Hearing on Fair and Equitable Tax Policy held on September 6, 2007
Mr. Chairman and members of the Committee, thank you for this opportunity to submit testimony on methods to achieve a fair and equitable tax system. My testimony draws heavily from research conducted by scholars at the National Center for Policy Analysis (NCPA), particularly from NCPA Brief Analysis numbers 537, 571, and 588 – all of which can be found at the ncpathinktank.org website.
The Alternative Minimum Tax (AMT) enacted in 1978 was intended to tax the small number of wealthy individuals who, in any given year, legally owe no personal income tax due to the many exemptions allowed by the U.S. tax code. The AMT has its own set of rules, which limit deductions. Individuals with incomes above a certain level calculate their taxes under both sets of rules and pay whichever amount is higher.
However, the exemption levels are not indexed for inflation. Thus, as incomes have risen, more and more middle-class Americans have been forced to pay the AMT. Congress has addressed this problem by passing a series of temporary increases in the exempt amount, but when these temporary fixes expire, millions of middle-income citizens will be forced to pay a tax intended only for the super-rich. Rather than creating another temporary fix, Congress should use this opportunity to permanently restructure the tax system.
Problems with the AMT
In addition to the burden that awaits middle-class families when the AMT extensions expire, there are other problems.
Uncertainty for Taxpayers . By continuously setting back the date when the 2000 exemption levels return, legislators create uncertainty in the economy. In any given year, if Congress cannot agree on legislation to temporarily extend higher exemption levels, the middle class will be hit by the AMT. Furthermore, should Congress allow a return to 2000 exemption levels, the complexity of the AMT creates uncertainty for individual tax filers as to how they will be affected. Thus, even in the years when Congress is successful in extending higher exemptions, middle-class taxpayers may reduce their investments in order to protect themselves against a possible future rollback.
Future Dependence . Because of the growing number of taxpayers filing the AMT every year, the federal budget will increasingly depend on it for tax revenue. Though repealing the AMT will cost an average of $74.5 billion annually over the next decade, if it remains in place, the costs increase over time. Every year, over two million more taxpayers will file AMT. By 2008, the AMT will be more expensive to repeal than the income tax — $100 billion versus $72 billion — according to the Tax Policy Center .
Unfairness . Currently, the AMT taxes individuals a flat 26 percent of gross income minus deductions for mortgage interest and charitable contributions. Therefore, the brunt of the AMT falls on taxpayers earning between $200,000 and $500,000. This is because they are most likely to fall under the AMT, but have lower mortgage interest and charitable deductions than higher-income taxpayers. While 43.4 percent of these individuals filed AMT in 2005, only 26.4 percent of taxpayers with incomes of more than $1,000,000 did, according to the Tax Policy Center . Ironically, the AMT does not achieve its original goal. Even with the AMT, 5,650 tax filers with incomes over $200,000 owed no income taxes in 2002.
The Regular Income Tax versus the AMT
In the 1970s and 1980s, supply-side economists and journalists noted that high marginal tax rates create a large "tax wedge" between the after-tax income workers receive and the value society places on their output — and between the after-tax return on investment and the value of the production that investment makes possible. A big tax wedge, and high marginal tax rates, stunt economic growth by discouraging work and investment. For a given amount of tax revenue raised, the lower the marginal tax rate the better.
The supply-siders' insight wasn't novel. In the United Kingdom , the top marginal tax rate in the 1970s was 83 percent on earned income and 98 percent on interest and dividends. James Mirrlees, a “left-wing” economist and Labour Party adviser, concluded that the optimal top marginal tax rate was only about 20 percent and that rates for other income groups should be close to 20 percent. An optimal tax rate would generate substantial government revenue while not greatly reducing individual incentives to work and invest.
In other words, Mirrlees provided an economic rationale for a "flat tax," such as an income tax that imposes the same rate at all income levels. Although such a reform is desirable, the odds that such a flat rate will ever be implemented are small. But it is possible to get much of the way there by flattening the AMT.
The AMT versus a Flat Tax
Most flat tax advocates want a zero percent tax rate on a minimum level of income and a tax rate of about 19 percent on all additional income, with few, if any, deductions allowed. The current AMT differs from this flat tax system in three main ways: 1) The basic exemption is higher, 2) the marginal tax rates are substantially higher, and 3) the expenses that are deductible are more numerous than under a flat-tax regime. All three aspects of the AMT could be modified easily, while raising the same amount of revenue for the federal government.
