The <i>Freedom</i>Tax: A 10% Flat Tax Plan

The FreedomTax: A 10% Flat Tax Plan

Fundamental tax reform to bring simplification and fairness to everyone

The FreedomTax is the only income tax reform plan proposing fundamental change in the income tax, its nature, and how it’s administered. Other reform plans merely tweak the marginal tax rates, the tax brackets, and the tax breaks, without proposing fundamental change. The FreedomTax is not one of those plans. It’s the plan for an income tax revolution – to junk the existing income tax system, and its concept and its design, for a modern 21st century income-tax system.

The FreedomTax revolution would close all tax loopholes, end all tax breaks, and establish a non-IRS-driven income tax system with a 10% single-rate tax on all income. It would bring dramatic tax simplification, tax efficiency, and fairness to all taxpayers. And, even more dramatic, the FreedomTax would free most Americans of their responsibility to file an income tax return – not even a postcard return would be required!

The income tax system would be restructured into a true tax on income, not the person-taxing system as it now functions. Wherever possible, and for most taxpayers, the FreedomTax would restructure the system away from its recipient-based, self-assessment structure requiring personal tax returns to be filed, to a modern system levying the income tax directly on income at the source of payment. The FreedomTax, from a massively broadened income tax base and with a low 10% tax rate, is expected to raise the same revenue as the existing system it would replace.1

The revolution will result in all income bearing its fair share of the income tax burden.2 This will bring major tax simplification and a huge gain in tax system efficiency, saving the Treasury billions in administrative costs. And, from the lessened compliance burdens, taxpayers will save even more (measured in dollars and time).

The FreedomTax will achieve tax neutrality to the economy and an end to tax-driven decision-making. Most important for the economy, the FreedomTax will significantly increase the after-tax returns on saving and investments and thereby foster U.S. job and wage growth to the benefit of everyone.

General Observations. Our tax law is inordinately complex and difficult to administer, consisting of more than 70,000 pages of tax law, tax regulations, tax rulings, and other materials and requiring use of more than 500 tax forms. And, the ever-burdened IRS now requires nearly 100,000 employees and an annual budget of over $13 billion to keep the decrepit system running.

The IRS has grown so large and intrusive that the Office of the National Taxpayer Advocate has been created to champion taxpayer rights. Long ago, in her 2012 Annual Report to Congress, Taxpayer Advocate Nina Olsen pleaded unsuccessfully for simplification of the income tax law with this observation –

… it takes U.S. taxpayers (both individuals and businesses) more than 6.1 billion hours to complete filings required by a tax code that contains almost four million words and that, on average, has more than one new provision added to it daily. Indeed, few taxpayers complete their returns without assistance. Nearly 60 percent of taxpayers hire paid preparers and another 30 percent rely upon commercial software to prepare their returns. To inspire confidence and trust, the tax laws should be comprehensible and the computation of the tax should be transparent and relatively simple, yet few taxpayers today can confidently say they understand the tax code or even that they have correctly computed their tax liabilities.3

Beyond this damning observation, many point to the high marginal tax rates asserting that high rates undermine economic growth, hurting us all. Many more condemn the tax “loopholes” eroding the income tax base. And then, there’s the mantra of the demigods about people not paying their “fair share,” despite the fact that there are so many more who pay little or no share at all.4

It is no secret that our income tax system is used as a political tool to pick winners and losers. It distorts the free-market allocation of capital and resources. The undue compliance burdens it places upon so many Americans, in terms of compliance expense and time incurred, are akin to an additional tax on them. And, its plenitude of special deductions, exclusions, and tax credits (properly labeled, “tax expenditures”) function as open-ended government spending programs independent of the Congressional budget and appropriation process.

There are many vested-interest constituencies who don’t see these complaints as sufficient to justify reform of our system of taxing income. However, as already noted, the system is so costly and difficult for the IRS to administer that this reason alone would justify its complete revamping.5

For those in doubt about the need for a system overhaul, there is the anomaly to consider of the Treasury being tasked to run an “income tax” with the payers of that tax paying vastly different effective-tax rates on their income. If one stops to think about this, could it be that income is not the real focus of the tax? Could it be that we have a “something-else” taxing system?

