May 28, 2017

The Republican led Congress has promised tax reform in the coming year.  This week I’ll introduce an income tax program that I think will clarify the debate.

Let me begin with those on the left side of the political aisle who talk about the rich paying their fair share.  The kernel of the Democratic social plan is a promise to take care of the poor by giving them benefits. Even if I don’t get any of those benefits, I like voting for politicians who help out the poor because I’m a good person.

If I ask House Minority Leader Nancy Pelosi or Senate Minority Leader Chuck Schumer “Where should the money come from?” they answer “People with too much money.” Nancy and Chuck know which people have enough money and which ones have too much.

BBLR has long been a rallying cry for those on the right. The acronym means “broaden the base, lower the rate.” As Majority Leader in the House and as Vice-Presidential candidate, Paul Ryan has espoused this philosophy. Here is a PolitiFact article on the issue during the 2012 presidential race. Tax reform champion Grover Norquist has advocated for the same principle.

The term “broaden the base” means to have more people paying at least some income tax so that they have skin in the game, so to speak. In a very progressive tax system, people who pay little or no taxes will vote for politicians who promise them benefits. After all, it is OPM, or other people’s money. In Democratic circles, BBLR stands for a mean tax system. Here’s the debate between Nancy and Chuck on the political left, and Paul and Grover on the right:

Paul and Grover: A minority of people are being forced to pay for federal programs that benefit other people who pay almost nothing into the system.  Those people will vote for more programs because it costs them nothing.

Nancy and Chuck: Republicans are bad people because they want to tax poor people. Poor people already pay Social Security and Medicare taxes so they are paying into the system.

Paul and Grover: Medicare and Social Security taxes are essentially forced saving programs that will return that money to the taxpayer in the future. Payroll taxes do not support the other functions and expenses of government like defense and the justice system.

Nancy and Chuck: Those taxes all go into the same pot.

Paul and Grover: Democrats have always been careful to separate Social Security and Medicare programs in their rhetoric. You champion the preservation of these programs as though they are separate. You can’t have it both ways. Either they are separate or they are not.

Nancy and Chuck: You Republicans are really mean and you are pawns of rich people.

These debates usually end in name calling, particularly during election season.  Some of the rhetoric is political branding but each side remains convinced that their way is the best way.

Let’s turn to recent history and take the chance that facts might get in our way. The non-partisan Congressional Budget Office (CBO) routinely analyzes proposed House and Senate laws for their estimated impact on the budget. In this report the CBO separated income, government transfers and taxes paid into income quintiles. (Click here if you want to know more about a quintile).

In the table above, the lowest and highest quintiles received the least amount of money in government transfer payments like Social Security. The highest quintile had ten times more before-tax income than the lowest quintile but paid 87 times more tax than the lowest quintile. Notice that the CBO analysis includes all taxes paid to the federal government, including Social Security and Medicare.

Pretend you are a reporter. Ask House Minority leader Nancy Pelosi “How much more should the rich pay than the poor, Ms. Pelosi? If 87 times is not fair, what is fair? 100 times? 200 times?” Each of us is an expert on what “fair” means.

In the past 35 years, despite all the rhetoric, state and federal policies have had only a small effect on income inequality. The GINI index is a standardized measure of the inequality in a data set. The scale runs from zero, perfect equality, to one, or perfect inequality. The CBO report showed a 35 year history of the separate effects of benefit and tax policies on inequality. In 1980, tax policy reduced inequality by 10%. 35 years later, the reduction was 9%. Despite major tax reform in 1986, the tax increases of the early 1990s and the tax decreases of the early 2000s, tax policy has had little to no effect on inequality.

Changes in social policy that directs government transfer payments have helped ease inequality in the past 35 years, but the CBO analysis finds the combined change from tax and benefit policies negligible. They reduced inequality by 25% in 1979. 35 years later the total reduction was 26%. The difference could be a measuring error.

Tax reform is tough because it involves contentious issues. We argue about tax rates and the income brackets for those rates. We argue about deductions and tax credits. Like pornography, we may not be able to define “fair” but each of us knows it when we see it. We can agree on what “cat” means but not “fair.”

