Tax Systems and the American Middle Class
On December 16, 1773 at approximately 7:00PM, 90,000 lbs of tea were thrown overboard from the Dartmouth, Ealeanor, and Beaver in Griffin Wharf. The Boston Tea Party, as it became known, helped spark the American Revolution. The Tea Party’s purpose of showcasing America’s disdain with the British governments unfair taxes did not go unnoticed and Americans have debated taxes ever since. Proponents of tax reform argue that the current system is unfair and is also unnecessarily complex. In order to understand what tax system will provide the most benefit to the majority of Americans in terms of fairness, simplicity, and incentive to continue increasing productivity several questions must be answered. First, what percentage of America is middle class and how is middle class defined in terms of income? Second, what tax systems exist and how does each tax and redistribute income differently? Finally, can the effects of a change to the tax system on tax payer behavior be accurately predicted? For example, if a Value Added Tax (VAT) is introduced can we predict how much consumer spending will decline? Once these elements are examined and a tax system is determined to be the most advantageous to the majority of Americans the implementation costs of this system should be studied for feasibility.
Defining the Middle Class
First, it is important to define the American middle class and determine if it contains the majority of the American population. The American middle class is defined by Gilbert as a broad range of people ranging from families of four earning over $27,500 (the poverty line) to the same family which earns more than $100,000 per year (Gilbert, 1998). This range is further subdivided by many sociologists into what is known as the lower, middle, and upper middle classes. For the sake of this research the middle class will remain general. According to the United States Census Bureau (USCB) slightly over two thirds (67.7 percent) of household’s income fell between $25,000 and $149,000 in 2006 (U.S. Census Bureau). Figure 1 provides a visual representation of the USCB data. The majority of American households are classified as middle class.
Figure 1. United States Census Bureau data on 2006 income.
Graduated Income Tax
Several tax systems have been proposed as replacements of the current graduated income tax system. In order to compare the proposed systems it is important to understand how the current tax system in the United States operates. According to Merriam-Webster the simplest definition of income tax is, “A tax on the net income of an individual or business”. The first income tax was enacted in 1894 and contained an exemption for any corporation or association organized exclusively for religious, educational, or charitable purposes (Fremont 56). Since the three percent flat tax on income in 1894 many rules have changed. In fact, since 1942 there have been over 30 major amendments to the tax code many of which introduced multiple changes in a single amendment (Hollenbeck Ninety Years of Individual Income and Tax Statistics). The most recent form 1040 from the Internal Revenue Service (IRS) contains over 75 line items. Items such as moving expenses, student loan interest deductions, and domestic production activities only apply to very specific segments of the population. Furthermore, the 1040 form references over 30 additional forms. Over 130 million income tax returns are filed under this system each year (Hollenbeck Ninety Years of Individual Income and Tax Statistics).
The current individual federal income tax system in the United States ranges from 10 to 35 percent based on a graduated income scale (2007 Federal Tax Rate Schedules). The federal tax rate for families considered middle class ranges from 15 to 28 percent. Using the graduated income tax bracket a family of four earning $25,000 would be taxed $3,750 and a similar family earning $130,000 would be taxed $36,120. The second family earns slightly over five times as much income, but pays nearly ten times as much tax as the first family. This large difference in income to tax ratio occurs within what is considered by most sociologists to be the middle class.
An understanding of how the current graduated income tax effects the middle class has been established. There is a large disparity between the upper and lower middle class in regards to the amount of tax burden carried. Two of the most popular replacements to the current system are the flat tax and the fair tax.
Flat Tax System
A flat tax, sometimes called a flat rate tax or proportional tax, is a tax system in which, “the tax rate remains constant regardless of the amount of the tax base.” (Merriam-Webster Online). Recent flat tax plans by Steve Forbes, Paul Bremer, and Arnold Schwarzenegger have caused conversation about a flat tax among Americans. Additionally, many countries in Eastern Europe have introduced flat tax systems and some experts claim it has boosted their economies (Bartlett). In an article called A Brief Guide to the Flat Tax, Mitchell provides two major advantages the average American would receive from a flat tax system:
the most persuasive feature of a flat tax for many Americans is its fairness. The complicated documents, instruction manuals, and numerous forms that taxpayers struggle to decipher every April would be replaced by a brief set of instructions and two simple postcards. This radical reform appeals to citizens who not only resent the time and expense consumed by filing their own tax forms, but also suspect that the existing maze of credits, deductions, and exemptions gives a special advantage to those who wield political power and can afford expert tax advisers. (3)
The majority of flat tax proposals introduce a rate close to 16 percent for all earned income. Utilizing the same scenario from the graduated income tax example this would mean that a family earning $25,000 would pay $4,000 while the second family earning $130,000 would pay $20,800 in tax. While the $400 increase in tax for the family earning $25,000 is not ideal the reduction of the tax burden by more than $15,000 for the family earning $130,000 is astounding.
A point of contention with the flat tax system is that it will not collect enough tax revenue especially from businesses and upper income earners. This is because although the capital gains tax, interest-income, and dividends tax would be eliminated, the personal income and payroll taxes would still exist (Moore). Most in the middle class would not benefit from the elimination of the capital gains tax, interest-income, and dividends as much as they would the elimination of personal income and payroll taxes.
Furthermore, a flat tax system would not address border-adjusted taxes, the tax built into products exported from our country through corporate taxes. According to Leo Linbeck Jr., a member of American For Fair Taxation:
Border-adjusted taxes are, quite simply, the most potent weapons foreign producers have against U.S. producers and workers. Border-adjusted taxes are consumption taxes removed on export by the producing nation and assessed upon imports as ad valorem taxes.