Would-be income tax reformers seem to ignore the anomaly. Clearly, real and lasting income tax reform must start by making income the focus of the tax, not other things. Yet, reformers typically present reform plans still with tax brackets, still with tax breaks requiring higher marginal tax rates, and still proposing use of the income tax for a “greater good,” whether that be to have larger income deductions and exclusions, or to add a new tax break, for example, as an adjunct to health-care reform.6

Root of the Problem. The fundamental flaw in our tax system – fostering the tax complexity and disparate treatment of taxpayers – is its design and structure with a self-assessment system making the tax a levy on the recipient, not income. As a result, income recipients (which the system calls “taxpayers”) are required to report their total income (with personal information) in individual tax returns filed with the IRS. The recipient computes the tax he owes which is assessed against him.

The assessed tax amounts to the Government’s share of the person’s income. This personal-tax-return filing system is the mechanism by which every taxpayer pays over the Government’s share of his income.7 Historians might see this arrangement akin to the medieval system where a feudal lord laid claim to the labors of his serf. The parallel is that the tax-return system operates to place citizens in a subservient role, obligated to report to a higher authority and make a “return” of portions of their income to that higher authority.

The personal-return requirement with its sharp focus on the person has been the vehicle allowing Congress to easily alter what otherwise would be a simple, uniform system of taxing all income the same. The income tax has been turned into a complicated system awarding special deductions, exclusions, and/or credits to individual taxpayers based upon personal information supplied in their returns.

So, it is incorrect to consider our system an “income tax system”, having a design for so much income to escape taxation and imposing the tax on the person, conveniently called the “taxpayer.” A true income tax would tax all income the same, regardless of recipient, the income recipient’s earning success, or how he spends his income.8

If Other Taxes Were Self-Assessed. It is easy to understand how our income tax system has fallen into such disrepute, when one considers what another tax might be like if it were structured to be self-assessed with personal returns and collected from the person in the same manner as is our income tax.

Take, for example, the federal motor fuel tax on gasoline purchased at the pump, collection of which now is easy, painless, and not seen as unfair or complicated. Suppose administration of this tax were to be converted to a self-assessment, personal-return system: The tax no longer would be levied on gasoline when purchased, nor would it be collected at the pump. Under self-assessment, the tax would be levied upon every motorist each of whom would be required to file an annual Individual Motorist Fuel Tax Return, reporting all gallons purchased and computing his total fuel tax owed for the year. Imagine the new record-keeping required of all the motorist taxpayers, and the many who would be struggling to prepare and file their personal tax returns every year and to pay the tax due.

And, with this design structure, Congress and the IRS, as the tax collector, would acquire a power over motorists not now present. Congress likely would move away from having a single tax rate on gallons purchased, perhaps adding graduated tax brackets to tax heavy users at higher rates if their annual gallons reported on the return exceed “fair” levels of motoring. Congress could create special fuel deductions for car-pooling trips, trips to see the doctor, or trips in service of a charity, etc. In the case of motorists driving luxury or gas-guzzling vehicles or who do too much recreational-driving, there could be special provisions imposing higher tax rates on their fuel purchases, but for those driving “green” cars or even American-made cars, they would have a lower fuel tax rate.

The FreedomTax. What distinguishes the FreedomTax from other income tax reform proposals is that these other proposals typically leave the personal tax-return structure in tact for all taxpayers. And, they do not completely broaden the income tax base to require that all incomes receive the same tax treatment regardless of recipient, total amount received, income source, or how that income might be spent.

These other reform proposals usually propose continuation of popular tax breaks, such as those for homeowners, and thereby continue endorsement of the faulty premise governing the present income tax system that some incomes (or portions thereof) deserve more “fair” treatment than do other incomes. By not fully rejecting this premise, they leave in place this concept as the foundation for the resurrection of tax complexity and disparate treatment of taxpayers.

By contrast, the FreedomTax addresses all these issues and more closely follows the actual wording of the 16th Amendment that the income tax authorized is to be levied and collected on “incomes, from whatever source derived”. 9

The essential elements of the FreedomTax are as follows:

1. Single-Rate Taxation. There would be a single income tax rate of 10%, imposed on all income without regard to recipient.10 As above noted, this is the key to real income tax reform, for a greatly simplified, tax-efficient income tax system. The FreedomTax would junk all of the tax-bracket schedules – whether the taxpayer is single, married and filing jointly, married but filing separately, a head of household, or is a trust, estate, or corporation.11 Marginal-rate taxation based upon total reported income would end, and with that, so would the so-called marriage-tax penalty. Also, to be junked would be all of add-on taxes, the Alternative Minimum Tax, the 3.8% Obamacare tax on investment income, and the regulatory taxes, such as the Obamacare penalty tax imposed upon taxpayers without an approved medical insurance policy.

