Finding the Road to Real Income Tax Reform

As a tax reform proposal, the FreedomTax is revolutionary. It’s more than just a proposal to clean up a tax mess. It would overturn and junk the establishment’s system of taxation, replacing that system in its entirety with a true income tax. This new tax would be a 10% flat tax on all income, taxing all income the same so that all income would bear its fair share of the income tax burden.  The FreedomTax would dethrone the IRS, transforming it into a mere ministerial agency charged with the benign task of administering a greatly simplified income tax and tax-neutral much like the motor-vehicle fuel tax.

By James K. Jeanblanc | April 6, 2016

finding the road

Various tax plans have been proposed by the presidential candidates and others to reform the income tax. These plans basically take the form of reducing the number of tax brackets, dropping the top tax rate, and curtailing tax breaks.  Noteworthy, all are “establishment” plans, not intended to change the fundamental nature of the income tax system.  Their design is for the continued use of the tax system to pick winners and losers. And, they even affirm such use.

The Candidate Plans

Two of the plans propose a new tax break to allow businesses to expense the cost of their capital investments.  Another proposes very generous income exclusions and tax credits to favor families.  Several would continue tax breaks for home mortgage interest and charitable giving.  Most would continue the practice of embedding in the income tax system off-budget government-spending programs, such as the Earned Income Tax Credit.  And, some of the candidates have campaigned that their reform plans are open to having new tax breaks added for expanded use of medical savings accounts.

Then, there are the plans claimed to be “flat-tax” proposals, which they are not. They are single-bracket tax proposals retaining the existing tax structure for the easy addition of more tax brackets later. Their design eliminates all of the tax brackets between the taxpayer’s lowest level of income (the portion sheltered and effectively taxed at a zero rate because of allowed exclusions and exemptions) and the top tax bracket. This top bracket is retained with a reduced tax rate and is what is claimed to be the “flat tax.” A true flat tax would tax all income the same and all at the same rate, without modifications and exceptions. (Indeed, the same flat-tax claim might be made of the top tax bracket in the multi-tax-bracket proposals because the tax computations below that top bracket, as in the case of the claimed “flat-tax” plans, are personal to the taxpayer.)

The present income tax system is horribly flawed in concept, design, and structure. Yet, the candidate plans propose mere cosmetic changes. To achieve real and lasting reform, the entire system must be completely redesigned and remade.  Short of this, nothing here proposed will be long-lasting, except to continue the stage for a replay of the income-tax-reform saga.

Lesson Ignored

The Tax Reform Act of 1986 also was a reform to reduce the number of tax brackets, drop the top marginal tax rates, and curtail tax breaks. Good intentions aside, it was a flop in terms of enacting real and lasting income-tax reform. Had the entire system been redesigned as above suggested, real and lasting tax reform would have been possible. Rather, this reform retained the existing tax structure, thus allowing easy ad hoc changes to be later enacted, increasing the number of tax brackets, imposing higher marginal tax rates and expanding the tax breaks. It allowed return to the tax mess of today.

Reformers should pay to heed the famous adage, “You can’t make a silk purse out of a sow’s ear.” The 1986 Act has demonstrated that the existing income tax system is a sow’s ear – unrefined, of bad quality, and something impossible to be made into a quality product.

The Sow’s Ear

Handicapping all reform efforts, past and those now proposed, is the mistaken belief that what we have is an income tax system.  Yes, it’s been labeled as such in the tax law and in all the tax forms.  And, yes, the tax rates are applied to dollars of income to determine the total tax owed. But, the system is so complicated and convoluted that it’s difficult to comprehend its true nature. We even have a Supreme Court Chief Justice who thinks a penalty imposed upon a person for not doing something the establishment wants him to do is an income tax.

Missed by most people is the reality that the income tax has the fundamental design and function of a person-taxing system, not an income-taxing system.  It is the taxpayer who is the subject of the tax, not their income. Each year, every taxpayer is required to file a personal tax return with the IRS. In this return, the taxpayer reports all of his income, claims his personal tax breaks, and computes, using the tax bracket applicable to him, the tax he personally owes to the IRS. That tax is actually imposed upon him, not his income.  (It’s a tax system off the tracks – the 16th Amendment authorizes a tax levied upon income, with no mention or authorization of any tax levied upon persons.)

In this person-taxing system, it’s rare to find any two taxpayers with the same income paying the same tax. Indeed, some people have income and pay no income tax at all!  If income were truly the subject of the tax, then looking at each and every person receiving income, everyone’s income would be taxed at the same effective rate of taxation.

Contrast all this with the tax imposed upon motor vehicle fuel purchased at the pump. Under this tax system, all fuel is taxed and taxed at the same rate – regardless of the motorist, his marital status, the number of passengers he drives, his total fuel purchased for the year, the number and types of vehicles he owns, total miles driven each year, miles driven for charity work, etc.  This is a tax system which works efficiently without the motorist ever having to file a personal motorist fuel-tax return with the IRS.  The design is for purchased motor fuel to be the subject of the tax, not the motorist.

What We Have

However the income tax system might be characterized, there can be no doubt that it’s a terrible mess – insanely complicated, difficult to comply with, and tax-inefficient.  Yes, the world is complicated, but this does not mean that the income tax also has to be complicated or that the world is an excuse for what the income tax has become.

