A RATIONAL APPROACH TO TAX REFORM
by John R. Schuyler
Most of us complain about taxes and, especially, the taxation methods.\A0 This paper summarizes an alternate tax system that I conceived for the United States using a zero-based approach.\A0 Preliminary testing with a simple taxpayer\92s financial model demonstrated the effectiveness in virtually eliminating the cheating incentive.\A0 Further, the model anticipates taxpayers\92 behavior under different tax parameters and structures.\A0 The system is auditable, progressive and extremely simple.\A0 Further, it seems to provide the correct incentives for education, savings and investment.
\B7 A new "Consumption Tax" and a new "Wealth Tax" would replace all of the following:
w federal and state income taxes
w FICA contributions
w sales taxes
w property taxes
w inheritance taxes
w gift, excise, and communications taxes
\B7 A large portion of federal receipts (e.g., 40%) would be redistributed to state and local governments through a fair allocation process.\A0 The amount and design of this allocation would be a major issue and could be based upon such considerations as population and taxpayer assets.
\B7 Corporations would not be taxed directly, but through their ultimate ownership by individuals.\A0 Cash dividends would be income used in the Consumption Tax calculation.\A0 Equity and debt market prices would be used in the net worth calculation for Wealth Tax; interests in non-public corporations would be valued by fair market value appraisals.
\B7 Financial accounting would be reformed so that balance sheets would reflect asset fair market values.\A0 This applies also to balance sheets for individuals and governments.\A0 For businesses, a goodwill value would reconcile any difference to market.
\B7 Social policy incentives would be outside the tax system, e.g., by paying subsidies.\A0 This would provide both simplicity and visibility to constituents.
\B7 Capital gains are automatically sheltered so long as the investment value remains in the person's portfolio.\A0 Also, the approach presented here automatically recognizes the effect of inflation.
TAX SYSTEM DESIGN OBJECTIVES
\B7 Efficiency: Savings in collection, reporting, records-keeping (outweighing minor tax burden inequities).
\B7 Perceived Acceptance and Fairness: Providing a high level of acceptance and compliance (and easier detection of any attempt at cheating).
\B7 Proper Investment Incentives: For education, savings, investment, and economic growth.
These objectives are suitable criteria for evaluating proposed tax system alternatives.
MAIN DESIGN PRINCIPLES
\B7 Simplicity, clarity, and uniformity.
realistic accounting.\A0 Tax = Financial =
Fair Market Value accounting bases would be identical.\A0 This provides administration and compliance
economy and ensures meaningfulness.
Key requirement:\A0 Net Worth on balance sheets would represent net worth, valuing tangible and intangible assets and equities at market.\A0 Goodwill and human capital would be recognized by the entity's market valuation.
\B7 Design tax system to minimize income-shifting and tax-avoidance schemes.
\B7 Example current problem areas include:
w corporate vs. personal income
w earned vs. investment income
w differentiation between ordinary income, dividends, capital gains, and asset appreciation
w tax deferrals and acceleration gambits
w tax brackets
w service vs. non-service sales
w location of sales, businesses, and residences
w gifting vs. willing in estate planning
\B7 Consumption Tax:
w A fixed, flat rate which is multiplied by
- costs of earnings
- interest expense
- qualified donations
- insurance premiums
w The Consumption Tax rate would have to be high, perhaps on the order of 40%, because many former tax schemes are being replaced.
\FA Income includes earned income, dividends, asset appreciation, gifts, inheritances, and insurance proceeds.
\FA Asset appreciation does not cause or affect Consumption Tax.
\FA Costs of earnings would include all expenses related to producing income.\A0 Expenses for education toward a trade or profession could be capitalized (probably the better approach) or expensed.
\FA Interest and insurance expense are deductible personally to maintain consistency with the traditional deductibility when reasonably incurred during the course of business.
\FA Donations are deductible because of tradition, business allowance, and to encourage and partially match altruism.
\FA "Savings" is inter-period change in net worth.
This is based on a person's net worth from balance sheet reporting.
w This provides a progressive tax effect.
w The flat Wealth Tax rate would perhaps be in the 4% range (pay-as-you-go, rather than when you are gone).
w Inflation indexing would not be necessary; however, asset values would be adjusted for net appreciation.
w The proposed design would facilitate verifying tax compliance by providing a net worth audit trail;\A0 identifiable assets can be valued for easy auditing.
w Once a person's net worth is established, any error in an asset valuation affecting the wealth tax is offset to a large degree by the opposite effect on the Consumption Tax. (reducing the incentive to cheat; if Wealth Tax rate = discount rate x Consumption Tax rate, then any valuation errors nearly offset).
w .\A0\A0\A0\A0\A0\A0\A0\A0 It might be appropriate to capitalize training and education.\A0 The value of this intangible asset could be assessed from an earnings model.
OTHER FEATURES AND COMMENTS
\B7 A new requirement to report net worth can be expected to become a major issue due to the apparent diminished privacy.\A0 However, the IRS and credit reporting companies like TRW already know most of what there is to know about the finances of ordinary citizens.
\B7 All not-for-profit entities are tax-exempt.\A0 Examples:\A0 states, cities, universities, churches, sporting clubs, and homeowner associations.\A0 To qualify there must be no beneficial ownership to a small sub-group.
\B7 Partnerships would be treated as corporations so as to recognize any goodwill value.
\B7 Ownership in closely-held businesses would have to recognize a control premium in interest valuations.
\B7 A person's tax rates could vary according to his or her residence location.\A0 This would allow state and local governments an incremental taxing option (I don't recommend this feature because of potential for complication and abuse).
\B7 A "phantom stockholder" approach could be used to tax foreign owners of U.S. corporations.\A0 U.S. citizen holdings would be taxed as dividends are received and by the market value of the holdings.
\B7 State and local governments would not be able to tax corporations by mere presence.\A0 However, employee, gasoline, and other taxes would be available where they can be simply administered and meaningfully related to support services.
\B7 Social costs of natural resource consumption and pollution will probably be handled through a system of taxes.\A0 Hopefully, a free-market mechanism will be used to determine the optimal allocations.\A0 These taxes should not be related to the cost of funding government except mitigation efforts.\A0 Thus, the environment tax system should not be confused with this paper's citizen taxes.
\B7 An important need is an effective IRS.\A0 With good management, the centralized tax agency can be much more efficient than having many different state and local taxing authorities.
\B7 The retirement savings component of Social Security is eliminated.\A0 Welfare distributions should be labeled as such and would be clearly visible.
\B7 Interest from government bonds would be taxable.\A0 Targeted loans could be subsidized instead (if constituents will stand for it!).
\B7 Gifts received, inheritances, insurance proceeds, and the like would not be taxed if saved; gifts when made are taxed as consumption.
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The above outline summarizes my present thinking about tax reform.\A0 Thus far, I have been unable to think of any major deficiencies in this hypothetical system.\A0 The privacy issue with the wealth tax is the most common complaint I\92ve heard, yet this is already a non-issue with today\92s government and credit-reporting databases.
I will appreciate any questions, comments and suggestions.
\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0\A0 John R. Schuyler\A0\A0 (a consultant in risk and economic decision analysis)
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