2. Elimination of Tax Returns for Most Taxpayers. As already noted, most Americans would be freed from their personal tax-return and payment responsibility to the IRS. This would be true for everyone whose income is solely of wages, dividends, and interest.12 For recipients of that income, the 10% income tax would be deducted at the source of payment by the payor and remitted directly to the IRS. Those with income not subject to withholding at-source, such as from renting or conducting a trade or business, would continue to file returns to report that income and to take into account their income-producing expenses. They would compute the 10% tax on that income and pay it to the IRS. These returns would exclude the reporting of wage, interest, and dividend income, and personal information to the IRS.

At-source taxation of wage, interest, and dividend income will make for simple and compliance-easy taxation with the tax to be withheld and remitted directly to the IRS.13 The FreedomTax, however, would place no withholding burdens on everyday commercial transactions. Customers paying for goods and services, and tenants renting, will have no withholding responsibility on their payments for goods and services and rent. As explained above, businesses and landlords would continue to file tax returns to report their business and rent income. Similarly, borrowers paying interest to lenders will have no withholding responsibility because the lenders, such as banks and credit unions, will file returns to report their business expenses in determining the amount of their income.

Form 1099 (and W-2) reporting no longer will be necessary for payors of wage, interest, and dividend income. These payors will be withholding and paying the income tax on this income directly to the IRS, thus ending the need for the recipients themselves to again report that income to the IRS and pay the tax. This efficiency alone would be a major paperwork simplification in our income tax system.

3. Comprehensive Tax Base. The FreedomTax would greatly expand the income tax base. All compensation income would be included in the tax base, plus the value of all employer-provided fringe benefits.14 State and local municipal bond interest, all income earned from tax-advantaged investments,15 and income earned by tax-exempt entities would be included in the tax base.16 All exemptions, itemized deductions, and special deductions, exclusions, and tax credits would end.17 And, all Government transfer payments, such as the value of food stamps received, represent income received by, or paid for the benefit of, the recipient and would be taxable and subject to at-the-source withholding.18

The FreedomTax would end all special tax breaks to business, such as the Research and Development Tax Credit, the Renewable Electricity Production Credit, the Domestic Production Activities Deduction, and the Percentage Depletion Allowance. In a regime of low tax rates on income, these tax breaks lose their importance and represent unneeded complexity. Allowing any of them to continue would serve as a beacon for more tax breaks to be later enacted.19

It cannot be overstated that the guiding principle of the FreedomTax is that all tax-sheltered income, whether by deduction or exclusion or by a tax credit, which is earned within the United States enjoys the same protection of the U.S. Government as does all other U.S. income. This income, therefore, should be included in the tax base to bear its fair share of the cost of government.

4. Integration of Corporate and Individual Taxation. In contrast to present law under which corporate income is taxed first at the corporate level and again when distributed to the shareholders as dividends, the FreedomTax would tax corporate income only once. It would treat dividends paid the same as interest; i.e., corporations would be allowed to deduct dividend payments to shareholders in computing their income, just as they now do for interest.20 Corporations would withhold and pay the income tax thereon as noted above.21

The above should be contrasted from the reverse approach taken in other income tax reform proposals to deny a deduction for interest expense (and to continue the non-deductibility of dividend payments). This reverse approach is intended to give business income taxation a value-added-tax (VAT) focus, to be made like a consumption-based tax.22 But, interest expense is a cost of doing business; and if the goal is to have a tax on income, this reverse approach is an anathema to achieving real income tax reform. And inconsistent with overall tax simplification, it would require a different set of tax rules for the taxation of financial institutions and also special transition or relief rules for businesses heavily in debt.

