Most of our discussions of tax rates and tax fairness lack fundamental honesty because they ignore what people actually pay and why. Consider three married couples, each supported by one income earner. All three earn $60,000 in a year and after exemptions and deductions have taxable income of $50,000. The first, an entrepreneur or self-employed earner pays $15,791 in federal taxes or an effective rate of 26.3%. The second, an employee whose employer pays half of Medicare and Social Security premiums, pays only $11,201 in federal taxes or a rate of 18.7%. The third earns all income from capital gains and qualified dividends and pays federal taxes of $2,004 or 3.3%. This disparity never disappears. If we double all three incomes, to $120,000 total, and $100,000 taxable, the entrepreneur's real tax rate becomes 28.9%, the employee's 21.5% and the investor's becomes 7.9%
We have it exactly backwards. We love to talk about stimulating creativity and entrepreneurship, yet at their formative moment we tax entrepreneurs more severely than income from any other activity. We talk about our progressive tax structure but ignore the regressive nature of "social insurance" taxes that largely disappear on individual incomes over $117,000.
Some might claim that "social insurance" (Social Security and Medicare) taxes are really insurance premiums, but that is an absurd view. The "trust funds" are illusions. Surpluses of premiums over benefits in prior years have been "invested" in Treasury obligations. We call these "trust funds", but the Treasury has already spent the proceeds from the bonds for other government expenses. Social Security and Medicare now spend more on benefits than they collect in premiums each year, and are drawing down "reserves". When they do, they redeem the bonds, but the Treasury must then pay for the bonds with revenue from new bonds sold to others or from taxes. There are no real reserves. All benefits are paid for by current year government income or borrowing.
Nor are there contracts for benefit coverage. Regulators, not even elected officials, can and do change what Medicare will cover and at what rates it will pay. Similarly they change interpretations of disability and other Social Security regulations and payment schedules. Congress has and will again "tweak" the system by adjusting eligibility age, payment schedules and taxability of benefits. Any private insurance company attempting to sell "policies" without financial reserves or without contracts for benefits coverage would be deemed criminally fraudulent and its perpetrators would be jailed.
We have also deluded ourselves to believe that income from a persons labor is less valuable and should be taxed at a higher rate than returns on capital. This is also a regressive notion. By definition people with more wealth have more capital, and therefore a higher portion of their income is taxed at lower rates. How can we be impressed or surprised when Warren Buffett pays lower tax rates than his secretary? The highest possible tax rate for his capital gains and dividends is less than the effective rate paid by any of his employees earning less than $120,000 annually. What could be more regressive than that?
We compound the regressive structure of our taxes with complexity and deductions. People with capital gains income frequently get double deductions by donating long held appreciated assets to non-profit organizations. When they do, they pay no tax on the accumulated capital gain and take deductions from ordinary income for the fully appreciated value. This can result in a total tax savings (Federal and State) greater than 70% of the gift. Taxpayers with lower incomes, typically the 65% of taxpayers who do not itemize deductions, pay for this tax savings. The non-profit organizations chosen by the "donor" are funded through higher taxes we all pay. Similarly, people with larger homes and higher incomes get a multiplier on their local tax and mortgage interest deductions. They receive larger deductions from a higher tax rate. A taxpayer in the 35% bracket with a $1 million home saves nearly five times more in income taxes than a taxpayer in the 25% bracket with a $250,000 home. This savings is also paid for by the 65% of taxpayers who do not itemize deductions, including nearly 35% who do not own a home.
Lets be honest and admit that Social Security and Medicare are income transfer programs that are and by necessity must be paid for with current government income. Lets also recognize that our tax structure is not progressive as we claim. It is often regressive, causing many people with lower incomes to pay higher real tax rates than those with higher incomes. Lets also embrace the principle that a simple tax code with fewer deductions and shelters will reduce incentives and opportunities for cheating and the cost in time and money for all of us to prepare our tax returns. If we all admit and face these realities we can have a rational discussion about how to redesign our tax policy to balance our budget, stimulate economic growth and encourage progress up the economic ladder for all our citizens. Perhaps we could call the legislation the "Fair Tax and Free Time For CPAs Act of 2015.
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Michael Moffitt is the author of Granddad's Dictionary: Reflections on Life in America. In addition to being an author and grandfather, Michael Moffitt has been an inventor, entrepreneur and community leader. He received a bachelor's degree from Northwestern University and an M.B.A. from the University of Chicago.
Rather than accepting partisan stances, Moffitt encourages Americans to reflect on how they can come together as "We the People" to make real change happen. He believes that by coming together and looking to history and the values of our Founding Fathers, we can revitalize our nation.
I want to make a real difference in the way people think about the relationship between morality and politics and the need to focus on "We the People" versus the government and what it needs to do for me. "Granddad's" reflections is meant to inspire younger generations of Americans to think independently and rationally about events and trends in their country. I encourage readers to investigate current events and policies and come to their own conclusions through rational discussion and independent thinking, rather than letting others think for them.
"Granddad's Dictionary: Reflections on Life in America"
By: Michael Moffitt
ISBN: 978-1-4908-2916-6 (sc)
Published April 7, 2014