A flat tax applied to personal income, straightforwardly defined, has a number of advantages over the current system. Administrative costs, compliance costs, and the marginal tax rate would be greatly reduced, while productivity, compliance with the tax laws, and work incentives would all increase. The result should be a strengthened economy; thereby permitting a still lower tax rate. Critics contend, however, that to maintain current tax collections, the flat rate must be set at a level that would increase the tax burden on most of the middle class (or at minimum increase the relative tax burden on the middle class).

The greater efficiencies realizable under a flat tax system might permit the development of a revenue neutral flat tax that did not raise middle class taxes. Nonetheless, current flat tax proposals remain vulnerable to the criticism that they would reduce the relative tax burden on the wealthy, while increasing it on the middle class.

Since the United States is a democracy, our present system’s tax burden probably tends to reflect the will of the electorate. To be politically viable, proposed tax reforms need to be structured so that they neither increase the deficit nor the tax burden on the middle class. Compared to the existing tax system, flat tax reform (if it to sidestep the objections of its opponents) should simultaneously accomplish each of the following objectives:

1.   Reduce administrative costs.

2.   Reduce compliance cost.

3.   Reduce economic distortions.

4.   Reduce marginal tax rates.

5.   Not increase the middle class’s relative tax burden.

6.   Maintain current rates of tax collections.

While the existing proposals would only achieve the first four objectives, a flat tax could be structured to achieve all six objectives.

Flat tax proposals differ in various respects. They do, however, have two common features: (1) They simplify and expand the definition of taxable income. (2) They replace the present system of increasing tax rates with a single rate for all income above some threshold. Most experts agree that a flat income tax rate of about 20 percent would maintain the present level of personal income tax collections. [U.S. Treasury Department. 1995. An Analysis of the New Armey-Shelby Flat Tax Proposal. Washington: U.S. Treasury Department, Office of Tax Analysis. In this revenue and distributional analysis of one flat tax proposal it is concluded that it would be revenue-neutral at a 20.8 percent rate. This report was also published in Tax Notes, vol. 70, no.4 (January 22, 1996), pp. 451-61.]

Limitations of Present Analysis

This paper is restricted to analysis of personal income and social security (FICA) taxes at the federal level. Although corporate, state, local and all other tax issues are important, they are not the subject of this paper.

I do not address in this paper precisely how taxable income should be defined. Clearly the broader the definition is,  the lower is the tax rate that can be set and, therefore, the less is the disincentive either to forego income producing opportunities or to attempt to shelter income from taxation (legally or otherwise). Accordingly, a flat tax works best if taxable income is defined very broadly. (Appendix A shows how taxable income might be defined.)

I also do not address in this paper the question of whether taxes are justified. A substantial literature argues that they are not. And yet we are taxed. In this paper I seek to explore a means of enhancing the effectiveness of the tax system as it interfaces (rather heavily) with the economy. Whether the current or any proposed tax system is justified is beyond the scope of this paper. Rather, my proposal starts with the debatable assumption that we are going to have a tax system that will generate revenues more or less in line with the current system. Then the question becomes how might that system be structured so as to achieve its objectives, raising revenue without unduly distorting productivity, more effectively.

Some have argued that maintaining the current level of tax collections is unnecessary.  Advocates of small government would have us combine a flat tax with spending cuts; thereby generating a flat tax that does not raise taxes on the middle class. Existing proposals would, however, still tend to increase the relative tax burden on the middle class. In any case, the issue of the appropriate size of government is beyond the scope of this paper. In it I only seek to demonstrate how a revenue neutral flat tax could be fashioned that leaves the relative tax burden unchanged. Those who prefer a smaller government could combine this basic approach to tax reform with spending cuts and a correspondingly lower tax rate.

Literature Review

"The modern idea for a flat tax can be traced back to Hayek. [Hayek, F. A., "Progressive Taxation Reconsidered," 1956 In Mary Sennholtz (ed) "On Freedom and Free Enterprise," pp. 265-284], Hayek argued that the marginal tax rate for the highest income level should be set equal to the overall level of taxation as a percentage of income. A few years later in "Capitalism and Freedom, The distribution of income," pp. 161-176, 1962, Milton Friedman wrote that "All things considered, the personal income tax structure that seems to me best is a flat-rate tax on income above an exemption, with income defined very broadly and deductions allowed strictly for defined expenses of earning income." [p. 174.]

Since this early beginning, an extensive literature has developed about the flat tax. A detailed annotated bibliography may be found at the National Center for Policy Analysis Idea House (http: www.ncpn.org/n/pi/taxes/flattax.html). Among the items listed in that bibliography are a number of articles discussing the high costs of the U.S. tax system and the success of the Hong Kong economy under a flat tax system.

Another excellent resource is: Hall, Robert E., and Alvin Rabushka, 1995b, "The Flat Tax," second edition, Stanford, California: Hoover Institution Press. It was also  published as a special supplement to Tax Notes (August 4, 1995) at http://wwwhoover.stanford.edu/PRESSWEBSITE/FlatTax /notes.html. See Appendix B for a detailed listing of flat tax resources.

Current Flat Tax Proposals

Existing proposals produce a flat income tax rate but leave Social Security (including Medicare) tax rates regressive. Thus, a flat income tax (FEDTAX) coupled with a nonflat (regressive) Social Security tax (FICA) would lead to a regressive overall tax structure. At 2002 rates (used exclusively hereafter) the combined employer/employee pension and Medicare contributions are set at 15.3 percent for income subject to FICA below $84,900 and 2.9 percent (Medicare only) for income above that amount. Thus, a two-income family could pay the 15.3 percent FICA rate on up to a combined income of $169,800.

Quite clearly, the employee pays that portion of FICA that is deducted from his or her salary. The employee also bears most or more likely all of the cost of the employer's FICA payment. Accordingly, we may reasonably view the employee as bearing the entire FICA payment.

The marginal total tax rate (MTTR) takes both FEDTAX and FICA into account. A 20 percent flat tax coupled with the current FICA rates would yield the following MTTRs: For income subject to both FEDTAX and FICA (wages, salary, tips, and self employment income) the taxpayer would incur an MTTR of about (20+15 = 35 percent) on income below $84,900 and (20+3=23 percent) for income above that level. A two-income household could incur the 35 percent rate up to a combined income of $169,800. Not only would such a structure be regressive, it would also increase the tax burden on the middle class while substantially reducing the burden on those with higher incomes. (See the calculation of marginal and average tax rates in Appendix C.)

The Current Tax System

The federal income tax rate  rises with taxable income from 0 percent, to 10 percent, 15 percent, 27 percent, 30 percent, 35 percent and 38.6 percent. ( In 2002, rate declines are scheduled in subsequent years.) The complete schedule of marginal tax rates is, however, far more complicated. Even setting aside such issues as filing status and what determines taxable income (i.e. what can be subtracted from gross income as an adjustment or deduction), the typical taxpayer must deal with a complex tax system involving the interaction of at least three different tax regimes and tax rates based on at least four different income concepts.

