The Federal Income Tax is Broken
There are many problems with the federal income tax. One is that it allows politicians to protect friends, punish enemies, and to tax certain groups to give benefits to other groups. There are numerous tax loopholes and deductions which make the tax unevenly distributed, and not in a good way.
Another problem is that it is incomprehensibly complex. People who are willing to put in the time and effort to figure out the tax system are able to pay less in taxes. This leads to tremendous inefficiency and resentment. It also enables tax evasion through the use of loopholes. The tax laws are bad enough for individuals, but they’re also pretty awful for businesses.
Next, there is the economic argument. What we tax, we get less of, as long as the item is of elastic supply (and labor certainly is). The income tax discourages people from working: It reduces their incentives to work. Currently, the income tax takes about a third of what most Americans make, which is a large drain on the economy. Effectively, it’s a penalty on productive behavior. Furthermore, the administrative complexity adds additional cost.
In addition, our income tax is ostensibly progressive, so the more you earn, the more you’re supposed to pay. As the marginal benefit of extra work falls, people are less motivated to be more productive and creative. Also, due to deductions and loopholes, the current tax system is effectively regressive in many cases: as income increases, the effective income tax rate actually decreases.
Finally, there is the ethical argument against the income tax. Some believe that the income tax, as a tax on property that individuals create through their own labor, is equivalent to theft. It gives government a claim on our lives and our work, and destroys our privacy in the process.
Since the federal income tax is so broken, what can be done about it?
A Realistic Way to Eliminate the Federal Income Tax
The FairTax would abolish all federal taxes and replace them with a 23% nationwide sales tax that applies only to new goods and services. This rate was chosen because it would be revenue neutral (PDF), meaning that under the FairTax, the government would still collect about the same amount of tax money that it does today.
A used car and secondhand clothes would be exempt, while groceries would not. Also, everyone would receive a monthly prebate check, which eliminates federal taxes on the poor. The prebate untaxes spending up to the poverty level. It’s a vastly simplified tax.
In other words, it’s a single-rate national sales tax on final retail consumption with no exemption. Business inputs are not taxed. Education tuition is not taxed.
The IRS would be abolished. The FairTax would be administered by the states and a sales tax bureau in the Treasury Department.
U.S. exports are not taxed since they are consumed abroad. Imports are taxed on an equal basis as U.S. produced goods.
Compliance costs would be reduced by 90% because individuals would be exempt from filing tax returns. Businesses making retail sales will file sales tax returns for a total of about 20 million tax filers.
Some people think that the FairTax would be too generous to the rich, and harmful to the middle class. Well, the fact is that under today’s tax laws, about 55,000 millionaires already pay a lower effective tax rate than millions middle-income Americans, which is why The Buffet Rule has been proposed. So today’s income tax is not particularly generous to the middle class. And even if it were, I would argue that the rich probably should not pay inordinately more taxes than other people, from the standpoint of both fairness and economic reality (maximizing everyone’s overall wealth).
If you have more questions about the FairTax, take a look through their research here.
The Problem of Tax Dodging
Now, some people think the FairTax would not work because there will be too much dodging of it. Even though states have used sales taxes for over 60 years, some people think that the FairTax wouldn’t work because the 23% tax rate is “high”.
The U.S. Receipt Lottery
The solution I’d like to propose? A Uniform Invoice lottery, similar to the system that has been employed in Taiwan since 1951. With the Uniform Invoice lottery, better known as the Taiwan receipt lottery, consumers receive a Uniform Invoice receipt with every purchase.
This encourages merchants to keep things on the books. With millions in winnings on the line, customers now demand a receipt with every purchase, so merchants wind up reporting all their sales to the government.
A lottery system works a lot better than a stick-oriented approach, with penalties for businesses that don’t adequately and accurately report. It’s an easy and effective way for the government to maximize tax coverage. While penalties and enforcement are the “obvious” approach, the lottery system is a creative “carrot” incentive that actually works pretty well.
By the way, the receipt lottery would not be the sole means of enforcement. Sales taxes are not voluntary. They are (and still would be) required by law. The receipt lottery is merely an additional incentive in addition to everything else that already enforces sales taxes today. As I mentioned above, states have been using sales taxes for over 60 years.
Modern and Electronic from Day One
In recent years, Taiwan has been moving to an e-invoice initiative, where customers with smart cards or other identification can have the lottery numbers sent to them electronically.
Since the U.S. has yet to implement anything like the invoices that Taiwan has been using for over 50 years, I propose that we start it off the right way, and have e-invoices from Day 1.
Many private companies are doing it already. Remember the last time you bought something from the Apple Store? You just gave them your email address (or confirmed if it was already on file), and they emailed you a receipt. No paper necessary!
That’s the way the FairTax should work: as a lottery with e-receipts automatically emailed to customers. While there are a couple holdouts who don’t have email, I think it’s fair to require it. It’s 2013. People who don’t have an email address can forfeit their lottery number (or donate it to charity).
Hackathon Project Idea
Implement an e-receipt lottery system for online e-commerce sales. For extra credit, use Bitcoin.
Thanks to Pierre Johnson and Shaon Bhuiyan for reading a draft of this.