Principles-Based U.S. Tax Systems

Political expediency to retain power and garner votes has resulted in 80,000+ pages of tax codes that exasperate our current national problems. Fixing the nation’s present fiscal mess will require tax changes and spending controls. New tax systems are proposed that are based on a long-term focused set of principles rather then short-term politics.

The federal government’s income is dominated by corporate income taxes (~15%), individual earned and capital gains income taxes (~50%), and employment taxes (32%). Employment taxes are mostly “insurance policies” for retirement (e.g., Social Security), medical (e.g., Medicare), welfare (e.g., basic survival), and jobs (e.g., unemployment). Estate, gift, and excise taxes are the bulk of the remaining taxes (3%). The progressive individual and corporate income taxes constituting 65% of the federal income are the focus here.

Five principles provide a basis for corporate, and earned and capital gains income tax systems:

  1. Simplicity — Understandable, simple formulas are required that eliminate favoritism, and expensive tax preparation “busy work.”
  2. Stability—Uncertainty minimization is required to encourage individual and business risk taking, and reduce speculation.
  3. Invest in U.S. —All citizens, independent of income, and corporations must be encouraged to invest in their and the nation’s future.
  4. Minimize political manipulation — Changes must be linked to national indicators, i.e., average wages, GDP, and spending.
  5. Fairness — How much and who pays must be based on our nation’s long-term best interests. Two key issues are: (1) fair tax rates — the tax on each dollar earned by those being taxed, and (2) the instability caused by a majority of voters — citizens who pay no taxes and public sector employees whose wages are from taxes — dictating how much taxes the rest must pay.

Several assumptions support the Five Principles:

  • The  ~80,000 pages of tax codes and their exemptions are initially eliminated.
  • New or reinstated exemptions are justified by a Five Principles based cost/benefit analysis.
  • The long-term best interest of the nation trumps short-term political expediency.
  • Individual responsibility trumps group or government responsibility.
  • Income from all sources including governments is considered income.
  • Most adult citizens “own” a piece of the action by paying taxes.
  • Any increase in spending or taxation must be distributed across all taxpayers.
  • A multiyear phase-in plan is developed to allow transition adjustments, i.e., one-time increases to governmental provided incomes, long-term reduction of some deductions, etc.

Three type of taxes are utilized here:

  • Flat taxes —corporations, an individual or family pay the same rate independent of income.
  • Value added taxes (VAT) — a tax based upon the value added to provide a goods or service.
  • Progressive taxes — tax in which the rate increases as the amount subject to taxation increases.

A “wealth tax” on the super wealthy is also a possibility.

Business/Corporate Taxes —

Taxes on businesses are appropriate since businesses too benefit from many public financed functions. Today’s U.S. corporate taxes are the highest in the industrialized world and impact our nation’s economy. This tax and other costs, i.e., regulations, entitlement mandates, and wages that are driving U.S businesses to move functions, jobs, and profits offshore. Corporate tax changes are needed that help corporations compete globally and reverse recent offshore trends.

Despite present rhetoric, corporate taxes cannot and should not be used to solve our fiscal problems. For example if 100% of the Fortune 500 companies’ profits in 2011 were collected as taxes, the money would have covered only 21% of the deficit. Stakeholders who start or invest in businesses do so expecting to make money. Companies’ fail when profits and growth do not meet stakeholder expectations. In general low corporate taxes benefit the nation by increasing U.S. jobs and other opportunities.

Using the stated assumptions and replacing the present tax system with a flat tax and a VAT yields results consistent with the Five Principles. A small flat tax that paid on profits assures corporations pay for general benefits they receive. A zero or small flat VAT is applied for value added within the U.S., and a higher VAT is applied to value added offshore. These new tax systems will significant change U.S. businesses’ investments and labor models.

Tax offsets for paying foreign taxes, research in the U.S. and similar offsets should continue only if they satisfy more than one Principle. Costs for offshore goods and services to U.S. citizens would remain relatively unchanged. The businesses risk environment would be more stable with less political interference.

Individual Earned and Capital Gains Taxes —

Among the various types of tax systems, progressive tax systems are likely the only systems that can recapture a sound national financial base and be perceived as fair.

The proposed system uses annual income data and one formula for tax rate determination. The total tax curve is automatically calculated (as the mathematical integral) from the rate curve. The fraction of taxpayers and actual incomes from the preceding year are one axis of the tax rate and the total tax curves. This assures that taxes automatically reflect inflation and productivity changes, and avoids bracket creep — a cash cow for politicians — thereby improving stability while minimizing political manipulation.

