A Graphical Approach to Tax Reform

Tax Reform V.5

Introduction

There is no tactful way to say it: the Tax Code this country has suffered under for the past 100 years is an abomination. It is grossly unfair to the poor, especially when we factor in the effects of poorly contrived welfare programs; it is unfair to the middle- to upper-middle income earners, who pay a higher Effective Tax Rate (tax / gross income) than the very wealthy; and it is unfair to everyone in the sense that we all pay a wide range of different tax rates on similar incomes because of the vagaries of Special Interest deductions, exemptions and loopholes.

In Section 1 of this paper I have attempted to dissect and analyze the current code. I have gathered data which show that, without welfare, those with sub-median incomes would either starve or die from lack of adequate healthcare; with welfare, because of the many uncorrelated welfare programs distributed among different Federal and State agencies, the poor are locked into wage prisons from which few can escape. In addition, the government is realizing far less revenue than it could if the current tax and welfare systems both were scrapped and replaced.

In Section 2, I propose a framework for an alternative approach to the current system which, while still an Income Tax, cleans out ALL of the special interest code and results in what I view as a low and completely fair Flat Tax, complete with adequate protection from taxation of basic Cost-of-Living expenses. Everyone in the country could compete on the same level playing field.

In Section 3, I will show that the funding needed to cover the “Entitlement” costs of Healthcare, Education and Retirement can be built into this framework, along with a fully funded Tax Credit system that should eliminate the need for any other form of Federal Welfare. The details from Section 3 can be summed up as follows:

  1. Everybody will pay taxes on all Taxable Income (only Basic Cost-of-Living exempted),

  2. Everybody who is willing (and able) to work will be able to save enough to pay for normal Healthcare, Education and Retirement expenses, without Government involvement,

  3. All income saved toward these expenses will be taxed when it is withdrawn and used,

  4. More importantly, no income will be taxed more than once,

  5. The business cost of employment will not change; every business should always pay every employee his true worth to the business, but they should also be able to hire low-skilled workers – at their true value – without concern for Minimum Wage laws,

  6. No worker who has the will to work need be unemployed or live on a sub-poverty income.

Section 4 is devoted to describing how to shift incrementally away from today’s “Defined Benefit” pension plan (Social Security) to a “Defined Contribution” plan owned by the individual taxpayer. I show how this can be accomplished with little or no up front cost or increase in debt.

In Section 5, I will discuss business taxation and show why taxation of business profits is harmful both to business and to the nation’s total economy. I will show how there would be real advantages both to investors and to the government by incorporating investment gains into the same tax structure described in Section 2.

Finally, in Section 6, I will cover some simple concepts of Government Reform which should help to diminish the “them vs. us” conflicts that have created such a hostile environment over the past few decades, both between the two Parties and between our government and “We The People”.

Section 1 – Analysis of our Present Tax Code

With all of the Special Interest deductions, exemptions and exceptions built into today’s tax code, it is all but impossible to show in graphic form just how the system works. There is no clear mathematical relationship between Gross Income and Taxable Income because no two taxpayers with similar gross incomes make use of exactly the same deductions to arrive at their taxable income. However, it is possible to estimate upper and lower boundaries for a taxable income zone which will include the vast majority of our 150-million-odd U.S. taxpayers. There are minimum standard deductions available to everyone, and we have a clue to maximum deductions in the known fact that about 47% of taxpayers pay no tax whatever. These factors give us practical limits for the upper and lower boundaries at the low end of the income scale.

Logically, toward the upper end of the scale, high income earners will find ways to apply most of the exemptions and loopholes that are written into the tax code, so we should expect that the relative portion of total income of the wealthy on which they will pay taxes will decrease with increasing income. We also have clues such as the publicized statement by Warren Buffett recently that his 2011 taxes were only 17% of his total gross income. Since the highest marginal tax rate in 2011 was 35%, this tells us that Buffett managed to exempt about 52% of his total income from taxation (35% of his taxable 48% would equal 17% of the total). We also have Mitt Romney’s claim of only 14% effective tax rate which, with an income significantly less than Buffett’s, tells us that many people with incomes in the $10’s to $100’s of millions range can sequester at least 60% of their income where the IRS cannot touch it. With exemption levels up to 60% or more, many wealthy people pay lower effective tax rates than most middle-income people pay. The wealthy do still pay a disproportionately high percentage of the total tax burden, but that is primarily because they collect an extremely disproportionate percentage of the nation’s asset growth (income). In their defense, we should also point out that they likely will put these unpaid taxes to more productive (less wasteful) use than the government would.

With all of the above factors in mind, my first goal was to find a pair of curves that could serve as estimates for the upper and lower limits of the taxable income zone. The simplest model that seems to fit all of the data is that for each ten-fold increase in Gross Income we might expect that taxpayers will find ways to exempt corresponding linearly increasing percentages from their taxable income. Thus an upper boundary, for those taxpayers with sub-median income, will probably exclude little more than the standard deductions. Those with ten times that income are likely to exempt at least another 10% of their income; at 100 times median income at least 20% and above 1000 times at least 30%, and so on. For the lower boundary we might expect these percentages to double. This mathematical relationship is fairly straightforward; the details can be found in Appendix I.

First we must introduce a new variable to replace “income”: M = GI (Gross Income) / MI (Median Income). This gives us a monetary value that is valid despite a constantly changing dollar value. Graphs 1a and 1b show the effects of the model described above for low incomes (1a) to M = 10 (about $500,000 today) and for higher incomes (1b) out to M = 1000 (about $50 million). The shaded area shows the likely distribution of almost all of the 150+ million taxpayers in today’s America. A relatively small number of outliers may fall outside these boundaries. The vertical pale blue line at M = 1 in graph 1a divides the shaded area into sub-median and above-median halves, roughly 75 million taxpayers on each side. The same dividing line in graph 1b is too close to the origin to be visible.

Graph 1 – Taxable Income, Probable Limits

Graph 1a

1a – Low Incomes, M= 0-10 (~$500,000

Graph 1b

1b – Higher Incomes, M = 0-1000 (~$50 million)

(The tiny green square in the bottom left corner is the area covered in Graph 1a)

Graph 2a shows the range of taxes resulting from these assumptions out to Gross Incomes just past M= 10 (about $500,000). An average TI function is drawn to simulate a mid-trajectory between the upper and lower boundaries. A simplified marginal tax rate schedule is assumed as follows: 5% from TI = 0 to TI = 1.0; 10% from TI = 1.0 to 2.0; 20% from TI = 2.0 to 4.0; 30% from TI = 4.0 to 8.0; and 40% for all TI above 8 (about $400,000 in today’s dollars). While this is different from the 2011 or 2012 Marginal Tax Rates, it is similar in design to schedules over the past several decades, with small steps over lower incomes and larger steps, both in tax rate and between taxable income boundaries, as incomes increase.

This graph also shows the Effective Tax Rate (ETR, actual tax divided by GI) resulting from my model. The reader should note that the general effect exhibited by this ETR curve would be the same for any taxpayer group whose incomes and deductions parallel my boundary assumptions.

The most noteworthy observation from Graph 2a is that whenever an individual realizes an increase in income such that his TI stays within the same marginal tax bracket, his real tax rate increases by a very small increment, equal to his income increase times his marginal tax rate; but when someone realizes the same increase and his TI jumps into the next higher bracket, his ETR suffers a significant increase. This is a minor effect, but it may act as a mild deterrent to actively improving one’s job position. This is entirely avoidable if either the tax rate increases smoothly as a function of TI (or GI), or better, if we have a simple flat tax with TI formulated as a simple function of GI directly, and with no tax exemptions other than a simple Cost-of-Living Exemption so that everyone pays taxes by the same rules. There is no rational justification for the crude step function used for our current tax rates.

A more critical problem becomes apparent over the upper income range (Graph 2b). From the beginning of the 40% marginal tax range (at TI = 8 in my example) up to an M value of about 50 the ETR value increases rapidly from about 17% to over 25%. Above that point the ETR curve for this average TI curve flattens and then declines over all higher incomes. If we follow this decline out to the highest incomes reached today the ETR would drop to somewhere near 15%, less than the rate paid by those at the start of the 40% bracket. The numbers will vary with position within the TI boundaries, and from year to year with rates and brackets reset by the ever-changing Tax Code, but this still gives a reasonable picture of how poorly the present system behaves. In one sense, the claim by this administration that “our richest taxpayers are paying less than their fair share” appears to be justified; they actually do pay a lower real tax rate than those with less than a tenth of their income. A more reasoned conclusion would be that those in the middle to upper-middle income range are seriously over-taxed.

