The Personal Income Tax Made Simple

The more you make the more the government takes unless you jump through a twisty maze of loopholes and spend what you keep the way the government thinks you should spend it. Your finances or your freedom: which do you give up?

This is annoying.

And unnecessary. We could fund the government at its current size and maybe even cut the deficit while drastically simplifying the income tax. Yes, I did say income tax. I know many of you want something better than an income tax. Even with the reforms I’m going to outline below there are still inherent complexities in an income tax that cannot go away. However, a simplified income tax has two big advantages over the Fair Tax and similar proposals:

  1. We have the infrastructure in place. The IRS is ready to serve ;-)
  2. Unlike a national sales tax, an income tax features double entry accounting. Joe’s tax deduction is Fred’s income.

So while it’s nice to dream of and even plan for something better in the longer run (which we will do later right here), let’s look at something that could be implemented within a year: a super simplified personal income tax.

At this point the liberals and Occupiers in the audience are thinking: “Here it comes: another tax cut for the rich scheme sold as simplification.” Based on popular proposals to date, this fear is justified, though for The Simple Income Tax it is wrong. My simplified income tax is different. I would double Warren Buffet’s tax rate at least, while at the same time making the income tax simpler – and possibly flatter – than the flat tax ideas touted by the conservative establishment.

A paradox? No. Most flat tax proposals are regressive taxes in disguise. My proposal, while having only one or two brackets, is considerably more progressive than what we have today.

My Magic Income Tax Trick

For those who work for a living, the federal government collects three different income taxes: FICA, Medicare, and the Personal Income Tax proper. Not only that, the latter two are divided into employer and employee shares just to make it more complicated. (And then there is unemployment insurance, just to ensure that more people avoid employing others.)

What if we were to combine all these taxes into a single income tax? The regressive FICA (Social Security) tax offsets much of the progressivity of the Income Tax proper. Then we have the Earned Income Credit to offset the regressivity of FICA. However, I wonder how much of the EIC actually goes to the working poor and how much goes to sleazy inner city tax preparation firms. The eight pages (51-58 in the 2013 1040 instruction book) of flowcharts, instructions and worksheets devoted to the EIC confuse and frighten me, a theoretical physicist by training. Janitors and ditch diggers might be even more intimidated.

Anyway, if we take all the income taxes and put them together we get this chart for a single filer:

Current tax rates over a range of scenarios going from aggressive tax reduction (heavily mortgaged home; silver health coverage from employer) to passive filing (no health insurance, renting a home).

For a family of 1 adults and 0 children .

