By Dan Froomkin
The U.S. tax code is phenomenally complicated, not entirely fair and takes money out of your pocket. What's to like?
So there's no easier way for a politician to get a cheer than to say the current system should be abolished.
But taxes are, as they say, inevitable. And the alternative tax proposals being discussed these days ranging from minor tweaks to radical revisions raise intense political and even moral issues.
Someone needs to pay to support government programs, but who? Should corporations or individuals bear a larger burden? Should the rich be taxed at a higher rate than the poor? Should certain behaviors be rewarded with tax breaks? And what does our tax system say about who we are as a nation?
This Tax Policy Special Report includes key news stories from The Post, a collection of Post opinions and editorials and an annotated list of resources and links to related Web sites. There is also a revenue game that lets you guess where our tax dollars come from and a discussion area where you can express your views.
This essay provides an introduction to the following topics:
A major test for a tax system is whether it is progressive or regressive. A tax system is called progressive if those with higher incomes pay a higher proportion of their income in taxes. The theory behind progressive taxation is that lower- and middle-income individuals and families must spend a higher proportion of their income for essentials than the rich, who presumably have more disposable income and can afford higher taxes.
Federal tax receipts in 1996 amounted to about $1.5 trillion dollars. About half of that came from individual income taxes; about 13 percent from corporate income taxes, and the rest from employment, estate, gift and excise taxes.
Reflecting the progressive nature of the current system, income tax rates increase as taxpayers' incomes rise. Figures from 1995 show that individuals with adjusted gross incomes of over $200,000 accounted for 31 percent of the total income tax revenue from individuals, even though they accounted for only 1.1 percent of individual returns. By comparison, the 55 percent of individuals making under $25,000 contributed only 6 percent of the total.
In addition to salaries, interest and earnings on investments are taxed under the current system.
And there are a multitude of deductions and exemptions and credits. Some of the biggest and most cherished deductions in the current tax code are for interest on mortgage payments, medical expenses, state and local taxes, charitable donations and savings for retirement.
The federal government first levied the income tax in 1913, and the tax code has been modified many times since. One dramatic change in the last several decades has been the reduction in the top rate, paid by the richest Americans. In 1963, the top income tax rate was 91 percent. Currently, there are five tax rates, ranging from 15 percent to 39.6 percent. Most taxpayers are in the lowest bracket. The highest is for taxpayers with earnings over $250,000.
In spite of all the recent talk about tax reform, the changes in tax law passed in the summer of 1997 as part of the balanced-budget agreement were far from sweeping. Largely targeted at families, students, investors, homeowners, businesses and other special interests, they actually added to the voluminous internal revenue code. Tax rates on income from investments and inheritances were somewhat lowered.
Some of the proposals to change the tax system are fairly minor, but some call for major structural changes. A common rallying cry is simplification. The current tax code is by all accounts hideously complex.
Advocates say simplifying the rules would not only free people of the enormous effort it takes to file a return under the current system, it would also remove a slew of artificial incentives that they claim are putting a drag on the economy.
But predicting the economic effects of tax changes is difficult. In fact, the current system is so embedded that experts say uprooting it could have dramatic and unpredictable effects on all sorts of things, including the value of assets, salaries and benefits.
And although some alternative tax plans would be simpler in the long run, getting there would be complicated. Most supporters of tax reform acknowledge the need for phasing-in periods that could result in a confusing combination of the worst of both worlds.
In its purest form, a flat tax eliminates all loopholes and tax breaks, ends taxation of investment income, and puts everyone in the same tax bracket no matter how much they make.
Arguably, you could file your flat-tax return on a postcard: Wages times X percent, attach check.
A pure flat tax is inherently regressive, because the poor pay the same percentage of their income in taxes as the rich.
Not taxing investment income would eliminate the current "double taxation" faced by investors who pay taxes on their income, and then again when that income generates profits. That, too, would benefit the rich more than the poor. (A retired billionaire living solely off interest income, for instance, would pay no taxes at all.)
But the flat tax also eliminates all the existing loopholes and exemptions that the wealthy often use to lower their tax burdens. And advocates say there are ways to make the flat tax much more progressive for instance with a very large standard deduction.
