The Tax System: Too Complex, Unfair and Outdated

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

May 15, 2008

Stimulus checks in taxpayers’ mailboxes this year are a bright note in an otherwise unpleasant season. In most Americans’ minds, the annual tax-filing ritual raises two questions: Why is it so complicated? And, what’s the point of all these incomprehensible rules and exceptions?

The system is way too complex. Over the years, Congress has created many rules and exceptions as incentives for taxpayers to use their money in certain ways. But these incentives — such as encouraging certain forms of energy — are concealed under mounds of instructions, so many people don’t realize they exist and don’t get to take advantage of them.

Not only is our tax system too complicated; it’s also outdated. For example, payroll taxes — which cover fast-rising Social Security and Medicare expenditures — simply cannot meet future needs. In short, a better system would keep taxes as low as possible, make them more equitable, and still raise the revenue needed for government to run.

Yet, most proposals popular on Capitol Hill — such as making recent tax cuts permanent or raising limits on tax-deferred savings — are unrealistic and unfair to middle and lower-income families. With special interests more powerful than average taxpayers, tax policy largely reflects the schemes of entrenched Washington lobbies.

Presidential candidates and other national leaders should be advocating changes like making it possible for many taxpayers to pay without filing returns — as is commonly done in dozens of other countries.

The next Congress should streamline tax incentives for education, and combine the personal exemption, child credit and earned income credit into a higher standard deduction. Corporate income should be taxed only once, rather than taxing both corporations’ new income and individual investors’ capital gains — but clamp down on corporate tax shelters. Tax enforcement must be toughened, so slackers don’t make the rest of us pay more than we should.

A truly comprehensive tax reform package would eliminate the alternative minimum tax, or AMT. This monster was created to ensure that all wealthy people pay taxes. But the AMT increasingly threatens to gobble up more of the hard-earned income of middle-class Americans and doesn’t stop the wealthy from using generous tax shelters. Congress can afford to do away with it by raising income tax rates slightly or with other changes.

Comprehensive reform also would make it easier to save toward retirement. (Currently, half of all householders age 55-59 have less than $15,000 in retirement savings.) Research supports two strategies to increase personal savings: Employees should automatically be enrolled in their company’s 401(k) plan, unless they opt out. And, firms without 401(k) plans should have to set up individual retirement accounts, or IRAs, with automatic payroll deductions.

Further, the maze of tax advantages for different kinds of retirement plans should be replaced by one simple incentive: a federal match, up to a dollar limit, on all retirement savings. To illustrate, a 20 percent match would give each saver $2,000 for each $10,000 deposited in a retirement plan. In addition, Congress can contribute to a cleaner environment and reduce our dependence on foreign oil by adopting a carbon tax or other “green tax.”

There’s one other major issue facing framers of tax policy: making taxes more progressive, so that poor people aren’t kept poor. People who don’t earn enough to pay income taxes still should have the advantages of tax incentives for education and other social benefits. This can be done by giving the same cash payment (or “refundable tax credit”) to everyone eligible for the benefit. Then middle-income individuals, too, would reap the same advantage as upper-income individuals. In the present system, tax deductions are more of a boon to people in the highest tax brackets.

Although complicated and controversial, tax policy needs to be discussed on the campaign trail. The nation needs relief from the current tax system. Every candidate for the U.S. presidency, Senate, and House of Representatives should have a full and carefully constructed position paper on taxes, showing voters what they will do once in office. Mere sound bites — like “no new taxes” — are misleading and solve nothing.