Graph 2 – Conjectured Average Tax and Effective Tax Rate

Graph 2a

2a, M = 0 to 11

 Graph 2b

2b, M = 0 to 1000

(Here again, the tiny green square in the lower left corner is the area covered in Graph 2a)

Cause and Effect

Clearly our present tax code is anything but “fair” to many in the upper median income range. Now let’s look more closely at some of the more egregious examples of inequity over the lower median range.

In Graph 3, I have reproduced data (from the office of the Secretary of Public Welfare) that has appeared in numerous online commentaries, showing the effects of the many forms of welfare now made available to low-income families. In typical government fashion, each type of welfare is available to those whose incomes are below some arbitrary cut-off in dollars. Above those limits each welfare allowance is rapidly reduced or simply terminated. The most harmful cuts occur at income levels of just under $30,000 (M = 0.6) and just below $45,000 (M = 0.9), with smaller cuts near $9,000 and $58,000. The effect of these capricious gifts and penalties is that the recipients end up locked into their near-poverty range of income with no way out. If they strive to earn better wages, they lose a portion of their livelihood that they cannot afford to lose, so they must do anything they can to avoid earning a higher income! This is a perfect example of the destructive effects of welfare. Truly, this represents one of the worst aspects of Socialism – on steroids!

Looking back at Graph 1a, note that half of all taxpayers fall in the shaded area below M = 1; this area is the same as the left half of Graph 3. These sub-median taxpayers are the victims of all but one of the welfare cliffs shown here. Above Median Income, the only penalty for earning more is the small “CHIP” cliff; everyone is free to earn more if he or she has the will to put in the effort and learn the necessary skills. Below M = 1, the obstacles are all but insurmountable for anyone who starts out fresh from high school, or tries to re-enter the workforce after a period of unemployment, and fails to quickly acquire a job that has a good future. The “single mom” referred to in the inset typically has no chance at all. [Please take special note of the pale blue area in this graph identified as “Negative Income Tax”; I will discuss this further in Section 3.]

Welfare Cliff Effects

Graph 3

Graph 3

If we view this situation as the “Cause”, we must then look at other evidence to determine the “Effect”. The Census Bureau has posted a graph of income vs. population which demonstrates the effect so clearly that no one can deny the correlation (Graph 4 below). Analyzing these Census Bureau data we note that more than 30% of our tax-paying population falls below six tenths of MI and the peak of the population distribution curve occurs below 40% of MI rather than at the MI position. Not surprisingly, this distribution correlates well with the positions of the major “Welfare Cliff” points in Graph 3. There can be no doubt that our welfare system is grossly distorting the normal population / income distribution into a curve heavily weighted toward abnormally low incomes – and abnormally high levels of welfare payments. Any system which eliminated these capricious welfare payments and cut-offs would encourage workers to improve their skills and productivity and would push the income curve upward toward a more normal peak at or close to MI. It would also push the MI higher. This would yield both greater worker satisfaction and far greater revenue to the government.

Population / Income Distribution

[Note: The original Census Bureau graph was labeled in $5000 increments; I have added my more robust M values. The original labeling would be valid for 2010, but not for earlier or later years, while the M scale should be valid over all time.]

Graph 4

Graph 4

Probability Theory tells us that, barring overwhelming external influence, this population/income relationship should take the shape of a “Bell Curve”, peaking near MI. With a sample size of 150 million taxpayers, it is almost inconceivable that this normal distribution could be as distorted as the Census Bureau graph shows – unless the Welfare Cliff effect is so powerful that half of our population is literally enslaved by it. The expected distribution should look very similar to the pink area in my next picture (Graph 5). Because our set of all U.S. workers is closed at one end (wages cannot be less than zero) but open at the other (unlimited potential income at the high end), the classic “bell curve” must be plotted on a logarithmic scale, but the peak position should still fall close to the MI position. (Median Income is the value separating those with “higher income” and those with “lower income” into two equal numbers of taxpayers, or households.)

Graph 5, in addition to portraying the expected Bell Curve distribution of population vs. income on a logarithmic scale, also shows another aspect of the welfare distortion effects. The sum of the blue and red lines matches the distribution shown in Graph 4 quite well, but what the blue line shows is untaxed income earned by those with (mostly) lower incomes. Along with zero income taxes, this blue curve also contains a large portion of the taxes paid by others (the pink curve) and handed out as welfare. The sum of these two curves contains the same information as the curve shown in Graph 4, but Graph 5 shows the 2009 figures while Graph 4 shows the 2010 total. A close examination shows that the income distribution peak for 2010 has slipped lower than the 2009 figures, a loss that highlights the unhealthy state of our current economy.

Aggregate Income – Taxed and Untaxed, Logarithmic Scale

Graph 5

Graph 5

With this rather disturbing picture firmly in mind, let’s take a look at an entirely different approach to the income tax which, I believe, addresses all of the problems demonstrated above, and more. In the following section, the reader will see that the tax inequities over the middle- and high-income ranges are easily eliminated by using a modified “Flat Tax” – on ALL income, no deductions or exemptions for any income or any expenditures of any kind other than a very basic Cost-of-Living exemption. The need for Cost-of-Living protection is handled by introducing a simple formula for computing Taxable Income which applies to all those with incomes below the middle income range, and by a Tax Credit Fund (see Section 3) which eliminates the need for any form of Federal welfare. Again, this system is based on the monetary unit M , GI / MI, rather than the dollar so that my formula will work indefinitely, regardless of inflation or other variables over time, with no need for Congressional adjustments every year.

Section 2 – A Better Income Tax Code

Back in the 1990’s two Republican members of Congress, Jack Kemp and Dick Armey, advocated their simplified forms of Tax Code; the Fair Tax and the Flat Tax. The Fair Tax is a simple single-rate Consumption Tax; the Flat Tax is an Income Tax, basically similar to our current Tax Code but with a single tax rate on all income and a simplified set of deductions for low incomes only. Both would be vastly preferable to the monstrosity we have at present, but both suffer from a number of flaws, the two worst of which being that: (a) they do not take into account normal inflation effects: the annual growth in population, incomes, cost of living, and productivity; and (b) the greater problem of a constant need for adjusting (meddling) by Congress. The second problem is, in large part, a result of the first one; with ever-changing dollar values of living expenses and incomes, Congress must revisit the exemption levels every year to try to make the taxes affordable to the poor, and to “punish the rich”, all while assuring the Treasury enough revenue to pay for all the Special Interest loopholes given by Congress to attract political donations and votes. These efforts have never been beneficial to the nation as a whole.

The Fair Tax suffers from the additional problem that there is no way, at the time of purchase of any taxable item, to provide for a Cost-of-Living exemption for those with low incomes. Even if a tax rebate formula is used at the end of each tax year, the rules would have to be rather complex (like our present 74,000 pages of Tax Rules) to determine how much to refund to each individual taxpayer. Also this rebate would take place months after the actual purchases. A Tax Credit system could be used, similar to the one I will describe below, but then there would be a constant problem of how to finance the Tax Credit fund. With Congress always looking for more money to spend, any short-term surplus in such a Credit fund would disappear rapidly.

The Flat Tax is far simpler and, done properly, much fairer, but the 1990’s version was far too simplistic, and it would do nothing to alleviate the yearly Congressional meddling. By defining our Tax Code in monetary units that grow along with the economy, it would no longer be necessary to make annual adjustments, and the rationale for Congressional meddling could be eliminated, or at least greatly reduced. This goal can be achieved by defining our new Tax Code in terms of M (GI / MI), the basic monetary unit discussed earlier, rather than in dollars.

Let’s start with a few simple definitions. GI, Gross Income, is the total income collected by a taxpayer from all sources during a tax year, with nothing excluded. TI, Taxable Income, is the portion of GI to which we will apply our Flat Tax (FT) rate to compute every individual’s share of the nation’s tax burden. If we map GI in graph form with the same income units for both X and Y axes, GI must be a straight line from zero income in the bottom left corner up to some arbitrary maximum number in the top right corner. This is the dark brown line in Graph 6 below.

