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  Over the years, the income tax system has become more complex, and tax rates have risen to pay for wars and finance the growing size of the federal government. For example, in 1916 the lowest rate was raised to 2 percent and the top rate was raised to 15 percent for taxpayers with incomes in excess of $1.5 million (in 1916 dollars). The Social Security tax was added in 1935. Income tax rates rose again in 1941. Tax cuts followed after World War II, but the tax system got more complex and rates rose over time until the Reagan era. The Medicare tax was added in 1965. Major tax reform was achieved in 1986, but again the code has grown more complex and rates have risen since then.

  So how do we reform this system? This is a particular challenge, given our historical antipathy to taxes of any kind. But Americans believe in fairness, and I think a reform that emphasized making the system fairer by ending preferences would capture widespread support. However, any major tax reform campaign will have to be part of a much broader government transformation effort that engages citizens in new and unprecedented ways. And any effort designed to raise more federal tax revenues will need to be coupled with major entitlement reforms and statutory spending controls.

  MAKE THE SYSTEM SIMPLER

  The Internal Revenue Service has been working to crack down on tax cheats while improving its technology and efficiency. But a system like ours, with so many preferences and so much paperwork, is still way too complex. To really close the tax gap, we will have to streamline and simplify the entire tax code. Again emphasizing the idea of fairness, we should support tax enforcers by giving them more information about transactions in our economy—such as how much money investors make (or lose) when they buy stocks, among other things. We should also have tax withheld automatically from payments to independent contractors, partners in professional services firms, and others who now make their own estimated tax payments. If you work for a company, you have taxes withheld automatically from your paycheck. Why shouldn’t the same thing happen if you work as a contractor or partner in a professional services firm?

  Similarly, we should take another look at the tax breaks we allow for health care. In any reform leading to national health insurance, the government’s role might be to provide a safety net for all legal residents, to promote wellness and preventive care, and to protect us against catastrophic medical expenses. But suppose the cost of such a government health plan is $5,000 a year and our employer gives us comprehensive coverage costing $12,000 a year. Why shouldn’t we pay taxes on that extra $7,000 of health care coverage?

  We could take another huge step toward a simpler tax system by getting rid of the con game known as the Alternative Minimum Tax. The AMT dates back to 1969, when Congress decided to go after rich Americans who claimed so many deductions that they ended up paying little or no income tax. The problem is that the income levels that triggered the AMT were not indexed for inflation—which means that as inflation has raised salaries, millions of middle-income taxpayers have been hooked into paying the AMT. Maybe their incomes would have made them rich in 1969, but they aren’t rich today, especially if they live in New York City or other very expensive metropolitan areas.

  These AMT victims dutifully fill out their tax forms, taking normal deductions for state taxes, dependents, and so on—then discover that it was all no more than a pencil exercise because under AMT rules their deductions disappear and they owe much more. The government has just played a bait-and-switch game with them. Now you see your deductions, and now you don’t. Surprise! I can think of different language, but I won’t use it here.

  We should do away with this complicated and unseemly exercise in taxpayer deception—or at least reform the AMT so that it applies only to the country’s richest households, as it was originally intended to do.

  Congress won’t take such steps lightly; cutting the AMT would cost at least $800 billion in revenues over ten years, a loss that might require our legislators to raise tax rates. But our government should tax us honestly rather than conning us out of our money and making us waste a lot of time filling out forms that don’t really matter. I must tell you that I have paid the AMT four out of the past five years. To me, it is nothing more than a dishonest surtax—a surtax that resulted in me paying about 18 percent more in federal income taxes in 2008, and I’m not a wealthy person. This is one case where it would be better to raise rates than perpetuate the deception on nonwealthy taxpayers.

  The reality is, under the AMT, the only itemized deductions that individuals really get are for charitable contributions and for mortgage interest on a primary residence. As of this writing, I don’t have such a mortgage, since I practice what I preach—minimizing debt and maximizing savings. I had a mortgage until ten years ago, when paying mine off helped me afford to return to government service.

  MAKE THE SYSTEM FAIRER, TOO

  A streamlined tax system would be easier to comply with and easier to enforce. More Americans would pay the taxes they owe. But we also have to broaden the tax base so that more of us share the cost of financing the government we want. You’ve heard that old expression: “Don’t tax you, don’t tax me, tax the guy behind the tree.” Well, forget it. Today, as Pete Peterson says, it’s more like, “Don’t tax you, don’t tax me, tax the baby on your knee.”

  In a nutshell, we have to extend the reach of our income tax system and make it fairer. We have to keep payroll tax rates as low as we can but still deliver on the promises we have made for Social Security and Medicare. And if we can’t generate enough revenue from these traditional sources, we have to consider another source—some kind of national consumption tax, possibly earmarked to pay for the universal basic and essential health care plan I’ve discussed.

