The Fairness of the U.S. Tax Code

Answer

The Fairness of the U.S. Tax Code

A tax code is an important consideration not only by governments and employers, but also by employees and citizens. Taxes include payroll, income, sales, property, sales, capital gains, imports, dividends, estates and gifts, as well as various fees. It is the responsibility of every citizen to understand how the tax system operates because this can affect them in a number of ways. Taxes are a monetary assessment that is enforced on businesses and individuals by the legislative arm of the government. A tax mistake is likely to affect the business or person direly in terms of finances and legal implications. As such, tax laws are very critical to the American people. Tax regulations are put in place in order to prevent and protect chaos from occurring. A progressive tax system helps to restrain disparities in income and makes public services and systems available to all citizens. The US tax system is designed to be progressive (Sewalk & Leaman, 2014). By a progressive tax system, it implies that the proportion of income that an individual pays in taxes increasing with increasing income. Consequently, those with higher incomes pay more in total taxes and also pay a higher rate of taxes (Durante, Putterman, & Weele, 2014). The principle essence of a progressive system of tax can be conceptualized as fairness where people pay based on their income. However, evidence suggest that some elements of the US tax system are progressive while others are not and as it can be argued that the US tax system is partly fair and partly unfair.

Background

Before 1776, the various American colonies were subject to taxation regimes by the United Kingdom. The US federal government under the VIII of the Articles of Confederation Article did not have the authority to tax. The US Constitution that was adopted in 1787 authorized the federal government henceforth to lay and collect taxes. Some types of tax revenues were to be given to the states in proportion to population. Throughout the 1800s, tariffs were the principal forms of the federal tax. The first federal income tax in US was adopted as part of the 1861 Revenue Act (Menarini & Swenson, 2015). Consequently, the tax lapsed following the American Civil War. In 1913, the ratification of the Sixteen Amendment of the US Constitution permitted the federal government to levy an income tax on labor and income. It included individual and corporate income taxes. The tax allowed deduction from business expenses and few non-business deductions. The language used was derived from prior laws as “all income from whatever source derived” (Durante, Putterman, & Weele, 2014).

The tax law was expanded in 1918 to include a foreign tax credit as well as more comprehensive definitions of deduction items and income. Federal taxes were expanded largely during the World War 1. A series of fundamental income tax cuts were undertaken in the 1920s up to the time of the great depression of 1929. However, taxes were raised again following the depression and during the World War II. In 1986, the Congress adopted a major expansion of the income tax portion with little modification of the income tax portion of the internal Revenue Code (Sewalk & Leaman, 2014). The Tax Reform Act of 1986 substantially lowered tax rates, eliminated the lower individual tax rate for capital gains, adopted sweeping expansions of international rules, made significant expansions of the law, and added significant inventory accounting rules. By and large, there have been frequent modifications of the federal income tax rates with 34 changes occurring within a period of 97 years between 1913 and 2010 (Harrison, 2015).

The Problem of Income Inequality

Although the US income tax system is designed to be progressive where tax rates should increase in steps as income rises, recent evidence has revealed that this is no longer actually the case on the ground. For decades, the progressive tax system in US has helped to restrain disparities in income and has helped to make public services and systems available to all citizens (Hess & Meyer Alexander, 2015). However, today the system has largely eroded with many multi-billionaires and millionaires paying lower tax rates than the average American households.

 According to the 2011 Congressional Research service, changes that have occurred in the dividends and capital gains are the largest contributor to the rise in the overall income inequality. Recent research also suggests that taxes are less progressive than they were in 1996. Tax policy has also led to rise in income inequality between 1996 and 2015. Reports show that since 1996, the US income tax regime has become less progressive (Menarini & Swenson, 2015). If the tax system was more progressive, it would help mitigate the effects of the recession on consumers by taking a smaller proportion of income from the lower-income consumers than from the other consumers so that they can spend more of their disposable income on consumption and as such restore equilibrium. The assumption is that of automatic stabilizer believed to mitigate the effects of inflation by taking more from the wealthiest consumers so that their large level of consumption does not create a demand-driven inflation.

Over the past three decades, there has been a rapid rise in income inequality. While in 1979 the richest 1 percent of America’s wealthiest paid 37 percent of their income in federal taxes, today owing to numerous tax cuts the same portion is does to less than 30 percent (Johnson, 2015). While the amount of taxes paid by the wealthiest has fallen, so has the overall effect of the tax code on its post-tax distribution of income.

(Sewalk & Leaman, 2014)

While in theory the amount that many individuals are supposed to pay in taxes is 40 percent, in practice, the wealthy only pay a close to 22 percent for a number of reasons. First, many of the wealthiest Americans have a predominant of investment income and this is taxed at 20 percent (Durante, Putterman, & Weele, 2014). Secondly, some of the wealthiest enjoy tax breaks from the mortgage interest payments. Thirdly, a number of the wealthiest have rental income or donate to charities that are excluded. Fourthly, most of the richest people are able to deduct local and state taxes from their federal taxable income (Sewalk & Leaman, 2014).

In the current tax system, billionaires pay lower tax rates than average Americans because federal taxes on investment income are lower than taxes that average Americans pay on salary and wage and income. Because most of the wealthiest get a high proportion of their total income from investments, they pay a lower income tax rate. Currently, the top statutory tax rate on investment income is 23.8 percent while that on income from work is 43.4 percent.

Conclusion

Although the US tax system is designed to be progressive so that the proportion of income that one pays in income increases with their level of income, some elements of the tax code have rendered it ineffective and have actually contributed to a huge income inequality. The rich do not pay as much in terms of taxes as they should in order to contribute to a fairer system that equally redistributes resources and creates a more equal society.