Next we can define a Cost of Living Exemption as a percent of GI starting with 1 (100%) at zero income and decreasing linearly to zero at some selected value of M. I will call this zero position R to denote the Range of the Cost of Living exemption. I have arbitrarily assigned an R value of 4 here, but by changing R we can scale the resulting tax calculations if desired; I will discuss this in more detail later. This gives us the light blue line in Graph 6.

Multiplying this exemption percentage by GI, we get the value of the Cost of Living exemption in our monetary unit M, producing the dark blue line. Finally, we simply subtract this exemption value from GI to figure our Taxable Income, the dark green line. Note that this Taxable Income, TI, is a very small fraction of GI at the low end of the income scale, but grows until it equals GI at an M value of 4, where the exemption percent goes to zero. This very simple model forms the basis of my reformed tax code.

Structural Elements for New Tax Code

Graph 6

Graph 6

I could use this model for all incomes below M = 4 and simply switch to TI = GI for all incomes above M = 4, but this would be unfair to those with incomes in the M range near 4 because of the sharp change in slope of TI at M = 4. A smoother transition can be achieved by using an inverted version of the first TI curve to blend it back into GI over an M range from 3 to 6. This gives us maximum protection from over-taxation for very low income earners and a gradual decrease in that protection well into the middle-income range. The full configuration of all of these elements is shown in Graph 7:

Tax and ETR with New Tax Code, Current Tax ETR Comparison

Graph 7

Graph 7

In Graph 7 I have included a comparison of two values of R (R = 4 is the solid curves, R = 6 is the dotted curves), and a comparison between the ETR estimate from our current Tax Code (see Graph 2a) and the ETR resulting from my proposed tax code with both R values. Note that the ETR for R = 6 is a close match to today’s code, below M = 8, but does not have the clumsy step functions or the degree of unpredictability inherent in our current code due to the wide range of deductions. The scale along the left axis serves both as the M value and as the ETR percent value.

Note that TI is the same small fraction of GI as in Graph 6 for incomes less than 3 * MI, but then merges smoothly into GI for all incomes greater than 6 * MI (if R = 4), or 9 * MI (if R = 6). The equations for all of these elements can be found in Appendix II.

Using a Flat Tax rate of 15%, I have compared the tax load from this model (with R=4) to the actual tax paid in recent years by friends who were willing to share with me the approximate amounts of their total gross income and taxes they had actually paid. These comparisons produced surprisingly similar results at least up to an M value of 10. If I had used the R = 6 curves, my sources would have paid slightly less taxes than they did with our current Tax Code. Above M values of 10 our present Tax Code may yield as much as 10 to 15% higher net taxes (ETR), for many people, than my proposed model, but most if not all of this added revenue now goes into paying for welfare and entitlement benefits. If we could gradually rein in these costs, and eventually eliminate them altogether, the tax model described here should cover all of the legitimate costs of government defined in our Constitution with a comfortable margin of surplus.

Section 3(a) – Entitlement Costs

Under today’s rules, entitlement and welfare expenses are essentially unlimited and come under the jurisdictions of many competing and uncoordinated departments with little oversight. Our government presently charges every taxpayer 6.25% of his/her paycheck, before tax, to cover the cost of retirement (Social Security). It charges every employer the same amount to help cover this same cost. Employers must also figure in additional costs for employee health insurance, vacation time, sick time, retirement pensions, unemployment insurance and a host of other benefits, mostly mandated but not taxed. This is a sham of course. Every employer must consider these employment expenses when determining the pay scale for each employee, so they are really a portion of each employee’s total compensation; but the government loses revenue by not leveling income taxes on true total compensation. In addition, Congress has admitted for years that the cost to government to provide a “decent” income level for retirement through Social Security would be far greater than the combined 12.5% it has been collecting, so everyone expects their “payroll taxes” to go up again, regularly and increasingly frequently.

Not satisfied with repaying our “Payroll Taxes” with a poverty level income once we retire, Congress also decided that we are not smart enough to plan for our own medical expenses, so they added another 2.5% to the 12.5% retirement service fee so that they could make many of our healthcare decisions for us as well. They also take out a fixed amount of our Social Security checks to help cover the inevitable shortfall, but these combined payments still don’t come close to paying the actual cost of these “benefits”. Does anyone today believe that 2.5% of our paychecks will cover the cost of healthcare? Does anyone believe that government bureaucrats can make better healthcare decisions for us than we can make for ourselves?

If we analyze the real cost of all of these items we find that every employer is paying about 20% or more of total compensation to cover the cost of the many (mostly mandated) benefits for every employee. When we add in the employee’s (also mandated) contributions for the Payroll Tax and Medicare, the total cost of all this comes to roughly 30% of everyone’s total employer compensation expense, and that 30% is all essentially untaxed.

It would work to the best interests of both employers and employees – and government as well – if we were to standardize this as a fixed cost of employment, have employers calculate the total value of each employee, deduct 30% of that and put it into a Tax-Deferred Savings Account (TDSA), owned by the employee, then pay the employee the balance as reportable income. This income would be virtually identical to today’s paychecks, and would all be subject to income tax, but the Payroll Tax (FICA and Medicare) payments will have already been fully deducted and no longer paid directly by the employee. Like today’s IRA and 401K funds, the TDSA money would be invested in minimum risk investments, with cautiously maximized growth and income potential, and left untouched until needed for one of the three “entitlements” that most people have difficulty budgeting for: healthcare, education and retirement. The important difference would be that as that money was withdrawn from the TDSA the Flat Tax would be paid, on the whole amount over time, with none of it left untaxed.

Healthcare is unavoidable, but unpredictable in timing and cost. Education covers both the cost of improving one’s own training and skills toward a better job and the cost of a better education for one’s children. Retirement is fairly predictable, but the constant devaluation of the dollar can leave most people poorly prepared. TDSA funds would start accumulating from the first day of employment, the contributions to them would be regular and would grow with the employee’s pay increases, and the investments themselves would earn income and grow independently with the market. Since withdrawals of TDSA funds would be restricted to the three “entitlement” uses only, it should be in only the rarest cases that these funds would fail to accumulate to significantly greater sums than would be needed to replace Social Security and Medicare.

Healthcare is the one area which invokes the strongest differences of opinion, but an honest analysis of the cost of healthcare will show that, for most people, real medical cost is only a tiny fraction of what we all pay now for insurance, malpractice coverage, lawsuits, and a mountain of regulatory costs. The sum total of all the “middle-man” costs – insurance company profits and personnel, and armies of accountants reporting to doctors, lawyers and government regulators – all add to our grossly inflated medical bills. Removing these costs, and government intrusion in our healthcare, would reduce our medical bills and result in higher quality care for all of us. I estimate that an annual 10% of Median Income should cover normal medical costs, including insurance to cover occasional catastrophic medical expenses, for most people.

In keeping with the logic behind today’s CAP on income eligible for the Payroll Tax (FICA), the maximum annual deposit into each person’s TDSA should be set at 50% of MI. So at M levels of 1.67 (approximately $83,000 today) and above, the employer deposit would shift from 30% of (annual) Total Pay to a fixed 50% of MI. Using similar logic, when the 30% portion drops below the 10% of MI mentioned above, the deposit into a taxpayer’s TDSA would become too small to accumulate enough to cover normal medical expenses and still leave anything for retirement so, as with today’s minimum wage, we need to put an absolute minimum on how much even an unskilled high school dropout may be worth in a full-time job. While our current $7.25 / hour minimum wage (now just over $15,000 a year, or 30% of MI) works to deny jobs for many of those with minimal skills or experience, an annual set-aside of 10% of MI ($5000 today) for future needs should not be considered beyond the worth of anyone looking for a full time job.

This gives us a continuous “total compensation” line from MI / 10 up to MI / 3 with 10% of MI going into the employee’s TDSA, the rest as GI; from MI / 3 to MI * 1.67 with 30% going to the TDSA and 70% to the employee as GI; and finally, for all income greater than MI * 1.67, with 0.5 * MI going into the TDSA and the rest as GI. Graph 8 shows this distribution, with Total Compensation (the value of the employee to the employer) as the dark blue line, the employee’s GI, brown line, and the TDSA deposit as the shaded area. Under these rules, everyone will be accumulating at least as much in their own TDSA as they and their employers now put into payroll taxes and other benefits, plus growth. If, in addition, Social Security and healthcare are removed from government control (privatized) and managed by the TDSA owners, everyone should expect far less costly – and far better managed – medical, education and pension plans.

