The Naked Truth About and Income Taxes and Income Tax Reform

by Dean Peters

Personal income tax is like a wart. It is there but we only discuss it with specialists. Like a man who develops hemorrhoids, only he and his proctologist know. But 2008 is an election year, the filing deadline is just a few weeks passed, and Wesley Snipes will be enjoying jail food from now until the election begins anew sometime in late 2010. In the spirit of the season and in memory of Wesley Snipes this is a good to time reflect on our American tax system and its future.

In 1053 AD, Leofric of Mercia was well into his governance of the small city of Coventry, England. In his zeal to promote public works he taxed everything imaginable including manure. His wife, the Lady Godiva, complained to him that his excessive taxation caused the citizens to work all day such that they had no time to reflect on and appreciate art, philosophy and the teachings of the Church. Leofric thought her somewhat daft but he humored his wife. He explained and she concurred that if the human body was made by God then it was the highest form of art. He said if she would ride completely nude through the market at its busiest hour then the citizens could experience art, philosophy and God through her. Also, he assured her that if she did he would indeed suspend taxes on all but horses for one year. Leofric was certain she would not. But, the very next day, the Lady Godiva, escorted on either side by fully clad chamber maids, rode through the noonday market of Coventry wearing nothing but her regal smile. It matters not that the Lady’s ride was more for the support of art and culture than tax protest - she did it and Leofric kept his word.

Now what does this bit of history have to do with income tax reform in 2008? Simply this; to get real tax reform the White House and the Congress would have agree philosophically then propose a dare between them. Philosophically, they might both agree that America needs a rational approach to taxation and budget that builds the economy, strengthens the dollar and dissolves the treasury debt. Then, Congress could dare the President to always submit a balanced budget. In return, the President could dare Congress to pass a flat income tax. No, I am not on medication but I am definitely dreaming here. But I’m not the only one.

There has been a lot of debate during this campaign for President about tax reform. As much as I love paying taxes, the word “reform” makes me simply ooze with delight. Of course the Democrats want to roll back the President Bush tax cuts, which is funny because I never noticed any tax cuts to begin with. Republicans, well, they definitely have a biggest wish list. Almost every candidate (except for the one with the dang nomination) proposed some variety of flat tax and running the IRS out of town.

But if you are voting based on any candidate’s tax plan you are wasting your time. Neither the President nor the US Senate sets tax policy. Why? The First Amendment gives that privilege and power solely to the US House of Representatives. That was fine for the first 100 years of our existence as a nation but by 1890 Congress had a country to support and a bureaucracy to rear. Excise taxes were not enough to build roads, fight wars, and pay pensions. When they did attempt to place taxes on the booming corporations formed out of the Industrial Revolution, they got their hands slapped badly. Congress needed the passage of the 16^th Amendment to the Constitution in 1913. These 31 words approved by two-thirds of the States made it legal for Congress to tax everything that generates income (even manure). It’s such a simple amendment:

“The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

And it poses such a simple question:

“What in the hell were we thinking to give that much power to Congress back then?”

The answer is right there in the 1895 case of Pollock v. Farmers’ Loan and Trust Co. The Supreme Court held that the 1894 law for a national income tax was unconstitutional because it was a direct tax - a power that only the States had under the Constitution. A direct tax stays in the place from where it is collected. Congress sought to collect the tax and use the resources elsewhere. In those days, the government was not supposed to keep the money, instead they redistributed back to the States through apportionment – shares of revenue based on congressional representation. Adding to the complexity, corporations at that time operated across State lines and overseas. The corporations claimed that taxation of their income should only be governed by the rules of the place in which the income was produced or from where they were based depending on which approach cost them less.