Nominal
Income
Total
Income
Payroll
Tax
Income
Tax
Total
Tax
Average
Rate
Marginal
Rate
$5,000 $5,383 $765 $-383
to $-383
$383
to $383
7.1%
to 7.1%
7.1%
to 7.1%
$10,000 $10,765 $1,530 $-332
to $-332
$1,198
to $1,198
11.1%
to 11.1%
21.3%
to 30.6%
$20,000 $21,530 $3,060 $640
to $1,054
$3,700
to $4,114
17.2%
to 19.1%
20.6%
to 28.1%
$30,000 $32,295 $4,590 $1,543
to $2,554
$6,133
to $7,144
19.0%
to 22.1%
23.8%
to 28.1%
$40,000 $43,060 $6,120 $2,571
to $4,054
$8,691
to $10,174
20.2%
to 23.6%
23.8%
to 28.1%
$50,000 $53,825 $7,650 $3,600
to $5,929
$11,250
to $13,579
20.9%
to 25.2%
23.8%
to 37.4%
$60,000 $64,590 $9,180 $4,629
to $8,429
$13,809
to $17,609
21.4%
to 27.3%
23.8%
to 37.4%
$70,000 $75,355 $10,710 $6,103
to $10,929
$16,813
to $21,639
22.3%
to 28.7%
30.1%
to 37.4%
$80,000 $86,120 $12,240 $7,818
to $13,429
$20,058
to $25,669
23.3%
to 29.8%
30.1%
to 37.4%
$90,000 $96,885 $13,770 $9,533
to $15,929
$23,303
to $29,699
24.1%
to 30.7%
30.1%
to 37.4%
$100,000 $107,650 $15,300 $11,248
to $18,493
$26,548
to $33,793
24.7%
to 31.4%
30.1%
to 40.2%
$110,000 $118,415 $16,830 $12,963
to $21,293
$29,793
to $38,123
25.2%
to 32.2%
30.1%
to 40.2%
$130,000 $138,934 $17,869 $17,235
to $26,781
$35,104
to $44,650
25.3%
to 32.1%
24.2%
to 29.1%
$150,000 $159,224 $18,449 $22,004
to $32,101
$40,453
to $50,550
25.4%
to 31.7%
26.8%
to 29.1%
$175,000 $184,587 $19,174 $28,064
to $38,751
$47,238
to $57,925
25.6%
to 31.4%
26.8%
to 29.1%
$200,000 $209,949 $19,899 $34,125
to $45,544
$54,023
to $65,443
25.7%
to 31.2%
26.8%
to 33.8%
$300,000 $311,399 $22,799 $61,300
to $77,409
$84,099
to $100,207
27.0%
to 32.2%
32.0%
to 34.8%
$500,000 $514,299 $28,599 $119,904
to $145,864
$148,503
to $174,463
28.9%
to 33.9%
36.6%
to 39.9%
$1,000,000 $1,021,549 $43,099 $291,319
to $333,964
$334,418
to $377,063
32.7%
to 36.9%
36.6%
to 39.9%
$2,000,000 $2,036,049 $72,099 $634,148
to $710,164
$706,247
to $782,263
34.7%
to 38.4%
36.6%
to 39.9%
$5,000,000 $5,079,550 $159,099 $1,662,635
to $1,838,764
$1,821,734
to $1,997,863
35.9%
to 39.3%
36.7%
to 40.0%

Some explanation is in order. “Nominal Income” is what your boss says he or she is paying you. “Total Income” is what your boss actually has to shuck out to employ you at the Nominal Income rate. This total is the Nominal Income plus the employer portion of FICA and Medicare taxes. All the percentages in my table are with respect to this Total Income, since that is what we’ll be using for the Simple Income Tax. The Payroll Tax column is the total of employer and employee contributions to FICA and Medicare.

For Income Tax, I give a range of values. The low end is for a filer who buys health insurance through employer (assuming $300/month/adult and $150/month/child) and pays as much mortage interest as the banks will take, along with a 1.5% property tax to go along with the home. The high end taxpayer forgoes health insurance and rents instead of owning. Both get the Earned Income Credit if apropos, and deduct state income tax (assuming a rate of 5%) if total deductions exceed the standard deduction. The Earned Income Credit and the Additional Child Credit can make the Income Tax go negative as you see on the first lines.

I purposely did not have either filer take a charitable deduction or put money in a tax deferred account, as I intend to handle those issues separately in future articles. Nor do I factor in any exotic tax dodges used by the rich. All income on this chart is earned income – not dividends or capital gains. For the gory details of my baseline tax model click here.

Anyway, now that you know what you are looking at, take a look at the last column. The marginal income tax gets up to around 30% rather quickly and then bumps around that value for quite a range. It then goes up to 40% for those in the professional class who don’t live their lives as the tax code sees fit, but then drops back down once they get above the maximum for FICA.

The average tax rate looks a bit more progressive. Even for uninsured renters, the average rate gradually works up towards 40%. We can get a similar average rate curve for a one or two tier tax system with prebate, which I’ll show in a moment. But first, let’s look at the current rates for a married couple with three children.

Current tax rates over a range of scenarios going from aggressive tax reduction (heavily mortgaged home; silver health coverage from employer) to passive filing (no health insurance, renting a home).

For a family of 2 adults and 3 children and we assume each adult makes half the income.