Structure of Tax-Deferred Savings Accounts

Graph 8

Graph 8

Since today’s Minimum Wage is equivalent to 0.3 * MI, very few if any workers with full time jobs will fall into the gray-shaded area at the bottom of the income scale. Close to half of all taxpayers will fall into the green-shaded 30% zone; and the remainder, almost half of all taxpayers, will be in the blue-shaded middle- to upper-income zone which extends to the right far beyond the range of this picture.

Those workers who have only part-time jobs, and who are not dependents of someone with full time employment, should be handled with scaled versions of this same set of rules. For those taxpayers with more than one job, it must be either the taxpayer’s or his TDSA manager’s responsibility to notify each employer when his TDSA limit (50% of MI) has been reached. Any inadvertent over-deposit must be immediately withdrawn and treated as taxable current income. For self-employed taxpayers, these same basic rules should still apply, but Congress will have to enact laws to formalize the details. All funds remaining in TDSA accounts after the death of the owner will be immediately taxed at the current FT rate and then distributed to the owner’s legal heirs. No income remains untaxed, and no income is taxed more than once.

Section 3(b) – Welfare Costs

In Section 1 above I have already discussed the shoddy mess government has made of welfare. With literally hundreds of separate Federal and State Welfare programs, few if any of them coordinated with the others, government is wasting billions of dollars on poorly planned programs to “alleviate poverty” while actually making matters worse for many people and opening the doors to fraud and abuse by many others, all at the expense of the “under-taxed millionaires”. Here again I believe I can offer a solution, in the form of a Tax Credit Fund, to provide a basic cost-of-living level of income to those whose job pay is below an acceptable minimum living wage. The funding for this will come from a designated portion of the Taxable Income plan I described in Graph 7 above.

First, let me define my concept of a Tax Credit Fund. Its purpose is to provide supplemental income for those whose job income is below an accepted standard basic cost of living. Today we have a minimum wage which is intended to assure that everyone who has a job will earn a living wage. Translating the current $7.25 / hr. minimum wage to annual income we get just over $15,000 per year. For a single person with no dependents or other commitments, this is more than enough to live on, frugally. For a family of three of four people, it might be enough in some areas of the country but grossly insufficient in other areas; in other words it would be borderline poverty level. So we need a set of rules for who can access what amount of this Fund. Clearly, access to this fund must be dependent on family size (see Graph 10, below), but it should not vary with where one lives. We should not expect the Federal Government to set rules that cover different circumstances in different parts of the country, but instead let them set the minimum standards and then require that the States or local governments take up the slack as needed.

The source of the money for the Tax Credit Fund must be a clearly defined and limited portion of all Taxable Income. The tax from this source must be used solely for funding the Tax Credits; it cannot be accessed by anyone for any other purpose, and preferably no other source should needed for funding the Tax Credit account once it is fully set up and running properly. This Fund should never become a burden on the country’s economy, nor should it become an invitation for people who lack initiative to freeload at the expense of others; yet it must be adequate to cover basic living costs.

In Graph 9 I have replotted the key pieces of my basic tax structure (using R = 4): GI (brown), TI (green), and Tax (15% of TI, red). To these I have now added a line tangent to the lower curve of TI and parallel to the GI line (labeled GI – 1, blue), its equivalent tax line (“Tax – TC” = 15% of GI – 1, orange), and one example from my set of Tax Credit (TC) curves (TC for two dependents, pale green) in the bottom left corner of the plot. I have shaded the interval between the TI curve and the GI – 1 line in blue and indicated that this area is the income source for the taxes which will pay for my Tax Credit Fund. The 15% tax applied to this income source is the pale red area between the Tax curve and Tax – TC line along the bottom.

This mechanism relies on a balance between the amount of cash needed to fund the Tax Credit (pale green area) for the relatively large number of people with very low incomes who will draw from that Fund, and the tax on the much larger income zone (blue) derived from the smaller number of people in that higher income zone. Since the per person Tax Credit is small (far less than .4 * MI in most cases) but the number of users likely to be quite large (nearly 14% of all taxpayers), the per person tax contribution by higher income taxpayers must necessarily be significantly greater to offset the smaller number of such contributors (12% of all taxpayers or less). These values all come from an analysis of the Census Bureau data in Graph 4, above.

A majority of the Credit Fund users will have no more than two dependents (the “TC” line shown in Graph 9), and most of those will need only a portion of their credit allowance because they will be employed and have some income of their own, so clearly the funds available from the Tax Credit Source area should be more than adequate to provide for all of the low-income Tax Credit users. Because Tax Credit users will have little money beyond cost-of-living basics, they should understand that accessing their TC Funds will necessarily require that their Credit Rating be reduced to a minimum until they can become self-supporting. If a greater incentive to improve their performance is found to be necessary, I would suggest freezing the dollar value of their Tax Credit after some period of usage rather than allowing it to grow with Median Income. Since the Tax Credit funds are defined as a function of MI, the resulting yearly loss (in dollar terms) of 2% to 5% of one’s available purchasing power should be a strong incentive to put more effort into finding and keeping a better job. This incentive should remain in effect until they show that they are both able and willing to earn their own living. There will be no mandatory repayment and no interest charged on outstanding Credits used, but the loss of purchasing power and Credit Rating, plus the chance to remove this welfare stigma should encourage most people to “kick the habit” and become self-sufficient productive members of society as quickly as possible.

Tax Credit Source Income with Resulting Tax Source and Credit Fund

Graph 9

Graph 9

An enlarged view of the Tax Credit zone is shown in Graph 10, below. My choice of dependent levels is arbitrary and can be changed if necessary, but it is based on my assumption that 20% of MI is a reasonable base level for a single taxpayer living independently, and double that, or 40%, should suffice for a family of five (Head of Household plus four dependents) or more. It is to be expected that each added dependent will increase the family’s living costs, by a larger percentage of the single person’s costs at first, then by smaller increments as family size increases. So I have selected the intermediate percentages at 28%, 34%, and 38%. Note that only the colored areas above the GI line would be accessed by the poor to supplement their income.

Note also that each curve in the set parallels the TI curve; this is intended to act as an incentive to Tax Credit users to improve their earning capacity. Without this upward curvature there would be little incentive for Credit users to earn a higher GI because their net spendable income would remain constant. I have included the orange curves to show the Spendable Pay resulting from this; although difficult to see, the orange lines fall below the Tax Credit curves by the very small amount of the tax. This logic is carried a step further in Section 3(c) below.

Tax Credit Fund Curves for Numbers of Dependents

Graph 10

Graph 10

I pointed out the “Negative Income Tax” (in the last line before Graph 3 above) for a comparison with the Tax Credit scheme here. The Negative Tax shown in Graph 3 starts with zero value (at zero income) and increases to about $7500 at an income near $17,500, then decreases to zero again at about $40,000. I was unable to discover whether this plan has ever actually been implemented, but discussions in articles I have Googled gave several variations of it and suggested that there were many good reasons for not implementing it. The most obvious of these is that it starts at zero value for those with the greatest need for income supplementation (zero income), and grows to a maximum at just about the income where it should no longer be needed!

Sloth, Greed, and Feedback

We must realize that as long as we enable those who are simply unmotivated to succeed, the sheer number of Credit users would likely explode. By allowing only those who actually have income (or are recently unemployed and actively looking for work), and who are not claimed as a dependent on another person’s tax return, to access this Tax Credit I hope and expect that this system will provide all the help needed to eliminate real poverty (and concomitant welfare) without acting as an excuse for indigence. A more powerful form of feedback can be added if it becomes necessary in order to discourage indigence. The rules above already deny access to the Tax Credit Fund by those who have never earned their own living, but for those who have worked and then become unemployed, the Tax Credits are intended as a short-term substitute, not a permanent one. I suggested above that if unemployment extends beyond some maximum time limit (say, one year?) then the dollar amount of the accessible Credit Fund should be frozen from that point on until that individual becomes productive and economically independent once again. Since the Credit Fund is based on M, the amount accessible would normally increase from year to year, so this restriction should act as a gentle but urgent incentive to find a job.