Under the AMT, instead of basic deductions, the first $45,000 of income is exempt for a married couple filing jointly. The tax rate on this income is zero. As the figure shows:
- On income above $45,000 the marginal tax rate is 26 percent, up to $150,000.
- Above $150,000 the marginal tax rate is 32.5 percent up to $206,000.
- Above $206,000 the marginal rate is 35 percent up to $330,000.
- Above $330,000 the marginal tax rate falls to 28 percent.
Although the IRS publishes AMT tax rates of 26 percent and 28 percent, in practice there are 4 rates since the exemption on the first $45,000 is phased out at higher income levels. After the exemption is completely phased out, the rate falls back to 28 percent.
AMT reformers usually advocate raising the amount of income that is exempted, which has been done in past years. Instead, Congress could reduce the exemption, further limit deductions and cut the AMT marginal tax rate to 24 percent, or even 20 percent. As recently as 1986, the AMT marginal tax rate was 20 percent. (The 1986 Tax Reform Act raised the marginal AMT rate to 21 percent, the 1990 tax bill raised it to 24 percent and the 1993 tax bill imposed the current nominal rates of 26 percent and 28 percent.)
Is a Flat Tax-Rate Desirable?
As supply-siders have emphasized, a low flat tax-rate has a positive effect on the incentives to earn, save, invest and become more productive, whether through training, education or experience. The lower the marginal rate, the stronger the incentives.
Critics of supply-side economics have admitted that the marginal dollars taxpayers are allowed to keep are an incentive to earn more income. But they also argue that since cuts in tax rates make taxpayers better off, they may use this higher real income to “buy” leisure — that is, work less. But this criticism warrants little attention unless the choice to work less resulted in less government revenue. Instead, the tax system could be changed to keep the federal government's revenues constant by reducing AMT deductions in exchange for lower marginal tax rates. In economics jargon, the system could be changed so that there is a substitution effect (working harder in response to higher after-tax incentives), but no income effect (that is, working less hard because of the tax break on nonmarginal dollars). The net effect would be more work and more output.
Long-Term Solutions: Flat Tax or Consumption Tax
As it is currently imposed, the AMT is complex and ineffective in ensuring that the wealthy pay taxes on their incomes. But even if it were repealed this year (while leaving the rest of the income tax system in place), by 2010, over 9,000 high-income filers would pay zero income tax, due to exemptions.
Congress should create a system that taxes everyone fairly and efficiently, and simplifies the entire federal tax code. One solution is to replace the bloated, complex income tax system with a flat income tax. Another, purer, solution would be to implement a national sales or consumption tax.
A Lower-Rate Flat Tax
A lower-rate flat tax can be structured in a way that:
- Ensures the rich continue to bear more of the burden than they currently do; thus, the plan can be more progressive than the current system.
- Taxes income only once (when it is earned), and does not tax savings or investments; thus, the plan promotes efficiency and economic growth.
- Does more to help low-income families by providing incentives to purchase health insurance and invest for retirement.
Steve Forbes has proposed a flat rate of 17 percent, with generous personal exemptions for all families, so that a family of four would not pay taxes until its income exceeded $46,000. Moreover, the Forbes plan encourages growth by exempting income that is saved and invested. Which means that the Forbes plan approximates a consumption tax. It taxes people based on what they take out of the economy, not on what they put in. It is a good plan, but can be improved upon.
The tax rate can be lowered further — 14 percent as opposed to 17 percent — and at the same time do more to help low-income people. With the assistance of Boston University economist Laurence Kotlikoff, an advocate of a national retail sales tax, the NCPA put together a plan that works in the following way.
First, it would eliminate the across-the-board $9,000-per-person exemption in the Forbes plan. Why should billionaires like Bill Gates get an exemption? Forbes' plan gives too much money away to rich people. Eliminating the across-the-board exemption would allow the money to be rebated to the bottom third of earners, those who bring home roughly less than $25,000 for a family of four.
Second, Forbes doesn't address the 12.4 percent Social Security payroll tax (split between employer and employee), although the payroll tax is an example of a pure flat tax. Currently, income over $90,000 a year is not subject to the tax. It is a regressive feature of the current tax system that a $50,000-a-year autoworker has to pay payroll taxes on all his income while a million-dollar-a-year auto executive does not. Under the NCPA proposal, the income ceiling would be lifted and all wages would face the same income and payroll tax rates.