In addition to the impacts of FEDTAX and FICA, low income taxpayers may be eligible for an earned income credit (EIC). Thus one's tax liability (or possible eligibility for a government payment) may depend upon the net impact of the relevant FEDTAX, FICA and EIC rates. The alternative minimum tax (AMT) adds yet a fourth tax regime and a fifth income concept. The AMT only comes into play, however, for taxpayers with relatively high total incomes and disproportionately large amounts of otherwise nontaxable income. Accordingly, we shall hereinafter ignore these complications. We shall also ignore the complexities created by provisions for the special treatment of capital gains as well as the existence of tax credits for such things as child and dependent care, the elderly and the disabled as well as for foreign taxes paid.

The applicable rates for FEDTAX, FICA and EIC are each based on distinctly different income concepts and in the case of the FEDTAX rates, at least two separate income concepts. Specifically the EIC is based on the taxpayer's earned income and number of dependents. The FICA, in contrast, is applied to the taxpayer's income subject to FICA, which is similar, but not identical, to earned income. The FEDTAX rate is largely determined by the taxpayer's taxable income. At higher income levels, however, the effective rate is also impacted by the phase outs of the tax shelter provided by exemptions and deductions, which in turn are determined by the taxpayer's level of adjusted gross income.

Income subject to FICA includes wages, salaries, tips, and self employment earnings. Earned income differs from income subject to FICA in that it also includes non-taxable earned income such as 401K contributions and military housing and subsistence.

Gross income is the sum of income subject to FICA and income from other sources such investments, trusts, and estates. Adjusted gross income is determined by subtracting adjustments (IRA, Keogh, alimony payments, etc.) from gross income. Taxable income is the result of subtracting deductions and the allowance for exemptions from adjusted gross income. Above certain adjusted gross income levels, however, only a portion of the unadjusted amount of deductions and exemptions may be subtracted. The complications continue even once taxable income is determined. A number of tax credits may come into play under various circumstances. These further complications are ignored in this paper.

A Consistent Set of Tax Rate Computations 

      The income concept that applies varies with the income level. That is, the overall tax rate shifts with the level of taxable income at one point; adjusted gross income at another point; and the level of income subject to FICA at yet another point. Moreover, the rate of change for one income concept does not necessarily correspond to the rate of change for another income concept. Thus, a one dollar change in adjusted gross income may correspond to a one dollar change in taxable income, no change in taxable income, or anything in between.  A table that reports realistic tax rates for different levels of a common income concept is much more meaningful than one that ignores how the definition of income changes. To generate such a table, however, one must hypothesize how the various concepts of income relate to each other. Specifically, information is needed regarding the taxpayer’s:

1. proportion of gross income subject to FICA; 

2. percentage of gross income excludable as adjustments; 

3.  filing status and number of dependents; 

4. income subject to FICA earned by other family members; 

5. percentage of income that is deductible. 

That is one need to derive a taxable income number from a gross income total.

Each of these factors will vary from taxpayer to taxpayer. For this analysis assumed as representative is:  

1. All of gross income is subject to FICA.

2. Five percent of gross income is excludible as adjustments.

3. Married filing jointly with four exemptions

4. One taxpayer earning 60 percent of the wages of the second

5. Deductions equal to 20 percent of gross income

The above admittedly arbitrary assumptions are designed to reflect representative circumstances. These assumptions are in line with the aggregate statistics collected by the Internal Revenue Service. (See Internal Revenue Service, Statistics of Income Bulletin, Spring 1996, Washington, D.C., 1996.) This structure reflects steady state relationships as opposed to short term incremental adjustments. The specific assumptions are explained as follows: The vast majority of income for most taxpayers is in the form of wages, salaries and self employment income and, as such, is subject to FICA. Hence assumed is all such income is subject to FICA. Adjustments include such diverse payments as IRA and Keogh contributions, one half of self employment tax, alimony payments, moving expenses and penalty on early withdrawal of savings. Such adjustments tend to be a modest percentage of the total for most taxpayers. Assumed is 5 percent. While family sizes vary across the population, a relatively high percentage of filers are married (eligible to file jointly) with a couple of children. Actually, the average taxpayer reports only two exemptions. This analysis is not designed to capture the precise average of taxpayers. Rather, the purpose of this exercise is to mirror the tax liability of a typical taxpaying unit as its income and deductions vary.  Additionally a high percentage of families have two wage earners, one of whom has significantly more experience and/or education than the other.

One family member will generally earn significantly more than the other. The 60 percent assumption is arbitrary but not unreasonable. Sixty percent is in line with the ratio of female to male income levels.  Finally the assumption that 20 percent of total income is deductible is based on the following considerations. The primary itemized deduction are: 

1. state and local income taxes which, above a certain threshold level, may tend to increase more or less proportionately with income; 

2. mortgage interest and property tax which increase with the value of one's home in turn tends to increase (more or less proportionately) with income; 

3. investment interest tends to increase proportionately with wealth and income;

4. charity contributions tend to increase more or less proportionately with income.  

For homeowners the following percentages of income for itemized deductions seem not unreasonable.  

Thus, in the steady state an increase in gross income tends to correspond to a more or less proportional increase in deductions. I assume the rate of deductions increase is about 20 percent of the increase in gross income. This assumption is conservative. According to FEDTAX 1993 statistics total deductions equaled about 23 percent of adjusted gross income. A more detailed analysis would allow for different percentages of deductions at different levels of gross income. For present purposes, however, this 20 percent deductible rate assumption seems not unreasonable.

The percentage of total income subject to adjustments and not subject to FICA tends to be higher for higher than for lower income groups. Similarly, the percentage of taxpayers who itemize and the percentage of itemized deductions claimed tends to increase with income levels. The special treatment of capital gains (capital gains income as percentage of total income tends to rise with income levels) further reduces the progressivity of the income tax. For the sake of simplicity (the tax code described herein is still quite complex) these complications are ignored. These additional complexities tend to reduce the relative tax rates on higher income groups below the levels reported herein. In other words a still more realistic table would show marginal tax rates to be less progressive than shown here. Table 1 (below) reports total and average tax rates for the end point of each income range.  

Table 1

Marginal and Average Tax Rates for Various Levels of  Income

Where:

            S = subsidy

Average = total tax ¸ total income with FICA gross up  

Table 1 reveals a very interesting picture. The marginal tax rates vary substantially. The highest marginal rate (41.62 percent) is encountered for incomes in the range of $22,437 to $34,578 where the taxpayer is subject to both FICA and FEDTAX while losing EIC. Interestingly, however, the next highest marginal rates are all in the low 30s. Specifically the MTTR is in the range of 32 percent or 33 percent for the following income ranges $14,107 to $22,437 (32.79 percent); $84,254 to $146,231 (33.72 percent); $240,210 to $360,217 (32.10 percent - 32.97 percent); and above $412,367 (31.78 percent).

Except for income below $14,102 the remaining marginal rates range from 26.79 percent to 28.73 percent. Moreover, these rates only show progressivity over the income range from $155,246 to $360,367. Above and below that range the marginal rates move regressively as often as they move progressively.