The flip side of this same argument is that some business owners may be greedy enough to deliberately keep wages lower than their business can afford, simply to pad their own pockets and/or to increase the apparent profitability of their business for investment purposes. A form of feedback could be implemented here as well. I suggest that for every 2% of a company’s employees who receive wages so low as to qualify them for Tax Credit access, the company would be required to report as “profit” all payments that exit the business as taxable income (see Section 5(a), below), and to set aside 1% of that total to be deposited into the Tax Credit Fund. This way any company that is actually profitable, but wants to boost its investment outlook by short-changing its employees, will not be able to avoid this consequence. Those companies which pay low wages because they have little or no real profit would not be affected by this rule and both they and their employees would benefit from the Tax Credit Fund.

Section 3(c) – Entitlement and Welfare Costs Combined

With the key pieces now defined, Graph 11 shows how they all fit together in a composite of Graphs 8 and 9. The Employer contribution to the TDSA (gray area) is wedged in between the employee’s GI (brown) and his Tax Credit eligibility (pale green-shaded). This does not change the actual eligibility amount, but appears to distort the TC due to the bend in the Total Pay line (dark blue). Now we can see how, when GI drops below the poverty level, the employee’s wage income can be supplemented from the TC fund. The TC functions bow upward from zero GI in parallel with TI so that even after paying tax on the Taxable Income, the employee’s spendable income, nominally GI – Tax, still increases with increasing GI below the Tax Credit limit (heavy orange line). To sum up the essential points:

  1. Everybody will pay taxes on all Taxable Income (Only Basic Cost-of-Living Exempted),

  2. Everybody who is willing (and able) to work will be able to save enough (in his TDSA) to pay for normal Healthcare, Education and Retirement expenses,

  3. All income saved in a TDSA toward these expenses will be taxed when withdrawn,

  4. Most importantly, no income will be taxed more than once,

  5. The cost of employment to businesses does not change; businesses should always pay whatever the employee is worth to the business, but now they will be able to hire low-skilled workers – at their true value – without concern for Minimum Wage laws,

  6. No worker who wants to work should have to remain unemployed or to live in poverty,

  7. Everyone who is able to work will be encouraged to accept any available job rather than remain unemployed for a long period of time, and

  8. All employers will have an incentive to pay their employees better than minimum wages if their business is profitable enough.

    Items 7 and 8 refer to the Feedback conditions in the preceding sub-section.

Composite Showing TDSA, Tax Credit and Tax Zones

(plus Spendable Income with Two Dependents)

Graph 11

Graph 11

I set up a spreadsheet to estimate the cumulative TDSA amount after 40 years, assuming an unskilled worker who starts out with a wage right at the first bend in the blue “Total Pay” line (just above 0.2 but below today’s Minimum-Wage at 0.3). I then assumed an annual MI growth of 3.5% (it has averaged 4.5% for most of the past 60 years) and an annual wage increase of 2% times MI growth = 5.57%; (note that “wage increase” implies MI growth multiplied by percent raise). Finally, I assumed that the TDSA fund would realize market growth of 5% per year. All of these assumptions are well within modern norms, probably overly conservative. My analysis shows that the TDSA value after 40 years would be 10.5 times the Median Income as of the 40th year. To get a better grasp of that, starting with today’s MI of about $50,000, the 40th year TDSA value would be over $2 million! How many of us can hope to retire with that kind of nest egg under today’s Tax Code and Social Security, especially starting out at minimum wage? Even with reasonable medical expenses along the way, this is vastly better than a typical minimum wage worker can expect under today’s system.

Graph 12 shows this growth effect for the more normal case of someone who starts working in 2020 with an initial GI of half the Median Income. I have assumed that MI will be $60,000 by 2020, so the total employer outlay for that employee in 2020 would be $42,857 ($30000 / 0.7). I have further assumed that all of the growth conditions are the same as above and that my TDSA rules will have been fully implemented as described in Graph 11. Under these conditions the 40th year TDSA would total well over $4 million, more than adequate to cover all reasonable Entitlements plus a comfortable retirement.

Relationship Between MI, GI, TDSA Input and TDSA Growth

Graph 12

Graph 12

Section 4 – Privatization of Social Security

I have previously published a simple plan for shifting gradually from today’s Social Security to a Defined Contribution plan based on these TDSA funds. To recap, this method involves starting with those older taxpayers who have already paid in most of their share of the FICA tax and will start collecting it back after retirement. Those who have deposited the maximum limit for the mandated minimum number of years, and who have reached a required age, can expect to receive the standard full monthly Social Security retirement check. Based on the assumption that a normal working lifetime is approximately 40 years, we can start as of a “Year 0” to allow those who have paid into the FICA fund for at least 35 years, and have reached an age at or above the mandated retirement age minus five years, to terminate their payroll tax and instead put that amount of their income into their TDSA account. To offset the loss of their payroll tax, they will accept a reduction in their monthly Social Security checks of 1.25% for each year they are short of the mandated retirement age at the time they stop paying into FICA. Their employers will continue putting the employer portion of the payroll tax into FICA. If both employee and employer had switched from FICA to TDSA, the reduction would have to be 2.5% of each monthly check because one year is 2.5% of 40 years. But to assure that sufficient money continues to flow into FICA during the early years of the transition, the employer half of the FICA income should be retained. (I am assuming for now that this sequence is started independently of my Flat Tax plan. It would be better to implement both simultaneously.)

The following year, “Year 1”, this plan would reduce the year and age groupings to 30 years of FICA contributions and an age no less than retirement age minus 10 years. The same rules as above would apply to this larger group as of Year 1. A year later, Year 2, the numbers would drop to 25 years of FICA contributions and retirement age minus 15, and so on. If the year groupings are set at five-year groups, this option would work through workers of all ages and take a period of eight years to complete. Please note the words allow and option in bold print above. The intention is that this transition be optional to every taxpayer, at least during this initial phase, not mandatory. The first few years will be critical to the success of this plan and there are likely to be many people who trust investment markets even less than they do our government! Those who feel uncomfortable during this early phase should be allowed to continue with their full payroll tax and the low returns expected from Social Security.

Note also that I suggested starting with five-year groups during the phase-in period. Anything from one-year to 10-year groups could be used; the goal is to make the transition “gradual” but not too slow. A final recommendation is to change from optional to mandatory to complete the privatization process once the phase-in period has been implemented (presumably) successfully. After the final year of the phase-in, all taxpayers should be committed to the new system and only those who were already retired and collecting (partial) Social Security checks will still be a burden on the Treasury. This load will be much smaller than at present by that time and will diminish fairly rapidly with each additional year, so at this same time the employer portion should also be switched over to employee’s TDSAs for all those newly employed. I envision eliminating the entire Entitlement Spending problem in under 40 years from year 0 if it is done this way, and even this could be shortened by offering a generous final Social Security “pay-out” in the form of a single payment by the government into each retiree’s TDSA to replace the anticipated amount still owed under S. S. at some point beyond the end of the phase-in.

Even if Congress delays shifting from our present “Defined Benefit” scheme into a “Defined Contribution” plan, the tax formula described in Section 2 can still be put in place to solve many of our problems. It provides more than enough income source to continue to support our present Payroll Tax and Medicare mandates, and it would still produce a small accumulation into each person’s TDSA. However, no matter how great the Defined Benefit concept sounded in the 1930’s, with the advantage of hindsight we can see that there is no guarantee that the money will be there when needed. Today’s economy drives this point home with a vengeance! At this point the Defined Contribution plan, into an account owned entirely by the taxpayer, clearly makes it a much better choice for everyone. With the Median Income dropping over the past six years, it is highly likely that at some point in the near future it will begin to recover back toward its normal growth line, so the ideal time for starting Entitlement reform should be now.

Section 5(a) – Business Taxes

The reason people form businesses is to make a living; that is, to make money for themselves. The only way this can work is for the business creators to develop an idea for a product or a service that their business can provide and which they believe will be useful to other people, at a price that their consumers will be willing to pay. Therefore, the concept of a business profit is inherently a flawed concept; any money the business brings in always goes either to maintaining and expanding the business, or to people: the business owners, managers and employees. It is people who realize or “enjoy” any profit, not the business itself.

As a general rule, any form of “Profit Tax” on a business operation has a net negative effect, directly on the business and its owners, indirectly on the national economy. It automatically diminishes the ability of businesses to hire more employees and it discourages higher wages. In addition, any tax imposed on a business will necessarily be passed on to those who would become purchasers of the business’s products or services, increasing costs and further reducing efficiency and depressing the economy. No company could remain profitable if it did not add the cost of taxation into the cost of its output. Following this logic, I propose the following rules:

  1. Business income/profit which stays in the business, to be used for operating expenses and for growth and improvement of the business, should never be taxed.

