Analysis  

Why Tax Reforms Don't Reform

by David A. Welber, C.P.A.

Many people think a national sales tax or a flat tax would lighten the burden of government and quash the hated IRS. Fat chance.

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Our current system is an abomination. It consists of zillions of pages of legislation, kazillions of pages of regulations, revenue rulings, and court decisions. At the federal level, taxes are extracted by the IRS, which has broad powers, acts arbitrarily, and consists of a bureaucracy that combines heavy-handedness and bureaucratic ineptitude (don't they all?), against which most of us have no recourse because most administrative agencies often ignore courts. Everybody loves to hate the IRS, and with good reason.

But in spite of occasional caterwauling by grandstanding congressmen and senators, the IRS does exactly what it has been assigned to do by Congress — collect taxes. It is what columnist Joseph Sobran has called "the business end of government largess." If you get a check from the federal government, it has most likely been collected by the IRS.

The reason our system is such an abomination is that it combines revenue collection with social engineering, wealth redistribution, and mean-spirited revenge against those who have done well. Any tax code that raises huge amounts of money while also redistributing the wealth and punishing the wealthy and providing a mass of incentives, often at cross-purposes, is inevitably byzantine in its complexity.

Not surprisingly, an awful lot of people would like to replace the complicated and arbitrary tax code with one that is simpler and fairer. But simplifying the code is no simple matter. For one thing, the same people who have legislated our current tax system will have to enact any replacements for it, and they will be influenced by the same special interest groups and voters supporting them.

Two major alternatives have been proposed: a flat-rate income tax and a national sales tax. These sound quite simple in theory, but in practice they are anything but simple. And if they were enacted and implemented, the resulting system might very well be more complex and more arbitrary than the current system.

Let's look at these proposals.

Flat Income Tax

At current levels of federal expenditure, proponents say, any flat-rate tax would have to be somewhere between 17 and 21%. But, its advocates say, it would simplify taxes. Hah! With Congress generating the legislation? The idea that Congress can pass anything that is simple is pure fantasy. We've already had a flat-rate income tax, and recently. It was anything but simple.

In his 1985 State of the Union message, President Ronald Reagan proposed such a flat-rate tax. He proposed increasing exemptions to take millions of low income people off the tax rolls, while simplifying the tax code so that most people could file their income tax using a postcard-sized form. I began to fear for my livelihood as a CPA. Well, I had nothing to worry about. What happened? Congress got hold of it.

The theory was sound. Apply a flat rate of taxation to all income, disallowing as deductions and credits those items that are essentially used to shelter income from taxation. But, oh the practice. What Congress enacted was a tax law that contained more text than the previous three tax laws combined. Yes, we got a flat rate of taxation, but, because Congress refused to change its profligate spending habits, they had to pass a bill that was "revenue neutral." After debating these problems for almost two years, they arrived at a rate that had to be so high, 28%, that a lower rate, 15%, was applied to lower levels of income, in effect, creating a graduated flat tax. And, in order to prevent higher income taxpayers from benefiting from the lower levels of taxation for the lower levels of their income, a so-called bubble rate of 31% was inserted to phase out the benefit of the 15% bracket for higher income taxpayers. The intention was to have a flat rate of 28% for higher income taxpayers. As complicated as that sounds, it really could have worked, had the rest of the tax law not been written.

The act got rid of a lot of tax deductions, credits, and other tax benefits that we CPAs used to reduce our clients' taxes. But most tax benefits were not simply done away with. Only a few were repealed, such as the investment tax credit, or the General Utilities provision, which had protected corporations and their shareholders from double taxation upon liquidation. Most, however, were limited, reduced, or had conditions placed on them, requiring that these limitations, reductions, and conditions be computed after computing the tentative benefit. This so complicated tax return preparation that I have prepared every tax return by computer since this law went into effect. Because it takes more time to to prepare these computer-generated tax returns than it took to manually prepare returns before tax reform, the fees that I have had to charge my clients have increased dramatically.

As most of us in the tax preparation business had become cynical about tax legislation — and tax legislators — our predictions were that, with the tax benefits eliminated or reduced, the rates would soon start drifting higher. We did not have long to wait. The law had so many flaws in it that Congress passed two laws in quick succession to attempt to correct them — the Revenue Act of 1987 and the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), which were essentially what we have come to call "technical corrections" acts. While they did correct some of the errors, and some of the injustices, in the '86 act, they began the process of increasing the marginal tax rates, destroying the flat tax aspect.