5. No Capital Gains Taxation. Capital gains are not income, but are due to an increase in the value of property already owned before its being sold or exchanged for other property of the same value. This means the sale or exchange transaction itself does not increase the owner’s wealth, nor amount to an in-flow of income.23 Thus, the taxing of capital gains is akin to property taxation of one’s assets and wealth.24

The FreedomTax recognizes that assets used in a trade or business are of a different nature, some depreciated as a cost of doing business and some bought and sold from business inventory. Gains from the sale of these assets would not be considered capital gains,25 but instead income from a trade or business.

6. Simplification. At the more mundane level, many of the complicated rules under the present system intended to determine what is regarded as the “proper” or “theoretically-correct” income of the taxpayer, 26 can be eliminated in a regime of low-rate income taxation. Many of these complicated rules relate only to the timing of income and are aimed at accelerating the recognition of income that will be taxed anyway in a later year. A low tax rate renders many of these complications academic and unnecessary.

At the broader level, with the overall simplification of the present tax system under the FreedomTax, entire parts of the Internal Revenue Code can be repealed as moot. Among these are the many provisions granting tax credits, those granting itemized tax deductions, and those related to tax-exempt organizations (which no longer would be tax-exempt). In a regime where corporate income is to be taxed only once and at the same tax rate as for individuals, the special taxes on the accumulated earnings of corporations and on personal holding company income would be unneeded and repealed. Where capital gains are no longer treated as income, still other provisions can be repealed or substantially simplified. And, with the redesign of our current tax system, inefficient in its operation and easily assaulted by tax avoidance and tax abuse, most of the civil tax penalty provisions added to prop it up no longer would be necessary and can be repealed.27

And at the legislative level, there will be an end to a major cause of tax complexity. Frequently, taxpayers are targeted for revenue increases by change in the tax provisions as applied to them, raising their tax liabilities. This practice is not expected to continue under the FreedomTax, which would establish a principled-income tax mandating the no-exception inclusion of all income in the tax base and end the universal filing of personal income-tax returns. Under the FreedomTax, it’s envisioned that revenue increases (or decreases) would be accomplished by changes in the general income tax rate, uniformly applicable to all income regardless of recipient.

7. Territorial System. TheFreedomTax would adopt the territorial system of taxation ending the current system of worldwide taxation, which most other countries do not follow. Worldwide taxation requires elaborate rules to deal with the many tax avoidance and double-taxation issues presented.28 It complicates the decision-making of U.S. companies operating abroad, and places them at a competitive tax disadvantage to companies headquartered in countries under the territorial system.29

Even worse, worldwide taxation represents very poor tax policy. It places the U.S. in the position of taxing income it has no justification to tax; e.g., income earned outside its borders under the laws and protection of a foreign country and under that country’s own tax policy. This system disadvantages, not only U.S. companies with operations abroad, but also the U.S. economy. It requires U.S. companies to pay an income tax on their foreign earnings when deployed to the U.S. (deterring them from investing those funds in the U.S., which would advance U.S. economic and job growth). However, foreign companies are not so taxed when deploying their foreign earnings to the U.S.

So, it’s natural for U.S. companies with international operations to view “corporate inversions” as attractive, to reincorporate themselves abroad and avoid worldwide taxation by the United States. The Treasury has failed to see the system as one based upon shoot-yourself-in-the-foot tax policy. Rather, it has doubled-down with new tax regulations designed to impede corporate inversions and re-enforce the system for the imposition of the tax when, and if, U.S. companies decide to deploy their foreign earnings in the U.S.

The FreedomTax is a plan for a simple, common-sense income tax system. It’s low-rate income tax on all income earned within the borders of the United States will be a major positive for the U.S. economy and keep U.S. companies domestic.

8. No Death Taxation. Estate and gift taxation would end. These taxes cost the IRS almost as much to administer as the revenue they raise. The estate tax with its near-confiscatory rate of tax causes many businessmen to take steps to mitigate its ultimate impact, diverting them from growing their businesses to the detriment of our overall economic growth.30

Conclusion: The FreedomTax is the plan for an income-tax revolution. It would overturn and junk the present tax regime in favor of a true income-tax system – one simple, low-rate, tax-efficient, and tax-neutral. It would be a principled tax system taxing all income and at the same rate. From a fully-broadened income tax base, it would raise as much revenue as the old system replaced.

The FreedomTax would restructure the income tax system into one focused upon what’s supposed to be taxed – income.31 No longer would the income tax be structured as a tax imposed and levied upon persons. This person model of taxation is the mechanism making it possible for the income tax to be used to pick winners and losers and used against political opponents.

