In Part One of this series, I updated several “quick hit” actions a Biden Administration could take to restore some measure of sanity to the U.S. tax system. In this part, I want to update my four basic principles for a fairer, simpler, and more effective federal income taxing system. I believe these principles also to be legislatively achievable. But first, a little story:
In the late 1990s, before moving to England, I was managing editor for the largest-selling series of university tax texts and software. One of the authors on that series, a leading professor in the field, liked to tell us that, “The thing about the U. S. tax code is that you always need more intelligence to do your own taxes than it requires to do your day job.” And, he said, “This includes me.”
“Intelligence” is probably not the word I would use here; it is more like arcane information that is otherwise quite useless. Odd exceptions to rules, complex “if:then” calculations, an unanswerable yes/no question. By this second definition I would include myself as well. It is a long-standing myth that the rigorous CPA qualification examinations primarily measure tax knowledge. They do not. Nor does publishing tax books, and I am proof of both. I have spent many an hour cursing at my tax software for asking for information that I do not have, and which likely will not change my ending tax balance by one dollar.
My key tax law reform proposals are aimed at reducing this “arcane information factor” in the U.S. tax code for the overwhelming majority of taxpayers.
Principle #1 – The vast majority of “tax expenditures” are special interest favors that muck up the system and make it more unfair.
I discussed this a bit in Part One. Tax expenditures are any deductions, credits, special calculations, and other exceptions that reduce the taxes for one taxpayer and thus shift the burden to the remaining taxpayers. We know the popular ones, like the mortgage interest deduction, but most of them (and even that one) are the result of political favors more than any “moral equity” adjustment or even rational math correction. We are talking $1.3 trillion annually in “favors,” at least a third coming from hundreds of rules benefiting only handfuls of taxpayers each.
Another way to state this basic principle is that “The rest of us should not have to pay your taxes.” Indeed, many pages, perhaps most pages, of the U.S. tax code originate from language slipped into closed Congressional committee sessions, often written by lobbyists specifically for favored taxpayer clients. They pay less, and the math says that the rest of us must then pay more as a result.
My longstanding recommendation is to create a bipartisan “Tax Realignment and Closure Commission” on the order of the old military base closure commissions. Starting at some rating measure and working up, say, 1-in-10,000 taxpayers who benefit, every special deduction, credit and exception gets designated for sunset, and can only be resurrected by Congressional super-majority.
Most of these rules, I contend, would die with public airing. Hundreds of special favors, thousands of pages of tax code, and numerous annoying tax software questions GONE, just like that. Millions of taxpayers benefit and billions in cash come into federal coffers.
Potential benefit: Up to one-half trillion dollars of new revenue annually, which is the effect of the bottom 80% of tax expenditures in terms of quantity. Many thousands of pages in the U.S. tax code would be eliminated, with a resultant major simplification of tax compliance.
Principle #2 – Income is income.
The literal definition of income from that market-leading textbook noted above is quite simple: Income is an increase in wealth that has been realized. “Realized” means that a financial transaction nailing down “wealth value” in cash terms has occurred, such as the receipt of a paycheck or a dividend. 
Like deductions and credits, this basic definition of “income” has been so cobbled up by special interest exceptions over the decades that we have lost this basic, elegant principle: If it makes you wealthier and we can measure it, then it is income. What makes, for example, “carried interest,” an artificial construction by tax lobbyists for the benefit of private equity and hedge fund managers, so special that it is assessed a lower tax rate than labor income? Mitt Romney got very rich through carried interest without getting his hands dirty and was rewarded by you with a much lower tax bill. Carried interest is an increase in wealth, and it is measurable. It is income. Full stop.
Carried interest is a particularly odious example of special interest, but there are dozens, if not hundreds more like it buried in the tax code. They should all also be subject to sunset and re-evaluation by the same “Tax Alignment Commission” criteria that I outlined above.
Clearly, reality can get more complicated than the simple textbook definition of income. However, the special interests must get cleared away in order to get back to some supportable expert consensus on incremental wealth measurement. Get rid of most of this inequality of income treatment and then watch tax assessment/compliance become much simpler. Not to mention the crashing of complex investment strategies for re-categorizing income into a favored classifications.
In dollar terms, long-term capital gains are the largest recipients of “rich man’s favoritism” in this category. Long-term capital gains already have a natural benefit to the holder in the form of the time value of money. You may have been depreciating a building, for instance, but it has really been growing in worth, and all of that growth in your personal wealth has remained untaxed for years. And when you finally do sell it, the lower tax rate on this type of income increases your wealth even further.
Really rich people can structure most of their income as capital gains if they want to. Here is their plea: “Woe is me! The asset I invested in doubled in value while I was sitting on my behind, and now you want to tax my good fortune. How unfair!”
Regular homeowners sometimes benefit from this tax break, which is a common “piece of candy” used by lobbyists to garner broader support. But the huge benefits here go to the most wealthy. If the issue here is protecting “ordinary folks” from house price inflation, well, there are simpler and more effective ways to address this than to “make the really rich much richer” in the process.