  2. Any business income which is extracted from the business for the benefit of an individual in any form should be taxed as income to that individual. Payroll, employee benefits, employee insurance premiums, bonuses, dividends, interest payments, etc., all should be taxed as personal ordinary income, to the recipient. This defines the “Profit” mentioned in my feedback section above: all taxable outflow from a business.

    Where it is simpler for the employer to pay both a benefit and its concomitant tax directly (as when an employer pays for a group policy, plus tax, for example for medical insurance for many employees), the total amount of the benefit plus tax must be used in calculating the correct total amount of the tax. My reasoning here is that the full insurance benefit is a part of each employee’s income. If the cost of the insurance (the premium) were simply added to each employee’s paycheck, tax would be owed on that premium in addition to his paycheck. If the employer added the cost of that tax to the paycheck to offset it, that increase in the paycheck would also be taxable, and so on ad infinitum. Done this way the cost would be much greater than each worker’s share of the cost of the group policy.

    Let’s assume a company purchases a group policy for all of its employees at a cost of X dollars. The net tax must then be FT * (X + tax), so the tax can be calculated as:

    Tax = FT * X / (1 – FT)

    To demonstrate this, let’s say that a benefit paid by a company has a cost of $100, and FT for this year = 15%. Then the tax will be $17.65, not $15, because 15% of the total benefit plus tax ($117.65), taxed at 15%, is equal to the amount of the tax, $17.65.

    In this special case, the employer will be paying a tax on behalf of all of his employees. It would be expected that the employer will take this cost into account in determining the appropriate pay scale for each employee. The employees in turn should realize that they are enjoying insurance benefits at significantly lower cost than if they bought their own.

  3. Non-commercial organizations, such as Unions, Churches, Charities, Social Groups, Homeowners Associations, etc., are all considered businesses under these rules, and they will pay no taxes on already taxed money that is contributed to them by individuals or households. When any organization pays money to others who classify as Personal Taxpayers, those persons will pay the appropriate Personal Taxes, as above. A charity or church, however, may provide food, clothing, general welfare materials to those it deems to be in need, without incurring any tax obligation on the part of the recipient or the provider. That is the nature of the charity’s business rather than payment for goods or services; for example, a union may provide temporary support in the form of food or housing for members who are unemployed, without being taxed. If that temporary support is given as a cash payment in lieu of wages, however, it is income to the worker and is subject to standard income tax rules, payable by the worker.

    Implicit in these rules is the requirement that unionized workers must pay the normal income tax on their earnings before paying their union dues. The only alternative would be for the unions to pay the tax out of the dues they collect. In this latter case, the unions would have to pay the full FT tax rate on all the dues they collect because it would be impossible to determine an average cost-of-living exemption formula covering all of the union members contributing.

  4. If a business contributes to a charity and such support does not qualify as a part of the business’s normal activity, then there will be a Personal Income Tax obligation to be paid by that business (again note the tax calculation under Rule 2, above) or by the receiving charity, a) because the end beneficiary of the donation is the person who receives the charity, and b) because no prior taxes have been paid on the amount donated.

  5. When one business buys stock in another business, to increase its cash reserves or improve its product, or any other legitimate business purpose, any profits realized from such transactions which remain in the business should not be taxed.

  6. Any business which sends money overseas, to open a new plant or start a new branch operation for example, will post a “tax bond” in the amount of the current income tax rate, FT, times the amount of money expatriated. Assuming that the foreign investment bears fruit and returns money or equivalent cash value to the U.S., there will be a refund, or bond reduction, at the same tax rate on the value repatriated. This serves two purposes: it prevents American companies from sending income to offshore accounts for favored executives without paying the appropriate income tax, and it minimizes the incentive for companies to ship jobs overseas where labor costs are less than in the U.S. When (if) the overseas operation returns the whole amount originally expatriated, the “tax bond” account will be closed and any further money coming into the U.S. for that account will be untaxed profit to the company. Note that this arrangement also eliminates the incentive for Congress to try to tax overseas earnings of either businesses or taxpayers.

Section 5(b) – Political Influence

It has been traditional for both individuals and businesses to deduct political contributions from their taxable finances each year before computing taxes due. New rules are needed in this area.

  1. Personal contributions:

    Since deductions from personal income will no longer be allowed, there is no reason to limit contributions that individuals can make, after taxes, to any politician or political organization. People should be free to give any amount to anyone they wish without penalty. This same logic applies to gifts from one person to another. Tax must already have been taken from the person giving the gift, so any additional tax would constitute double taxation of that amount of income.

  2. Business contributions:

    Since business profits will no longer be taxed in the traditional manner, it is necessary to consider the basis for any political contribution from a business source. The primary consideration, of course, must be that a business does not contribute to a political entity for purely altruistic reasons; such giving is necessarily always done to gain some influence or advantage that would not be available otherwise. In other words, money is used to buy favorable legislation and/or attention. For this reason, there should be a cost to the business for the advantage it expects to realize. This same reasoning applies to Unions, Charities, or any other business or organization.

    It might seem fair to penalize such behavior with a tax rate greater than the normal, but this would be self-defeating because the same end can be achieved by simply giving a trusted employee or company officer a bonus in the amount the company wants to donate and achieve the donation “by proxy”. The tax incurred would then be the standard FT times the bonus, “paid by the proxy” (and no doubt reimbursed in some manner not within view of the tax authorities). So the pragmatic solution is to simply treat political donations from businesses as income to the recipients and charge the standard tax directly to the company – once again noting the proper calculation under Rule 2 of the previous section. In this case, no political person or group should be deemed immune to taxation.

    Corporate and union influence in Congress both are notorious sources of bad legislation, and have been for as long as this country has existed. At least by taxing all such influence we may achieve a better balance. I suggest that taxes realized from this source be dedicated to paying down the National Debt rather than simply going into the General Fund. This again would go a long way toward defraying the cost of “business as usual” in our “crony capitalism” society.

Section 5(c) – Taxation of Investment Income

We tend to think of “income” as the weekly or monthly paycheck that almost all of us receive in return for the services we perform as employees. We tend to view investment income as something to which only the rich have access, although in fact all of us have bank accounts, IRA accounts, pension funds, etc., all of which are forms of investment. It is also true that Capital Gains, dividends and bond interest – forms of investment income with which most of us are familiar – actually add up to far more value than all the ordinary, or “earned”, income we receive as our paychecks. In addition, there are other sources of asset growth such as Real Estate and other Properties (art work, books and other collectibles) which increase in value just by sitting idle for extended periods of time. Bought today and sold years from now, they often become “worth” much more than their original cost, so that difference constitutes a significant “gain”.

Another huge source of income is Venture Capitalism, the buying and selling of “intellectual property” – ideas that the more inventive among us construct in our heads, write up in the form of patents, and then sell to others who can transform these ideas into useful real products. An obvious example of this would be the book publishers who pay authors to write fiction and non-fiction about any subject. The author has the idea and convinces the publisher that the idea is worth reading about; the publisher invests the money, materials and time to print many copies of the work and then sells them at a price marginally greater than his cost. Voila! Real profit.

What every one of these types of “income” have in common is that each of us does something – or even just thinks about something – and then converts that action or thought into money or other assets that he/she did not have before. Because it becomes a tangible asset at that point, it may be classed as income subject to taxation. I say “may” because sometimes these forms of income take so long to get transformed from thought into tangible asset form that governments do not perceive them as income, at least not in a time frame that is useful to their agendas.

Over the past six decades, inflation has averaged about 2.5% to 3% per year, but MI growth has averaged more than 4.5%, a 60 year growth factor of 14, just like compound interest. This number is readily derived from census information available online. Even the modest 3.5% growth used in graph 12, above, would show a 60 year growth factor of almost 8! These concepts of time frame and growth that have long been sticking points in determining whether, and at what rate, to tax long-term investments of any kind. Again, I believe my Median Income and M basis for all income taxation offers a workable solution.

Although MI growth has averaged 4.5% over the past six decades, it has seen years with over 6% growth and other years with zero or slightly negative growth. Since 2007, it has actually declined in value by 10% or more, depending on when and how one measures it. This is the first time, possibly in all history, certainly since the Great Depression, that the Median Income in this country has suffered such a loss. (Different people can lay the blame for this on many different causes, but the fact itself is indisputable.)

