Few topics spark debate as much as reforming the federal income tax. Some want to end it. Some want to mend it. With the right leadership, and the right solutions, we can build a simpler income tax that more effectively promotes economic growth.

In the coming weeks, the President’s Advisory Panel on Federal Tax Reform will complete their work and release their proposals. Press reports indicate, though, that the panel will fail to propose the sweeping reforms many expected. We can do better. We must set aside the petty partisanship that has stricken Washington D.C. these days in order to identify the problems generated by the federal income tax, and find solutions to these problems.

To me, there are two big problems with the federal income tax. First, the tax code is far too complex. The IRS estimates that the typical family that itemizes deductions will spend more than 20 hours completing their tax forms! In other words, people must devote one-half of a workweek just to determine how much money they need to pay the government. We need a simpler tax code.

But there are other problems with the income tax as well. Economists have long realized that compared to a consumption-based tax, the income tax discourages savings. To see this note that income taxes end up taxing people regardless of whether they spend or save. Yet consumption taxes only tax people when they spend their money — leaving savings to be tax-free. With lower savings on taxes, consumption taxes encourage more savings (and income taxes encourage less).

This is particularly troublesome when one recognizes that savings are the fuel for economic growth. It is from these savings that businesses find the capital they need to invest in the new technologies that contribute to economic growth. Thus, economies that save more, grow faster. And economies that save less, grow slower. By taxing savings — and discouraging saving — the federal income tax slows the rate of economic growth. We need a tax code that encourages savings.

It is because of this detriment to growth that some economists have proposed replacing the federal income tax with a consumption tax. Of course, consumption taxes create their own problems as well.

Currently, the federal income tax is a progressive tax — taxing the wealthy at higher rates than the poor and middle-class. A flat consumption tax — where every person pays the same tax rate — necessarily means that middle-class families will shoulder a greater tax burden. To protect middle-class families from a tax increase, a consumption tax must be progressive as well. While it is certainly possible to design such a consumption tax, such changes make the tax more complex to administer. We need a tax code that protects middle-class families.

And we still have the problem of determining exactly what we will tax. Taxing everything people consume means that families will pay taxes on many new items. Can you imagine paying a new 25 percent sales tax on top of college tuition? How about paying 25 percent more for prescription drugs — or that medical procedure that you need? Of course, we could exempt spending on education and health care, but this means we will have to pay much higher tax rates on everything else. Can you imagine paying a 40 percent federal sales tax? We need a tax code that helps people afford education and healthcare.

n Combine the various tax preferred savings accounts (like IRAs, 401k, 403b, 457b, 529 plans, etc.) into a single type of account called an Individual Savings Account (ISAs). Allow each individual to contribute up to $15,000 per year ($30,000) per couple into these accounts (employers could contribute more).

All contributions and earnings would be tax-deferred until they are withdrawn. Individuals can withdraw money at any time without paying a penalty — but they must pay taxes on the withdrawals. However, all withdrawals used to pay for healthcare and education expenses would be tax-free.

Essentially, this makes savings tax-free for most families (just like a consumption tax). Yet, it still incorporates the progressivity of the current income tax.

Additionally, this proposal would make it easier for families to afford the rising costs of education and healthcare. Consequently, this reform would encourage savings, foster economic growth all the while improving access to education and healthcare.

n Eliminate all other deductions and exemptions and decrease tax rates. Currently, individuals take their gross income and begin subtracting off various deductions and exemptions to arrive at “taxable income.”. A family of four earning $40,000 per year actually only pays taxes on about $17,000 of income — paying about $2,000 in federal taxes (or 5 percent of gross income). We could eliminate all the deductions and exemptions and just have this family pay a 5 percent tax on the $40,000. The family would still pay the same amount of tax.

So why change the laws to pay the same tax? To make it simpler. Under my plan, there would be no need to keep track of your deductions. There would be no need to file schedule A — which the IRS estimates would save the typical family over 6 hours of tax preparation time. In other words, we could pay the same tax — and save time. Imagine having an extra 6 hours of time to spend with your children instead of figuring your taxes.

n Establish a new Student Loan Interest Tax Credit — effectively making most student loans interest-free. The cost of a university education is rising rapidly, thereby forcing many students to rely upon using student loans to finance their education. With this proposal, for every dollar a student pays in interest on their student loans, they would receive a one dollar reduction in their federal income tax (up to $2,500). Essentially, this makes most student loans interest-free.

n Allow stay at home parents to qualify for the Childcare Tax Credit. Stay-at-home parents pay for childcare just like parents who work outside of the home. However, stay-at-home parents pay in the form of lost income. Consider the case of a husband and wife who each could earn $40,000 per year ($80,000 combined). If one of them becomes a stay-at-home parent, the family loses $40,000 per year of income. Essentially, this family is paying $40,000 for childcare! Yet, they currently do not qualify for the Childcare Tax Credit. This proposal ends this inequity.

n Establish a charitable gift tax credit equal to 20 percent of all charitable gifts. Currently, taxpayers can deduct the value of charitable gifts if the taxpayers itemize their deductions (I proposed above that we eliminate this deduction). Yet many families do not itemize deductions and therefore cannot receive tax benefits from charitable donations. By establishing a charitable gift tax credit, all families would be able to receive tax benefits from charitable donations. And charities would reap the benefits.

Combined these proposals would encourage savings, foster economic growth, help families afford education and health care, encourage more charitable giving, all the while making the tax code more simple. To me, this is the sweeping tax reform we need.

(Contact Dr. Hepner via e-mail at mhepner@ucok.edu)

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