The border-adjusted tax policy is one of the major flaws of the current graduated income tax system. This can be better understood through a short illustration. If an American company named Megacorp which specializes in making $100 dollar widgets is taxed under the corporate tax of 17 percent it must then pass the cost of the tax onto the consumer through the sale of their product. So, a $100 dollar widget would cost $117. When this widget is exported overseas to Latvia the widget price remains the same. However, Foreigncorp, a Latvian company does not pay a 17 percent corporate tax and within Latvia can sell the same widget for $100. Megacorp has lost 17% of it’s competitiveness due to the border tax. Some critics believe there is no point in altering the tax system in the United States if we do not fix the fundamental problems such as border-adjusted taxes.
Fair Tax System
The fair tax system is based on a national sales tax of 23 percent on new goods and services. There are several concessions for impoverished families and a tax rebate to ensure that necessary goods would not be taxed. According to Neal Boortz, a leading advocate of the plan, the fair tax, “would constitute the biggest transfer of power from politicians to the people since the beginning of this country.” (Boortz 193). Proponents argue this would benefit all Americans in several key ways. First, the fair tax would truly make the tax system participatory rather than mandatory. People who do not spend money on new goods and services would not pay the tax. Second, with the elimination of the corporate tax new corporation growth in the country would be unprecedented. This would lead to more jobs and a stronger economy for America.
Some critics argue that the Fair Tax System would not work because of the tax rebate policy. For example, a family earning $22,400 a year could pay $4,253 in national sales tax if buying only necessities. The same family might actually receive a rebate of $5,152 (Hirsch). This scenario illustrates a situation of income redistribution occurring within the system and is precisely what the fair tax system is supposed to eliminate. Scenarios such as the tax rebate policy are only half of the argument from critics.
Moreover, opponents claim that the Fair Tax System is part of a conspiracy to put more of a tax burden on the poor through taxes on everything purchased. This claim is quickly refuted by Fair Tax proponents. They argue that by encouraging investment and savings without taxation the working class will begin to build wealth. Small business owners would also benefit from the ability to grow their businesses without worry about the tax implications. Perhaps the greatest example is given by Neal Boortz who reminds critics, “As things are now, wealthy Americans with no current income have no income tax bill to pay” (Boortz 197).
Implementing a New Tax System
The effects of changing the current tax system can only be theorized. No fundamental changes to the tax system have occurred since its inception. Much of the anxiety about altering the tax system can be attributed to the fact that over 68 percent of American income comes from salaries and wages. The following examples illustrate the challenges of implementing an alternative tax system. Figure 2 illustrates the sources of total income for individuals in 2005.
Figure 2. Internal Revenue Service Statistics on Income
If the Fair Tax System is implemented some critics argue that a black market of goods may develop. Amity Shlaes, a writer for Bloomberg News, argues that a 30 percent tax on goods and services would have a negative effect on the consumer market:
Implement the FairTax, though, and the U.S. will find its tax-scape taking on a certain sleaziness. Vendors will materialize on street corners selling that DVD player without tax.
Even citizens who never thought of breaking the law will snatch up those DVDS. Thirty percent is simply too great a take to ignore. Especially vulnerable will be younger people, who already view property rights as an option, not a given. Think Napster — if you don’t pay for downloads, you certainly won’t feel the need to pay a sales tax six times the one your state charges.
If Shlaes theory is correct this would add an additional cost to the implementation of a Fair Tax system. The cost of policing the sale of goods and services to ensure they are being taxed appropriately would ultimately be passed back to the citizens in the form of a higher tax rate.
Another major concern of the implementation of the Fair Tax System is the double taxation of individuals during the transition period. For example, if a frugal individual worked for ten years without any major expenditures and earned $500,000 total in a ten year period. The $500,000 was taxed under the graduated income tax system and $100,000 in taxes was paid. After the implementation of the Fair Tax System if the individual wanted to purchase a $40,000 vehicle with the money he saved and was already taxed the person would pay a VAT of nearly 30 percent, or roughly $12,000. This is obviously a major concern for individuals with large amounts of savings. Although some savings will be passed onto consumers through the Fair Tax System in the way of lower prices it would not even come close to compensating those individuals that fall into the double taxation scenario.
Recommendations
Upon inspection of several alternative tax systems the Fair Tax System proposal appears to be the most viable candidate as a replacement. This is due to the fact it would create a culture of saving and investment while simultaneously simplifying the complexity of the tax code and promoting economic growth. Although this alternative tax system has been proposed the current graduated tax system cannot be replaced quickly. Research into several areas should be completed prior to any actions to change the graduated income tax. First, factoring geographic location into the effect of each alternative system would have on the middle class needs to be completed. For example, a family of four in rural South Dakota may live comfortably earning $50,000 annually while the same family in New York City would need to earn twice that to maintain a similar standard of living. Second, unintended consequences should be researched more fully for each alternative plan. For example, a study of how a national sales tax under the fair tax plan would impact consumer spending should be performed.
Conclusion
Several alternative tax systems show they may benefit the middle class either primarily through paying less taxes or secondarily through a better national economy. These systems also simplify the amount of paperwork and confusion leading to more faith in the tax system as a transparent and fair entity. The systems, especially the Fair Tax System, should be studied regressively in more detail to determine which system is best for the American middle class.
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