Mar. 7, l988 INCOME TAX REFORM by David S. Lawyer The present income tax structure urgently needs reform. The tax rates for the rich were 90% during and after World War II but they have since crept down to under 40%. High income persons are the ones best able to bear the burden of increased taxation needed to reduce the national debt (and eliminate the deficit). At the same time, taxation needs to be adjusted for inflation so as to tax only real income. Much tax is being paid on fictitious capital gains where much of the increase in the dollar value of an investment is due only to inflation and represents no real increase in actual value. Depreciation fails to provide sufficient funds to replace worn out capital goods due to the inflated cost of new equipment and buildings. The following reforms are proposed: 1. Go back to a large number of tax brackets (preferably an infinite number of brackets) and tax the top bracket at a 90% (marginal) rate. 2. Adjust taxes so that they tax only real income by properly accounting for inflation. 3. Stop the double taxation of corporate profits by reducing/eliminating taxation of dividends/capital-gains. 4. So as to discourage large families, the deduction for dependent children should decrease as the number of children per family increases. So called tax reforms have reduced the number of tax brackets. If we did not have computers, perhaps such a simplification would have been justified. However, by using computers to calculate taxes, it is feasible to make tax brackets continuous so that there is no jump between brackets (tantamount to an infinite number of brackets). All one needs is a formula which gives the marginal tax rate for any taxable income x. For example: Marginal_tax_rate_in_percent = 90(1 - exp(-kx) ) where k is some constant (say 1/50,000) and "exp" is the exponential function ( exp(y) is the base of the natural logarithms e raised to the power y). To find the average tax rate for a given income y, one merely finds the average of the marginal rate with the average taken over x=0 to x=y. The resulting formula for the average rate for a given taxable income y is: 90(1 - (1/ky)(1 - exp(-ky))). One merely multipies this by his taxable income to find his tax and a computer can do this almost instantly at an insignificant cost. If an individual has no access to a computer, the IRS could make this calculation for him on their computers. Of course, curves and tables would be published so that one could rapidly find his approximate tax without use of a computer. Having "continuous" tax brackets as proposed above is inherently more equitable since individuals are not penalized by sudden jumps in their marginal tax rate as their income goes through a dividing point between the existing income tax brackets. Since in the future, computers will likely be even cheaper and more ubiquitous than they are today the burden of making such a tax calculation should decrease in future years. By failing to take inflation into account, a great deal of taxes are assessed on fictitious profits. For example, if I bought a home for $100,000 and sold it later for $200,000 at a time when prices had doubled due to inflation, I would actually have made no real profit on the home but would still have to pay tax on $100,000 of fictitious profit. The same situation exists for investments in stocks. Businesses depreciate their plant and equipment based only on the original cost and thus do not (usually) accumulate sufficient funds via depreciation to adequately replace their worn out (or obsolete) plant and equipment. Not only does this result in them paying taxes on "fictitious" income but such accounting makes stockholders think that companies are making good profits when in fact they are actually making little or no real profits (and often are actually losing money on a real basis). Other fictitious profits are made by the increase in the selling price of inventories due to inflation when the actual increase in their real value is often zero (or even negative). The result of this is a decreasing real net worth of many corporations and an increase in their debt burden which they often take on to compensate for their real (but unreported) losses. The corporations are thus free to pay excessive wages, management salaries, and dividends by borrowing and this tends to decrease the real value of investment in American industry. To be competitive in foreign markets and to increase our standard of living, we need more real investment in industry. Capital gains are actually "earned" over a period of time, often over a period of many years. Thus one should be permitted to pay taxes on such gains based on approximately the average tax bracket which the taxpayer was in over the years which the capital gain occurred. Such a calculation would be complicated since a portion of such gains would in effect be allocated to every year over which the asset was held, thereby increasing the income for each year and putting the taxpayer in a somewhat higher "bracket" for each such year. The IRS would normally make this calculation using its computer programs and could even assess the taxpayer the interest (calculated at real rates) due for "late" payment since the capital gains tax is paid at the end of several years in one lump sum instead of a little bit every year. Of course, adjusting accounting and taxation for inflation would result in taxing interest income only on the basis of the what the earnings would have been at the real rate of interest (the interest rate which the investor receives less the rate of inflation). This would often result in taxing interest income at a much lower rate than other income and create a very strong incentive to save. Still another needed reform is the elimination of double taxation of corporate profits. Presently, both corporations and individuals pay income tax on it. Simply making dividends and capital gains on stock exempt from taxation would not be fair to persons of widely different income since this is tantamount to charging high-income persons the same tax rate on corporate profits as low-income taxpayers since the corporation has already paid the taxes on it. Instead, dividends and capital gains from corporations should be taxed at a rate so that the total tax paid (by both the individual taxpayer and the corporation) is the same as the individual would have paid at his tax bracket rate. For example, if the corporate tax rate is 50%, individuals should be able to retain twice as much after-tax dividends and capital gains as their tax bracket would normally entitle them to. For example, a rich taxpayer in the 80% bracket would pay only a 60% tax rate on such income while a middle income taxpayer in the 50% bracket would pay no tax on such income. A poor person in the 10% bracket would not only pay no tax on such earnings but would receive a 80% income tax credit. He might even obtain a payment from the IRS if this tax credit exceeded his tax liability. This reduction of taxation (or in some case a "negative" tax) on dividends and capital gains on stock as well as taxing interest income at much lower than normal rates would be a very strong incentive for Americans to save, especially those of middle and lower income. Even for those with high incomes, the incentive to save is very strong since for example, a person in the top bracket (90%) normally could retain only 10% of his corporate earnings but now could keep 20% (twice as much). In spite of the benefits offered to the rich by this proposal, they would (on average) bear more of the tax burden than they presently do due to higher tax rates on high incomes. In order to discourage large families (leading to overpopulation) the deduction for the first-born child dependent should be say $3000. The second would get a $2000 deduction and the third a $1000 deduction. Additional children would receive no deductions. For persons who have children with more than one spouse, an average would be taken. For example, if a child is the first for one spouse but the forth for the other spouse, then a deduction of $1500 would be allowed. The phase-out of deductions for dependents of high income taxpayers would be retained. Overall, the author believes that the above taxation policy would make a very significant contribution towards increasing the savings rate in America which will tend to both raise the standard of living and reduce the imbalance of foreign trade. It should also make the tax system fairer and benefit lower income taxpayers as well as contributing to reduction of the budget deficit. Please note that the numerical figures given as examples are only examples. The exact amounts should be calculated so as to provide sufficient tax revenues to balance the budget (and repay some of the national debt).