A Tax Reform Plan that Both Parties Can Like
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John Goodman
Laurence Kotlikoff
October 20, 2013

Notwithstanding its entertainment value, Americas hate party politics and political gridlock.  They are desperate to get our country's problems fixed. And one area that needs immediate fixing is our tax system.  

Our tax system is unfair, distortionary, wasteful, and a user’s nightmare. Most important, it’s limiting our country’s economic potential. But can we have a far simpler tax system that generates at least as much revenue and is more progressive? 

Yes, it’s called the Common Sense Tax (CST). It’s designed to be revenue neutral and kick start our ailing economy. It features just two taxes. One is a payroll tax that taxes all labor earnings at a flat 13 percent rate. The other is a personal income tax with a 25 percent tax on household income above $100,000, in the case of married households, and $50,000, in the case of singles.  

The CST has no explicit corporate income tax and no explicit estate and gift tax. But the CST income tax base includes imputed corporate profits and gifts and inheritances received. 

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Why is the Common Sense Tax fairer?  Consider first payroll taxation. Today’s FICA tax is highly regressive, taxing wages at 15.3 percent up to $113,700, but then at 2.9 percent for a range, before rising to 3.8 percent.  

True, the FICA tax is divided 50-50 between employers and employees.  But economists don’t believe this distinction matters, at least in the long run. This said, to ensure that middle- and low-wage workers benefit immediately from the reduction in the FICA tax rate, the Common Sense Tax levies its 13 percent payroll tax only on employers. 

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Consider next the Common Sense Tax’s personal income tax. By setting high thresholds for taxable income, the Common Sense Tax would instantly end the income taxation of all households of low or modest means – about two thirds of American households.   

But how can cutting the payroll tax rate and taxing incomes only above high thresholds be revenue neutral?  

First, the change to the payroll tax – lowering the rate at the bottom and raising it at the top – comes close to breaking even.  Second, the Common Sense Tax’s income tax is comprehensive. It taxes all income above the thresholds no matter how or where it’s earned. It also eliminates all deductions and other tax breaks, with three exceptions – the charitable deduction, the Child Tax Credit, and the Earned Income Tax Credit. The charitable deduction is an important mainstay of our religious and secular non-profit institutions. And these two tax credits are refundable, making them critical support systems for those in most dire need.

Under the Common Sense Tax, households above the thresholds will pay taxes on the labor income they receive as employees, the profits they earn on all the businesses they own, the interest income they earn on their loans, and the rental income they earn on their real estate.

Under today’s tax system, households with small businesses have to pay taxes on their business income as they earn it.  But if they own shares of large C-corporations, no taxes are due on their share of the corporation’s income until they receive dividends or sell their shares.

Under the Common Sense Tax, owning shares of a C-corporation would be no different from owning a share in a small business. If you were above the relevant threshold, you’d have to pay taxes on the income earned on your behalf by your C-corporations as it was earned. And to make sure you’d have the cash to pay the taxes, C-corporations would be required to distribute a minimum of 25 percent of their annual profits as dividends. This may sound onerous, but corporations, on average, already distribute close to half their profits each year as dividends.  

By taxing all corporate profits (whether earned at home or abroad, whether earned by U.S. or foreign corporations, and whether earned as trading profits by banks, hedge funds, etc.) immediately as they accrue, there is no need to tax capital gains, with all the difficulties and distortions that entails.  

Taxing corporate income at the personal rather than business level would make the U.S. the world’s most business-friendly country. This should stimulate substantial new investment and job creation in the U.S., leading to higher wages for U.S. workers. This negative relationship between wages of workers and the corporate income tax rate is why many, if not most, economists think the corporate income tax is really a disguised tax on labor. From this perspective, eliminating the corporate tax is yet another reason the Common Sense Tax is much more favorable to American working men and women than the current system.

In addition to being simple, transparent, and fair, the Common Sense Tax would improve incentives to work and save, eliminate an entire army of corporate and personal tax accountants and lawyers, and make April 15th just another day for most Americans.  For those who need to file, their tax return would fit on a postcard.  Most important, the Common Sense Tax would help grow the economy and provide, at long last, the American people with a tax system they understand, respect, and deserve. 

John Goodman is President and CEO of The National Center for Policy Analysis and Laurence J. Kotlikoff is a Professor of Economics at Boston University and President of Economic Security Planning, Inc.