Unlike marginal rates, the average rates are progressive over most income ranges. Note, however, that from $146,232 to $412,367 the average rates are all in the range of about 26.5 percent to 29.5 percent. Indeed for income of $146,232 to $250,330, the average rates are all within 1 percent of 27 percent. At $412,367 the average rate only rises to about 29.50 percent. Even at the lower income ranges, the degree of progressivity is small. For $35,000 the average rate is around 17.5 percent  rising to around 21 percent for the $42,000 - $84,000 range. Thus, we already have rather flatish average tax system with a modest degree of progressivity at the lower rates. Indeed, when factors such as the tendency for higher income groups to have greater percentages of their incomes in the form of capital gains and municipal interest as well as a rising percentage of income not subject to FICA (e.g. interest and dividend income), the tax system is seen to be even less progressive than Table 1 suggests. In other words, we already have something approaching a flat (average but not marginal) tax rate system but with a very large degree of complexity and much higher are more variable marginal tax rates than are necessary to produce the amounts of revenues raised.

Table 1 indicates that our tax codes do a much better job of producing "fairness" than they do producing effective "work incentives." That is, the average tax rates for various income levels do exhibit a modest degree of progress­ivity, which probably corresponds to the electorate's sense of fairness. Marginal rates, in contrast, are much more variable and for many income levels much higher than they need to be. As a result our tax system fails to produce appropriate work and compliance incentives. High marginal tax rates discourage individuals from earning additional income while encouraging them to structure the income that they do earn so as to avoid or even evade taxes on that income. We should be able to do better.

A Flat Tax Proposal

A tax system can be structured to produce an overall flat rate for the combination of EIC, FEDTAX and FICA (including the employer's FICA payments). Thus one overall tax rate could be established for income broadly defined with a portion of the total paid to FICA and the rest to IRS. Such an approach has two significant drawbacks. First, it would not reflect most taxpayers' views that FICA payments yield much greater personal benefits than do their FEDTAX payments. Taxpayers tend to view their Social Security and Medicare benefits as "earned" by their FICA taxes notwithstanding the actuarial unsoundness of the system. Any benefits that taxpayers believe their income tax dollars "earn" are much less obvious or identifiable. The net burden on the taxpayer of a tax that earns the payer a benefit is less than one that does not. Furthermore, these perceived benefits from FICA payments are probably much greater for taxpayers with lower than those with higher income levels. Indeed, taxpayers with relatively low pre retir­ement incomes tend to rely much more on Social Security for retirement support than do those with higher pre-retirement incomes. Moreover, the ratio of FICA benefit payouts to FICA taxes paid in tends to be higher at lower income levels. Second, setting a flat overall tax rate would tend to shift the relative tax burden away from the middle class and toward the wealthy.  Such a shift is no more politically acceptable than a burden shift in the opposite direction.

Accordingly, I propose that the overall tax rate be set to produce a single flat tax rate for the combination of FEDTAX and the employee's direct FICA payments. Recall that a 20 percent rate for FEDTAX would not be expected to increase the deficit. Accordingly, we need only gross up the overall tax rate sufficiently above 20 percent to cover the employee's portion of Social Security revenues. Since most taxpayers do not reach the 2.9 percent FICA rate, the needed gross up is at least 1.45 percent but no more than 7.65 percent  (the two rates paid by the employee depending upon the level of income subject to FICA). Since most taxpayers do not reach the 2.9 percent FICA rate, I estimate the needed gross up to be approximately 5% percent (closer to 7.65 percent than 1.45 percent), which produces an overall flat tax rate of 25 percent. Clearly. the required rate would depend upon how broadly taxable income was defined. See Appendix A. See also Appendix D for a feasibility check on a 25% percent levy.

If we set the overall flat tax rate at 25 percent, taxpayers with income subject to FICA of less than $84,900 would (as under the present system) pay 7.65 percent to FICA and 17.35 percent to FEDTAX. Those whose incomes subject to FICA exceeded this level, would, at the margin, be subject to an FICA rate of 1.45 percent and an FEDTAX obligation of 23.45 percent.  Income not subject to FICA would also be taxed at 25 percent with the entire amount going to FEDTAX.

I suggest no change in the Social Security system (at least as part of the reform of the present tax system). I do not mean to suggest that the Social Security structure is not in need of reform. Rather, I wish my proposal to be viewed as independent of what else might be done with respect to related issues. That portion of the tax collection now going to Social Security would remain the same, as would the levels of Social Security benefits. In addition to establishing a flat tax rate, some mechanism is needed to establish the threshold above which incomes become taxable. Such a mechanism could also be structured to provide the kind of work incentives that the EIC is supposed to provide.

I propose that each taxpayer receive a personal tax credit of $1,000 times the number of allowed exemptions. A taxpayer with four exemptions would have a $4,000 tax credit. At a 25 percent tax rate this credit would shelter the first $16,000 of income from both FEDTAX and the employee's direct FICA obligations. Only the employer's share of the FICA would be paid on this level of income. General revenues would be used to cover the employee's FICA obligations on that portion of his or her income that was sheltered by the personal tax credit.

The earned income credit in its present form offers the working poor an incentive to earn additional income up to a pre-specified level ($10,200 for a family of four). Above $13,100, however, the credits’ phase out coupled with the FICA and FEDTAX obligations produces a major disincentive to earn additional income. A more effective system is needed both to incentivise the very low income worker to earn additional income and avoid disincentivising the slightly less poor worker from earning additional income. Accordingly, I propose a system of cash payments for the working poor to be based on the unused tax credit. Specifically, the earned income payment (EIP) would equal the product of the unused credit times the ratio of the used credit to the total credit. A worker with four exemptions who earned $12,000 would utilize $3,000 of his or her $4,000 tax credit to offset what would otherwise be due in taxes. He or she would then receive a government payment equal to 75 percent ($3,000/$4,000) times the unused portion of the credit ($4,000 - $3,000 = $1,000). The resulting $750 (.75 x $1,000) would be paid to the individual in cash. Had this same worker only earned $8,000, the payment would have been $1,000 (50 percent of $2,000 in unused credit). So, by earning an additional $4,000, (i.e. earnings rise from $8,000 to $12,000) the worker would incur no additional tax liability and only lose $250 ($1,000 - $750) in cash payments. This earned income incentive structure would pay out an increasing subsidy up to the point where the worker's income equaled twice the total allowed tax credit. For a taxpayer with four exemptions, this EIP system would yield the maximum credit for an income of $8,000 (2 x $4,000).  Thereafter the subsidy would decline, but initially at a very modest rate. The rate of subsidy loss would always be less than the 25 percent rate for the MTTR for income above the level at which the credit is exhausted.

While the marginal tax rate is particularly relevant for work incentives, the average tax rate is more relevant for evaluating a tax system's fairness. Under the above proposal an individual with four exemptions would receive a subsidy payment (up to $1,000) and pay no tax (other than the employee's portion of FICA) up to $16,000 of earned income. The total tax obligation would accrue at 25 percent of the income in excess of $16,000. At $32,000 the family's total tax liability would be $4,000 or 12.5 percent of their income. At $48,000 the family's tax liability would rise to $8,000, which corresponds to an average tax rate of 16.67 percent. At $64,000, the tax obligation would be $12,000, which corresponds to an 18.75 percent average rate. At $80,000, the tax obligation would rise to $16,000 and a 20 percent average rate. The average tax rate would continue to rise thereafter approaching the 25 percent level asymptomatically. Table 1 illustrates these relationships. Note that the amount of $1,000 per exemption tax credit is arbitrary. The amount could as with the current system be set to rise with the price levels.  

