Tuesday, December 13, 2011

Tax Paper

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Tax Paper

The federal income tax system takes an increasing percentage of money from people who produce more. Since it was first introduced in 2011, the income tax code has been revised numerous times because of the efficiency and equity problems it has caused (Rosen). Its wrong that the very ideals America holds high - hard work, responsibility, risk-taking, and investing for the future - are penalized. To better illustrate why our current system is flawed, take for instance to families A and B respectively. Family A makes an extra $2,000 as a result of working more hours; since it is in the 15 percent tax bracket, it pays $300 taxes and keeps $1,700. Family B also makes an extra $2,000 as a result of hard work; but since it is in the 0 percent tax bracket, it pays $600 in taxes and only gets to keep $1,400. Although both families put in extra hours to make  the extra $2,000, family A gets to keep more of its hard-earned extra money than the other family. With the extra $1,700, family A gets to take a vacation and isn’t subject to paying further federal income taxes. However if family B decides to invest the $1,400 in stocks to create financial security for the future, the current tax code would compel them to pay even more taxes should they make any profit on the stock. It’s obvious that our current federal tax system favors family A over family B. This essentially gives people less of an incentive to work harder if for each extra dollar earned they take home less. Therefore, a system that uses a flat tax rate for any income would make more sense if we want to take power away from political groups and treat people equally. A new federal taxation proposal calls for a flat 5 percent tax rate on consumption for all individuals in the economy. Implementing this new tax system would treat all consumption the same with one tax rate. Ideally, ending taxes on the capital income generated by personal savings would encourage people to save and invest more (Graham). This would help lower the cost of capital for businesses, thus leading to more risk-taking and faster growth (Graham). People would no longer be penalized for working harder or smarter. It would be a fairer system where a taxpayer with 50 times the consumption of another taxpayer would pay 50 times the federal consumption tax. This would give more Americans more opportunities to make their lives better.

The implementation of this new federal consumption tax bill would shift the focus on consumption of individuals, as opposed to income. There are several advantages of a federal consumption tax system. One advantage of the consumption tax system is that there is no longer a need to measure capital gains (Andrews). For instance, if a person earns interest off of bonds or profits off of stocks, he/she would be further taxed on that additional gain. Another advantage is there is fewer problems with inflation (Andrews). Since there is no need to measure capital gains, the calculation of the consumption tax involves only the current year transactions. Finally, with the consumption tax system, a separate corporate tax is unnecessary (Andrews). A new federal consumption tax would mean that everyone would be required to pay 5 percent of the amount that they consume. Consumption “C” is determined by taking the difference of the total income “I” and the amount that people save “S” (Rosen). One obvious effect of this new system is the significant increase in savings. In the current federal income tax system, people have less of an incentive to save because the basis for taxation (income) is determined by adding consumption and savings together. In other words, if people save less, they have less of an income that they could be taxed on. Inversely, this new proposal would compel people to save more. The more they save, the more they can subtract from their Adjusted Gross Income (AGI); thus leaving them less consumption to be taxed on. In order to increase savings under this new system, taxpayers would invest more money in stocks as well as purchasing more and more bonds. In addition, the savings in bank accounts would increase significantly because the interest earned in banks and in stocks and bonds would not be subjected to taxation, unlike the current system. However, one of the provisions of this newly proposed federal consumption tax doesn’t seem all that fair for everyone. It places a standard lump sum tax of $8,000 per person in each household. Although the purpose of this tax is to enhance the efficiency of the system, it is quite unfair to everyone in the economy. This means that in every household, every person including kids living under that roof would be taxed a standard $8,000 for consumption. This policy would surely favor a household that has multiple people living under that roof. For instance, say household A has three people with only one person earning a consumption of $50,000 and household B has one person earning a consumption of $50,000. With the standard $8,000 deduction per head in each household, household A would end up with $6,000 left for taxable consumption while household B would end up with $4,000 left for taxable consumption. As you can see, household A deducted $4,000 dollars from its total consumption while household A was only able to deduct $8,000 from consumption. Therefore, household A would end up paying less consumption tax than household B simply because there are no tax brackets in this new system and everyone pays a flat tax rate of 5 percent. The person in household B would end up paying $10,500 in consumption taxes compared to only $6,500 for household A. Therefore under this new federal tax system, people could actually pay “less” consumption tax if they decided to live with other people in the same household. With this mentality, people would have less of an incentive to buy a house on their own. More and more people would want to move in with other people just so they could all pay less of a consumption tax, thus creating an increase in housing rental rates. In addition, this new tax system would also discourage people from owning homes on their own because of the new taxing policy. Although a down payment on a house would be treated as a savings, all other payments that include interest or improvements to the home would all be taxed for consumption. We all know it is the “American Dream” to ultimately own a house, but people also want to minimize the amount of taxes they have to pay. This is why people would be partial to renting.

Overall, I don’t believe this new federal consumption tax is the best solution. There are several disadvantages that make the consumption tax system undesirable. The first and most obvious disadvantage is that it is difficult to administer (Rosen). Since business expenses are deducted from the taxable consumption, it is oftentimes difficult to distinguish whether something is purchased as a business investment or personal consumption. For instance, if a person owned a business and worked from home, would the purchase of a new desk be considered a capital investment for his company or just for his personal consumption? This is just one of the many loop holes that people would indulge in if a new federal consumption tax system were implemented. Another disadvantage is the difficult transition from taxing on income to taxing on consumption (Rosen). One group of people that would take a significant hit by the transition is the elder generation. The problem is that people that fall in this category have spent most their lives accumulating wealth for their retirements while being taxed on their income. Now with this new system, they not only wouldn’t be able to enjoy their retirement wealth, but they would also be subject to taxation once again for consumption. Finally, the last disadvantage of a consumption tax system is the dilemma of taxing gifts (Rosen). There is constant debate on whether to tax the donor of the gift or to tax the person who receives the gift upon consumption. The fact that this system would make people save more implies a good thing because people would want to save and invest more for the future. Although this reassures a cushion for their future retirement, the downside is that the amount of money in circulation within the economy would significantly decrease. The wellness of the economy depends on the increase in consumer spending, not decrease.


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