Re-Engineering the Tax Code: Part II
Part II -- Closing Loopholes
In Part I we established that for this thought experiment, we need a new way of thinking about our be-loathed tax system. It just doesn't make sense to keep gluing new doodads (exclusions / extensions) onto the old one; the best thing we can do with the rusted old contraption is to toss it out and start over from scratch. Starting from scratch, we can implement 21st century concepts, materials, and thinking applicable to our 21st century economy.
Because this new system of taxation is being designed specifically to encourage businesses, organizations and/or entities with excessive profits to more generously reward the "low men on the totem pole," the progressive tax bracket system makes the most sense. A business can choose to minimize total tax payments by paying its workforce more, or it can voluntarily pay more in tax than it must to when it chooses to keep profits concentrated among the few at the top. This system rewards benevolence and discourages greed, both at a corporate and individual level.
This progressive idea is the core strength of our system. Continuing with our bicycle analogy, it can be likened to a design innovation -- visualize this fantastically awesome carbon fiber frame reinforced with Kevlar. This frame has made the "guts" the lattice for increased capacity to wear and tear with none of the dead weight of its predecessor; it does more with less, and it provides a good framework to hold together the rest of our moving parts.
Traditionally, the "corporate" tax rate structure has been different from the "individual" tax rate structure. Corporations create "jobs," right? That's why we have two different systems? In the industrial manufacturing economy, this was more true; it made sense to tax a corporation more aggressively on its profit (which does not include payments to workers).
Quick accounting concept here: income (AKA revenue) is not profit. At a very basic level, profit is what is left over after various business expenses have been subtracted. There are all kinds of lovely accounting / finance acronyms (NOPLAT, EBITDA) outside the scope of this article, but for the purpose of this discussion, the main point to take away is that the US tax code historically treats business revenue differently from individual income, even though both are essentially the same when we think of them in the context of earned dollars with the potential to be taxed.
Historically, taxing business profit differently than worker pay, did NOT stop executives from underpaying workers; budget accountants have almost always had an incentive to minimize DL -- or "Direct Labor" costs (typically workers on the floor of the manufacturing plant / construction workers / wage-hour slaves) -- lower labor costs imply better efficiency, and greater efficiency means larger bonuses to managers and executives. Because of this practice, companies have always sought to pay laborers as little as possible, and erroneously rewarded executives and managers who egotistically presume they are responsible for the "efficiency".
Plant managers and executives, driven by the need to minimize "costs," would run through workers, with no heed to overtime, working conditions or general welfare of the workers. Perhaps the only good thing to come out of this historical treatment is the federal minimum wage (which is another can of worms for another day).
Key: Tax revenue inclusive of salaries and wages. Tax-free dividend distributions to non-employee shareholders
Historically, if a business had, $2M in revenue and $1M in non-wage / salary expenses for a net profit of $1M ($2M - $1M = $1M), the corporate tax would be the same whether that business' $1M in payment expenses was $900,000 to the CEO and $20,000 to each of its five employees, or if the $1M was divided equally among all the workers. With our new system, we tax revenue inclusive of salaries and wages; a business has tax liability on the full $1M to be distributed. The actual tax payment due will vary, and depend upon how it's divvied up. Thus, each dollar "paid out" in the form of wages and salaries should be taxed only once; the leftover profit residual to keep the business going would be distributed tax-free to non-employee shareholders. For employee shareholders, the stock and dividends are essentially "additions" to salary, and be added to regular income.
Keys: disallow mortgage interest deductions; disallow deducting the "cost of obtaining a loan"; Dis-incentivize tax breaks for single companies managing multiple properties
The second loophole from the twisted mass of rusted-out metal that we don't want to duplicate on our new system has to do with property ownership.
First, let's look at the mortgage interest deduction. This "individual" income tax deduction, as well as its "corporate" twin -- amortized lease expense -- is a cunning and insidious loose little thread. As we saw from the sub-prime mortgage industry crisis of 2008, this loose thread unraveled the housing / commercial real estate industry and drew an impossibly deep rift between those individuals and businesses beneath the threshold of poverty, and those who teeter barely above its brink.
When Realtors and mortgage brokers collude, the result is disaster. The 2011 documentary The Flaw discusses the "how" and "why":
Landlords and PMCs use the "steady income" of rent payments to take out larger and larger chunks of debt (not to mention get bigger and bigger tax breaks). They refinance and restructure their mortgages, always passing the cost of doing so on to the renter, while -- like a snake shedding its skin -- getting out of the liability of such "risky ventures."
Indeed, the IRS code for tax handling of residential rental property and business expenses expounds further.
So . . . given all of this, we know what is wrong. How can we help our new system work better? There are two possibilities: dis-incentivize bad behaviors or incentivize good behavior. In Part III we'll dig into each possibility.