Principles of Taxation Walther Grot, (<w.grot@juno.com>) June 4, 2005

The cause of the complexity of the current income tax system is the
attempt :

**To make "A" pay more tax than "B"**

"A" and "B" are not persons, but attributes or conducts of taxpayers. An
individual taxpayer will usually have both "A" (high income, for
instance) and "B" (many dependent children, high mortgage payments)
attributes. These attributes are assigned A or B status according to 3
principles :

1)  Ability to pay

2)  Desirability of conduct

3)  Perceived willingness to use the money wisely

Note that in most cases, principles 1) and 2) conflict with each other
because conduct, which results in the ability to pay large amounts of
taxes is, in general, desirable. **The fact that this conflict is
usually resolved in favor of 1), is the major cause of the
destructiveness of the current tax code.** Principle 3) is rarely
employed, fortunately, because the government does not have a clue how
to spend money wisely.

Approaches to reduce the complexity and destructiveness of the current
income tax system, have been proposed : The so called "Flat Tax", which
taxes people in proportion to their income (a truly "flat" tax, where
everybody pays the same amount of tax, is not practical) and the "Fair
Tax", which taxes people in proportion to their spending. While
particularly the "Fair Tax" not only satisfies the principle of
fairness, but also advances the overall welfare of the nation, it may be
difficult to implement for political reasons. In the following, I
suggest therefore approaches to make the current tax code not only
fairer, but, more importantly, less destructive :

In weighing the merits of principles 1) versus 2), the degree to which
the "Ability to Pay " is subject to the taxpayer's control, must be
considered. At one extreme, for instance, age as a factor in determining
taxation, is not under the control of the taxpayer and tax incentives to
maintain the population in the most desirable age bracket, would not
make sense. Other factors on the other hand are under partial or total
control of the taxpayer. I pick 2 examples for discussion : 1) The
taxation of 2-income couples and

2\) of early retirees.

2-Income Couples / The Marriage Penalty :

There are 2 ways to escape the marriage penalty : Divorce (or not to get
married to begin with) or for one spouse to quit. While the "Christian
Right" may be concerned about the moral justification of the government,
through the tax code, to encourage divorce, I am more concerned about
negative impact on the welfare of the nation as a result of taxpayers
taking the second approach. I believe the marriage penalty, at least as
it applies to earned income, must be eliminated. This must be done
straightforward and without any of the usual diversions (Republicans :
Tax relief for large families; Democrats : for poor families). I
recognize the loss of tax revenues that will result. This loss may not
be as large as estimated under the "static" assumption. Any loss should
be recovered by increasing the tax on motor fuels.

The elimination could be implemented in stages : In the first stage, the
spouse who has the lower earned income, would be given the **option** to
file as a single taxpayer on his earned income. The other spouse would
file as "married filing separately" on the remainder of the couple's
income. In the second stage, either one of the spouses would have that
option on his/her entire income. In the final stage, both spouses would
have that option and the table for "married filing separately", which
spells out the penalty, would be eliminated.

I believe that this change would substantially increase the number of
2-income couples resulting in additional direct and indirect (taxes the
employer pays, taxes on the additional spending of the couples etc.)
revenues. The Social Security System would also receive additional
taxes, with little or no additional pension obligations (the "at home"
spouse has coverage through the working spouse anyway).

Even after complete elimination of the marriage penalty, 2-income
couples would still carry an unfair tax burden as a result of the extra
workload they are taking on. The same goes for overtime and
moonlighting. But elimination of this unfairness may wait until the
effect of the other changes outlined here is recognized.

**Early Retirement**

Early retirement is almost always entirely voluntary. It results in a
large loss of income, social security and Medicare tax revenues and
results in additional pension outlays. Currently the pension when
retiring at age 62 is 80% of that for standard retirement (age 65). This
amount has to be reduced to 50% or less. On the other hand, the pension
penalty for working retirees ages 62-65 (I believe 33 % above a certain
threshold), needs to be eliminated or at least sharply reduced.

These changes will entice many people to forego early retirement or do
part time work when retired; most likely with positive results for their
physical and mental health. The additional income tax revenues would be
substantial and there would be a positive effect on the financial health
of the Social Security System, regardless whether a person chooses early
retirement or not.

# Summary

The main theme of the above proposals is to reduce the barriers to full
employment. The elimination of the marriage penalty may involve some
revenue loss. The reduction of the incentives for early retirement on
the other hand would have a positive effect on both tax revenues as well
as Social Security / Medicare finances. Gas tax could make up the
difference. Taxes on motor fuels need to be increased anyway. Gradually
(5 cents/gal each year for 10 years), in order to allow both motorists
and car manufacturers to adjust.

The second theme is the reduction of the complexity. I use the insane
complexity of schedule D worksheet for dividends as an example : **If**
it is really necessary to tax the dividend income of A and B at
different rates, would it not be easier to simply exempt

50 % of the dividends from taxation and tax the rest at regular rates ?
This would make the effective top rate for dividend income equal to 17.5
% (or exempt 57 % for an effective rate of 15 %). Or exempt the first \$
1000.- and tax the rest at 15 % ?

Walther Grot P.O.Box 133, Rockland, DE 19732

w.grot@juno.com