Comparison with a Generic Flat Tax Proposal

As previously noted, prior flat tax proposals have focused on the income tax, leaving FICA rates uncharged. To be revenue neutral, such proposals needed to be set at a rate of about 20 percent (FEDTAX). Accordingly, I shall now compare my proposal with a generic flat tax proposal that has a 20 percent FEDTAX rate and the current FICA rates This generic proposal is designed to be representative of the typical flat tax proposal that we have seen to date. In this generic flat tax I also include a $1,000 per dependent tax credit and again assume that the family of four has two wage earners with the lower paid worker earning 60 percent of the income of the higher paid. I also assume the earned income credit stays in place as is. Given these assumptions, the family would pay no income tax on the first $20,000 of income (20 percent of $20,000 = $4,000 which is offset by the tax credit). They would however be subject to FICA and be eligible for the EIC where applicable. Table 2 (below) also includes calculations for this generic flat tax proposal for comparison.  

Table 2

Average and Marginal Tax Rates Under:

Assume in Table 2 is a family of four. The impact of the employer's FICA payments is ignored.

S = Subsidies ; T = Tax  

Consider first the average rates for the two flat tax proposals. At very low income levels the generic proposal (which combines a $1,000 per exemption tax credit with the existing EIC) is considerably more generous than my proposal. Starting at $32,000, however, my flat tax proposal has a lower average rate (12.50 percent versus 15.15 percent) and continues to have a lower average rate up through $216,000 (23.15 percent versus 24.37 percent). At higher levels, in contrast, the generic proposal offers lower rates. For example with my proposal the average rate rises from 23.73 percent to 24.61 percent as income increases from $316,000 to $1,016,000. The generic proposal in contrast has average rates that decline from 23.51 percent to 21.96 percent over the same range. Clearly, the generic proposal shifts the tax burden from the higher income to the middle class as compared to my proposal. Thus my proposal is likely to be much more acceptable to the vast majority of the taxpayers electorate.

A comparison of the marginal rates reveals a similar picture. The generic tax proposal implies a marginal tax rate of 27.65 percent for incomes ranging from $14,000 to $116,000 compared with 25 percent for my proposal. At higher income levels however, the marginal rate falls below 25 percent for the generic proposal while it remains at 25 percent for mine. Thus my proposal has a constant marginal tax rate which is lower for the middle income groups and higher for upper income groups than is the generic proposal. Such a structure should be viewed as fairer and should also be politically more attractive than the generic proposal.

Conclusions

I submit that, compared to either the current tax system or the existing flat tax proposals, my own flat tax proposal is far more effective in meeting the following package of objectives:  

1. Simplifies the tax structure

2. Avoids a major shift in the tax burden between different levels of income.

3. Avoids an increase in the deficit.

4. Produces a flat overall tax rate for income levels above a pre-specified minimum.

5. Reduces the marginal tax rate for virtually all taxpayers.

6. Enhances the work incentive of the existing earned income credit.

7. Produces increasing average tax rates for all levels of income.  

Appendix A

Thoughts on How to Define Taxable Income

  Setting up or revising an income tax system involves two primary issues: (1) establishing a rate structure and (2) defining what constitutes taxable income. The rate structure issue is dealt with in the body of this paper.

The primary purposes of moving from our present system to a flat tax are to simplify the tax system and to enhance work and risk taking incentives. Both objectives can best be met with a very broad definition of taxable income. Most of the current tax system's complexity stems from efforts on the one hand to provide incentives for various social purposes (retirement planning, medical coverage, education, environmental protection, charitable contributions, home ownership, entrepreneurial risk taking etc.) and on the other hand to limit the revenue loss from providing such incentives. An income tax designed exclusively to raise revenue would be much simpler (and perhaps just as "fair"). Similarly, a broad definition of taxable income would facilitate a low tax rate, which would in turn enhance work and risk taking incentives (or more correctly reduce the disincentive of income taxation).

  Accordingly, I suggest that gross income be defined to include the total of line 22 on the form 1040 (gross income before adjustments), municipal bond interest and the fair value of all fringe benefits that are not now reported on lines 7 through 21. Taxable income would differ from gross income only to the extent that legitimate expenses were incurred in producing income or the value of the benefit was deminimis (e.g. free parking at work.) Otherwise the income would be taxable.

  Such a tax system would largely remove incentives to structure payments or expenditures for tax planning purposes. Similarly, it would force the government to use expenditures (which can be targeted much more effectively than tax preferences) for all social incentives. Thus, for example, if the government wishes to encourage home ownership, it can subsidize interest payments for modest income first time homebuyers. As a result, the cost of providing an incentive will be clear from the amount of the appropriation, rather than hidden in the form of a revenue loss.

 With a truly broad definition for taxable income, a revenue neutral flat tax rate could probably be set well below the 25 percent proposed proposed in this paper. The lower the marginal tax rate, the greater is the incentive to earn income (either by working or by taking risks) and to report it as taxable income (rather than conceal it or seek to structure the income so that it bears a lower tax rate).

A low tax rate on income that is very broadly defined will tend to remove or at least limit the economic disincentives present in the current system. The broader the definition and the lower the tax rate, the less the tax system's distortions.  

Appendix B

Literature Review

1. Studies attempting to measure the cost of federal income tax include: James L. Payne, Costly Returns: The Burdens of the U.S Tax System (San Francisco: Institute for Contemporary Study Press, 1993). Payne summarizes the estimates of compliance costs that appear in the following studies: Joel Slemrod and Nikki Sorum, "The Compliance Cost of the U.S. Individual Income Tax System," National Tax Journal 37 (December 1984): 462–65; Arthur D. Little, Inc., Development of Methodology for Estimating the Taxpayer Paperwork Burden (Washington, D.C.: Internal Revenue Service, 1988), pp. III–23; James T. Iocozzia and Garrick R. Shear, "Trends in Taxpayer Paperwork Burden," in Internal Revenue Service, Trend Analyses and Related Statistics, 1989 Update (Washington, D.C.: U.S. Government Printing Office, 1989), p. 56; Annual Reports of the commissioner of the Internal Revenue Service; and a variety of other IRS memoranda.

