Deep in the Heart of Taxes

My 2011 W-2 statement has arrived on the day Mitt Romney recollects his effective tax rate is “probably” 15% (those darn decimals).  So with nothing better to do, I poked around the IRS “taxstats” web-page to find a humongous spreadsheet—Publication 1304, Table 1.2—which I downloaded in order to mangle for my own curiosity.

So many big numbers, where do I start?  Well for one thing, the rows in table 1.2 are arranged by Adjusted Gross Income (AGI) from “zero” to “over $10,000,000.”  Each of these brackets appears twice in the first column: once for those who had taxable income, and a second time for those who didn’t.  Now I had read/heard (dreamt?) that 43% of those who filed returns had paid no taxes.  My downloaded Publication 1304 (for the 2009 tax year) indicated that of the 140.5 million returns filled (individual & joint lumped together here), 81.9 million are defined as “taxable returns” and 58.6 million are listed as “non-taxable returns.”  Mitt, if you’re reading this: 58.6/140.5 = 0.417 (42%).

Who are these guys?  As we might expect, many are lower income folk—but not as many as I would have thought.  Of the 59 million filings with an AGI of $20K or less, only 10 million (17%) are in the “non-taxable” bin.  More curious is that while the mean AGI for the taxable group in this bracket is a meager $5.6K, for the non-taxable returns the mean AGI is $13.4K.

Once we move into the “middle class” and higher, the taxable/non-taxable return numbers split about 50-50: in the $50-$100K bracket, 47.6% pay no taxes; above $100K it’s 49.8%.  And within each bracket the mean AGI for the TR and NTR cohorts are nearly identical: $70.9K and $71.7K respectively, for example, in the $50-$100K bracket.  I am trying to imagine the circumstances that separate two filings near the mean of $70K AGI where one delivers $5800 (the mean tax for this cohort) to the federal coffers and the other none.  I suppose there are circumstances of exorbitant property taxes and unfortunate medical expenses for blind, over 65 with 10 kids households that would absolve some, but 50% of the filings?  This phenomena repeats at all levels above $100K where, at the over $1MM level (mean AGI $3.06MM) the taxable half fork over an average of $750K-plus while 235,000 of their brethren nada.

My Turbo-Tax© summary includes a statement of “Effective Rate.”  It’s easy to figure out where that number comes from.  It’s Total Tax/AGI (for me in 2009, 10.52%) and that includes payroll taxes, which are not part of this discussion and it is unclear whether they are included in the downloaded Table 2.1.  For the tax-paying cohorts in Table 1.2, the Effective Rates (mean Tax/mean AGI ratios) are 8.1%, 15.8% and 24.6% respectively for the $50K-$100K, $100K-$1MM, and over-$1MM brackets.  If Mitt were in that middle group, no prob.

The point is that a debate over tax rates is a sideshow when a byzantine tax code allows 43% of 1040 filers to pay any (pick one) percentage of nothing regardless of adjusted gross income.  Whether the Bush tax cuts for the over-$250K crowd are rescinded or not (the present 33% and 35% marginal rates would return to the pre-2001 36% and 39.5% levels), the conundrum of “fairness” remains.  Sure revenues would increase, as would the burden on (half of) the “rich.” The raising of effective rate for your $1MM earner would increase from 16% to 18.5%- (double those %’s if based on post-deduction income rather than AGI) will undoubtedly be unsatisfying to some and infuriating (another $50K to Uncle Sam) to others depending on who’s “we” and who’s “they.”

My feeling is that simplicity is a larger component of “fairness” than any array of percentages.  I could have used the trendy “transparency” label for that component, but I always find myself wondering whether something transparent is visible or invisible.  I suppose if it refers to the container and not the contents it would be a better descriptor. 

My simple fantasy, as in “imagination esp. when extravagant and unrestrained,” is as follows:

Tax the AGI directly in some schedule of progressive rates.

Those rates should be determined at the end of some reform process, not direct it.  Most simple, of course, would be a flat rate, but here fairness and simplicity would only correlate if the percentage of disposable income required for subsistence were flat as well.  We know that isn’t the case—there must be a progressive rate schedule. 

I would favor more “brackets” than less.  In fact, a rate formula (effective rate as a function of AGI) that is smooth (i.e. without break points) intrigues me greatly.  I can hear the mockery at an infinite set of tax brackets, which would be literally true for a “continuously differentiable” (as my mathematician son would say) function.  Jot down the AGI and compute electronically or look up manually the tax rate & amount.  Would it be that simple—it isn’t.

But there could be a family of functions (columns in a table if you like) each reflecting a filing status (individual/joint) and family size, etc.  And with the (non-linear) rate curves starting out very low, everyone with a positive AGI would contribute even if it were a pittance.  A rate of, say, 0.1% at $20K is 4 bucks a week.  Then as rates rise more steeply with increased AGI before flattening at some maximum rate, there would be no need for standard (.i.e. subsistence) deductions. 

Most importantly, almost all income regardless of source (wages, dividends, capital gains, etc.) would be treated equally as addends to the AGI sum.  Together with universal contribution, equating the fruits of pushing paper with those of shoveling road gravel (& elimination of the “Buffet complaint”—“carried interest”) would go a long way to establish an air of fairness.  There is some logic to treating truly long-term capital gains differently (selling your home upon retirement, etc.), but perhaps even that and other windfalls could be addressed through some income-averaging scheme.

Encourage long-term savings.

The A (Adjusted) in AGI implies not every dollar earned is counted.  IRA’s and the like are the obvious examples of “above the line deductions” (above the AGI line on the tax form), but I would like to create a temporary vocabulary that distinguishes “exclusions” (income not spent and/or not immediately available to spend) with “deductions” (earned income spent, or assumed to be spent in some specific way).

Deferring taxation on retirement annuities until withdrawal at some prescribed age still makes sense as long as these exclusions are capped at some dollar amount or percentage of gross, whichever is lower (higher?).  Without getting into the healthcare quagmire, I would likewise encourage capped, Health Savings Account exclusions.  Withdrawals from HSA’s applied to legitimate medical costs, including preventive health maintenance might even be deemed non-taxable. And coupled with relatively inexpensive, high-deductable, catastrophic medical insurance might even allow the market competition to temper medical cost inflations.  Education Savings Accounts?  Maybe; let’s discuss.

Eliminate all deductions, carefully replacing the most worthy with a limited number of tax credits at a fixed rate.

The concept of allowable deductions for income spent for the benefit of others (e.g. charities), society at-large (e.g. local taxes), or enhancing the overall economy (e.g. mortgage interest—assuming home ownership is nationally beneficial) has a noble history.  The problem with a deduction scheme is that it is regressive, rewarding “noble” spending disproportionately for the wealthy. 

Putting $20/week in the collection plate or writing a $1000 check to Doctors Without Borders reduces the contribution to national revenue of those in the 35% bracket by $350, while the exact same largess—presumably the identical societal benefit—offsets only $100 to a taxpayer in the 10% bracket.  Instead, define a set of voluntary, socially beneficial, income disposal categories (capped as per the exclusions above) and give a tax credit at the national median AGI tax rate to any and all for their contributions.

Once a template for exclusion and credit categories is fleshed out—the caveat being that today’s incentives are tomorrow’s loopholes—then, and only then, devise the tax rate equations.  Applying candidates across historical AGI data, income tax revenue can be projected as the equation parameters are tweaked. 

And there’s this big question: chicken or egg?  Do we define an equitable set of tithes for the common good and then optimize the good that can be supported from that revenue? Or, do we document exactly what we need to do communally and determine the tax base demanded by our societal needs?  Right now we do neither.

 

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