Most people regard the person-tax model as benign, not realizing its nefarious nature. They miss seeing that it has been the open door for turning the income tax into a-something-else tax, fostering the present-day tax mess. Tax reformers seem oblivious to this reality. The typical tax reform proposal retains the model as the foundation upon which to build reforms. As has been demonstrated, the model if left in place, is an easy and ready vehicle to compromise and undo any reforms made.32

In contrast to other tax reform proposals, the FreedomTax is the only plan having the design and intention to free most Americans from ever again having to file an income tax return – not even a postcard return. For them, the income tax would become as simple and easy as paying the motor fuel tax at the pump. Indeed, most people are not even aware that the IRS is the tax administrator of the motor vehicle fuel tax. Enactment of the FreedomTax, achieving a simple and tax-efficient income tax, will result in a massive downsizing of the IRS such that, for most Americans, the IRS will have the same involvement in their income and personal affairs as at the gas pump.

Stated again, under the FreedomTax, all income would bear its fair share of the income-tax burden. The FreedomTax Revolution would free taxpayers from today’s oppressive tax-compliance burdens and, important to the country, free the U.S. economy of the existing high-tax-rate constraints, so inimical to economic growth, investment, and needed job and wage growth.

 


 

1 A 10% tax rate on the greatly-broadened tax base likely would raise even more revenue than does the current system. The current system is a drag on economic activity, growth, and jobs, and lacks the full revenue-raising potential of an efficient income tax. If, initially, the 10% rate were deemed to be too low to raise the same revenue, it might be set at perhaps 12% for the first year of operation and structured to phase-down by 1% for each following year to perhaps even 8% in the 5th and later years.

2 TheFreedomTax, with its low rate of taxation uniformly applied to all income, would be a more democratic tax system and would foster a more common perspective among voters regarding our nation’s troubled fiscal affairs.

3 National Taxpayer Advocate 2012 Annual Report to Congress, Executive Summary, p. vii, www.taxpayeradvocate.irs.gov/userfiles/file/2012-Annual-Report-to-Congress-Executive-Summary.pdf.

4 It’s a ruse to contend that those shielded from the income tax but who have FDIC taxes and Medicare taxes deducted from their wages, are still paying income taxes (because these taxes are based upon the amount of their wage income). These payments, called “taxes” for collection purposes, are measured contributions to specific insurance programs run by the Federal Government for the benefit of the individual worker. When credited to his individual account in the program, these program taxes accrue him a contribution benefit. By contrast, the income tax paid on wage, interest, and dividend income does not earn the taxpayer any benefit in his individual Social Security or Medicare account.

5 Emblematic of this are the frequent TV commercials of tax professionals offering help to the many who are heavily indebted to the IRS for unpaid income taxes. This would be Exhibit A in the case that we have a failed income tax system, a system which leaves the IRS owed billions in uncollected income taxes and tens of thousands of citizens caught under-the-bus and struggling to free themselves from the consequences of an inefficient and poorly-designed income tax system. And, Exhibit B would be the recent IRS scandal about IRS agents using the intrusive power of the IRS to intimidate and disrupt political opponents of the Administration, proof that excessive power eventually corrupts those in charge of exercising it. This Exhibit B raises two questions: First, why, in a free democracy, should any government agency be permitted to possess such intrusive and extensive power over the citizenry? Second, if our income tax system requires the IRS to have this level of power in order for the system to be viable, then shouldn’t the system be redesigned into a simple and efficient system that can function without need for the IRS to have such power?

6 Indeed, some of these income-tax reform proposals are more venturesome (1) to build value-added tax (VAT) features into the income tax (e.g., by treating imports as income and excluding export sales), and (2) to allow business a 100% expense deduction for investments made (as an incentive to spur investment and, not said, to compensate for tax rates left too high).

7 This view is not far-fetched. Today, when a tax reduction is under consideration, those in the Treasury and in Congress, for their budgetary purposes, score a tax cut as a “cost” to the Treasury as if the Treasury owns a share of taxpayer income and Congress is distributing or paying it out, not raising less revenue.