To avoid these problems with investment gain, using my tax code, we can define real gain as the MI-indexed difference between purchase price (including the usual transaction costs) and current year-end price or sale price, then simply apply the tax rate, FT, to that corrected gain. The IRS always knows what the Median Income for “This Year” is, to a very close estimate, at the end of each tax year (December 31). From this information it is no problem to calculate MI for any day of the year closely enough for tax purposes (see Appendix III, below).

Assuming that MI normally has positive growth over time, investment values would be expected to grow faster than MI in order to generate a real gain. “Today’s” break-even value of an investment would be the purchase price times the MI growth from date of purchase to “today”. An investment value less than this break-even value, but above the purchase price would constitute a “loss-risk” value, and a value below the purchase price would be a real loss. Investors typically estimate these values when deciding when and whether to sell an asset.

This relationship is demonstrated in Graph 13 where I show the performance of a hypothetical investment over an 11 year period. A detailed analysis of this method of calculating Capital Gain is given in Appendix III.

Investment Returns Related to Median Income Growth

Graph 13

Graph 13

In general, when a stock holding falls below its cost basis, there is a real loss. This loss may be used, if the stock is sold at this time, to offset an equal amount of real gain in other holdings or to claim a tax refund on the current year’s loss against gain taxes paid in previous years. If other current gains or previous gain tax payments are not adequate the loss can be used to offset a portion of regular “earned” income. Current tax rules limit the deduction of such losses from regular income to $3000 per year, a totally arbitrary and meaningless choice since MI has grown by a considerable amount since this rule was put in place. A more reasonable choice would be to limit the loss offset to 15% of the lesser of: a) the net loss (after offsetting other gains) or b) the available Gross Income. Such an offset should be applied to GI before calculating TI for regular income tax purposes.

This MI growth adjustment should be available to the investor only if he agrees to declare gains annually and pay the accrued Flat Tax on all real gains (realized and unrealized) every year. Stock prices vary enough over long holding periods that it would be expected that many holdings would vary from gain to null (risk zone) to loss and back fairly frequently. When any given stock is in a null or loss position but is expected to recover, using the rules above should make the choice to hold or sell at an optimal point much simpler and wiser. Selling while a stock is in the risk zone would result in no gain and no tax (any tax paid at an earlier position of real gain would be refunded), while a real loss would result in the gain-loss offset options described above. If a stock is sold at a real gain which is less than the position a year earlier, then the tax paid the previous year would constitute an overpayment and the excess would be refunded. Since the MI growth can be calculated relative to the exact purchase date (see Appendix III), the original cost basis can be used, along with that total growth, to calculate the correct tax owed each year and any final tax at the time of actual sale. In any case, the same Flat Tax rate applied to normal “earned” income will be applied to the net real gain realized at the time of sale and adjusted for gain taxes paid in prior years.

Section 6 – Government Reforms

Congress has, for far too long, viewed its own members as though they were a “Ruling Class”, not bound by the same rules they write for the “rest of us”. This is perhaps the clearest sign that our government has turned its back on the Constitution and has taken upon itself the role of a Monarchy. A new set of rules is needed to get our nation back onto the track established by our founders. I recommend, in the strongest possible terms, that the following rules should be encoded in the form of an Amendment to the Constitution so that the resulting benefits would be much harder to abrogate in future years.

  1. Congress shall make no law that in any way restricts or penalizes all of the Citizens, which does not apply equally to Congress and all members of the Government Bureaucracy. (E.G., Insider Trading laws)

  2. Congress shall make no law that in any way benefits or favors its own members, or other Government employees, which does not apply equally to all citizens. (E.G., Government pension and medical plans)

  3. Congress shall pass no law which it is not certain is clear and devoid of damaging “unforeseen” consequences, or which it is not convinced is enforceable. (E.G., Illegal immigration problems.) See also Rule 5 below.

  4. In keeping with the letter of the Constitution, no new laws or binding regulations may be made and enforced without full Congressional approval. Furthermore, all laws and regulations which are approved by Congress (and signed by the President), once passed, must be fully enforced. There must never again be situations where a new administration decides unilaterally that it doesn’t like laws passed by a previous administration and then refuses to enforce such laws; nor will Congress ever decide that it doesn’t approve of a law from an earlier administration and simply refuse to fund its enforcement. Once properly passed, every law must be followed rigorously unless and until it is determined that the law was not well advised and needs to be altered or removed (E.G., DOMA, Immigration laws). A government divided against itself is destructive, self-defeating and useless.

  5. As a simple method for implementing Rules 3 and 4, every complex law, especially any that involve “Social engineering”, which is likely to cause unforeseen consequences, must have built into it a Sunset Clause so that it can be more easily removed if those consequences are found to be damaging to the country.

  6. Congress shall make a concerted effort to remove any and all old laws which have proven to be poorly written, are unenforceable, which duplicate other better written laws, or otherwise are simply not worthy of retaining. I would certainly vote for a Congressman who would promise to get rid of bad laws in preference to one who would promise to try to pass a law that would benefit me personally!

  7. Congress shall permanently terminate the practice of adding riders to bills unless the riders relate clearly and objectively to the primary subject of the bill in question. If the subject matter of any unrelated rider is worthy of passage, it must be considered on its own merits as a separate bill, with no exceptions.

  8. Congressional salaries should not be determined by Congress alone. Any general increase in Government salaries must be approved, on a case-by-case basis, by both houses of Congress and the President, and where appropriate by the people of the Congress member’s district. There should never be a general Congressional salary increase without voter approval. Note also my recommendation for Federal salary decreases in response to deficit spending, in item 11 below.

  9. Voter fraud has been much in the headlines recently. The Constitution clearly states that all Citizens have the right to vote (with rare exceptions for mental disability or for criminal status), but it also states that only Citizens have this right. To enforce this rule, we should require that a biometric voter ID card be issued to every eligible citizen and that this card be used as proof of right to vote in every election. Early voting or vote-by-mail may still be used, but each year voters should have to produce their ID card to remain on the early voting rolls. With recent advances in internet capabilities, this could be adequately managed online after the original citizenship checks and issuance, but an annual verification in person would be preferable where possible.

  10. All military personnel should be granted automatic vote-by-mail privileges when on active duty. Special precautions must be observed to assure that they can record their voting preference at an opportune time prior to any election so that they are never denied their right to vote. It sometimes happens that non-citizens are on active duty with our U. S. military; these personnel are normally extended a special right to vote also, so the same vote-by-mail privilege should extend to them as well.

  11. Halting Government Over-Spending – The structure detailed in Sections 2 and 3 above shows that tax revenue, welfare, entitlements and living expenses can all be balanced equitably. But how can we put a stop to the insatiable lust of our politicians for ever-bigger government and ever-increasing revenue to pay for it? In an earlier version of my Tax Reform plan, I suggested simply resetting “this year’s” FT, the Flat Tax rate, equal to “last year’s” FT times last year’s spending divided by last year’s total revenues. So every year spending exceeds income (deficit), FT will increase and people will pay a higher tax rate the next year. My thought was then that the people would eventually change their voting habits and get rid of profligate politicians. With the degree of corruption and bias I have seen in politics and the media recently, I no longer have much faith in relying on people’s voting habits to correct these problems.

    A better way would be to increase FT by 1% each year our government posts a deficit, and simultaneously reduce the pay of ALL government employees, specifically including all elected politicians, by 1%. This should happen every year there is a deficit, and the reduced pay scales should not be brought back to pre-deficit norms until the total debt is also reduced to the pre-deficit level. If the value of FT would have to go above 20% to fulfill this requirement, the FT increase should be waived and in its place the government pay scale should be cut 2% each year until the problem gets serious attention from those in our government who are causing it.

    I am well aware that proposing such a cure for over-spending will not make me popular with those feeding at the public trough, but I suspect that if the media were to advertize this possibility publicly it would be extremely popular with all the voters!

A Concession to Congress

Recognizing that our Members of Congress will always feel that they must tweak and fiddle with the economy in order to justify their position, I would like to offer some possible modifications to my Tax Functions in the mid- to high-income zone. I anticipate that those of a more “Socially Progressive” political mind will view the Tax Credit allowance described above to be less than adequate for many low income families. I can also see the possibility that the TDSA funds may be insufficient for those with higher-than-average Healthcare or Education expenses during their working years, which would result in inadequate retirement reserves.