The result, they say, would be a vastly simpler system that treats all taxpayers evenhandedly and increases the incentive to invest.
Two alternative tax systems being proposed sales taxes and VAT taxes are fundamentally different from income taxes. They're called consumption taxes.
The basic difference between an income tax and a consumption tax is that a consumption tax only taxes money when it is spent. (Income taxes, by contrast, tax all the money you earn including the amount you put away in your savings and the amount you get paid in interest.) Critics say the current system artificially increases the incentive to spend, while a consumption tax would encourage people to save and invest.
Sales Tax: Replacing the income tax with a national sales tax would entirely eliminate the need for individuals to file a tax form. (And, if the taxes were collected by the states, the need for the IRS as well.) The federal government would set a federal sales tax rate, and you would simply pay as you buy.
A straight sales tax is also the ultimate in regression. Advocates say there are ways to make it less hard on the poor, by exempting such essentials as food, medical care and housing from the sales tax or, alternately, giving everyone a substantial rebate every year.
But raising needed revenue in either of those circumstances might require an unpalatably high tax rate on what's left. On top of local and state taxes, a federal sales tax of 30 percent or more could make people nostalgic for their 1040 forms.
Critics also note that enforcement of sales taxes is notoriously difficult, and that a high tax rate would increase the temptation to cheat.
Another structural problem with the sales tax is the potential for double taxation or more as goods go through several owners on their way to the consumer market.
VAT Tax: The value-added tax, or VAT, is a form of sales tax used in more than 50 countries, including most major industrialized nations.
Unlike a traditional sales tax, which is imposed at the point of sale, a VAT is imposed on goods and services at each stage of the production process.
A business would pay a tax on the value it adds namely, its total sales minus its costs for raw materials, labor, and so on.
The end result, of course, remains that consumers pay the tax when they buy the product.
As with other consumption taxes, a VAT tax is regressive. As a percentage of income, the burden would fall much more heavily on the poor. But advocates say there are ways to fix the regressivity. Many European countries, for instance, exempt necessities such as food, housing and medical care from the VAT.
Most of the proposed tax overhauls are coming from Republicans and the right. But there is at least one significant alternative being proposed from the left. The "10 Percent Tax" would broaden the tax base, "flatten" the tax rates, and still maintain the progressive elements of the current system.
The plan espoused by House Minority Leader Richard A. Gephardt (D-Mo.) calls for the elimination of all credits and deductions save the mortgage interest deduction.
Under Gephardt's plan, most Americans would pay tax at a 10 percent rate, while there would be four higher tax rates, up to 34 percent, for the more wealthy. (See the Other Proposals section of the Resources and Links page.)
The only way to lower taxes without reducing spending is to broaden the tax base. The more income you tax, the lower the tax rate has to be to raise the same amount of revenue.
Eliminating tax breaks and loopholes is one way to do that. But consider that some of the biggest breaks are also some of the most popular: deductions for mortgage interest, state and local taxes, interest on municipal bonds and charitable contributions.
In fact, the recent trend has been to add tax breaks, as a way of creating incentives for such things as education and savings for retirement.
Every break and loophole has a constituency and Congress tends to respond to constituencies. So while most everyone likes the idea of broadening the tax base, doing so has turned out to be extremely difficult.
A frequent refrain among tax policy experts is that all proposals to change the tax system lose attractiveness the more closely you look at them.
Someone often the poor person inevitably gets hurt more than with the current system. And as soon as proponents start fiddling with their proposals say, to make them less regressive the result is tax rates so high that even some supporters gag.
IRS-bashing and tax-cutting undeniably win the hearts of a lot of voters. But polls also show a growing number of people who say they are actually willing to pay higher taxes if governments spend the money on things that really matter, such as education and roads.
Taxation has a long and complicated history in the United States. Resistance to unfair taxation was key to our becoming a nation in the first place. So it is not a surprise that our struggle with the question of what constitutes "fair" taxation continues.
Dan Froomkin can be reached at firstname.lastname@example.org
© Copyright 1998 The Washington Post Company