8 Those who fancy themselves Constitutional scholars should take pause: Our current income tax system, requiring self-assessment by and levy of the tax on persons, appears to constitute direct taxation in violation of the Constitution’s ban against direct taxes unless apportioned among the States (Article I, Section 2, Clause 3) or levied in proportion to the Census (Article I, Section 9, Clause 4). There’s an exception to this direct-tax prohibition. The 16th Amendment provides, “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” (Emphasis added). The literal language of the 16th Amendment authorizes only direct levy on incomes, not on persons.

Indeed, for those who might argue that the income tax is not a direct tax but rather is an indirect excise tax, Constitutional literalists will note that the income tax then would be in violation of the uniformity clause (see Section 8 of Article I of the Constitution). The Constitution specifically states that all excise taxes “shall be uniform throughout the United States.” And, “uniform,” the income tax is not – its imposition on income varies with the payor, by whom received, and use to which put. Moreover, in too many cases, income is not taxed at all, but when it’s taxed, the rate of taxation is varied under arbitrary rules (e.g., based upon the amount of other income received and the allowance of deductions and tax breaks having nothing to do with income production).

9 Other reform proposals would repeal and replace the income tax with some other tax, such as the “FairTax” or a value-added tax (VAT). Often overlooked in these proposals is that the repealed income tax, no longer wanted, could likely be reenacted. If so, this would result in the country having two taxing systems with broader funding for even bigger government. To prevent re-enactment, a Constitutional amendment would be required to specifically prohibit re-imposition of an income tax in all forms. Recognizing such a Constitutional change improbable, the FreedomTax accepts continuation of the income tax, and follows the reform path of redesigning the tax that we already have, to restructure it to be more closely aligned with the language of authorization in the 16th Amendment. The intention of the FreedomTax is to establish an efficient, simple, and uniform low-rate taxing system that, once in place, would leave it less susceptible to return of the objectionable features of the present system.

10 Our badly-eroded income tax base is what denies us from having a very low rate of income taxation. A 2005 study of the well-respected Tax Foundation puts all this in perspective. This study concluded that if the tax base were expanded to include all income, the marginal income tax rates could be markedly reduced. In particular, it found that an all-inclusive tax base would allow for a flat tax rate of 9 percent. The study was published under the title “America’s Shrinking Income Tax Base Requires Higher Rates for Everyone” by Patrick Fleenor and Andrew Chamberlain, and included a fact sheet, Special Report No. 135 (September 21, 2005). See: http://taxfoundation.org/sites/taxfoundation.org/files/docs/ff-20050921.pdf.

Specifically, and based upon its estimate of 2005 per capita income and tax statistics, the study observed that just 40% of actual income in the U.S. is taxed under the individual income tax. It concluded that the overall effective rate of taxation under current law was more than twice the rate that otherwise would be required. The study showed U.S. personal income to be $34,340 per capita, but only $13,789 of this was taxed (leaving $20,551 untaxed). According to the study, the untaxed $20,551 portion stemmed from (1) the allowance of special credits, deductions, and exemptions sheltering $9,647 of income; (2) $5,677 of untaxed transfer payments and employee benefits; and (3) $5,227 of unreported income and income of non-filers (including legal non-filers), leaving the taxed $13,789 per capita portion to be taxed at an effective tax rate of 19.5%. The study concluded that if the tax base were broadened to include all the above items, a single income tax rate of 9% would have raised the same revenue to the Treasury.

The income tax base assumed in the Tax Foundation study above appears to be narrower in scope than the comprehensive income tax base of the FreedomTax (described later in this paper in section 3). This suggests that the FreedomTax could raise the same revenue for the Treasury using a single rate of tax lower than its proposed 10% rate, and even lower than the Tax Foundation’s 9% rate. Although the Tax Foundation’s study does not discuss lowered tax rates in the case of corporate income, the FreedomTax’s lower 10% tax rate on corporate income comes with a greatly expanded corporate income tax base. This means it still would be revenue-neutral in terms of its overall low 10%-tax rate applicable to the income of corporations as well as individuals.

11 Some tax reform plans claim to be flat-tax proposals, but, in reality, they are single tax-bracket plans not intended to tax all income the same and at that flat rate. The single bracket comes into play after the lower level of the taxed-person’s income is exceeded. It’s a tax system still calling for personal returns to be filed and one structured for the later addition of more and higher tax brackets.

