A Simple, Clear, and Progressive Income Tax

Introduction.  The personal income tax is one of the largest sources of revenue for the federal and most state governments.

Governments have also made it one of the most complex taxes.

• They define multiple categories of income–wages from work, income from the trading of stocks, bonds, and other types of asset, interest and dividends from the owning of stocks, bonds and other assets, different types of pension receipts, rent and other types of income from real estate, income from self-employment, and so forth.
• They define numerous types of exemptions and credits, each with its own often-obscure definitions and record-keeping requirements.
• They tax each category of income at different rates or not at all.

An idea.  It need not be so complicated.  The income tax can be both straightforward and progressive:[1]

1. Simplify and make uniform the definition of income. Count each dollar, regardless of its source or type, as taxable.

If you want a reason for treating all income the same, consider that when you spend it, no one asks whether you obtained the money as wages by performing maintenance on apartment buildings or as capital gains by buying and selling apartment buildings.  Regardless of how obtained, the dollars are all exchangeable with each other and all can reasonably be taxed the same.

2. Provide everyone with an equal but meaningfully large personal exemption. Let’s say $20,000 per person.  For a household of two, that would be $40,000; for three, $60,000; etc.  This income would be exempt from taxation, and it would be the only exemption.
3. For income over the household exemption, apply the same tax rate to everyone.

The result is a simple, clear, and progressive system in which low- and moderate-income households have zero or very low tax liability while higher-income households pay progressively higher taxes at progressively higher tax rates.

An example.  The table below illustrates how such a system could work in practice, using Illinois data from 2015.¹ Illinois has a uniform tax rate of 4.95 percent applied to taxable income, but the system includes a very low personal exemption ($2,175 in 2015) along with a variety of other exemptions, deductions, and credits that make it almost impossible to determine whether the actual tax is progressive, regressive, or proportional.[3]

In order to obtain the same revenue as now, after broadening the definition of income and increasing the standard deduction as in Steps 1 and 2 above, Illinois would need a tax rate of 6.15 percent.  The actual rate paid by most households as a fraction of their total income would be considerably lower than this because of the realistically high personal exemption.

Data in the table below are for a household of two. Results are similar for other size households.

Simple, easy, and fair, with plenty of after-tax income compared to pre-tax.

Two refinements.  One easy refinement is indexing the personal exemption to inflation.

Another is to make the difference between the personal exemption and actual income refundable, for households with incomes below the exemption amount.  Variously known as a “negative income tax,” “guaranteed minimum income,” or more generically as a “refundable credit,” a tax policy such as this has been espoused by people as diverse as the free-market economist Milton Friedman and the social reformer Martin Luther King, Jr.

A refundable credit could make possible the elimination of most or all poverty-related welfare programs.  Balancing cost savings from reduced poverty programs against the added refund expenditure will require computing a tax rate slightly higher or lower than the rate without a refundable credit.

With regard to work incentives, a refundable credit would seem to be positive because, unlike with many existing poverty programs, there is no “cliff” effect–no point at which an additional dollar earned leads to lower total income.  Income earned up to the exemption level replaces the refund dollar-for-dollar but adds to work experience and the hope of higher income in the future.  Income earned over the personal exemption leads to a significant increase in total after-tax income, intensifying the incentive.

A discussion point:  double taxation.  “Double taxation” occurs when the same income is taxed twice with no intervening productive process.  For example, personal income is taxed, through the income tax, when an individual first receives it, and then that same income, or what remains of it, is usually taxed again, through sales taxes, when the individual spends it.

United States tax laws provide other examples of double taxation, but economists often advise against it.  For the simple progressive income tax described here, one example that readily comes to mind is income received by an individual which must, by law, be passed through to another person, such as alimony and child support.

Some people might argue that, especially because the personal exemption is so large, it is perfectly appropriate for the original recipient to count the money as part of their total income and pay income tax on it, and then for the second household also to include that money as part of their total income and pay tax on it if it exceeds their household exemption (but only if it exceeds the exemption).

Other people would argue that, especially because the original recipient has no discretion over the money and serves simply as a conduit to someone else, the original recipient should not have to count the money as part of their own income and pay tax on it.  Instead, only the person to whom the money is transferred should pay taxes on it because only the second person can decide how the money will be spent.

Conclusion.  The income tax described here is a straightforward system that is progressive despite a single tax rate.  It can serve as a model not only for state and local governments but also for the federal government.

Copyright © 2019 Arthur Lyons

[i]

[II]Data are from the Illinois Department of Revenue and the Comptroller’s Office.

[1] Progressive, when used in relation to taxes, means that as a household’s income increases, they pay not only a higher dollar amount of tax, but also a higher fraction of their total income in tax.  Many people believe taxes should be progressive.

Regressive is the opposite of progressive; under a regressive tax, as a household’s income increases, the tax paid as a percent of total income declines.  Proportional means all households pay the same fraction of their total income as tax.

There is a crucially important distinction between tax rates as applied to taxable income and the rates as computed from total income.  Government definitions of taxable income, exemptions, credits, and deductions can, and often do, convert a tax that appears to be progressive because of its rate structure into a tax that is effectively proportional or even regressive after allowing the definitions take effect.

1. Regressive is the opposite of progressive; under a regressive tax, as a household’s income increases, the tax paid as a percent of total income declines.  Proportional means all households pay the same fraction of their total income as tax.