Justifications aside, the income-tax mess is what’s to be expected from the ill-conceived concept and design of the existing tax system.  That system was conceived in the late-19th and early-20th centuries and designed for the world of that time. The tax mess of today shows the system woefully unsuited for today’s world.

Now in the 21th century, there are various tax-collection-and-payment systems employed for limited purposes, but they can be easily expanded. From this, it’s possible to have an income tax system of modern conceptual and structural design. Such a system would greatly ease compliance burdens, yield massive tax-system efficiency, and eliminate the need for an intrusive and oppressive IRS to keep the archaic system of taxation still functioning.

The Road to Real Income Tax Reform

The FreedomTax is the only road away from the tax mess. It’s the only road to a simple, low-rate, easy-to-comply-with, and tax-efficient income tax.  But, passage on this road requires the junking the two pillars of the existing tax system, bearing responsibility for the tax mess and blocking real and lasting reform. Cleared of these two impediments, the road becomes passable to a conceptually sound and tax-efficient income tax system.

The first pillar to be junked is the concept that people and their income should be taxed differently.  This pillar is the siren call which inevitably leads to the taxing system losing its focus upon what’s to be taxed, thus making for tax complexity and tax inefficiency.

Second is the requirement for the universal filing of personal tax returns.  This is the mechanism which inevitably turns what should be a tax on income into a functioning tax on persons.  It even does the devil’s work by fostering anti-tax reform constituencies who fervently believe that their personal tax breaks are for the greater good and that any reform proposal to eliminate them is unacceptable.

(Current tax reformers seem to have a love affair with these two pillars.  All of the candidate proposals rely upon them. Even the Fair Tax proposal, to abolish the IRS and to repeal and replace the income tax with a 23% national sales tax, draws upon this two-pillar design.  Families would be required to file an annual personal application with the taxing authorities to receive personal “pre-bates” of the sales tax.)

The FreedomTax

As a tax reform proposal, The Freedom Tax is revolutionary. It’s more than just a proposal to clean up a tax mess. It would overturn and junk the two pillars of the establishment’s system of taxation, replacing that system in its entirety with a true income tax. This new tax would be a 10% flat tax on all income, taxing all income the same so that all income would bear its fair share of the income tax burden.  The FreedomTax would dethrone the IRS, transforming it into a mere ministerial agency charged with the benign task of administering a greatly simplified income tax and tax-neutral much like the motor-vehicle fuel tax.

Most Americans would be freed from ever again having to file an income tax return. Ended would be their worry about having to deal with the IRS, worry over documents to be retained, and worry about personal information in IRS hands which might be hacked or misused.

No longer needed would be the vast cadre of tax-return professionals, the tax advisors on what to do or not to do, the “experts” on the proper tax policy, and the TV ads offering escape from heavy tax debts owed to the IRS.

The revolution would be even more far-reaching.  Much needed tax efficiency would be brought to the income-tax system, saving the Treasury billions in administration costs. Lifted would be the present system’s drag on saving and investment, on job and wage growth, and on the domestic economy overall. No longer would we see the corporation “inversions” of American companies moving abroad, and their already foreign-taxed earnings could be deployed without tax penalty here in the United States rather than left exiled for use abroad.

The FreedomTax would bring about a massive tax simplification, reducing the Tax Code by an estimated 95%.  And, unlike the candidate proposals, it is expected to raise the same amount of tax revenue to the Treasury (maybe more) than the existing tax system it would replace.

How Would the FreedomTax Work?

As already noted, all income would be taxed at the same low 10% flat rate, no exceptions or special rules. This 10% tax would be imposed and collected at the source of payment in the case of interest, dividend, wage, and retirement income. Because the tax on this income will have already been paid and collected, its receipt no longer would require the filing of a personal tax return by the recipient for the tax to be paid.  This is why most Americans, who have only this income, never again would have to file a personal return with the IRS – not even a postcard return!

The only returns required under the FreedomTax would be for business income where business-generating expenses are incurred and return-reporting is necessary to determine the business income to be taxed.  No income already at-sourced taxed would be reported in a business return.  Business income would be taxed at the same rate as all other income – at a 10% flat rate.

Other reform proposals lack this simplification, instead proposing business income to be taxed separately and at different tax rates. Some of the candidate proposals would tax business income separately to give the tax system a valued-added-tax (VAT) focus.  Some even would tax business income separately to replace the payroll-tax system to give Social Security and Medicare a funding structure coming from general revenue. These proposals seem oblivious to the unfavorable ramifications likely to follow and are proposals diverting attention from the goal of achieving real and lasting income tax reform.

Concluding Observation

The FreedomTax would replace the tax mess with a tax-efficient income-tax system of modern design with a clear focus on what’s supposed to be taxed. It’s the only proposal holding promise to be a long-lasting reform.  It’s a principle-based income tax system, that all income should be taxed and taxed at the same rate, no exceptions. This principle will give the new income tax a grounding and conceptual integrity so lacking under the present system where eroding tax changes are easily made with tax-avoidance justifications.  With the establishment’s tax system entirely junked, no longer will there be that open door inviting return of tax-bracket taxation and the addition of personal and business tax breaks for a repeat of the tax mess.

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.