The "bubble" rate, as we had predicted, became the top marginal rate. Then, in the Bush and Clinton tax increases of 1991 and 1993, the top rate was raised to 39.6%, purportedly to decrease the deficit, but actually to cover for the profligate spending ways of Congress. But the 39.6% rate does not tell it all. The real marginal rate is actually higher. Because of phase-outs of itemized deductions and personal exemptions for taxpayers with higher incomes, these deductions being reduced as income increases, the real top marginal rate may actually be as much as 3% higher. Even if one does not account for these hidden or marginal rates, the top rate is only 10% lower than it was before the flat tax was tried.

This illustrates the critical weakness in any flat tax — politicians write and pass the legislation, and they have powerful reasons to tinker with it constantly. Not only do they inevitably want to get more money from taxpayers, they also find tax-code tinkering to be a powerful incentive when it comes to fund-raising.

Don't get me wrong, I favor a tax rate that is the same for all taxpayers. I find no moral or constitutional justification for discrimination in taxation. No matter what its base — income, consumption, or sales — I think our tax rate should be flat.

So let's suppose Congress has the will, once again, to pass a flat-rate income tax. (I know, that's a very large supposition, but bear with me.) How do you define "income?" Income is easily defined, isn't it? Ask Enron about that. Whole forests have been leveled to provide paper for the text that defines income for tax purposes, and an equal number of trees have given their all to provide the Financial Accounting Standards Board (FASB) with enough paper to define income for accounting purposes, and both definitions are still works in progress, and, as Enron has shown, both definitions are easily manipulated.

Well, then, as some have demanded, why don't we just simply tax everything, all income, no deductions? Since a number of people actually believe that it can be done, I'll even dignify it with an answer — actually, with a question. What is income? Stupid question?

You work, you get paid. That's easy. Your pay is income. You get a W-2 form and report it as income. What about gifts? Are they income? Your father pays your college tuition. Is that income? "Only money you receive is income," you might reply. What if your parents give you money to help you buy a house? Is that income? If it is going to be treated as income, what happens if they buy the house and give it to you? Is that income? If so, what about that ugly tie your kids give you on Father's Day?

What if your boss provides you with lunch instead of making you pay for it with your taxed income. It's not money. But, shouldn't it be considered income? If not, your boss could help you avoid paying taxes entirely by paying you in kind, i.e., with the goods and services that you need. If only cash receipts were income, you could avoid taxes by bartering your goods and services for those of others.

What about the grocer down the street? He receives payment for his goods in cash. Is that all income? Should his tax be paid on his gross sales, while yours is paid on your wages? What about what he must pay the wholesaler for the groceries that he sells? Shouldn't his tax be figured on his gross margin? What assumptions should he use in determining his cost in his beginning and ending inventories so that he accurately deducts his cost of goods sold? What about those expenses that he must incur to operate his store, such as electricity, heat, water, trash disposal?

So, you still think a flat tax would be simple? I hope you see, now, that the graduated rates of taxation, while perhaps the most unfair part of the tax law, are, by no means, what complicates it. It is the definition of income that is the most complicated part of our income tax system. That will not change with a flat tax, and in fact did not change, except for the worse, when we actually tried a flat tax in 1986. And there will always need to be an agency — even if you scrap the IRS and call it the Federal Revenue Collection Agency (FRCA) — to enforce the tax law, collect the taxes, and to audit taxpayers to see if they have accurately reported their income and paid their tax.

National Sales Tax

Okay, let's forget the flat tax. Let's consider a national sales tax, to be collected by retailers and forwarded to the appropriate government taxing agency, after withholding a percentage as compensation for the retailer's efforts. With a national sales tax, assuming that it replaces our income tax system rather than merely supplementing it, you would never again be required to fill out one of those hated income tax returns. Right?

Not so fast!

Most states still have an income tax, many requiring the completion of a tax return. My state, Pennsylvania, even authorizes municipalities and school districts to collect taxes based on earned income and net profits. Some states base their taxes on federal taxable income, while others collect taxes that are a defined percentage of the federal income tax. Pennsylvania creates its own definitions of income, requiring the filing of a state tax return that starts from scratch and adds up income as defined by Pennsylvania personal income tax laws. In all of these cases, any abolition of federal income taxes would not completely abolish the need to file annual income tax returns, unless . . .

