Aspects of the Current Tax System that are Unfair

Aspects of the Current Tax System that are Unfair With all due respect, I don't know if it would be possible to cover all the inequity contained in the current Code if the esteemed Panel allowed 500 pages per comment. Therefore, I will offer a brief executive summary followed by a few concrete examples.

I feel the current Code is unfair because:
  1. It doesn't treat all taxpayers equally (in effect, 'discriminates' against some);
  2. It does not make any allowances for regional cost-of-living differences;
  3. It does not fully consider taxpayers- resources vs. their obligations (in other words, the ability to meet the tax burden);
  4. It makes compliance essentially voluntary because the IRS neither has now, nor will ever have enough manpower and resources to audit each and every return & this creates a situation where the tax burden is carried by honest people, while crooks, drug dealers, prostitutes, illegal aliens, etc. can get away with paying no taxes;
  5. Because of lack of inflation indexing, the AMT (Alternate Minimum Tax) each year affects more and more taxpayers whom it was never meant to affect.
With respect to the first allegation, just consider that some employees are able to get a substantial tax break on retirement savings or healthcare/childcare expenses, while other workers are not afforded an equal opportunity simply because their employer doesn't want to bother with establishing a 401(k) or a Cafeteria Plan, or because they are self-employed (even more unfair!).

As for some concrete examples to illustrate my other points, please consider the following case study, in which I will try to demonstrate how the current Code is unfair because of being blind to regional cost-of-living differences:

2004 Tax Return
Smiths(NYC) Johnsons(FL)
AGI 150,000 100,000
4 Exemptions (12,400) (12,400)
Std/Itemized Ded (13,418) (9,700)
Taxable Income 124,182 77,900
Fed Inc Tax 24,728 12,950
Child Tax Credit 0 (2,000)
Child Care Credit (4,800) (2,400)
Net Fed Inc Tax 19,928 8,550

2004 Cash Flow
Income 150,000 100,000
Net Fed Inc Tax (19,928) (8,550)
State/Local Inc Tax (13,418) 0
After-Tax Income 116,654 91,450
Rent (36,000) (15,000)
Childcare (24,000) (12,000)
Healthcare (6,000) (6,000)
All other living exp. (50,000) (40,000)
Disposable Income 654 18,450

As can be seen from the above case study, the Smith family of New York City - considered by the Code to be the 'rich folks' because of their $150,000 AGI & actually ends up barely breaking even, while the Johnsons from Florida end the year with $18,000 more of disposable income, even though they make $50,000 less per year!

This regional comparison would work out even more in favor of the Florida family if they made the same amount of money as the New Yorkers ($150,000) & in that case, even though they would pay about $3,500 more in Federal income taxes for the year, they would end up with a disposable income of over $53,500 given the same scenario assumptions! I think this is also a perfect example of how the tax code affects and distorts important personal decision i.e., where one may choose to live.

As for the assertion that the Code is unfair because it does not fully consider taxpayers- resources vs. their obligations, please consider the next case study. Mary and Beth are both single mothers who work as paralegals in the same town. They make exactly the same amount of money and file as Head of Household.

2004 Tax Return
Mary Beth
AGI 40,000 40,000
2 Exemptions (12,400) (12,400)
Std/Itemized Ded (7,150) (7,150)
Taxable Income 20,450 20,450
Fed Inc Tax 2,558 2,558
Child Tax Credit (1,000) 0
Child Care Credit (1,100) 0
Net Fed Inc Tax 458 2,558

2004 Cash Flow
Income 40,000 40,000
Net Fed Inc Tax (458) (2,558)
After-Tax Income 39,543 37,443
Rent (12,000) 0
Childcare (5,000) 0
Healthcare (4,000) (4,000)
All other living exp. (18,000) (18,000)
Disposable Income 543 15,443

As can be clearly seen from the above table, Mary is barely able to stay in the black, while Beth has plenty of disposable income, even after paying $2,000 more in Federal income tax. This is because Beth lives rent-free with her folks who also care for her daughter when she's at work, while Mary lives on her own and must pay for an after-school program and summer day camp for her son.

While I could come up with many more examples, I know that I have already exceeded the page limit, so allow me to move on to some suggestions for what the Panel should consider in fixing the system.

Goals that the Panel should try to achieve in reforming the system
It is my strong opinion that the Panel should not recommend replacing the current income tax system with another one. (Before going further, please note that this comment only applies to personal income taxes, not payroll taxes i.e., FICA, FUTA, etc., or corporate income taxes). First of all, taxes are levied on such items as cigarettes, alcohol, etc., so why should the government employ an inherently punitive system with respect to income? The only instance I can think of where taxing personal income would make some sense and achieve a positive social aim would be with respect to executives and directors of publicly-held companies who give themselves lavish compensation packages at the expense of their shareholders and employees.

Second of all, there is simply no way of introducing any form of tax based on income that would be fair and ensure universal compliance. I believe that the only revenue-generating system that could be fair and ensure universal compliance would be one based mainly on consumption (similar to the VAT in many foreign countries). Such a system could be augmented with a very basic filing similar to today's income tax return to permit people who cannot make ends meet (like Mary in one of my examples above) to get a refund of some of the VAT paid. Additionally, it could also perform a function similar to today's AMT by increasing the tax share for those who end up with a lot of discretionary cash flow (i.e., Beth or the Florida family) and do not contribute their fair share to the system through the VAT. Such a tax form could also serve to maintain the current relation with respect to the taxability of various investment vehicles i.e., bank, corporate bond interest and monies removed from traditional IRAs would have to be included, while municipal interest, annuity earnings and contributions to retirement plans would be excluded. There could also be a schedule similar to today's Sched. C that would enable self-employed people to claim credit for VAT paid on business-related purchases. However, I would not recommend adding any kind of equivalent to today's Sched. D (Capital Gains & Losses); instead, everybody would be better off if financial institutions were required to collect and remit to the Treasury some form of a flat tax on each sell transaction. This way, the Treasury would be better off by having a reliable influx of revenue throughout the year, and the taxpayers would be better off by not having to keep track of their cost basis (and short-term investors would still be as disadvantaged as they are today by having to pay a tax on multiple trades, as opposed to somebody who buys and holds for a long-term gain).

In order to ensure fairness, a consumption-based system would have to be multi-tiered so that a poor single mother would only pay some minimal amount (or perhaps nothing) on the milk for her child, while a wealthy executive (or a drug dealer) would end up contributing their fair share on the purchase of a big-screen TV or luxury automobile. While coming up with the appropriate tiers in order to ensure fairness would be a little bit of an undertaking, I think it would still be a lot simpler than trying to achieve equity in our current income tax code. For instance, basic food items, healthcare and childcare could be excluded from the VAT or only taxed at a minimal rate; on the other end of the spectrum, luxury items such as boats, planes and expensive automobiles would be taxed at the maximum rate; finally, everything falling between basic necessity and luxury could be taxed at some rate between the minimum and the maximum.

In summary, I believe that what I outlined above would be a solution superior to revamping our current tax code because it would be simpler, more equitable to taxpayers, ensure universal compliance while greatly reducing the IRS manpower required to police the system, and provide the Treasury a more steady and predictable inflow of revenue.

Please note that FICA has been omitted from the calculations in the case studies for the sake of greater simplicity.