Alan Reynolds

A related "Myth of '86" is that itemized deductions were a major source of tax complexity, so the extremely complicated 1986 law was thus said to be a big move toward simplification. From this, it is now said to follow that "true" tax reform is impossible simply because people prefer their complicated itemized deductions to the simplicity of standard deductions.

This is just politically convenient nonsense. It is not difficult to open an envelope and copy the amount spent on property tax and mortgage interest. What is difficult is reporting every tidbit of income and expense related to investments or a small business. We are required to "itemize" too many things as individual income, not too many deductions. Defining tax reform in terms of what is deducted -- rather than what is taxed -- is like being unduly fond of the wrong end of the horse.

The third myth was that a system with two tax rates would be inherently much simpler than a system with four or five. This notion apparently arose from a misunderstanding of the many complex benefits of a genuine flat tax. People simply jumped to the conclusion that if a single tax rate was better than two, then a system with two tax rates must likewise be much simpler than system with four.

There are many advantages of a single rate, but simplicity is the least of them. In his book Economics of the Public Sector, Joe Stiglitz notes that a flat tax "means that income can be taxed at it source: taxing income at is source will reduce compliance costs and increase compliance rates." Once a single rate is abandoned, Stiglitz adds, there is no reason to prefer two rates to three or three rates to four. A flat tax of 40 percent on salaries is not obviously preferable to a graduated tax of 15, 20 and 25 percent.

On the other hand, a single tax rate is absolutely essential, in terms of economic efficiency and simplicity, when it comes to returns on business investment. The United States has three corporate tax rates, with the lower 15-25 percent rates phased-out in a way that imposes the highest marginal rate on companies with puny profits.

Then we add all sorts of extra tax rates on the individual returns from corporate profits. Capital gains taxes vary from 18 percent to 35 percent, depending on how much time passed before it made sense to sell the asset and pay the tax. That is a policy no economist could possibly explain, much less defend.

Half of all dividends pay zero, the rest pay five different rates. Congress is currently wrangling over how much "the other half" should pay, as though that has nothing to do with the fact that half pay nothing. The amount of interest expense deducted far exceeds the amount of interest income taxed at various rates. Capital taxes are an incoherent mess, causing maximum damage for very little revenue.

The main reason the individual income tax is so complicated is that it tries to collect different tax rates on each dollar of investment income, depending on who earned it and how. If such income was taxed at a single rate, a reasonable tax could easily be collected at the source. With a flat tax of 15-20 percent on interest income, for example, banks and brokerages could simply withhold that much before sending you the check.

It is only because we try to charge Smith a higher tax than Jones on the same amount of investment income that individuals are required to report reams of information about investment returns.

It doesn't work. Taxpayers can often arrange their affairs to keep assets in tax-exempt funds and foundations, or in the hands of relatives in low tax brackets. Half of all dividends, three-fourths of all capital gains and a big share of interest income are untouched by the individual income tax.

A low, flat tax on investment income is the simple way to simplify. Zero sounds like a nice round number, but I might settle for something less simple than that.


Alan Reynolds

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