Although tax increases may be needed to help balance the budget, all reasonable options for cutting spending and growing the economy should be exhausted first.
Tax rate increases typically yield less “revenue” than expected due to changes in taxpayer behavior and drag effects on the economy. Moreover, proponents of the increases typically push for at least part of the additional revenue to be "invested" in new spending programs rather than used to balance the budget.
Polling has consistently shown that the majority of Americans prefer spending cuts to tax increases. A survey that SAFE conducted in September 2007 showed a 4-1 margin in favor of spending cuts. Does this mean the tax system should be kept as it is? No, because the current system has many problems, such as.
Excessive complexity - The Internal Revenue Code grows longer and more complex with every session of Congress. Just think of all the nonproductive effort to interpret and hopefully comply with its provisions (as supplemented by thousands of pages of IRS Regulations, Revenue Procedures, Revenue Rulings, etc.).
Erratic application – Due to the exemptions, deductions and credits that are available, over half of Americans pay more in Federal payroll taxes (to cover their Social Security and Medicare benefits) than in income taxes (to cover general costs of the Government). Indeed, many people pay negative income taxes (receive money back) due to the Earned Income Tax Credit and other “refundable” tax credits.
Double taxation – The earnings of large businesses are typically taxed twice, once at the corporate level and again when shareholders receive dividends or realize capital gains. second time (albeit in some cases at a reduced rate) when paid as dividends to shareholders.
Noncompliance – The Federal income tax has worked reasonably well over the years due to a high level of voluntary compliance. Given the foregoing problems, however, voluntary compliance is eroding.
Three options for overhauling the tax system seem worthy of consideration.
Option One: Flat Tax – In addition to overhauling the Internal Revenue Code (option one), replace the graduated tax rate table with a single tax rate (e.g., 17%). As a result of increasing personal exemptions, about half of the population would be removed from the tax rolls. As the result of the exemptions, the effective tax rate would vary from 0% to nearly 17% for very high earners.
Option 2: “FairTax” – Replace Federal income, payroll (and also self employment), corporate and death taxes with a Federal sales tax (“the FairTax”) levied at a rate (perhaps 23% of purchase amounts) designed to raise the same amount as the several taxes eliminated. To temper regressivity, consumers would receive, in equal monthly installments, an annualized FairTax rebate on poverty level (determined by the Government for the household size) expenditures. Thus, a worker who consumed the poverty level amount would pay zero tax.
Option Three: SimpleTax – A thorough overhaul of the current tax system to make it a vehicle to raise revenue vs. fostering social policy goals. Thus, for the individual income tax: broaden the tax base; repeal tax credits, Alternative Minimum Tax and most exemptions; eliminate double taxation of corporate income and marriage penalty for 2-earner households, reduce tax rates by 5+ percentage points at all income levels.
In our opinion, the SimpleTax is the best of these options. For detailed discussion, see SimpleTax, November 2010.