2. Studies that seek to measure the disincentive costs of the U.S. federal income tax include: Edgar K. Browning, "On the Marginal Welfare Cost of Taxation," American Economic Review 77 (March 1987): 21; Jerry A. Hausman, "Labor Supply," in Henry J. Aaron and Joseph A. Pechman, eds., How Taxes Affect Economic Behavior (Washington, D.C.: Brookings Institution, 1981), p. 61; Charles Stuart, "Welfare Costs per Dollar of Additional Tax Revenue in the United States," American Economic Review 74 (June 1984): 358; Roger H. Gordon and Burton G. Malkiel, "Corporation Finance," in Aaron and Pechman, eds., How Taxes Affect Economic Behavior, p. 178; Jane G. Gravelle and Laurence J. Kotlikoff, "The Incidence and Efficiency Costs of Corporate Taxation When Corporate and Noncorporate Firms Produce the Same Good," Journal of Political Economy 97 (August 1989): 774, table 6; Charles L. Ballard, John B. Shoven, and John Whalley, "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States," American Economic Review, March 1985, p. 135, table 3; Dale W. Jorgenson and Kun-Young Yun, "The Excess Burden of Taxation in the U.S." (paper prepared for presentation at the Coopers & Lybrand Foundation symposium U.S. Tax Policy for the 1990s, New York, November 7–8, 1990), p. 18; Michael J. Boskin, "Efficiency Aspects of the Differential Tax Treatment of Market and Household Economic Activity," Journal of Public Economics 4 (1975): 12; Martin Feldstein and Joel Slemrod, "Inflation and the Excess Taxation of Capital Gains on Corporate Stock," National Tax Journal 31 (1978): 107–18; Michael J. Boskin, "Taxation, Saving, and the Rate of Interest," Journal of Political Economy 86 (1978):S3–S27; Martin Feldstein, "Tax Rules and Business Investment," in Martin Feldstein, ed., Taxes and Capital Formation (Chicago: University of Chicago Press, 1987), pp. 63–72; and Roger H. Gordon and Joel Slemrod, "Do We Collect Any Revenue from Taxing Capital Income?" in Lawrence H. Summers, ed., Tax Policy and the Economy 2 (Cambridge, Mass.: MIT Press, 1988), p. 120.

3. Estimates of the extent of tax evasions include: Official and unofficial estimates exist on the extent of tax evasion. Official estimates include Estimates of Income Unreported on Individual Tax Returns, Department of the Treasury, Internal Revenue Service, Publication 1104 (9-79); Internal Revenue Service’s 1988 Report on the "Tax Gap" (hearing before the Subcommittee on Oversight of the Committee on Ways and Means, U.S. House of Representatives, 100th Congress, 2d Session, March 17, 1988); and General Accounting Office, Who’s Not Filing Income Tax Returns? IRS Needs Better Ways to Find Them and Collect Their Taxes (Washington, D.C., July 11, 1979). Academic and popular accounts are contained in Vito Tanzi, ed., The Underground Economy in the United States and Abroad (Lexington, Mass.: D.C. Heath, 1982); Dan Bawly, The Subterranean Economy (New York: McGraw-Hill, 1982); and Carl P. Simon and Ann D. Witte, Beating the System: The Underground Economy (Boston: Auburn House, 1982).  

4. Information to the extent of tax avoidance include: the annual Internal Revenue Service publication titled Statistics of Income, Individual Income Tax Returns (Washington, D.C.). It lists the value of every deduction taxpayers declare on their returns by category. It provides evidence on the overall size of tax shelters in published information on itemized deductions, partnership returns, and other business tax returns. The quarterly Statistics of Income Bulletin, published by the IRS, contains detailed analyses of tax returns. The total aggregate value of all tax subsidy items in the economy is enumerated by category in each year’s federal budget in Special Analysis G. Tax Expenditures: The Budget of the United States Government, Office of Management and Budget, Executive Office of the President, annual report.

5. The history of the U.S. income tax is covered in: Joseph A. Pechman, Federal Tax Policy, 4th ed. (Washington, D.C.: Brookings Institution, 1983), pp. 290–92; Bill Bradley, The Fair Tax (New York: Pocket Books, 1984), pp. 68–89; and John F. Witte, The Politics and Development of the Federal Income Tax (Madison: University of Wisconsin Press, 1985). Details of recent tax increases are found in the various conference reports of the U.S. Congress published by the U.S. Government Printing Office.  

Appendix C

Calculation of Marginal and Average Tax Rates

Computing marginal tax rates for various income levels requires certain simplifying assumptions. In what follows marginal total tax rates (MTTR) are computed for a hypothetical family of four. These rates take account of the impact of the earned income credit (EIC), Social Security tax (FICA) and the federal income tax collected by the Internal Revenue Service (IRS). Both the employer and employee's FICA payments are attributed as taxes paid by the employee. Similarly, the employer's share of the FICA payments is added to the employee's gross income to compute his or her MTTR.  MTTRs are computed using 2002 rates. This analysis ignores the Alternative Minimum Tax (AMT); the special treatment of capital gains; tax credits (e.g. foreign taxes, child and dependent care as well as the elderly and disabled). Similarly, the impact of additional gross income on what proportion becomes taxable is not considered. Finally, the calculations reflect MTTR only for income that is subject to FICA. Using these simplifications, the following analysis reports the derivation of MTTRs for various income levels:

Computed is the marginal total tax rates for gross income (line 22 on the IRS form 1040) for a taxpayer with a representative profile of tax characteristics. For these computations 2002 rates are applied to the following representative circumstances: married filing jointly, four exemptions, two incomes with the second equal to 60 percent at first, deductions equal 20 percent of gross income, adjustments equal five percent of gross income. 

Gross Income Level $0 - $10,980 (Full EIC)

Up to an earned income level of $10, 200 a family of four would be eligible for an earned income credit of 36 percent and pay 7.65 in FICA watched by their employer (15.3 percent total) but pay no income tax. As a result their marginal tax rate would be:  

Adding the employer FICA contribution to the individuals base income grosses it up to $10,960 ($10,200 x 1.0765) and reduces the MTTR to

MTTR = 20.7 ÷ 1.0765 = 19.23 percent (refunded)

At an earned income level of $10,200 the family is entitled to an earned income credit of 36 percent or $3,672. FICA on $10,200 is 15.3 percent or $1,506. The gross up of FICA for the employer is 7.65 percent; so $10,200 of earned income corresponds to $10,980 in total income. Net tax payment equals a credit (negative payment) of $2,112 for a marginal rate of: 19.23 percent credit and average tax rate (actually subsidy) of:

$2,112 ÷ $10,980 = 19.23 percent

Gross Income Level $10,980 - $14,102(EIC phase-out begins)

  Beginning at a gross income level of $10,980 the EIC ceases to increase, but it is not yet at the level where it beings to be reduced. The individual pays no income tax but is subject to FICA. The MTTR is:

            15.3 percent 1.0765 = 14.21 percent MTTR

An earned income level of $13,100 grossed up for employer FICA equals $14,102. The earned income credit remains at $3,672 but FICA rises to $2,004 reducing the net credit to $1,668, which yields an average tax rate (credit) of:

$1,668 ÷ $14,102 = 11.82 percent credit

Gross Income Level $14,102 - $22, 437(EIC phase-out begins)

At a gross income level of $20,844 an adjustment of 5 percent equals $1,044  which, when combined with a standard deduction of $7,850 and exemptions of $12,000, exactly offset a gross income level of $20,894. Therefore, up to this level the marginal tax rate of total income becomes:  

An adjusted gross income level of $19,850 corresponds to $20,842 when grossed up for adjustments and $22,437 when further grossed up for FICA. This is the maximum total income before federal income tax comes into play. An earned income of $19,850 results in a credits of $2,442 (recall that EIC equal to 20 percent of the earnings over $13,100 are lost). For income subject to FICA of $20,842, FICA is $3,108 for a net tax of $746 resulting in an average tax rate of:

$746 ÷ $22,437 = 3.32 percent

Gross Income Level $22,437 - $32,121  (The federal income tax [FEDTAX] rate begins at 10 percent.)