The federal sales tax legislation could force or entice the states to abolish their income taxes and to replace them with a sales tax that integrates with the federal sales tax system. One proposal even has the states being forced or enticed into collecting and enforcing the national sales tax, with the state tax piggybacked onto the federal tax. I see a real Tenth Amendment problem with that, but what the heck? What's a constitutional right when we're talking about taxes? If the states don't comply, proponents propose to authorize a neighboring state to go in and collect the tax. I can envision national guard troops and state police of non-complying states clashing with those of tax-collecting states to protect their citizens from foreign tax collectors.

Then there is Social Security. Revenue for Social Security and Medicare benefits, at least on paper, is provided by a tax collected from employers, and a self-employment tax collected from self-employed taxpayers when they pay their income tax. Half of the tax collected from employers is withheld from employees, half is paid by the employers. Then the U.S. Treasury gives the Social Security Administration bonds in the amount of any current surplus so that the general fund can continue to spend more than it takes in. One of the benefits claimed by the proponents of a national sales tax is that it would abolish employer withholding of taxes, which effectively hides the magnitude of the taxation from the taxpayers. That won't happen, unless Social Security is abolished (my choice!) or financed by some other method.

National sales tax proponents propose to replace the revenue from Social Security and Medicare taxes with revenue from the sales tax. But, how much should be credited to Social Security and Medicare? There's the rub. Social Security taxes, and accrued benefits, are based on income as defined by Social Security — mostly personal service income. How would Social Security and Medicare know the benefits to accrue, and how much to claim from general revenues? It's simple. You would have to report to them manually. I don't know about you, but to me this smells suspiciously like a tax return.

It gets worse. The hated IRS, and its audits, would be abolished, or so crow the proponents of the national sales tax. But, if you are required to file an annual report to the Social Security Administration, who is to verify the accuracy of those reports? As benefits are based on lifetime income, participants will have strong motivations to show as much income as possible. Those among us of deficient character will even find it in their hearts to cheat — to overstate income, understate expenses, and report non-reportable income, such as rent, interest, or dividends. Someone will have to check the accuracy of the annual reports, correct errors, and punish deliberate offenders. This smells to me like (choke, gasp) an audit.

Furthermore, no matter what the rate of taxation, there will be those who will cheat. Merchants will try to get a leg up on the competition by not collecting the tax from some of their cash customers, or by not remitting all that they have collected, or by interpreting the law in such a way as to make their business tax-free. There will be customers who will try to get out of paying the tax, and there will be a black market, a thriving underground economy dealing in all commodities at the retail level to avoid the paying of the sales tax. How do I know this would happen? Because it already exists in states and nations that tax transfers of ownership of personal property. Businesses try to be classified as wholesale, purchasers try to convince retailers that they are also retailers or manufacturers, cash transactions take place, buyers purchase from out of state, cigarettes are smuggled from North Carolina to New York, booze is smuggled from Maryland into Pennsylvania, buyers and sellers wink and exchange goods for cash, or goods for goods, all to avoid the tax. With the addition of a national retail sales tax, there will be an even greater incentive, on a greater array of products, for all sorts of tax avoidance schemes. No matter what other taxes are eliminated, no matter how low the rate, there will always be people who will try to avoid paying. For lower income people, it may become a matter of survival to avoid paying the sales tax on such necessities as milk and bread.

The point here is that, even if this sort of thing does not happen very frequently, the government tax collectors will want to root it out. This will motivate them to (choke, gasp) audit. They will audit sellers of merchandise to make sure that all retail sales are taxed, that wholesale transactions are not retail, that all taxes collected are remitted. But, as there are ways of beating auditors, such as cash transactions, they will need to go further into the records of the businesses, and the lifestyles of the owners, to make sure that they are not hiding untaxed transactions. At some point, they will be invading private homes, perhaps at random, demanding to see the receipts for all purchases made to see if people have paid the tax on all purchases. We may find ourselves getting nostalgic for the good old days of IRS audits.

Then there is the claim that a national sales tax would be simpler. There are two problems with this. First, any tax system that has been around a long time will get complicated. There will be legislative revisions, regulations, and court decisions, none of which is ever simple. This is what has happened to the Internal Revenue Code.

Second, sales tax laws are not particularly simple. I have extensive experience with the sales tax enforced by Pennsylvania, my home state. Let me assure you, it is far from simple.

People will try to avoid paying the tax. Some will cheat as I have described above. Still others will try to get their particular transactions legislated, regulated, or adjudicated to be tax free. In Pennsylvania, taxable commodities are taxed only if sold to the ultimate user, and whole forests have been leveled in describing who is and who is not the ultimate user. In any retail tax system, as many people as possible will want their transactions to be classified as wholesale.