  Right now, our system is anything but fair and balanced. After the Bush 43 tax cuts, two-thirds of all working Americans paid more in payroll taxes—which finance Social Security and Medicare—than in income taxes. In addition, more than 40 percent of Americans pay no income taxes at all. That is, they pay nothing to finance just about every other federal expenditure, including all of the express and enumerated functions envisioned for the federal government by our Founding Fathers. Obama’s tax proposals would make the percentage of freeloaders even larger. Under his changes, as many as half of all working Americans would pay only payroll taxes. Think of that: Over half of all working Americans would probably end up paying no income tax at all!

  What does this trend mean? For one thing, we have to become more holistic in our thinking. When we talk about the federal tax burden, we can’t just consider income taxes; we have to think about the combination of income and payroll taxes.

  When you look at the combined tax burden, you get a very different picture of the distribution of taxes. (See figure 9.) What you see is that the top 20 percent of taxpayers pay about 69 percent of the total of all income and payroll taxes. What you don’t see is that payroll taxes are inadequate to keep Social Security and Medicare afloat. In addition, fewer people are paying for bedrock government programs like defense, homeland security, foreign relations, the federal judicial system, our national infrastructure, environmental protection, and the like. All of these programs are funded via the income tax. Do we want a tax system in which most of us don’t pay for national defense and homeland security? I don’t.

  Figure 9 Who pays what in taxes (2006 tax year). The graph shows where the money raised through federal payroll and income taxes comes from. For instance, just 1 percent of the revenue comes from the poorest 20 percent of the population. The top 40 percent of households pay about 86 percent of all federal payroll and income taxes. (The income ranges are the combined annual pretax income of a two-person household.)

  We need to distribute our taxpaying burden more equitably. We should ensure that all Americans except the poorest pay some minimum level of income tax—say, 10 percent of the amount of income above a geographically adjusted level.

  This is where my proposal for a new consumption tax comes in. I can hear you screaming, but let me reem
phasize a major point of this book: There are only two kinds of taxes, the ones we pay now and the ones we pay later or defer to our children and grandchildren, with interest. I say we take on our responsibilities as citizens now, cleaning up our deficits and debts when the costs are cheaper than they will be if we pawn them off on our kids. As George Washington said, “We should avoid ungenerously throwing upon posterity the burdens that we ourselves ought to bear.” These are timeless words of wisdom that today’s elected officials should heed.

  Let’s put things in perspective. Americans pay less in taxes than people do in other major developed countries. In 2007, taxes at all levels of government represented nearly 28 percent of our economy, compared with an average of 37 percent in the Organization for Economic Co-operation and Development (OECD), the club of major market economies. Among the thirty members of that global club, only Mexico, Japan, Korea, and Turkey had lower overall tax burdens than the United States.

  If we do nothing at all, our taxes will rise in the near future. Bush 43’s tax cuts all were enacted temporarily and are set to expire at the end of 2010. Our elected officials need to decide which of those tax cuts to retain, which should be modified, and which should be allowed to expire. If they all expire, that would raise our federal tax rate from its historical level—about 18.3 percent of the economy over the last four decades—to 24 percent by 2050 and rising. That won’t happen, since there is bipartisan support to extend the middle-class and selected other Bush tax cuts.

  Americans are not likely to support a 24 percent and rising overall federal tax burden without another real Tea Party. Yet that level is still not enough to pay the federal government’s bills. At the same time, total federal tax burdens could be less than this if we start to make tough choices. So we need to act sooner rather than later to impose long-overdue statutory budget controls, entitlement and tax reforms, and other changes necessary to keep future taxes at a reasonable level. The truth is, the longer we wait to institute tough budget control, reform entitlement programs, and make tax changes, the higher taxes are likely to go up over time. Timely action can get the power of compounding to work for us rather than against us, as it is now.

  TAXING CONSUMPTION

  Consumption taxes, especially progressive ones, make sense because they spread the burden of taxation and encourage saving. We already have some forms of consumption tax; for example, state sales taxes and federal excise taxes on items like gasoline and guns. I am for consumption taxes as long as the essentials of life (basic foodstuffs, clothing, shelter) are exempt or otherwise recognized. Until now the United States has shied away from the widespread use of consumption taxes because they can serve to penalize poor people, taking a relatively bigger bite out of their financial resources. The rest of the world has not been so shy. The OECD countries take more than 30 percent of their tax revenue on average from consumption taxes; the United States takes less than 10 percent, ranking at the bottom of that list.

  One particular consumption tax is more popular than all the others around the world. In the past half century, more than a hundred countries have adopted a value-added tax (VAT), a form of indirect sales tax. Every OECD country—except the United States—has a VAT.