Nominal
Income
Total
Income
Payroll
Tax
Income
Tax
Total
Tax
Average
Rate
Marginal
Rate
$5,000 $5,383 $765 $-2,550
to $-2,550
$-1,785
to $-1,785
-33.2%
to -33.2%
-41.5%
to -41.5%
$10,000 $10,765 $1,530 $-5,550
to $-5,550
$-4,020
to $-4,020
-37.3%
to -37.3%
-41.5%
to -41.5%
$20,000 $21,530 $3,060 $-8,074
to $-8,074
$-5,014
to $-5,014
-23.3%
to -23.3%
19.8%
to 19.8%
$30,000 $32,295 $4,590 $-6,418
to $-6,418
$-1,828
to $-1,828
-5.7%
to -5.7%
33.8%
to 33.8%
$40,000 $43,060 $6,120 $-4,312
to $-3,482
$1,808
to $2,638
4.2%
to 6.1%
33.8%
to 43.1%
$50,000 $53,825 $7,650 $-2,717
to $-1,148
$4,933
to $6,503
9.2%
to 12.1%
20.6%
to 28.1%
$60,000 $64,590 $9,180 $-2,031
to $353
$7,149
to $9,533
11.1%
to 14.8%
20.6%
to 28.1%
$75,000 $80,738 $11,475 $-896
to $2,603
$10,579
to $14,078
13.1%
to 17.4%
23.8%
to 28.1%
$100,000 $107,650 $15,300 $1,676
to $6,353
$16,976
to $21,653
15.8%
to 20.1%
23.8%
to 28.1%
$150,000 $161,475 $22,950 $8,191
to $20,433
$31,141
to $43,383
19.3%
to 26.9%
28.4%
to 42.1%
$200,000 $215,300 $30,600 $18,288
to $34,590
$48,888
to $65,190
22.7%
to 30.3%
30.1%
to 40.2%
$300,000 $318,449 $36,898 $40,175
to $63,928
$77,073
to $100,826
24.2%
to 31.7%
26.8%
to 38.8%
$500,000 $521,349 $42,698 $102,008
to $135,746
$144,706
to $178,444
27.8%
to 34.2%
31.0%
to 39.9%
$1,000,000 $1,028,599 $57,198 $269,895
to $323,846
$327,093
to $381,044
31.8%
to 37.0%
36.6%
to 39.9%
$2,000,000 $2,043,099 $86,198 $612,724
to $700,046
$698,922
to $786,244
34.2%
to 38.5%
36.6%
to 39.9%
$5,000,000 $5,086,599 $173,198 $1,641,212
to $1,828,646
$1,814,410
to $2,001,844
35.7%
to 39.4%
36.7%
to 40.0%

For low income families, the average tax rate actually goes negative! At least, it does for those who can figure out the Earned Income Credit and Additional Child Credit without losing most of it to sleazy tax preparation services. But the marginal rate pops up to 30% or more once the EIC starts phasing out.

30%. It’s a nice round number. Suppose we were to combine all the income taxes into a single Simple Income Tax with a flat rate of 30%. Instead of the Earned Income Credit, just give every adult citizen a per capita dividend (a prebate, in Fair Tax parlance). With a prebate of $3000/adult, we get the following chart for a single taxpayer:

Simple tax with a rate of 30% and a prebate of $3000 per adult . Compared with current system.

For a family of 1 adults and 0 children.

Total
Income
Total
Simple Income Tax
Simple Income Tax
Average %
Change
from Today
$5,383 $-1,385 -25.7% $-1,768
to $-1,768
$10,765 $230 2.1% $-969
to $-969
$21,530 $3,459 16.1% $-655
to $-241
$32,295 $6,689 20.7% $-455
to $556
$43,060 $9,918 23.0% $-256
to $1,227
$53,825 $13,148 24.4% $-431
to $1,897
$64,590 $16,377 25.4% $-1,232
to $2,568
$75,355 $19,607 26.0% $-2,032
to $2,794
$86,120 $22,836 26.5% $-2,833
to $2,778
$96,885 $26,066 26.9% $-3,633
to $2,763
$107,650 $29,295 27.2% $-4,498
to $2,747
$118,415 $32,525 27.5% $-5,599
to $2,732
$138,934 $38,680 27.8% $-5,970
to $3,577
$159,224 $44,767 28.1% $-5,783
to $4,314
$184,587 $52,376 28.4% $-5,549
to $5,138
$209,949 $59,985 28.6% $-5,458
to $5,961
$311,399 $90,420 29.0% $-9,788
to $6,321
$514,299 $151,290 29.4% $-23,173
to $2,787
$1,021,549 $303,465 29.7% $-73,598
to $-30,953
$2,036,049 $607,815 29.9% $-174,448
to $-98,432
$5,079,550 $1,520,865 29.9% $-476,998
to $-300,869