The tax rate curve[1] allows selection of a maximum rate (Rmax), initial slope (C1) “progressiveness” rate (G), and initial starting point (C0). Different tax rates are established for earned and capital gains income as part of the Fairness Principle. Taxpayer payments are easily determined from the total tax curves given earned and capital gains incomes.

The following earned income tax rate (blue) and total tax (green) curve examples demonstrate the concepts. In this earned income example, Rmax=25%, CI=1, G=2, and Co=0. In the capital gains tax rate (gold) curve example, Rmax=37.5%, CI=1, G=4, and a Co provides a “negative tax” for one-third of the population. The constants used need to be vetted, but stability requires initially agreed upon constants not be subject to frequent manipulation by politicians. The left vertical (Y) axis is the tax rate percent, and the right vertical axis is the automatically calculated total tax percent. The horizontal (X) axis is the fraction of the total number of taxpayers. The actual dollar amounts for the preceding year replace the fraction shown (some 2010 values are shown). Also note:

  • This system will maintain today’s total tax base with lower rates due to the assumptions, i.e., elimination or reduction of some tax deductions.
  • For graph simplicity the total tax percent capital gains curve is not shown.


Examples of Individual Earned and Capital Gains Income derived from the Five Principles

Several items relevant to the Five Principles are evident in these graphs.

  • The earned income rate is modestly progressive:
    • One-half (median) and below earned income payers’ rate is 7.5% or less, and their total tax paid is 3.275%.
    • The top 10% earned income payers’ rate is from 20.13% to 25%, and their total tax paid is from 13.725% to 18.25%.
  • The capital gains income rate is more progressive:
    • Favors over 85% of the taxpayers (to encourage investing) with capital gains rates less that the earned income rates
    • Top 10% pay capital gains rates that start at 24.22% and rapidly increase to 37.5% significantly higher than earned income rates
    • Encourages investments by citizens with lower and middle incomes while upper income citizens pay much higher capital gains.
    • The bottom one-third pays no capital gains taxes also to encourage investing.
  • The “negative capital gains tax” dollars shown is a “tax return” to individuals in the form of a tax-free retirement investment saving account.

Manipulation control requires that any increase in spending and/or taxes be distributed. If our government leaders want to increase taxes by 10% then everyone’s taxes must increase by 10%. This takes away politicians’ ability to wage “income or class wars,” and requires every citizen to consider the impact of spending and taxation on themselves and their families.

A closing observation: The “millionaires and billionaires must pay more” mantra cannot be addressed by income taxes since most of their wealth is accumulated through corporate growth. For example, Warren Buffet’s $46 billion wealth is accumulated within Berkshire Hathaway, Inc. that does not pay dividends; thus, he personally receives no (taxable) dividends and pays no capital gains. If a 1% wealth tax were collected based on Warren Buffet’s wealth, he would pay $460 million per year in taxes. A wealth tax is utilized in other countries.

Conclusions —

Our present income tax systems fail all desirable principles because they’ve evolved over decades by career politicians focused on short-term political expediency. The proposed new systems are implementable and form a rational framework for future tax policies.

The two corporate taxes will change the present business model by helping U.S. businesses be globally competitive, and driving investments and jobs to the U.S. The proposed individual tax model provides simpler and more stable systems. Political manipulations are more difficult because the model is linked to national variables, and requires a one-time consensus for the rate curve constants. All income sources are taxable and increases in spending and/or taxes distributed to all taxpayers enhance “citizen ownership” and fairness. Investments are encouraged by clear rate structures that strongly encourage savings investments by every citizen receiving income.

The present short-term political “ fixes” our leaders offer at the expense of future generations portends a dim future for our nation.  Bold steps, including major changes to our tax systems, must be taken now to avoid a disastrous future.

[1] Tax rate curve: Y = C0 + [Cs*X + EXP(G*X) – 1]*(Cnor), where Cnor is an axis normalizing constant.

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Dr. Cleland’s Ph.D. is from Purdue University where he specialized in complex systems theory. His technical training and experiences includes analyses of many types of systems, involvement with numerous federal, state, and local agencies, and management of a broad set of set of professionals, services, and trades people. He has managed scientists, engineers, policemen, firefighters, environment, health, safety and emergency planning experts, building trades and maintenance crafts personnel, and others.

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October 2012
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