  The VAT doesn’t hit just consumers at the point of final sale, like other sales taxes. Rather, it is imposed at every stage in the production process that adds value—for example, when a tree becomes a plank of wood, when the wood becomes a chair, when the chair is sold wholesale, and finally when it’s sold retail. Businesses with long production chains are not penalized because they pay taxes only on the value added in their transaction and can take credits on earlier taxes along the chain. Governments can allow for other credits or rebates as they see fit—to certain industries, say, or to low-income citizens, or to tourists. If you’ve had your VAT refunded at a European airport, you know how this system works.

  In my ideal world, we would get rid of our income tax system with all of its complications and rely on consumption taxes for a significant share of federal revenues. The VAT is easy to administer, deducted automatically in every transaction. (According to some, we might be able to get rid of the IRS!) Policy makers can favor certain industries and taxpayers simply by adjusting the relevant rates and credits. (No more squadrons of lawyers finding loopholes!) Finally, a consumption tax encourages savings over conspicuous consumption: You can dodge taxes only by being more careful about how you spend your money. It is also a way to tax very wealthy people without having to distinguish between their accumulated wealth and their current income. Their tax shelters would no longer save them from taxes.

  Okay, time to stop dreaming. Some version of Form 1040 and April 15 will probably continue to be aspects of the American nightmare for many years to come. But let’s at least include a national consumption tax as part of an efficient, fair new system to generate the revenues we need to close the deficit, reduce our debt, and address other key national priorities. We need more money to pay our bills, and adding a new tax, after we enact tough new statutory budget controls and spending limits, may make sense as an alternative to dramatically raising our income and payroll tax rates and putting more pressure on an already creaky foundation of our tax policy.

  And what about the estate tax? In my view, it should not be repealed but the exclusion limit should be raised and indexed for inflation, and the tax rate should be held at a reasonable level. Why not repeal it? Because, can you imagine how wealth would be further concentrated in this country over time? My Walker family line has never had enough money to worry about the estate tax, but I know many other families that have. The truth is, many people who benefit from second-and third-generation inherited wealth do not necessarily use it wisely.

  LET’S BE WORLD WISE

  You’ll note that my argument considers our national tax system in the context of the rest of the world. Some Americans—including many of those “Tea Party” protesters—don’t buy that approach. They argue that the rest of the world doesn’t count: America has to stay true to its own culture of taxing and spending.

  It’s not that simple in an increasingly interconnected and interdependent world. Many countries have higher taxes than ours because they finance national health insurance. Does that give their workers more flexibility and mobility than ours, who always have to worry about health care before switching jobs? Does it help their economies ride out downturns better than ours, where a worker can suffer a catastrophic loss of job and health coverage simultaneously? We should consider questions like these, which tell us a lot about our domestic compassion and global competitiveness.

  What about corporate taxes? Right now, the U.S. corporate tax rate is more than 12 percent higher than the OECD average. In fairness, there are numerous special tax preferences accorded to U.S. corporations that serve to reduce the rate that many major corporations pay. In fact, many corporations pay little to no income taxes as a result of these special tax provisions. Furthermore, there are a number of special deferral arrangements and other deals that apply to multinational corporations. These are very complex and very difficult for the IRS to enforce. The truth is, the IRS is largely outgunned and out-resourced when it comes to corporate tax compliance, especially when it has to deal with very large multinational corporations.

  If we are going to have corporate taxes, which should be debated, we need to make sure that our corporate tax structure is appropriate to the times. For starters, U.S. corporations work for their shareholders, not for the American common good, and will use their considerable legal brainpower to avoid taxes wherever they can. Once again, simplicity is our best tool. We need to broaden the base of corporate taxation, keep the tax rates low, and minimize the number of deductions, credits, and exclusions that the corporate lawyers can use to reduce their companies’ effective tax rates.

  It’s also important that our corporate tax structure should help improve our competitive position abroad. For example, the United States taxes income earned abroad at much hig
her rates than most countries do. These rules make dodging U.S. taxes almost a competitive necessity for our multinationals—and cry out for a simpler system featuring lower rates and a broader base of taxable income.

  Please keep two important principles in mind. While most Americans have no desire to move anywhere else, corporations will if the tax laws or regulatory structures become too onerous. At the same time, we must realize that corporations don’t really pay taxes. Rather, they pass along any tax, in the form of higher prices to consumers, lower wages to workers, and/or lower returns to shareholders.

  THE REFORM DEBATE

  The changes I’m suggesting in this chapter fit the principles I’ve kept in mind throughout this book. They respect our values, make best use of our financial resources, and are fairer for the next generation. They also make common sense. If we want to raise tax money the American way, we have to keep the rates low and make sure we all pay our fair share.

  There are, of course, many other voices in the debate. Let’s not spend much time on the voices from the fringes, such as those that argue for either a welfare state or tax-free capitalism. Keep in mind, contrary to assertions by some, not all tax cuts stimulate the economy, and very few tax cuts pay for themselves. To pay for themselves, they have to result in more gross tax revenue after the tax cut than would have been received without the tax cut.