In Pollock v. Farmers’ Loan and Trust Company the government tried to prove that a capital asset, like a property bond, had a cash equivalent that made it taxable if it had grown in value. The Supreme Court ruled that a capital asset was simply a piece of paper that had no taxable value until redeemed. Capital assets were a necessity of business but until actual conversion, no income was lost or created by the trading of these kinds of assets. By 1913 capitalism was working a little to well. It was the era of the monopoly busting and fair work and trade laws. The common wage earner in 1913 believed the big corporations were using the findings of this case above to avoid taxation. Thus they whole-heartedly supported those 31 words in the 16^th amendment.

In the 95 yeas since, the 16^th amendment had two far-reaching affects. Congress learned to distribute funds from income taxes in many new and creative ways. Congress is allowed to collect income taxes from any income source, no matter how much pretzel logic is required, from all US citizens and companies in the United States and abroad. This first affect has resulted in the United States of Entitlements and Earmarks (also called U-See!). The later affect is where the problems with income tax administration come into play. Since 1913 those 31 words grew to become the US Tax Code, a document that is somewhere between 44,000 and 60,000 pages (depending on the font used). At least 60,000 (although there are no hard numbers on this one) IRS employees work year round managing the interpretation and enforcement of the Code. This is the equivalent of two armies of clerks to oversee a regulatory forest that is largely dedicated to plugging tax schemes and making sense of new loopholes. In this way, the Code is very comparable to Microsoft Windows operating systems.

The vast majority of Americans exchange their services to an employer for monetary compensation - regardless whether this exchange is profitable or not. A portion of that compensation is kept from them and placed into a non-interest bearing account held by the US Treasury. At the end of the calendar year, all who have received income must justify their poverty to the government in the hope of getting back some of those withheld funds. The government makes available to Americans a variety of tax estimation and tax credit forms that somehow express what the House of Representatives intended. Each individual wage earner invests time and expenses to complete these forms to the best of their ability. Each wage earner confident in their knowledge of the forms and righteous expenses believes they are due some of that withholding. The US Internal Revenue Service, who are employed to understand the mind of the House of Representatives better than individual Americans, review these forms with computer efficiency and reports back to the individuals about six-weeks later. Shock and awe ensue. The IRS discovers all oversights (never the under sights), omissions, errata and goofy deductions. Hope is dashed by the demand for $340.16 of additional taxes – “please pay immediately.”

It is even worse for corporations. Without boring the reader to death, it takes a corporation three years to fill out last year’s income tax return. Corporations also get taxed twice. Once when they declare a profit was made. Then the shareholders who get those profits distributed to them as dividends and perhaps more stock, that income is taxed again. That is a 50% tax on the very organizations that create wealth and jobs for Americans. This does not sound like a country whose strength is in its capitalism. As a result corporations hire their own armies of CPA’s and lawyer-lobbyists and deploy every avenue possible to avoid the appearance of being profitable. It is a fine line to walk that balances the need to grow shareholder wealth on one side, keep a business running and growing in the middle, and deflects income taxes on the other side. This is not capitalism. This is madness.

The Tax Foundation estimates that tax payers in the United States spend $203 billion per year paying CPAs and administering the IRS.

Dick Armey, former Speaker of the House wrote in his USA Today editorial that Americans spend 6.2 billion hours just filling out their tax forms.

The IRS offers 1,116 tax forms on its 2008 web site (tax years 2006 – 2007).

Income taxes collected from private citizens are five times that collected from businesses.

The total amount of U.S. Treasury debt increased 70% over the past 10 years:

• On April 26 2008 the Treasury debt stood at $9,333,202,141,247.10
• Ten Years ago on this same date this debt was $5,505,293,755,428.21

Whatever is going on, costs too much, causes capital flight, and it is not working! It is time to do something before we are all left naked and broken by the outcomes of the 16^th amendment.

Back in 1994 during the “Contract with America” years a number of Republicans touted the advantages of a flat income tax for individuals and businesses. Some even made it into a bill that went to the House of Representatives but all of them died by 1997. The concepts behind flat tax proposals can in part be attributed to a 1983 book by two Stanford University economists Robert Hall and Alvin Rabushka entitled Low Tax, Simple Tax, Flat Tax. Having reviewed all the plans and the gist of a recent speech by Mr. Rabushka, a flat tax can be summed up as follows:

“People, not businesses, pay taxes.”

