direction of single-payer health care (National Health), with possible implications for the future of Obamacare. So, hidden in the hype about eliminating the payroll taxes, the Plan may foster consequences well beyond those expected from a mere income-tax reform proposal.
A Detour from the Road to Real Tax Reform
Senator Paul’s “Fair and Flat Tax Plan” is not a road map to real tax reform. Among the many other features already discussed, it would retain two pillars of the Tax Code and structure its reforms around them. Bluntly put, this makes for a road map for an inevitable trip back into the woods, to the vast thicket of tax complexity and uneven tax treatment of taxpayers and income.
To really “start over,” the Plan must “blow up” the universal requirement that taxpayers must file with the IRS a personal return reporting all their income and paying the tax as a personal tax. And, it must “blow up” the misguided design of the present system for people and income to be taxed differently.
These two pillars – the universal filing requirement and the misguided design – are the source of the income-tax mess today. And, so long as they are viewed as off-the-table for any tax reform, they stand as mountains blocking the road to real tax reform. They have been, and will continue to be, the enablers for the income tax to function as a person tax, rather than as a true income tax. They have enabled all the tax complexity and disparate treatment of people and income seen today. And, they will enable all the Paul reforms to be undone, the income-tax base to be further eroded, and brackets of higher marginal tax rates to be added. In short, the Paul Plan is no career threat to would-be tax reformers.
Here’s a prediction – at some future time, with the new tax system back in the woods, we’ll hear the voice again to “blow-up the Tax Code and start over!”
James K. Jeanblanc is a CPA and Tax Counsel to the law firm Grove, Jaskiewicz & Cobert in Washington, DC. He is also Senior Fellow for Tax Policy at the Selous Foundation for Public Policy Research, author of The FreedomTax and a contributor to SFPPR News & Analysis.