Potential benefit: More taxes collected from the most egregious and wealthy avoiders of income taxes. Also, the dismantling of many unauditable “tax shelters” designed solely to reclassify income.
Principle #3 – Labor income should not be treated as inferior to capital income.
This is really subsumed under the prior principle, but it deserves flagging on its own. The rise in income inequality over the past 30 years can be primarily attributed to the growing gap between earners of labor income versus earners of capital income, ballooned several times by the “time value” of that added wealth. A diversified investment in the S&P 500 has increased in value by about 7% compounded annually after inflation over the last several decades, at least doubling every ten years. Labor income has grown at less than half that rate. And that is primarily where “income inequality” has come from.
You do not have to be a Marxist to recognize how the biggest holders of capital, in the name of “sacred capitalism,” continually find creative ways to enrich themselves through the tax code via favors that labor income earners do not get. And this is after the flat-rate Social Security and Medicare taxes that even the poorest individuals pay on their first dollar of income, which capital income earners escape.
If your response to these flat-rate payroll taxes is, “Yes, but the Social Security Trust Fund…”, you only have to consider why there is also not a “Military Spending Trust Fund.” More recently, the massive 2020 corporate bailouts should make it plain that the U.S. government will spend trillions of dollars spun out of whole cloth according to its real priorities. “Trust funds” in sovereign spending are accounting fictions designed to “silence the rabble.”
Indeed, a primary reason why we need a much more progressive rate structure is because, when all is said and done, earners of labor income pay a high percentage of their incomes in taxes other than the Federal Income Tax (see Part One). We are probably not at the point where we can realistically think about eliminating all first-dollar taxes on the bottom end of the income scale, but capital income certainly does not deserve any more favors than it naturally has.
Potential benefit: An opportunity to greatly simplify the tax code by broadening and combining multiple, overlapping tax collection schemes.
Principle #4 – Labor income is more like business income than you think.
Part Three of this series deals with issues around business and corporation income, but there is an important link here to personal income. There is a deeply ingrained assumption in our current system that labor income and business income are not the same. But something important has happened in recent years to the whole idea of “What is labor income?”
The phenomenal rise of the “gig economy” should demonstrate to us that all individual providers of labor, not just gig workers, are in the business of selling “labor services.” This disconnect had gradually become a bigger and bigger definitional problem over the past decades by the rise of contracted labor in fields like information technology. The “self-employed versus employee” rules remain confusing and inconsistently applied to this day. Internet-enabled gig work in everything from transportation to delivering liquor to your door added millions of people into this categorical limbo.
Once Uber drivers figured out the cost of amortizing their total vehicle expenses, they realized that they were often netting near-minimum wages. In a number of places, many began pressing for some of the protections traditional workplace employees have garnered over the years. The California Public Utilities Commission ruled last year that Uber and Lyft drivers should be considered employees rather than independent contractors. Immediately after that ruling, Uber and Lyft mounted an expensive campaign to get the issue on the November ballot, and the California voters sided with the ride-sharing companies to preserve independent contractor status.
But the problem will not just go away; indeed, it will only get worse. We might be able to resolve this “employee vs. contractor” problem, however, through some re-thinking. Laws giving “protections” of various sorts to workers should not have any relation to their “labor income” status. Instead, think of these protections as necessary and natural governmental intervention into an exploitation of differentials in economic power. Yes, you are “selling” your labor to your employer, whether you are an employee or an independent contractor, but for most Americans, this is a very lopsided power transaction.
Karl Marx predicted that unfettered capitalist employers would set their workers against one another to bargain for the lowest wages in order to survive. Again, one does not need to be a Marxist to realize that this pretty much describes the gig economy labor market today, and that California vote. Fortunately, not all companies exploit their workers, and that does not make them Marxist. Rather they are capitalists who treat their “labor service” providers as persons of innate human worth. It is called human decency.
The practical applications here come in how we re-think valuing the “labor services” of all people, independent of “employee status.” For instance, executives often get company cars as tax-free perquisites while most employees bear their own transportation expenses. Tax-free “perks” need some serious re-thinking, if you are to address the persistent imbalance of economic power and employ that simple definition of “income”: an increase in wealth that has been realized. Anybody who has ever worked in a company that bestowed generous executive perquisites knows that tax rules are usually stretched to the limit.
Potential benefit: A restoration of a more equitable power relationship between “labor” and “management,” as well as an avenue to simplify the vexatious “self-employment” problem.
If you have any government or campaign contacts working for tax fairness and equity, please pass this post on. As I have noted, this last principle takes us into “Business Tax World,” which is worth a post of its own. Part Three of this post, in the queue, will look at business taxes.
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- South-Western Federal Taxation 2021: Essentials of Taxation: Individuals and Business Entities, 24th Edition