Most Americans feel some level of negative emotion about federal income taxes: confusion and anxiety over the complicated filing process; fear about how much they still owe and how they’ll pay it; or frustration that taxes are so high compared to the value of the benefits they see. No matter how much one is expected to pay, complaining is a given.
“It doesn’t matter what the level of income. People always complain at tax time,” said Connie Weaver, associate professor of accounting and Mays Fellow.
All these emotions are part of the challenge of tax reform. Reasoning and rhetoric are drowned out by shouts of “taxes are too high!” versus tales of disadvantaged children losing access to food or health care due to budgetary cuts in the social services financed by taxation.
At a recent round table discussion, six members of the accounting faculty at Mays discussed the problems that face U.S. taxation, touching on the history of the systemâ€”recent and long pastâ€”and ways the system might be modified. It’s a timely topic, as the Bipartisan Tax Fairness and Simplification Act of 2010 Bill recently introduced in the Senate proposes simplification of the tax code. Some are forecasting that after health care, tax reform will be the next big debate on Capitol Hill.
Tea parties and taxation: a history lesson
One political party suggests less taxation leads to greater prosperity for all, while another party says the reverse, and yet another suggests that elimination of taxes is the best option. Should soaring deficits be tamed by raising taxes or cutting spending? Viewing the issue through the lens of American history is enlightening, says Thomas Omer, Ernst & Young Professor of Accounting, who notes that the first instance of income tax in the U.S. was a temporary measure to finance the Civil War. Prior to that, the federal government was funded by tariffs and excise taxes. There were no entitlement programs (unemployment, welfare, Medicare, etc.). State governments were powerful. Federal taxes provided primarily for the defense department.
Originally, “trade was the only way that they raised funds to run the government,” says Omer, who recommends the HBO miniseries John Adams for understanding the founding fathers’ ideas about taxation.
“Even under that temporary income tax and the constitutionally adopted income tax in 1913, relatively few individuals were subject to the tax,” interjected Adam Myers, senior lecturer. “The 1913 tax only applied to those with taxable income in excess of an amount equal to $63,000 in today’s dollars.”
Looking back at history isn’t helping members of the Tea Party Movement see more clearly says Omer, remarking that a recent poll shows many of them are confused about the state of taxation in the country: a mere two percent responding to the poll understood that taxes have decreased since Obama became president; the other 98 percent said taxes had risen or stayed the same, or that they didn’t know.
Moving beyond U.S. history, Omer comments that in Europe, taxes are much higher, but there are more direct benefits (universal health care chief among them) to taxpayers, resulting in less discontent about the tax burden.
Myers doesn’t think the U.S. is likely to adopt the European model. He believes that approach to government is incompatible with history and a widely held perception of American society. “Since Jamestown, America has existed for wealth-building fueled by entrepreneurial zeal. In the Declaration of Independence, the founding fathers did not declare we are entitled to happiness. They declared we are entitled to the pursuit of happiness. The key word is pursuit, not happiness,” said Myers. “I believe that’s what President Bush really meant when he talked about the “ownership society.'”
Omer says that in the U.S. we are in danger of pursuing happiness at the expense of social welfare and social consciousness. He sees that as part of the need for taxesâ€”it keeps us as a society from imploding from the pursuit of happiness via private ambition. “That’s the reason why the government needs funding. To keep a moderate amount of civility in the worldâ€¦you cannot control chaos without money.” There has to be a conscious effort on the part of the citizenry, who will put aside that pursuit in favor of maintaining society, he says.
“So philosophically, there’s a need for an income tax,” said Dennis Lassila, Deborah D. Shelton Professor in Taxation. “The second question is, does it have to be as complex as it is?…Could as much revenue be generated with a simpler system?”
Tax reform is a complicated issue. Even with endless debate by top economists, there is no clear solution, says Lassila. Whatever changes are proposed, it’s inevitable that the government will continue to tax individuals and businesses increasingly until federal deficits are under control. “The government is going to be searching for additional sources of revenue, simply because there’s a lack of political will to address the other side of the equation: government expenditures,” he says.
One alternative Lassila brought up was the value-added tax or the VAT. A VAT is similar to a sales tax. But rather than being tacked onto purchases, a certain amount of tax is assessed at each stage of production (i.e., as value is added) and is added directly to the price of the product. Eventually, 15 percent of the price paid by the ultimate consumer may be due to the VAT. This is a simpler system than adding various excise, local, and state taxes on good and services. Myers says, among other negative characteristics of a VAT, the system is easily corrupted. A recent study estimates VAT fraud in the European Union reduces annual revenues by up to 30 percent. The comparable estimated number in 2005 for the US income tax was 12 percent, he says.
