I field questions all the time about federal income taxes. Unsurprisingly, people rarely think they should pay more into the system but quickly list off areas of profligate government spending or preferential treatment toward other taxpayers. Of course, there is no clear answer to create a better system, but there are some academic principles that should guide how you form an opinion.
These principles are: simplicity, efficiency, revenue, fairness, and social policy. Unfortunately, no one system can fully embody all of these characteristics because each one is a tradeoff for one or more of the others. But the goal is to find a healthy balance, so here is an overview of each one:
Simplicity: A tax system should allow people to easily understand and comply with its rules. It’s safe to say that our current system is not simple. Filing any type of tax return now requires a lot of taxpayer information, and the very existence of tax professionals (CPAs and lawyers) indicates that our system is in fact quite complex.
Efficiency: If a tax system is efficient, it means that the imposition of a tax does not significantly change the way people behave. In the case of income taxes, do people work more to increase their earnings and offset what they pay in taxes? Conversely, do they work less because the tax burden no longer makes it worthwhile to them? If either result occurs, then the tax is not very efficient.
Revenue: Obviously, a tax system needs to generate revenue. This is how our government can provide public goods and services such as maintaining roads and bridges, equipping our military, and administering requisite programs.
Fairness: There are two related ideas about fairness—vertical equity and horizontal equity. Vertical equity is the idea that people with more ability to pay are taxed more. This idea is why we have progressive tax rates that tax higher levels of income at a higher rate. Horizontal equity is the idea that people who are similarly situated should be taxed in the same manner.
Social Policy: Tax systems can be used to encourage (or discourage) certain behaviors based on social policy. For example, our current system encourages home ownership and charitable contributions by allowing them as itemized deductions. Notably, this tenet is in direct opposition to the tenet of efficiency.
So the next time you engage in cocktail chatter about the emotionally charged topic of tax reform, consider these five tenets and ask questions about how change could affect each of these areas. There is always a tradeoff, and it’s important to understand both what you may gain and lose under a new system.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.