12 Other cases where Americans would be freed of their return filing and tax payment responsibility would include income from life annuities and Social Security retirement payments. It should be noted that distributions from partnerships, trusts, and estates also would not require any return filing by the recipient. These entities would be distributing already-taxed dividend and interest income or already-taxed business or rental income, as explained further.

13 In the case of life annuities, the payor would withhold the income tax, but doing so in recognition that the gross amount of every payment is not always the measure of the annuitant’s income. The payor, having the record of the purchase price paid (or tax basis) of every annuity, will commence income-tax withholding on the payments being made once the annuitant himself reaches the point of being in receipt of “income” from the payments; i.e., when his receipts at that point exceed the acquisition cost of his annuity. Retirement payments under Social Security would receive the same treatment. Here, the Social Security Administration would have the record of all the FICA taxes paid by each recipient (and by his employer on his behalf), and it will commence withholding when the recipient first realizes income from the program. The FreedomTax deliberately rejects use of a life-expectancy method to determine taxability of every annuity payment under which the annuity cost would be allocated over the life-expectancy period of each recipient, and instead would employ the simple cost-recovery method, requiring the cost be allocated to the first payments received (i.e., be recouped) before the at-source taxation of later payments could occur.

14 This includes employer-paid health and life insurance premiums, employer- and employee-paid contributions to retirement plans, plus the employer-paid portion of the employee’s FICA taxes (not now subject to income tax, but which like the employee-paid portion which now is income-taxed, are contributions made on behalf of the employee for his retirement).

15 With the elimination of deductions and income exclusions for contributions made to pension plans, Section 401(k) plans, and IRAs, the FreedomTax would include in the tax base all income earned with respect to the assets held in those plans. This means that the payors of dividend and interest income into those plans would apply the same at-source withholding rules already discussed. Similarly, the “income build-up” in life insurance policies would be currently taxable with the insurance company responsible for at-source tax withholding and payment. Accruals to these arrangements would be net of tax, so that distributions from these arrangements, when made, would be tax-free to the recipient. Income having already been taxed would not be taxed again on receipt.

16 Charities would have their dividend and interest income subject to the at-source withholding rules already discussed, and in the case of income from any businesses they carry on related to their charitable purpose (now exempt from income taxation), they would file income tax returns reporting that income as would all other business taxpayers. Gift contributions and bequests to charities would continue to be treated as gifts, not income to be taxed. Donors will be free to make gifts to charity without having this reported to the IRS, and charities would be free to operate in any manner consistent with their purpose without any tax second-guessing from the IRS on how they operate.

17 Repeal would include the refundable Earned Income Tax Credit, which represents very poor tax policy for it to be embedded in a income-taxing system, the purpose of which is to raise revenue. Not only does this Credit erode that revenue-raising purpose, but it functions as a welfare program left on auto-pilot and shielded from Congressional oversight via the budget and appropriation process. Also, the Credit has a perverse effect on the goal to return people to work. Its phase-out feature reduces the amount of the Credit as the taxpayer’s total income increases, such as from getting employment. This is illustrative of the disincentive effects on people confronted with a high rate of income taxation on their economic activity. Moreover, the IRS is a tax collection agency, not suited to have responsibility for such programs. If the income tax is to be principled, simple and tax-efficient, all tax-expenditure provisions must be summarily rejected.

18 This would not apply to Medicare payments. Under present law, Medicare payments are not income. Medicare is structured as an insurance program for which participants pay premiums in the form of taxes, thereby becoming eligible for benefits. As previously discussed, both the FICA and Medicare taxes paid from wages (not being income-producing expenditures) would not be deductible in determining income, nor would common insurance premiums paid for life, casualty, and medical insurance provided by private insurance companies where insurance proceeds paid on those policies are deemed compensation for a loss and thus are not deemed income to the recipient.

19 Good fiscal management is not possible, to have embedded in the revenue-raising system, a helter-skelter universe of provisions each operating on its own to forgive the collection of revenue.

20 This reform would eliminate the current tax-law’s bias in favor of leveraging companies heavily with debt rather than financing with equity. This also would remove the reason for, and allow for the repeal of, the special corporate taxes on accumulated earnings and personal holding companies, intended to force the payment of dividends. Other tax provisions built on the premise that corporate income should be taxed twice, again at the shareholder level, would be repealed.

