Principles-Based Income Taxes

 Summary: The nation’s financial situation requires control of spending and improved tax systems. Many income tax systems, e.g., flat taxes and others, have been proposed. The present progressive income tax would be hard to replace, but it needs to be re-engineered starting from a set of principles. A re-engineered income tax system can expedite solutions to today’s fiscal problems, reduce future problems, and help unite a divided citizenry by being a simple, fair, and long-tern focused.

Politicians seeking votes and support from special interests have corrupted our present progressive income tax system. Their only principle seems to be short-term political expediency. Five principles should be used to re-engineer the present system: (1) fairness, (2) simplicity, (3) stability, (4) encouraging poor and middle-class citizens to save and invest, and (5) minimizing political divisiveness.

Fairness involves many issues that suggest the form of the tax system. Who pays and how much? How much of the last dollar earned should be given to our government? Although open to debate, this proposal assumes:

  • All voting age citizens receiving income pay income taxes so they feel the impacts of taxes and spending.
  • Progressive taxes need to be balanced when different income sources use different rate values.
  • No one should give up more than X% of his or her last earned dollar to the Federal Government, where X is a vetted number.
  • A principles-based cost-benefit analysis is used to determine if and when tax deductions, credits, etc. are warranted.

The proposed model uses one formula for tax rate determination, but allows great flexibility in its design while retaining simplicity. By changing constants the maximum rate, initial slope, “progressiveness” rate, and initial starting point can be set. This allows different tax rates to be established for earned and capitol gains incomes.

The total tax amount paid curve is derived directly from the rate curve[1]. The total tax curve is the sum of the incremental totals (the mathematical integral) of the rate curve. Thus the amount of taxes each person is to pay is easy to determine with one simple curve. The following aggressive earned income tax rate and total tax curve example demonstrates the concepts. In this example, Rmax=50% (maximum rate), CI=1 (initial slope), Co=0 (initial offset), and G=2 (aggressiveness). These constant numbers need to be vetted, but once constants are agreed upon, Principle 5 dictates politicians must not frequently change the curves.

Several items are relevant to the five principles are evident by the curves. The vertical (Y) axis is both the tax rate percent (blue curve) and the automatically calculated total tax percent (green curve). The horizontal (X) axis is the fraction of the total number of taxpayers. The actual axis dollar amounts from the preceding year are used to set the annual dollar tax basis, e.g., 2010 income numbers are used for the 2011 tax basis. Several household incomes for 2010 are shown in the example. This feature assures taxes reflect inflation, productivity and other changes are automatically accommodated, and bracket creep — the cash cow for politicians — is avoided. Other features include:

  • Below one-half (median) earners’ have a top rate of less than 15%, and their total tax paid is less than 6.55%.
  • Three-quarter and below earners’ have a top rate of less than 27.5%, and their total tax paid is less than 17.2%.
  • The top 10% earners’ have a top rate of more than 40.3%, and their total tax paid is more than 27.5%.
  • The top earners’ rate is 50% (Rmax), and their total tax is 36.5%.

5 Earned Curves for 1-15-13 Article.002

Every income-earning citizen “owns a piece of the action.” Everyone pays some taxes independent of their income source. This eliminates the unfair situation where a majority of mostly non-tax paying citizens and others receiving a government check can vote to take (“free money”) resources from a minority of productive citizens. Also any increase in spending and/or taxes must be distributed. If our government leaders want to increase taxes by say 10% then everyone’s taxes increase by 10%. This takes away politicians’ ability to wage income distribution wars. 

Principles 1, 2, 3 and 5 are addressed for earned income, but Principles 1 and 4 require a balance between earned and capitol gains income (fairness) verses assuring jobs, liberties, and future opportunities (investments).  In the following graph the capitol gains rate (gold curve) and corresponding total capital gains tax (red curve) are shown to address these balances. An aggressive Rmax=75% (maximum rate), CI=1 (initial slope), Co=-5% (an initial offset that provides a “negative tax” for one-third of the population), and G=4 (aggressiveness). Again, concepts are shown, but the constants need to vetted through debate.

Sample Tax Chart 10.01.12 6 All Curves for 1-15-13 Article.001

This capital gains rate curve strongly encourages all taxpaying citizens to save and investing in the U.S.  Several Principle impacts are clear:

  • Citizens with lower capital gains income pay zero or small taxes while upper income citizens pay more taxes.
    • One-third of citizens with the lowest capitol gains incomes would pay no capital gains taxes. The “negative taxes” shown are Government provided funds for lower income citizens’ IRAs or similar restricted investment/saving accounts.
    • The next one-half of citizens with capitol gains incomes would pay capital gains income rates ranging from 0% to 35% that are less than earned income rates.
    • The remaining top one-sixth of citizens would pay capital gains income rates higher than earned income rates, ranging from 33% to 75% (assumed Rmax).
    • The total capital gains taxes are less than total earned income taxes for all taxpayers so all benefit from investing. The maximum total tax is 17.23%, a number that can be adjusted up or down by changing the constants G and Rmax.
  • The playing field between the poor and middle class verses the wealthy is leveled. The wealthy have sufficient resources to own a wide range of risk-return and inflation protection investments that are too risky or costly for the less wealthy. Higher risk investments yield higher returns, and precious commodities (gold, art, etc.) hedge against inflation. Thus, the rich get richer because their returns on investments are greater than those of us who have modest or no excess funds for investments.

A final Comment: The above example is an aggressive income tax system. A much less aggressive example is clear by reducing the “Y” axis percentages by one-half, e.g., Rmax=25% for the earned income maximum, and Rmax=37.5% for the capital gains income maximum.

Our present progressive tax system has been corrupted by career politicians seeking votes and money from special interests and, therefore, is not fair, simple or in the long-term best interest of the nation. It is time to re-engineer whole U.S income tax based on principles that citizens can understand. This principles-based proposal has many needed features. It should also help unite rather than divide our citizenry, and result in a prosperous future for our nation.  It is time “we the people” take charge of our present dysfunctional political system and its leaders by demanding rational changes.

[1] Income rate curve: Y%={Co+ CN*[-1+C1*X+ EXP(G*X)]}, where EXP is a mathematical constant, and CN =[1/(Y value for CN with CN=1 and X=1)]*[Max. rate fraction, e.g. 0.5 for Rmax=50%)] is a 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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February 2013
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