I propose something different, something that will give us less to argue about. Let’s recognize that there are socio-economic classes and assign a portion of federal tax revenues to each income quintile. Using the CBO’s analysis, the 1st and lowest quintile paid 8/10ths of 1% into the kitty. It is such an insignificant amount that we might has well make it zero. What this means is that poor people would pay no income tax and no payroll tax. Paul Ryan led the effort on last year’s Better Way tax proposal which included the same concept:  poor people should pay nothing.

If we can agree on that, we have four things left to argue about: the percentages that each of the remaining four quintiles would pay. Let’s begin the discussion by looking at the CBO analysis of the federal revenue “pie” in 2013.. The second lowest income quintile #2 paid 4% of total individual federal income and payroll taxes, the middle quintile paid 9%, quintile #4 paid 17-1/2%, and the top #5 quintile paid 69-1/2%. I rounded the percentages.

There will be a fight over these percentages but we will be fighting over four concrete numbers, not 100 million interpretations of what the word “fair” means as it relates to thousands of pages of tax code. Once that portioning is settled, a bipartisan committee representing each quintile can argue over the details of how they raise their portion of the anticipated revenue.

Taxpayers in the highest quintile may want tax breaks for angel investors who invest in early startup companies. Sounds like a worthy cause. The members of that quintile’s committee can argue amongst themselves as to whether they can afford to carve out tax breaks for that subgroup and still raise the required revenues. Should some of the income of hedge fund managers be taxed at a lower rate like capital gains? Under the current tax system, that is an emotional issue. Why should those guys get a special interest tax break? Under this proposal, I don’t care because I’m not in that quintile. A hot button issue turns into a yawner for most Americans.

A majority of taxpayers in the middle quintile might want the mortgage interest deduction. Those people can put political pressure on that quintile’s committee members to include that carve out. The majority in the next lower quintile might prefer tax breaks on child care. Should capital gains be taxed at a lower rate? This group has little in the way of capital gains so they might prefer that all income be taxed the same. Those in the lowest three quintiles who pay small tax percentages might be attracted to the simple grade school arithmetic used by some states to calculate their state income tax. Adjusted gross Income x 10% = $tax, as an example. Tax filing made simple.

Could this proposal make the tax code more complicated than it already is? Yes, but most of the complications won’t affect each person. Under the current system, my tax software asks me questions about tax credits and situations that have nothing to do with me or my family. Why? Because all of the tax code applies in theory to all of us. Under this proposal, my tax software would know what quintile I was in and the tax rules that applied to me and my family.

But what if people move from one quintile to another? How will they plan? Incomes do change. A person gets a raise, a better job, goes to school, loses a job or retires. A simple rule would help: a person’s quintile this tax year is based on their income the previous year.

The setting of the quintile brackets could be done by another simple rule. The IRS can not provide summaries and analysis of tax data for a particular tax year till about two years have passed. Each year we could adjust the income brackets of each quintile by the annual inflation rate based on the most recent tax year data available.  Families with fairly predictable income will know in advance what their tax expense will be in the coming year.

What about the Earned Income Tax Credit (EITC) program for poor people? This program largely offsets the payroll taxes that poor people pay with tax credits paid directly by a person’s employer. The program is fraught with abuse. Under this proposal, payroll taxes for the lowest income workers are eliminated so the offsetting tax credits aren’t needed.

Will those workers in the lowest quintile still be eligible for Social Security?  Sure.  There is still a record of their labor income, which is the basis for determining Social Security payment amounts.

Tax reform has come infrequently because the tax code tries to be all things to all people. The top 40% pay most of the individual income taxes so naturally they lobby for special interest tax breaks which are slipped quietly into the tax code.  Under this proposal, those special interests can lobby all they like, just as long as they meet their revenue targets.

Is it fair that someone making a half a million dollars gets a tax break on their vacation home on the Outer Banks in North Carolina? Of course not. Under the current system, I get angry about that. Under this proposal, I simply don’t care. If that person is getting a break, some other equally rich person is having to pay for that tax break. None of my business.

As it is now, we struggle to understand the various tax proposals. Politicians talk in non-specific terms about what is fair, or they speak in slogan tax talk like BBLR. Tax reform rhetoric has become a rallying cry to get out the vote.

This proposal will not stop the political fights. We will continue to debate the amount of  federal spending, the role of government and what tax revenues should be spent on. We will fight bitterly about the percentages of tax revenue expected from each quintile. But this proposal will direct the debate to specific percentages that most of us can understand. So let’s put on our debating gloves and get into it!