These changes should make a flat tax plan more politically appealing. Politicians are unlikely to adopt a new system that taxes the paychecks of the rich at a lower rate than those of blue-collar workers. Under the NCPA proposal, all wages would face the same income and payroll tax rates. And they would be taxed only once. All savings would accumulate tax free and be taxed only when withdrawn.
A More Progressive Flat Tax
This plan allows a lower flat-tax rate and produces results that should appeal to liberals as well as conservatives. What conservatives most want is an uncomplicated system that taxes income only once (when it is earned) at one low rate. Liberals are more concerned about progressivity. They want the rich to bear more of a burden than the poor.
The left objects to most consumption tax proposals because they mistakenly believe they aren't progressive. Low- and middle-income people would pay a greater share of what they earn than rich people. This proposed system is more progressive than the Forbes flat tax. It's also more progressive than the current system. Using economic modeling, Kotlikoff found that under the NCPA flat tax the rich would bear more of the burden than they currently do.
Health Care and Pensions
Most flat-tax proposals ignore health insurance and retirement saving. Yet the failure to insure or save — especially for low-income families — is a social problem. For that reason, the rebate of tax dollars to the bottom third of taxpayers would be used to help solve these problems. For example, as a condition of receiving the 14 percent rebate, low-income families would be required to show they have health insurance and a retirement pension. Specifically, to get one-half the rebate (7 percent), they would have to produce proof of health insurance. This would encourage millions of people who qualify to enroll in Medicaid or in their employer's health plan. Barring that, families could apply the tax rebate to health insurance they purchase on their own. The other half (7 percent) of the rebate would be contingent on proof of a pension, an IRA, a 401(k) or some other savings account . So instead of national health insurance and more government spending on the elderly, this flat-tax proposal would encourage people to solve these problems on their own.
A Higher Rate of Economic Growth
The tax system itself drags down the economy with the cost of keeping mountains of records and filling out voluminous forms. It also distorts economic decisions — everything from whether a spouse works to how much families save. The U.S. Government Accountability Office recently published estimates of these economic costs by various researchers. They found the efficiency cost of the tax system — the output lost over and above the amount of taxes collected — is 2 percent to 5 percent of gross domestic product. [See the figure.] In short, we lose between $240 billion and $600 billion every year just collecting taxes.
A post-card-sized tax return would slash compliance costs. A single tax rate applied to all wages would make the system more equitable and transparent. By improving economic efficiency, it would raise productivity and hence the rate of economic growth.
National Consumption Tax – The Fair Tax
Another innovative tax reform proposal that deserves consideration is the national sales or national consumption tax, more recently called the Fair Tax. The Fair Tax would build on these fundamentals of taxation:
- Only people pay taxes.
- Consumption tax rates are self-limiting.
- Uniformity of taxation wards off special interest manipulation.
As described at fairtax.org, the Fair Tax proposal would replace all federal income and payroll taxes with a progressive national retail sales tax. The Fair Tax would also incorporate a tax credit to ensure no federal taxes are paid on spending up to the federal poverty level. The Fair Tax would replace federal personal and corporate income taxes, gift, estate, capital gains, AMT, Social Security, Medicare, and self-employment taxes and it would be administered primarily by existing state sales tax authorities.
Based on work done by Boston University economist Laurence Kotlikoff and Beacon Hill Institute, a Fair Tax rate of $0.23 out of every retail dollar spent on new goods or services would generate federal tax revenues of approximately $2.6 trillion – about $350 billion more than the revenues generated by the taxes it would repeal. The Fair Tax would likely lower the lifetime tax burden for most Americans and would greatly simplify federal tax compliance. The Fair Tax would also obviate the need for the Internal Revenue Service.
Conclusion
The AMT has not achieved its intended goals. It is inefficient because it discourages investment. At the same time, the AMT is ineffective in taxing the super-rich. Left unabated, it will cause a major tax increase for middle income filers starting in 2007. Congress could use this problem as an opportunity for restructuring the federal tax code.
Both the flat tax and the consumption tax are big improvements over the current mess. A low-rate flat tax would help the economy. A rebate to the poor would enhance progressivity. Making the rebate contingent on the purchase of health care and saving for retirement will improve the quality of life. A national consumption tax – with a provision exempting spending up to the federal poverty level – would dramatically shrink the costs of tax compliance and would promote an efficient, transparent means for federal revenue generation.
President Bush said that he wants to reshape our tax system. Many in Congress agree on the need for change. But an oft-repeated objection is that tax reform benefits high-income taxpayers at the expense of low-income taxpayers. With the ideas presented here, that objection need not apply.