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Economic News, Data and Analysis

How to Simplify the Tax Code

Hey! Guess what I got in the mail this past week – my 1040
Form
! Yea!

1998 is an election year, and as always taxes will be on the agenda
of people running for office as well as on the minds of the electorate.
One of the most common components contained in most fundamental tax reform
proposals is a promise to “simplify” the tax system. Filling out your tax
forms can be a pain in the rear and it certainly would be nice to have
only a postcard sized tax form to fill out. In Denmark, most people get
sent a statement of their tax account which they only have to sign and
return – nothing to fill out or calculate.

So, what is it that makes income taxes complicated? Contrary to many
of the recent claims by tax reformers, multiple rates do not complicate
things in the current system. The “flat tax” – by which I mean creating
only one tax bracket – does not by itself simplify anything:
only the table which you use to look up your tax would change.

The real effort in filing out your tax form comes from two primary sources:
1) dealing with tax rates that differ by source of income, and 2) dealing
with various deductions and exemptions.  To substantially simplify
tax returns, we must remove the individuality from tax determination. I
have one suggestion to add to the list below.

Individuality

In short, the reason that the tax forms you fill out are complicated
is that the IRS needs a good deal of information in order to calculate
exactly how much tax you owe.

For example, on the 1997-1040 form you have to list income from wages,
interest, dividends, capital gains, alimony, business income, IRA distributions,
pensions, rental real estate, farm income, unemployment compensation, social
security benefits, and, of course, “other”.

On the deductions and credit side you have to list deductions related
to IRAs, Medical savings accounts, moving expenses, self employment, health
insurance, Keogh plans, alimony paid, early withdrawal of savings, and
of course you might have to itemize your deductions for charitable giving
or mortgage interest.

To substantially simplify anything, we need to get rid of the preferential
treatment of different type of income and the variety of deductions – in
short, we need to remove individuality from tax forms.

Proposal for Simplifying the Charity Component

Removing the need to itemize charitable deductions would go a long way
in simplifying the tax code. One way to do this is to simply remove the
deductibility of charitable giving. “Wait, Wait!” I hear you yelling “Giving
is something that should be encouraged!”

Ah-ha! There is a way, however, to keep the current preferential treatment
of charitable giving without mucking up tax forms. Rather than giving you
a tax deduction, the federal government could instead match the funds as
they are contributed to the non-profit organization. The matching
rate
would give the same amount of preference as the tax deduction.
See the table below for an example.

 






Current system: 

 

 

































Income: $110
Giving: $10 

 
 
Taxable income: $110 – $10 = $100
 
tax rate: 30%, so tax:  $30
 
income after giving & tax $100 – $30 = $70

  

Bottom line: $10 to charity, $70 left to spend.
My Proposed system: 

 

 

































Income: $110
Giving $7 (+ 3$ matching) = 10$
 
Taxable Income $110
 
tax rate: 30%, so tax  $33
 
income after giving & tax $110 – 7$ – $33 = $70

 

Bottom line: $10 to charity, $70 left to spend.  

 

And no Deductions to itemize!

This system would also remove one of the more perverse aspects of the current
system — those at the higher tax brackets are currently rewarded more
for giving. By setting a single matching rate this preference would be
removed.

Conclusion

You will undoubtedly hear quite a bit in this next election season about
simplifying the tax system. It will be important to keep in mind what makes
the system complex and to make sure that the proposed simplifications match
the present complexities.

The calls that will be made for a flat tax must be evaluated in this
light. If the proponents only talk about creating a single rate – and do
not address the various deductions and income source differences – they
are not talking about simplifying your tax return. The reason for the omission
is obvious – people like their deductions – and talking about simplification
in the abstract is politically much easier than talking about removing
beloved deductions.

And, as a service to all of my kind and generous readers, my proposal
for charitable deductions would ease the pain associated with itemized
deductions.


See Also:



 




The “Flat Tax” may or may
not be more simple. 
 

Current system 

If a single rate “flat tax” is superimposed on the current system which
includes various types of deductions (e.g. IRA’s, charity) and preferential
treatment of certain kinds of income (like capital gains) there will be
no real simplification of the tax code – you would still have to fill out
roughly the same form as before. 

The only difference would be in the table in which you look up the amount
of tax you owe. 

Simplified system  

There is a case when a flat tax would simplify tax returns. 

If we were to remove all deductions, exemptions, etc., then a single
rate tax would allow the IRS to collect the tax directly from businesses,
and no real tax filing would be necessary. 

The reason that we need to file taxes is because taxes are very much
based on individual or family characteristics. The amount of taxes you
owe in the current system depends both upon your earnings as well as other
characteristics of your household (such as the earnings of your spouse,
charitable giving, number of kids, etc.). 

If we change our system so that no individual information is needed
to calculate your tax rate, then taxes can be withheld at the employer
level without having to fill out a return in April. The “flat tax” would
remove the need for the IRS to know your total income before calculating
the correct tax to collect.


 

 




Calculating the Matching
Rate for giving.
 

Current system 

yd is total income (y) after tax (rate t) and contributions (c). 

yd = y – (y-c)t – c 

yd = y(1-t) – c(1-t) 

Simplified system  

yd’ = y(1-t) – c’ 

where the ‘ denotes the new system. 

To equate final incomes under the two systems we get 

yd’ = yd 

y(1-t) – c(1-t) = y(1-t) – c’ 

or 

c(1-t)=c’ 

In order to contribute the same amount to the charity under both systems
we must have a matching rate (m) that sets 

c = m*c’ 

or 

c = m*c(1-t) 

giving 

m = 1 / (1-t).


 

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Filed under: Economics, Policy

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