With only minor changes to Graph 9 it is possible to provide a wide range of controls that can be altered according to need (and Congressional pandering for votes) to keep Congress busy without destroying the balance and protection this tax scheme achieves for the majority of the population with low and middle incomes. Graph 9 is reproduced below with two optional ways to tap additional funds. I would urge caution in making use of these options, however. In fact, I would argue in the strongest terms against using this tool as a means for balancing the budget and circumventing Rule 11 above.

Graph 9 Modified: GI, TI, TC and Supplemental Tax

Graph 9a

Graph 9a: M = 0 to 10 ($500,000)

Here I replace FT with an adjustable tax rate within the Tax Credit Source Zone to allow for a shortfall in the Tax Credit Fund (TC, bottom left of picture), or to provide for higher values for the various levels of the Tax Credit Allowances. I also have added the option for an additional source of “Supplemental Tax (ST)” income (pale pink below Tax Credit source and tax zones). One obvious justification for implementing this Supplemental Tax option would be to alleviate some of the burden of the costs of a war. Such an application should then be terminated once the war costs come to an end. The formula for this curve is similar to the logarithmic curves used in Graphs 1a and 1b, but the growth rate of this curve is only 5% in this example:

ST = (GI – 1) * (1 – 0.05 * log(GI – 1))

In both the Tax Credit and Supplemental Tax zones, the tax rates can be varied, and I would expect that to assure enough revenue, both rates will likely be greater than the 15% I have used as my base rate, FT. The TC source rate might go as high as 30%, although I doubt this much will ever be needed; the ST rate could be set as high as 40% or even 50%, analogous to today’s maximum tax bracket rates.

Graph 9b

Graph 9b: M = 0 to 1000 ($50 million)

(Area of Graph 9a is the tiny green square, lower left)

Note that the Supplemental source zone is far thinner than the Tax Credit zone over lower incomes, but grows to a significant fraction of the total income of the very wealthy, while the TC zone is too thin to be visible at the higher incomes. Even with this growth rate, however, the total tax burden on the wealthy would be no more than that imposed by today’s Tax Code. If the trend toward Socialized Medicine is seen as the future of Healthcare in America, and if nothing is done to bring Education costs under control, then the options outlined here would appear to be one simple and relatively painless way to pay the costs. All revenues going into the TC Fund and the ST Fund should be kept separate and made available to low-income people only (TC), or only those with proven need (ST). Both funds should be invested and managed by competent accounting groups with close federal oversight, according to the same rules as given above for the TDSA funds.

Appendix I – Analysis of Current Tax Code

  1. M = GI (Gross Income) / MI (Median Income)

    Using this new variable the Taxable Income (TI) boundaries can be written in the form:

    TI = (M – C) * (1 – E * log M), where E is the growth rate of exemptions with income and C is a constant which correctly positions the starting point for each boundary. Thus:

  2. TIUB = (M – 0.25)* (1 – 0.10 * log (M)), where the subscript “UB” refers to Upper Boundary. The upper boundary starts at M = MI * 0.25, and the growth rate is set to 10%.

  3. TILB = (M – 1.0) * (1 – 0.20 * log (M)), with the lower boundary starting at M = MI * 1 and having an exemption growth rate of 20%.

Appendix II – Tax Computations

The general equations for normal income tax computation are given above but repeated here:

  1. M = GI / MI

  2. R is the Range of the Cost-of-Living line that defines the first section of the TI parabola, set by Congress to a number in the recommended range of 4 to 6,

  3. TI = M2 / R, from M = 0 to 0.75 * R,

  4. TI = R * 2.25 – (R * 3 – M)2 / (R * 3), from M = 0.75 * R to 1.5 * R,

  5. TI = M for all M greater than 1.5 * R, and

  6. Tax($) = TI * FT * MI, at all income levels and over all time.

Appendix III – Capital Gain Computations

Since calculation of the Capital Gain tax is best shown by example, I will refer back to Graph 13 and add in a few more details. That graph does not indicate exact dates of purchase or sale, so for purposes of this example I will assume a purchase date of February 15th and an optimum sale date of November 15, 2009, to illustrate MI interpolation and its effects. Different government agencies use different methods for determining Median Income. Listed here, and used in Graph 13, are the “Current Dollar Annual Household Median Income” figures from the Census Bureau:

Date             Median Income         Growth Factor

1/1/2001 . . . . $40,610 (MI0)

1/1/2002 . . . . $40,772 (MI1) . . . . 1.03989

1/1/2003 . . . . $41,690 (MI2) . . . . 1.02252

1/1/2004 . . . . $42,653 (MI3) . . . . 1.02310

1/1/2005 . . . . $44,565 (MI4) . . . . 1.04483

1/1/2006 . . . . $46,348 (MI5) . . . . 1.04001

1/1/2007 . . . . $48,332 (MI6) . . . . 1.04281

1/1/2008 . . . . $48,395 (MI7) . . . . 1.00130

1/1/2009 . . . . $47,915 (MI8) . . . . 0.99008

1/1/2010 . . . . $47,425 (MI9) . . . . 0.98977

1/1/2011 . . . . $48,152 (MI10). . . . 1.01533

1/1/2012 . . . . $50,000 (est.) . . . . 1.03838

Thus we now have:

  1. Purchase: day 46 of “year zero”, 1000 shares at $19.75 + $250 fees (1.265% fee),

  2. Stock Value at purchase (“basis” – includes the transaction fees), V0 = $20,000,

  3. MI0 on January 1, 2001 = $40,610,

  4. MI1 on January 1, 2002 = $40,772,

  5. MI growth (first year) =1.0040%, so that

  6. MI on actual purchase date = 40610 + (46 / 365) * (40772 – 40610) = $40,630.4 [linear interpolation], or 40610 * 1.00400.126027 = $40,630.4 [exponential interpolation], so

  7. Zero Gain Level” at the end of 2001 = 20000 * 40772 / 40630 = $20,070 [linear method], or 20,000 * 40772 / 40630.4 = $20,069.7 [exponential method]. Note that because “growth” is inherently an exponential operation, the exponential method is technically more accurate, but the difference, even near mid-year purchase or sale dates, is negligible, especially after the dollar rounding used by the IRS. The 0.126027 exponent equals 46 / 365, the fraction of a year equivalent to Feb 15, and the 1.0040 value is the first year growth rate, MI1 / MI0. I will use only the exponential values from here on.

  8. Stock price at end of first year = $20.35, so V1 at the end of the first year = $20,350, or $280 more than the “zero gain” value of $20,070, so there is a real gain of $280;

  9. At 15% the 2002 tax would be $42.

  10. From 2003 through 2008 the calculations closely follow the analysis in Section 5(c), with minor changes relating to the purchase date used here.

  11. With a final sale date of November 15, 2009, we follow a sequence similar to the above;

  12. Proceeds from sale = share price ($27.50) * 1000 shares = $27,500 minus fees (1.265% of sale = $348) = $27,152.

  13. MI8 = $47,915 and MI9 = $47,425, so

  14. MI “growth” = -0.992%, therefore

  15. MI on Date of Sale = $47,485 (= 47915 * 0.98977(320/365)), and

  16. Zero Gain Level” on Sale Date = $20000 * 47485 / 40630 = $23,374. Then,

  17. Real Gain = $27152 – $23374 = $3,778, and

  18. Tax = $567. This would be the final total tax on this investment. Any prior taxes paid in excess of this will have been refunded as described in Section 5(c).

These calculations may appear complex and confusing to many taxpayers, but all of these rules will apply uniformly to everyone equally. It will be quite simple to code the program to do all of this, in a home computer or iPhone “app”, so that the taxpayer would need to key in only the most basic values: gross income, dates of stock purchases or sales, purchase price and fees, sale price and fees, etc., and click the button for “Taxes Owed”. Any variables from one year to the next – such as MI values for “last year” and “this year”, and FT values – will be downloaded automatically from the internet. Add the necessary bank numbers and click the “E-file” button and the tax return is done. The entire process would be vastly simpler than what is required today to submit even the simplest tax return. For those who lack equipment of their own, every library, city hall, bank and many other readily available establishments could provide both the computer equipment and the minimal professional help needed.

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