  At gross income of $22,437 our family would begin paying income tax at the 10 percent rate. Given our assumption of a five percent adjustment rate only 95 percent of income would be taxed. Therefore, the marginal tax rate would be calculated as follows:  

An earned income level of $32,121 (complete phase out of EIC) corresponds to an adjusted gross income of: .95 x $32,121 = $30,515. Standard deductions and exemptions of $19,850 result in a net taxable income of $10,665 taxed at 10 percent producing a federal income tax (FEDTAX) of $1,067. FICA of 15.3 percent on $32,121 is $4,915 for a total tax of $5,982.The average tax rate is:

            $5,982 ÷ $34578 = 17.30 percent

Gross Income Level $32,121 - $33,529 (EIC phased out)

The first $12,000 of taxable income is taxed at the 10 percent rate. Allowing for five percent in adjustments, $12,000 in taxable income corresponds to $12,635 in gross income. Adding the sum to $20,894 produces a total of $33,529. Grossing this sum up for FICA produces a total income level of $36,900. Accordingly, for this very narrow gross income range the marginal tax rate is:  

So we see that after only being allowed to keep about 58 cents of every dollar of additional income from $21,000 to $32,000, the marginal tax rate now drops to about 23 percent allowing the taxpayer to keep about 77 cents of each additional dollar of income.

The tax rate rises to 15 percent at taxable income of $12,000. The prior range ended with taxable income of $10,665, which is $1,335 below $12,000. Allowing for adjustments $1,335 corresponds to $1,405 in gross income. FICA on $1,405 adds $215 to the prior total ($ 4,915) or $5,130. Additional taxable income of $1,335 at 10 percent adds $133 to the FEDTAX total ($1067 + $133 = $1,200, 10 percent of $12,000). Starting with $1,405 and then grossing up by 7.65 percent for employer, FICA produces a total income increase of $1,511 for an overall total income of $36,090. The average tax rate is:

$6,330 ÷ $36,090 = 17.53 percent

Gross Income Level $36,090 - $44,365 (FEDTAX  rate rises to 15 percent)

Once the $33,529 income level is reached, the FEDTAX rate rises to 15 percent. Given the assumption of a 5 percent adjustment rate, the marginal tax rate becomes:  

The 15 percent tax rate applies for the taxable income range of $12,000 to $46,700 or a total of $34,700. Up to an income level of $39,250 ($44,365 after FICA gross up) the standard deduction produces the greater deduction level. At $39,250 adjusted gross income is $41,212 ($39,250 x 1.05). FICA on this sum is $6,310. Adjusted gross income of $41,121 is reduced by $12,000 in exemptions and $7,850 in deductions to produce taxable income of $21,362. The FEDTAX formula is $1,200 plus 15 percent of taxable income over $12,000 ($9,362 x .15 = $1,404). Thus, total FEDTAX is $2,604 ($1,200 + $1,404). FICA and FEDTAX  total $8,914. The average tax rate is:

$8,914 ÷ $44,365 = 20.09 percent

Gross Income Level $44,365 - $84,252 (Itemizing begins)

Taxpayers can either take the standard deduction or itemize. For the assumption that itemized deductions equal to 20 percent of gross income, itemizing becomes preferable where 20 percent of adjusted gross income exceeds $7,850 or at $39,250 of adjusted gross. Adding the 5 percent of income assumed for adjustment, yields a gross income number of $41,212 as the point at which itemizing begins. When grossed up for FICA, the total becomes $44,365. At this level the individual would be able to reduce gross income by 25 percent to determine taxable income. Reducing taxable income by 25 percent is equivalent to paying taxes on 75 percent of gross income. Thus the MTTR is determined as follows:  

Gross Income Level $84,365 - $146,232  (FEDTAX  rate rises to 27 percent)

  The FEDTAX  rate remains at 15 percent. for the first $46,700 of taxable income. Since $12,000 of total income is excluded because of exemptions the rate change occurs at $58,700 and given 25 percent of total income is excluded because of adjustments and deductions, $46,700 of taxable income corresponds to $78,267 of gross income:

            46,700 + 12,000 = $58,700

            58,700 ÷ .75 = $78,267

Above this $78,267 gross income level ($84,254 when grossed up for FICA), the FEDTAX rate rises to 27 percent, causing the MTTR to rise to:  

At this level of income the FICA tax corresponds to $11,974 and the FEDTAX to $6,405, for a total tax of $18,380. The average tax rate is:

$18,380 ÷ $84,254 = 21.80 percent

Gross Income Level $146,232 - $155,246 (FICA drops to 2.9 percent for first wage earner)

  The next gross income level at which the MTTR changes occurs where the FICA rate declines from 15.3 percent to 2.9 percent for the higher paid income earner.  For the assumption that lower income = 60 percent or higher, that level is reached when income subject to FICA totals $135,840 ($84,900 x 1.6).

At this income level the higher-paid income earner in the family has paid in his or her maximum for the Social Security portion of FICA, and the rate drops from 15.3 percent to 2.9 percent. The lower-paid income earner would, however, continue to have FICA withheld at the higher rate until he or she also reached the $84,900 level. The effect is to reduce the blended FICA rate from 15.3 percent to:  

 2.9% x .625   1.8125

15.3% x .375  5.7375

                        7.55%

Thus the MTTR becomes:

FICA on total income of $135,840 yields a total liability of $20,783. The FICA gross up total income is $146,232. The tax that the IRS levies for the first $78,266 yields a tax of $6,405. The additional $57,574 in gross income is subject to a 27 percent tax rate after adjustments and deductions reduce the total to 75 percent of the gross amount or $43,180. The corresponding tax is $11,658. Adding this sum to $6,405 produces a total FEDTAX bill of $18,063 and a total tax including FICA of $38,846. The average tax rate is:

$38,846 ÷ $146,232 = 26.56 percent

Gross Income Level $155,526 - $174,938 (Itemized deductions reduced)

The amount of deductions that can be subtracted from adjusted gross income to determine taxable income begins to be reduced at an adjusted gross income of $137,300.  Adjusted gross income of $137,300 corresponds to gross income of $144,526 ($137,300 / .95). At that point each additional dollar of adjusted gross income produces a three cent loss in itemized deductions. Such a deduction loss has the effect of increasing the taxable income by a similar percentage relative to gross income. If 20 percent of gross income is initially deductible, giving effect to the reduction in deductions would generate usable deductions equal to 17 percent of income. Adding in the 5 percent that is included as an adjustment (5 percent + 17 percent = 22 percent, taxable income equals 78 percent of gross income. Thus the new MTTR is computed as:  

The tax levied by the IRS (FEDTAX) equals $6,405 plus 27 percent of taxable income over $46,700. A gross income level of $144,526 is reduced to $108,395 by deductions and adjustments and then $12,000 by exemptions to a total taxable income of $96,395. Subtracting $46,700 from the total yields, $49,695, which is taxed at 27 percent for a tax levy of $13,418. Adding this sum to the $6,405 on the first $46,700 produces total FEDTAX bill of $19,823.