We have a simple tax which is a bit more generous than the current system for low income citizens. For middle to professional class we have something of a wash: a tax cut for those not taking advantage of available loopholes and a tax increase on those who are currently aggressive in their tax planning. We can be more progressive by dialing up the prebate. Dial up the prebate enough and we can start eliminating some federal welfare programs. Whether this is affordable would require a Congressional Budget Office or well-funded think tank to determine. (Then again, given the government’s willingness to run trillion dollar deficits, why not just try the experiment and adjust afterwards?...)

Simple tax with a rate of 30% and a prebate of $3000 per adult and $0 per child. Compared with current system.

For a family of 2 adults and 3 children.

Total
Income
Total
Simple Income Tax
Simple Income Tax
Average %
Change
from Today
$5,383 $-4,385 -81.5% $-2,600
to $-2,600
$10,765 $-2,771 -25.7% $1,250
to $1,250
$21,530 $459 2.1% $5,473
to $5,473
$32,295 $3,689 11.4% $5,516
to $5,516
$43,060 $6,918 16.1% $4,280
to $5,110
$53,825 $10,148 18.9% $3,645
to $5,215
$64,590 $13,377 20.7% $3,845
to $6,228
$80,738 $18,221 22.6% $4,144
to $7,642
$107,650 $26,295 24.4% $4,643
to $9,319
$161,475 $42,443 26.3% $-940
to $11,302
$215,300 $58,590 27.2% $-6,599
to $9,702
$318,449 $89,535 28.1% $-11,291
to $12,462
$521,349 $150,405 28.8% $-28,039
to $5,699
$1,028,599 $302,580 29.4% $-78,464
to $-24,513
$2,043,099 $606,930 29.7% $-179,314
to $-91,992
$5,086,599 $1,519,980 29.9% $-481,864
to $-294,430

For families, the Simple Income Tax with a $3000/adult citizen prebate is regressive compared to the status quo. We need to either dial up the prebate or provide it for children as well. Paying people a high prebate for children can lead to some moral hazard, so my inclination is to dial it up for adult citizens instead. We might want provide a lower prebate for children – perhaps as a voucher towards health insurance. Some of the prebate for adults might also come as a health insurance voucher. This would replace the exemption for employer-provided health insurance and the extremely complicated ObamaCare subsidy, which even the government struggles to compute.

Liberals in the audience will notice some rather significant tax reductions on the high end, and complain. So let’s try a two-tier tax with a 40% rate cutting in at $400,000. And since we are getting more from the well off, let’s crank up the prebate for adults to $8000 and take a bite out of poverty. And we’ll throw in a $2000 prebate for each child, mostly in the form of a health insurance voucher. For a family of 5 we get:

Two-tier simple tax with a lower rate of 30%, a prebate of $8000 per adult , $2000 per child and a higher rate of 40% starting at a per adult income of $400000. Compared with current system.

For a family of 2 adults and 3 children.