Solutions to Problems

Tax Income from Investments: Equitable

A progressive tax system is assumed a mechanism to address the economic inequalities in society. However, this is not the case in the US. In order to evaluate a tax system on the inequality, it is imperative to consider the distribution of taxes that are paid as well as the distribution of the benefits that are derived from the tax revenue. Notably, if the benefits that are being derived from the programs being funded by the taxation primarily benefit the low-income households and the high-income households pay the bulk of taxes, then the tax system can be said to operate as a transfer mechanism (Goncharov & Jacob, 2014). Meanwhile altering the distribution of benefits or increasing the progressivity of the tax system allows the redistribution of economic resources.

In order to reduce the inequality caused by the unfair unearned income tax system against the earned income tax system, tax rates should be raised on capital gains and dividends. This will match the tax rates that are deducted on salaries and wages. Such measures would raise over $ 1.3 trillion in ten years.

(Cohen, Manzon, & Zamora, 2015)

Tax hikes for the wealthiest is likely to result in reduction in inequality as illustrated in figure 2 above. In 1992 the average income before tax for an individual in the top 1 percent was almost 16 times greater than the average income before tax for an individual within the middle 20 percent but 13 times greater after deduction of the federal tax. This implies that the 1992 tax code had reduced inequality in relation to the pre-tax distribution by about 29 percent (Cohen, Manzon, & Zamora, 2015)

Cap Tax Deductions At 28 Percent for the Richest Americans: Economic

The wealthy are able to get much bigger tax breaks even for the same tax deductions as the ones taken by the middle class. for instance, a rich family living in a McMansion is likely to get a much higher tax deduction on the interest on their large proportion mortgage than another middle-class family would get on their smaller mortgage (Goncharov & Jacob, 2014).

Concerning the cap tax deductions at 28 percent for the richest Americans, a limit on the tax break on deductions taken by the richest to 28 cents on the dollar should be created. This way, the 3 percent richest would get the same tax benefit per dollar of deductions as another household within the 28 percent tax bracket and not more as it is currently at the higher 39.6 percent bracket. Moreover, this would raise about $500 billion in ten years for social development (Cohen, Manzon, & Zamora, 2015). With such hikes on the income of the wealthiest section of the society, there will be a more effective redistribution of resources and the government will earn more from the tax to spend in social and development projects. This would not only balance the problem of inequality, but also improve the welfare of the people.

The Estate Tax; Moral

The very rich are able to take advantage of the loopholes and avoid paying anything on inheritance taxes. They also take advantage of the fact that exemption levels for the estate tax are very high standing at $ 10.6 million per couple and $ 5.3 million per individual (Goncharov & Jacob, 2014).

Restoring the estate tax exemption to the 2009 levels of $ 7 million for couple and $ 3.5 million for an individual taxed at a 45 percent to rate will strengthen the estate tax. This reform would raise $130 billion over 10 years and only three deaths for every 1000 estates would be affected (Goncharov & Jacob, 2014). It would also be effective to ensure that large inheritances are taxed by closing income tax loophole that allows them to avoid capital gains taxes by holding their assets until they die. In this case their heirs avoid paying taxes on these gains. This way, the government would raise about $600 billion over ten years (Menarini & Swenson, 2015).

Conclusion

The relationship between the average effective rate of tax for the richest 1 percent and the subsequent impact of the tax code on income inequality shows a close correlation between the two. Increasing the tax rate for the wealthiest 1 percent indicate a positive effect on income inequality reduction. This implies that a more regressive tax regime would be more effective in addressing the issue of huge inequality that is attributed to the current US tax code. As such, it is imperative that the government comes up with several reforms to the current tax code in a bid to address the loopholes that are causing inefficiencies in what is supposed to be a regressive code with less income inequality.

Disadvantages

Disadvantage One

A more progressive tax regime would imply that the wealthiest be overtaxed. Overtaxing a section of the society would still be unfair and would raise concerns on the government policy to support wealth creation and prosperity as is inspired by the “American Dream” philosophy (Goncharov & Jacob, 2014). Since the tax system is supposed to be fair to everyone, a more regressive tax code would seem to contravene this premise by overtaxing the wealthy. It would also be seen as a discouragement towards owning much wealthy and as such against basic human rights.

Disadvantage Two

The estate tax can be considered in a different perspective as a “death tax”. It is seen as unfair to tax estates especially in this case which involves inheritance. In other words, taxing estates that are being inherited is unfair to the heirs or the owners because they already pay other forms of taxes such as income tax on the property (Menarini & Swenson, 2015). Besides, it can be seen an unnecessary burden on the side of the wealthy families and an unfair practice against their hard earned wealth.

Disadvantage Three

Tax breaks on large mortgages would largely discourage the rich who can manage to purchase houses without a mortgage from seeking such initiatives. This would in turn affect the mortgage market negatively and lower profits (Menarini & Swenson, 2015). The wealthy form an important section of any business and any measures that are likely to affect their spending behavior negatively is likely to affect the industry significantly.

Conclusion

As much as a more regressive tax code is likely to address the problem of income inequality, it is also likely to introduce some serious problems to the market and societal equilibrium. It is likely to cause overtaxing of the wealthy and unfair tax practices on this section of the population.

Conclusion

A progressive tax system helps to restrain disparities in income and makes public services and systems available to all citizens. Although the US tax system is designed to be progressive so that the proportion of income that one pays in income increases with their level of income, some elements of the tax code have rendered it ineffective and have actually contributed to a huge income inequality. The rich do not pay as much in terms of taxes as they should in order to contribute to a fairer system that equally redistributes resources and creates a more equal society. This has contributed to the problem of the huge income inequality being experienced in the country. As such, it fails to achieve one of its fundamental purposes of creating fairness and equality and requires some adjustments to address the problem.

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