FICA up to a total earned income of $135,840 is assessed at the 15.3 percent rate in $20,783. The remaining ($144,526 - $135,840) $8,686 is subject to a levy of 7.55 percent or $656 for a total FICA of $21,439. Total taxes sum to $41,262 and the average tax rate is:    

$41,262 ÷ $155,246 = 26.58 percent

Gross Income Level $174,939 - $229,473 (FEDTAX  rate rises to 30 percent)

The MTTR remains at this level until taxable income reaches $112,850 or another $66,150 in excess of $46,700 in taxable income.  We now need to determine how much gross income must increase to correspond to taxable income increase of $66,150. Up to the point where adjusted gross income reaches $137,300 ($144,526 of gross income) every dollar of gross income yields 75 cents of taxable income. Above that point a dollar of gross income correspond to taxable income of 78 cents.

  Seventy-five percent of $144,526 is $108,395. Recall however that taxable income is reduced by $12,000 because of the four exceptions ($108,394 - $12,000 = $96,395). Thus, the point at which itemized deductions begin to be reduced corresponds to $96,395 of taxable income. Above that level, taxable income increases from 75 percent to 78 percent of gross income. The tax rate on taxable income remains at 27 percent until taxable income reaches $112,850, which is $16,456 above $96,394, the point where deductions begin to be phased out. Taxable income of $16,457 corresponds to gross income of $16,456 divided by .78 or $21,098. This sum added to $144,526 of gross income establishes a gross income level of $165,624 where the tax rate rises to 30 percent. At that point the MTTR is calculated as follows:  

The 27 percent rate begins at a taxable income level of $46,700 and ends at $112,850. Thus, a total of $66,150 of taxable income is subject to the 27 percent tax rate. In the prior income level we saw that $49,695 taxed at the 27 percent rate was subject to no deduction reduction. Above that point, however, itemized deductions are reduced by three percent of adjusted gross income. Thus taxable income at this level equals 78 percent of gross income. As a result, only $49,695 of the $66,150 in income taxed at the 27 percent rate, is subject to a 20 percent itemized deduction rate. The remaining $16,445 is only able to use a 17 percent deduction rate or 23 percent allowing for adjustments. Accordingly, $16,445 in taxable income corresponds to $21,083 in gross income. Adding this amount to the prior sum of $144,526 produces gross income of $165,609. Up to $135,840 in gross income increases both income earnings are subject to the full 15.3 percent SSI rate for a levy of $20,783. Above this level taxpayers' income is subject to a rate of 7.55 percent or a total of $165,609 less $135,840 or $29,769. The FICA on this sum is $2,247 added to $20,783 yields $23,031. The tax levied by the IRS (FEDTAX) on this income is $24,265. The total of FEDTAX and SSI taxes is $47,296. The FICA gross up from the first $135,840 (x 1.0765) in gross income takes the total to $146,232. The remaining income of $29,769 is grossed up at a rate of 1.0377 to $28,706, which when added to $146,232 produces a total of $174,938. The average tax rate is:

$47,296 ÷ $174,938 = 27.04 percent

Gross Income Level $229,473 - $240,210(Exemption phase-out begins)

The next shift in the MTTR results from the phase-out of exemptions, which begins at an adjusted gross income of $206,000. Since adjusted gross income corresponds to 95 percent of gross income above $206,000, that level of adjusted gross income corresponds to gross income of $216,841. At this income level the assumed family of four will begin to lose their $12,000 exemption tax shelter pro rata over the next $122,500 of adjusted gross income. This $122,500 sum corresponds to $128,947 in gross income. Therefore, every additional dollar of gross income corresponds to an exemption shelter loss of 9.30 cents ($12,000 ÷ $128,947). This loss can be viewed as increasing the percentage of gross income that is taxable by a similar percentage (i.e., 78 percent + 9.3 percent = 87.3 percent).  Accordingly the MTTR is computed as:        

Exemption phase out begins where adjusted gross income equals $206,000, which corresponds to $216,841 in gross income. The FICA tax on this amount equals 15.3 percent of the first $135,840 ($20,784) and 7.55 percent of the excess on $80,001 x .0755 = $6,040. This totals to $26,842. Therefore, total income equals $230,252 ($216,841 + $13,412).

The tax levied by the IRS (FEDTAX) up to $174,938 total income ($112,850 taxable) equals $24,265. Above this sum the tax rate is 30 percent. We started with gross income of $206,000. To determine the taxable income that corresponds to $206,000 in adjusted gross, we reduce the total for the first $137,300 by 20 percent ($27,460) and then 17 percent of the rest (.17 x $68,700 = $11,679) for a total reduction of $39,139. We further reduce the sum by $12,000 for exemptions. The result is $154,861 in taxable income of which $42,011 is subject to the 30 percent rate or $12,603. This sum is added to the $24,265 tax on the first $112,850 producing a total FEDTAX of $36,868. Summing the  FEDTAX and FICA taxes ($26,642) produces $63,510 in total taxes and an average rate of:

$63,510 ÷ $230,412 = 27.56 percent

Gross Income Level $240,210 - $250,330 (FICA tax rate falls to 2.9 percent)

Recall that we assumed that the second wage earner in our tax unit is still paying FICA at 15.3 percent. At what point does this person's FICA drop down to 2.9 percent? When the lower wage earner's gross income reaches $84,900, the higher wage earner would be making (1/.6) $84,400 or $141,499 for a total family income of $226,399. At this point both wage earners are only subject to an FICA level of 2.9 percent. Therefore,  the MTTR for them is:  

At a total income of $226,400, both wage earners are at the maximum level for a 15.3 percent rate. For this income level FICA is 15.3 percent of the first $135,840 or $20,783. The remaining $90,500 is subject to an FICA rate of 7.55 percent or $6,837 for a total FICA of $27,620. Adding half of this amount ($13,810) to $226,400 produces a total income of $240,210.

In the prior segment adjusted gross income of $206,000 resulted in an FEDTAX of $36,868. The adjusted gross income for this segment is $226,400 x .95 or $215,080. Thus. the additional adjusted gross income is $215, 080 - $206,000 or $9,080. After allowing for the deductions (17 percent) and exemptions phaseout, taxable income over this range equals .923 times adjusted gross or $9,080 × .923 = $8,381. Adding $8,381 to the prior taxable income number of $154,861 produces a total of $163,242. The additional $8,381 is taxed at a 30 percent rate for an additional FEDTAX of $2,514 which when added to the prior FEDTAX  of $36,868 yields a total FEDTAX of $39,382. Adding in SSI of $27,620 produces a total tax bill of $67,002. The average tax rate is:

$67,002 ÷ $240,210 = 27.89 percent

Gross Income Level $250,330 - $360,217 (The FEDTAX rate rises to 35 percent)

  Next, the FEDTAX rate increases to 35 percent for taxable income of $171,950. This $171,950 sum reflects a taxable income increase of $59,100 over $112,850 where the 30 percent rate began to be applied.