Total
Income
Total
Simple Income Tax
Simple Income Tax
Average %
Change
from Today
$5,383 $-20,385 -378.7% $-18,600
to $-18,600
$10,765 $-18,771 -174.4% $-14,751
to $-14,751
$21,530 $-15,541 -72.2% $-10,527
to $-10,527
$32,295 $-12,312 -38.1% $-10,484
to $-10,484
$43,060 $-9,082 -21.1% $-11,720
to $-10,890
$53,825 $-5,852 -10.9% $-12,355
to $-10,785
$64,590 $-2,623 -4.1% $-12,156
to $-9,772
$80,738 $2,221 2.8% $-11,856
to $-8,358
$107,650 $10,295 9.6% $-11,358
to $-6,681
$161,475 $26,443 16.4% $-16,940
to $-4,698
$215,300 $42,590 19.8% $-22,600
to $-6,298
$318,449 $73,535 23.1% $-27,291
to $-3,538
$521,349 $134,405 25.8% $-44,039
to $-10,301
$1,028,599 $309,440 30.1% $-71,604
to $-17,653
$2,043,099 $715,240 35.0% $-71,004
to $16,318
$5,086,599 $1,932,640 38.0% $-69,204
to $118,230

This is a negative income tax all the way up to the median family income. Wall St. Occupiers should dance for joy. So should fans of Milton Friedman or Charles Murray.

And there is yet another reason for liberal celebration: the tax for Warren Buffet nearly triples. For the Simple Tax, income is income, whether it is earned income, dividends or capital gains.

In fact, it might be too big a hit on the rich. That’s why I presented the 30% flat version of the Simple Tax first. The 30% flat version “merely” doubles Warren Buffet’s tax rate. (And before ye Republicans start accusing me of being a commie, the top rate on capital gains was 28% after Ronald Reagan’s tax reforms.) The 40% top rate might turn Mr. Buffet into a Republican.

However, before ye liberals celebrate too much or ye conservatives grump too much, be forewarned that the negative income tax for the lower and middle class families shown above has already been granted in 2014 in the form of the ObamaCare Premium Tax Credit – at least for those who figure out how to qualify. This credit is even harder to figure out than the EIC. For this article I used the 2013 tax code as the point of reference because the 1040 guide for that tax year is available. I’m currently working up an approximate model for the 2014 tax year, including ObamaCare subsidies, and I’ll have comparative charts coming up soon.

The Subtleties of the Simple Income Tax

The Simple Income Tax is just that: simple. Either tax everyone at 30% or have a second bracket for the rich at 40%. Give every adult citizen a prebate/dividend. Some of the dividend could come as a health insurance voucher to encourage people to be insured. Ramp of the prebate/dividend enough and you can scrap the federal portion of the welfare system, therebly simplifying more than just the tax code.

For the most part there should be no deductions allowed with the Simple Income Tax. I would grant two exceptions:

  1. A deferral of tax for money put into a universal savings account (to be described later).
  2. A charitable deduction.

A stable economy requires more saving on the part of the average citizen. So does narrowing the wealth gap. If we get the middle class back into the habit of saving real money, we can do more to close the wealth gap than by going back to pre Reagan tax rates.

I have mixed feelings about charitable deductions. They mix Church and State, and the deduction is often abused. On the other hand, it is good for government to have competition in providing social services, and if you are giving it away, it isn’t income. On the net, I say keep the charitable deduction, but I’ll outline how to get rid of the worst abuses in a future article.

The remaining deductions should go. I’ll go into why they should go and also look into how to deal with transition problems for some of them, especially the home mortage deduction, in future articles.

There are some other issues which need to be addressed:

Beyond the Simple Income Tax

The Simple Income Tax merges and simplifies three income taxes, and with a big enough prebate simplifies the welfare system as well. But is it optimal? Should the Simple Income Tax be the only tax?

Probably not. The Simple Income Tax is a rather hefty tax on domestic labor. For workers paying workers, it is a double tax. Consider the case of a factory worker with leaky pipes at home. Should said worker take time off to go to Lowes and buy the parts and fix it himself? Or should he hire a plumber?

Should the factory worker go to work, the government takes 30% (marginally). The factory worker gets to take 70% home to give the plumber. But then the government takes 30% from the plumber’s net pay (labor – parts). The plumber keeps .7*.7 = 49% of what the factory worker earned in order to pay her! But at least under the Simple Income Tax the plumber doesn’t have to hire a payroll service to pay her assistants.

We might want to tax something else as well and tax labor a bit less. We’ll look into that “something else” in a future article. Stay tuned.

You can comment on this article here.