Many of the United States’ trading partners have incorporated the VAT in the price of goods imported, and it’s a point of debate as to whether this puts the U.S. at a competitive advantage or disadvantage in trade, says Lassila.
Myers believes the simple solution is a flat tax for individuals and businesses. All businesses would be governed by one set of rules. Sole proprietors, partnerships, and corporations would not be governed by differing sets of tax rules. A flat tax would eliminate complexity by reducing the number of pages of a return to a single page. Most proposals set a single flat rate of less than 20 percent, and include a generous exemption based on family size, eliminate deductions, exemptions, and loopholes.
Weaver disagrees, saying the flat tax idea, while it’s been bandied about for ages, is no simpler than the progressive income tax system we have now. “The calculation of the rate multiplied by income isn’t the hard part, so a flat tax doesn’t really do anything [different].” It’s still going to be subject to all of the same political considerations as the current system, she says.
Clair Nixon, PwC Accounting Excellence Professor, sided with Weaver: “I don’t think we will ever see a flat tax system in the U.S. There will always be a motivation to tax higher income individuals at a higher rate. It is perceived as a matter of ability to pay, not fairness.”
Myers pointed out countries in Eastern Europe and the former Soviet Union, including Russia, have enacted flat taxes since 1994 and are succeeding. Consider the Baltic states, he suggests, where the flat tax rates are less than 25 percent and economies are growing. “This is not such a wild idea,” he says.
Overhaul of current system
Lassila says that in the last 35 years since he’s been in the accounting field, the system has grown alarmingly complex. His proof? When he started out in the field, there was one volume of the Internal Revenue Code and three volumes of income tax regulations. Now there are two volumes as large as the first of Internal Revenue Codes, and six volumes of income tax regulations. All these changes over the years lead to confusion, leading to problems with compliance.
Omer suggests one easy way to simplify the tax code is to take out all of the special clauses that have accumulated over the years that at one time served a purpose, but are now merely annoying loopholes that may be of benefit to some businesses or individuals, but not the overall economy. “Part of this accumulation of code is merely inertia,” he says. “If we could get rid of the junk, it would be far less complex.”
Myers contributes that if he had his say in tax reform, he would remove double taxation. For example, estate taxes: the money is taxed when it is earned, and taxed again when it is passed on to heirs.
Myers also believes the development of tax software emboldened Congress to pass more complicated tax laws. “It’s ridiculous most of us have to use a computer to file our tax returns,” says Myers, pointing to complex tasks such as determining who is a dependant. In many working-class families, nontraditional family living situations exist, with children frequently being raised by someone other than both biological parents. Regular people who are making a wage shouldn’t need to use a computer or a tax preparer, Myers contends.
Kevin Roach, executive professor of accounting, agrees, saying many low-income people are unaware of the benefits built into the federal income tax system for them, such as credits that would provide a refund, even if they are not required to file because they are under the income requirements.
This is a topic that is important to Myers, who teaches the class “Special Topics in Taxâ€”Federal Taxation of Low Income Filers: Socio-Economic Forces” at Mays, which focuses on federal income tax legislation, its impact on low-income filers, and the socio-economic forces impacting low-income families and individuals. Each student in the class must volunteer to provide free income tax return preparation for low-income individuals and families.
Nixon says while some considerations must be made for this population, “For the majority of Americans, filing a tax return is fairly easy and relatively inexpensive. In many cases, the tax return can be filed for $50 by a paid preparer. If you are a wage earner who does not itemize deductions, the forms are easy to follow and there is an incredible amount of free assistance out there. In fact, less than half of Americans itemize their deductions. The complexity arises for the moderate to high income individuals who have home mortgages, investments, and self-employed activities.”
“Although we talk a lot about the burden of the income tax, in reality, for low income individual, the employment tax (FICA) is much more burdensome,” says Nixon. In fact, a third of Americans pay more in FICA withholdings than they do in income taxes.
In the end, there are conflicting interests on the part of the politicians, both red and blue, and conflicting interests among their constituents based on varying socio-economic situations and philosophy. If we could resolve those differences and arrive at consensus about what needs to be done, then much could be accomplished, says Myers.