As has already been noted, $112,850 of taxable income corresponds to $165,624 of gross income. At this point a dollar of gross income equals $0.78 of taxable income up to a gross income level of $216,850 for a difference ($216,850 - $165,624) of $51,226 in gross income. That difference corresponds to $39,956 in taxable income. Adding $112,850 to $39,956 produces a total of $152,806 of taxable income. This sum is still $19,144 below the point at which that tax rate shifts to 35 percent. For this income level, however, the phase- out of exemptions leads to a loss of deductions/exemptions such that each dollar of additional income corresponds to $0.873 of additional taxable income. Thus, $19,144 of taxable income corresponds to $21,928 of gross income. Adding this sum to $216,850 produces a total of $238,778. At this point the FEDTAX rate shifts from 30 percent to 35 percent of taxable income and the MTTR becomes:  

Tax on the first $171,950 of taxable income is $41,995. Above that level the tax rate shifts to 35 percent. In the prior segment taxable income totaled $163,242. Therefore, another $8,708 remains taxable at the 30 percent rate. This sum corresponds to a gross income of $18,708 ÷ 0.873 = $9,975. SSI on this total is $289 and total FICA is $27,909. Thus, total income grosses up for FICA is $240,210 + $9,975 - $145 = $250,330. The total of FEDTAX and FICA taxes is $27,909 + 41,995 = $69,904. The total tax bill is $69,904 ÷ $250,330 = 27.92 percent.

 70,183 ÷ $240,210 = 29.22%

Gross Income Level $360,217 - $412,367 (Exemption phaseout ends)

The next shift begins at the income level where the exemption phase-out ends. Exemption phase-out begins at $206,000 in adjusted gross income, which corresponds to $218,842 of gross income. The phase-out of exemptions continues until adjusted gross income increases by $122,500. An adjusted gross income of $122,500 corresponds to an additional $128,947 in gross income. Thus for gross income of $345,263 ($218,842 + $128,947) exemption phase-out ends. At that point MTTR becomes:  

The phase-out for exemptions is complete at an adjusted gross income of $206,000 + $122,500 or $328,500. Multiplying by (1/.95) yields gross income subject to a FICA tax of $345,789. Of this total the first $135,840 is taxed at the 15.3 percent rate or $20,784. The next $90,500 is taxed at 7.55 percent for a levy of $6,837. Adding $135,840 and $90,500 equals $226,340. Subtracting that total from $328,500 results in $102,160 being subject to the 2.9 percent rate or an additional FICA tax of $2,963. Thus, the total FICA tax is $30,584. Adjusted gross income of $328,500 corresponds to $344,925 in gross income. Grossing the total up for FICA adds half of the FICA total or $15,292 for a total income of $360,217.

In the prior segment $236,376 in gross income corresponded to taxable income of $171,950. Subtracting $236,376 from gross income of $345,789 produces an increase in gross income of $109,413. This sum corresponds to a taxable income of (X.873) $95,518 subject to a 35 percent tax rate for an additional FEDTAX of $33,431. Adding this to the prior total of $41,995 produces a total FEDTAX of $75,426. Adding a SSI  tax of $30,584 produces a total tax of $106,010 and an average tax rate of:

$106,010 ÷ $360,217 = 29.43 percent           

Gross Income Above $412,367 (FEDTAX rate rises to 38.6 percent)

  The final shift in the MTTR occurs when the FEDTAX rate rises to 38.6 percent at a taxable income of $307,050. This point corresponds to an increase in taxable income of $135,000 from a taxable income of $171,950 where the 35 percent tax bracket began. For our assumptions, $171,950 in taxable income corresponds to $223,993 in gross income.  From $238,778 to $345,263 gross income increases $106,485, which corresponds to a taxable income increase of $92,467. Subtracting this sum from $135,100 leaves $42,533 to be accounted for. Above the exemption phase-out each dollar of gross income corresponds to 78 cents in taxable income. Thus the $42,533 in taxable income corresponds to $54,529 in gross income. Adding this to $345,263 yields $399,792 as the gross income level where the 38.6 percent FEDTAX rate begins. For total income exceeding this level the MTTR becomes:  

At a taxable income level of $307,050 the FEDTAX rate increases to 38.6 percent. In the prior segment taxable income totaled $267,468; so taxable income has increased by $39,582. This corresponds to a gross income increase of $39,254 ÷ .77 = $51,405. A 2.9 percent FICA on this sum yields $1,490. Adding this to the prior FICA tax total of $30,584 produces a total of $32,074. Total income is the sum of $360,217 + $51,405 + $745 = $412,765. Taxes total to: (FEDTAX) $89,280 + (SSI) $ 32,074 or $121,354 and the average tax rate is:

$121,354 ÷ $ 412,367 = 29.43 percent  

Appendix D

A Feasibility Test

IRS data for 1993 may be used to illustrate the feasibility of a 25 percent tax levy. In that year adjusted gross income totaled $3,728 billion (B) for 87 million (M) individual tax returns reflecting 176M exemptions (approximately 2.0 exemptions per return). Income tax collections (including alternative minimum taxes) were $505B and employee FICA payments $214B. Thus combined FICA tax and income tax receipts from individual taxpayers totaled $719B.

We may compute the revenues from the proposed 25 percent levy on adjusted gross income in parts. First, consider those taxpayers reporting more than $15,000 in adjusted gross income. Most such taxpayers would fully utilize their $1,000 per dependant tax credit. A very few taxpayers with four or more exemptions would not fully utilize their personal tax credits and thereby be eligible for subsidy payments. A total of 44M returns with 117M exemptions and $15,000 or more in adjusted gross income reported a total adjusted gross income of $3,412B. The 117M in exemptions would shelter $468B in taxes (4 x 117 = 468), thereby yielding taxable income of $2,944B, which at a 25 percent rate would correspond to $736B in taxes.

  Computing the tax collections and earned income payments for the under $15,000 group is complex, as it depends upon the distribution of dependents within the groups. Still we can approximate the net tax for the three subgroups taken separately. First, 14M taxpayers earning less than $5,000 with 11M exemptions (many no doubt are dependant children who do not claim themselves) reported $37B in adjusted gross income. Their 11M in exemptions would shelter $44B in taxable income for an unused credit of $7B. Their ratio of used credit to total credit would be 37/44, which would yield a subsidy payment of $6B. This is an upper bound estimate for the size of the subsidy. The actual subsidy would depend upon the within class distribution of income and exemptions.

Next 14M taxpayers earning between $5,000 and $10,000 with 20M exemptions reported adjusted gross income of $107B. Their exemptions would shelter $80B in income. Thus they would pay tax on $27B, which at a 25 percent rate would yield $7B in net tax collections. This is a lower bound estimate of the tax liability.

  Finally, 14M taxpayers earning between $10,000 and $15,000 with 24M exemptions reported $169B in adjusted gross income. Their exemptions would shelter $96B in gross income yielding taxable income of $75B. At 25 percent this would produce $19B in taxes. This is a lower bound estimate of the tax liability.

Thus net tax collection in 1993 would have been $756B (736 ‑ 6 + 7 + 19) compared with $719 under the present system. While crude, I submit that these calculations demonstrate the feasibility of a 25 percent levy. Indeed, actual tax collections would increase to the extent that: a lower tax rate enhanced work incentives, risk taking, efficiency and compliance. Similarly, a broader income definition (than adjusted gross income) would produce either a higher level of tax collections or allow a lower marginal tax rate.  

B>Quest

(Business Quest)