Then there are specific use and organizational exemptions. Machinery used in manufacturing is exempted from Pennsylvania sales tax. Government agencies and jurisdictions are exempt, as well as religious institutions and charities. Therefore, there is a whole body of legislation, regulation, and adjudication defining what constitutes manufacturing and what does not, what constitutes government, what constitutes charity. And there are audits to make sure that the rules are being followed.

Pennsylvania does not tax all retail transactions. Goods that are classified as necessities are not taxed. Food and clothing are exempt, but not all food and not all clothing. Groceries are exempt, but not all groceries. There is a category of groceries that is not exempt, while food that is sold by an eating establishment is taxable, unless it is a grocery type of item that is sold in a separate grocery department. Clothing is tax exempt, but there are categories of clothing that are taxed.

Originally, services were exempt. In 1991, facing a huge budget deficit, Pennsylvania added some services to the list of taxable retail transactions, but not all services. Accounting and legal services were exempted at the last minute as a result of intense lobbying by the accountants and attorneys. However, data processing services were included, and accounting firms had to keep their billings for such services separate from their accounting, consulting, and tax services so that they could collect and pay taxes on the taxable services. Temp agencies found their services taxed in the new law, but were later able to have that reduced to include only their profit above and beyond the part paid to employees and payroll taxes.

This is only a cursory explanation of parts of Pennsylvania's sales and use tax, but it makes my point. No matter what the rate of taxation, no matter how much it reduces price levels or creates general prosperity, there will be people who do not want to pay it, or consider themselves too poor to be able to afford it. There will always be people who will arrange their affairs so as to reduce their level of taxation.

And so long as the tax code is written by politicians, some people will band together into special interest groups to reduce or eliminate the taxes they pay. There will always be people who think they are paying too much, and there will always be politicians who see political advantages in paying attention to them. As a result, there will be exempt transactions and exempt items, and whole volumes of text describing the exempt transactions and commodities.

First to be exempted will be government agencies. Then religious institutions will claim a First Amendment exemption. Then poverty pimps, aided by the food industry, will get certain categories of groceries exempted as "necessities." And there goes your simplicity. I predict that every year, new categories will be made exempt. Soon, the national sales tax will be every bit as complicated as the current income tax is.

One claim by the proponents of this tax is that it will be more visible than the current system, in which taxes are withheld at the source, and are never seen by the taxpayers, who see net pay, rather than gross pay as their real income, and what they don't see they don't miss. As a result of this new visibility, proponents claim, people will begin demanding lower levels of government expenditure so that their taxes will be lower, and I cannot deny that some will do that. But in the 2000 election, half of the voters cast their ballots for Gore for president because he promised to steal from the other half. We can never discount the kleptomaniac vote. People will simply not give up their government check in exchange for lower taxes. Rather they will vote for politicians who promise to shift the burden to others.

As with the flat-rate income tax, I cannot outright condemn a flat-rate retail sales tax as a viable replacement for our current abomination. But I want people to realize that it will not, as promised by its proponents, eliminate most of the problems inherent in our current system: we will still have an intrusive enforcement and collection agency and extensive audits by that agency; we will still have most of the complexity; and we will still have high taxes.

Until the government substantially reduces its levels of expenditure, there will not ever be an acceptable tax rate or collection system.

As Milton Friedman has observed, because government has no resources of its own, produces nothing, and creates no wealth, every expenditure it makes is, by its nature, a tax. It can be paid by taxes that are collected directly from taxpayers. Or by borrowing money, thereby taxing future taxpayers. Or by inflation, by creating new money to fund a deficit, which reduces the value of the currency held by everyone.

The only tax reform that will genuinely address the problems that proponents of the flat tax and of a national sales tax seek is to reduce taxes substantially, which requires reducing government spending substantially.

Politicians and bureaucrats, who have a taste for controlling the behavior of others, who maintain their power by lassoing ever more people into dependency on government expenditures, and who are able to convince large constituencies that they cannot live without government subsidies, or that nothing good ever happens without the government forcing it, will never approve any meaningful tax reform. As long as voters are willing to to demand government subsidies for themselves, while demanding that someone else be made to pay for it, as long as people demand that the government expend resources to control the behavior of others, as long as voters do not consistently, and persistently, vote for politicians who return the government to its constitutional boundaries, not very much will change in tax collections. In fact, until government is returned to its constitutional boundaries, there will be no tax system that will satisfy anybody. Given recent performances by politicians, bureaucrats, and, especially, voters, I'm not optimistic.

© Copyright 2008, Liberty Foundation

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