21 This would not apply in the case of a consolidated group of corporations. The FreedomTax would continue the current provisions related to consolidated return tax reporting for companies organized with controlled subsidiaries, under which inter-company transactions are eliminated and the consolidated group generally is treated as if it were a single corporation. But, it should be noted that the single-rate taxation of all income and dividend-payment reform means the elaborate tax provisions related to corporate reorganization transactions can be greatly simplified.

22 This is present in the hyped “business-activity tax” proposal designed to convert the corporate income tax into a VAT-like tax. The proponents here see their new business tax (to replace the corporate income tax) as one borne by the retail customer, not by the shareholder. Interestingly, that proposal also would deny corporations a deduction for salaries and wages paid. Real income tax reform is difficult enough to achieve without mudding the waters with other proposals compromising what is actual income.

23 The history of taxing capital gains as income stems from a dubious, and at the time much criticized, Supreme Court decision, Merchants Loan and Trust Co. v. Smietanke, 255 U.S. 509 (1921), reversing prior Supreme Court decisions holding capital gains not to be income. See Bruce Bartlett, Why the Capital Gains Rate Should Be Zero, NCPA Policy Report No. 245 (August 2001), at www.ncpa.org/pub/st245. Indeed, capital gains (outside the business of trading in capital assets, such as the trading in stocks and bonds) are not considered to be income by the economists who exclude them from their computations of GDP, because capital gains are not income in the economic sense. See https://www.quora.com/Why-are-capital-gains-not-included-in-GDP.

24 Analogous to the taxation of capital gains as income would be the taxing of the increased earning power of a worker changing to a higher-paying job, his gain measured by the extent the value of his earning power from his new job value exceeds the value of his earning power from his old job.

25 Existing tax law draws this same distinction.

26 An example of this would be the rules creating “phantom” income and expense under the imputed rent and imputed interest provisions found in IRC Sections 467 and 483. Another would be the special capitalization rules for inventories under IRC Section 263A, requiring taxpayers to keep an additional set of inventory records for tax purposes. A reform goal of the FreedomTax is to reduce the need for businesses to keep separate records for tax purposes, and to move the IRS back in the direction of allowing businesses to use the same books and records and accounting methods as are employed to run the business.

27 It’s estimated, that if the FreedomTax were adopted, it would reduce the size of the income tax law to less than 5% of its girth of today; namely, to less than 5% of its present five million words and to less than 5% of its current 70,000 pages.

28 Most of these provisions would be repealed, including the foreign tax credit rules applicable in cases where a foreign country is taxing the same income the U.S. is taxing. But, for instance, the existing rules under IRC Section 482 would be continued to assure arms-length pricing of transactions between a U.S. business and its operations abroad to prevent the shifting of U.S. income overseas. Nevertheless, low-rate taxation will remove much, if not all, of the incentive to engage in tax-shifting arrangements.

29 See Dittmer, Philip, A Global Perspective on Territorial Taxation, Special Report No. 202, Tax Foundation (August 10, 2012), http://taxfoundation.org/article/global-perspective-territorial-taxation.

30 See Costs and Consequences of the Federal Estate Tax, Report of the Joint Economic Committee, U.S. Congress (May 2006), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906812.

31 Well-worth stating again – Constitutional purists will appreciate what the present income tax isn’t, and that in contrast with all the other income-tax proposals, the FreedomTax would be the income tax most compliant with literal language of the 16th Amendment.

32 The last major income-tax reform measure was the Tax Reform Act of 1986, much ballyhooed at the time reducing the number of tax brackets, dropping the marginal tax rates, and curtailing tax breaks. But, it was a flop in terms of enacting real and lasting income-tax reform. It retained the existing person-tax model of taxation, thus allowing easy ad hoc changes to be later enacted, increasing the number of tax brackets, imposing higher marginal tax rates, and expanding the tax breaks. This allowed return to the tax mess of today.

In contrast, the FreedomTax would redesign income tax with a clear governing principle that all income is to be taxed the same. Tax brackets and tax breaks are incompatible with this principle. A single low-rate tax system reduces the value of tax breaks – this in stark contrast to a high-rate system making tax breaks valuable and making the integrity of the system, as a true income tax, much more difficult to defend.