It sounds incredibly far-fetched, impossible; ridiculous even. But the fundamental economic logic is there. While there are varieties of flat tax plans they all follow this distinct concept:

1. Establish a base income amount. Any person who does not earn over this amount would not pay any income tax. This amount will become the standard deduction for all other persons that earn income. Most proposals have concluded that this amount should be between $13,000 and $17,000 annual income. In a household where both spouses work, the total standard deduction would be $26,000 (assuming the lower base income amount).

2. Do away with the IRS Form 1040 Schedule A completely. The only other deductions then allowable would be those established by the House of Representatives to promote US economic policy as history dictates. Presently that would include expenses for higher education, contributions to retirement savings accounts, and tax waivers for Americans serving overseas in the military or as ex-patriot employees. Eliminate the AMT, earned income credit, and all other deductions. The result would be a tax form that is less than one letter-sized page in length.

3. Establish the flat tax rate for all income earned above the standard deduction and those deductions that promote US policy. Eliminate the progressive tax. Most flat-tax proposals and studies conducted by the US Treasury estimate this rate to be 17% to 21% (the US Treasury opts for the higher rate). This rate is fixed for all sources of income including capital gains regardless what the total amount of income is.

4. All benefits provided by an employer (or a business owner for himself) become taxable and include insurance, social security payments, other forms of compensation including personal use of cars, properties or any other assets not explicitly used for business purposes including entertainment.

5. Eliminate all deductions and income tax for wholly-owned businesses and corporations registered in the United States. Foreign-owned companies will be subject to US income tax.

6. U.S. Excise taxes for various trust funds will remain in effect but will not be deductible. The House of Representatives retains the authority to set excise taxes as it sees fit but must apportion these back to the States.

The impact of these six building blocks for a richer America will have no tax impact on the majority of wage earners in America. In fact, for those in the lower income brackets, taxes will decrease. Households with income between $80,000 and $200,000 will be the hardest hit. For one household that earned $91,500 in 2007, their flat-tax of 17% would have increased their tax burden by $600; just $50 per month.

But now that businesses no longer need to deduct or pay income tax, what will these do with extra money earned from the savings? What about the rich and the wealthy that see their tax burden fall by 50%? They will use that money to make more money (and pay more taxes). More importantly, when the corporations and the rich in America have more money available they will act to:

Benefit Citizens:

• Create a flood of investment in America that can be used to revitalize the lives and cities of the rust belt and economic loss centers;
• Improve the standard of living for all Americans making the cost of safety and security come down;
• Bring back long lost benefits like sick leave, long-term employment opportunities, and pensions;
• Reduce the need for entitlements because more Americans will be able to find decent work at a decent pay in a much more broad-based economy.

Benefit the Nation’s Security:

• Invest in business growth with profits rather than borrowed funds;
• Invest in new research avenues and invigorate the Spirit of Yankee Know-how;
• Keep US dollars at home instead of hiding them abroad;
• Cause the value of the dollar to strengthen and reduce US susceptibility to economic warfare.

Benefit the Morale and Management of the Nations Resources and Posterity:

• Improve the ethical conduct of business managers and boards of directors who will stop looking at ways of avoiding taxes and focusing on building shareholder wealth;
• This last affect will cause all Americans to invest in America again and make American a beacon of what is good about capitalism.
Is this a fairy tale? Hardly! Out of the chaos of the fall of communism, Russia and other former soviet states like Estonia and Czechoslovakia adopted a flat tax method. Since enactment of a 13 percent flat income tax, Russians are actually paying their taxes. There are no more tax forms to fill out and the ruble has increased in value by 28%. According to the Adam Smith Institute, a flat tax helps the poor by eliminating their taxes and encourages the rich to pay up. Rather than spending their money trying to avoid taxes, it’s cheaper for the rich to just pay what’s due and instead focus on making more money.