Smart Tax Details
The transparency of Free Money and Open Finance will make feasible a gross simplification of the tax system, while at the same time vastly reducing fraud, manipulation, and misallocation of effort done to “game” the tax system.
The goal is to make the tax system relatively neutral between sources of income, and between different industries, unlike today where the influence of Money in Politics results in our tax system treating different classes of incomes very differently, and full of special tax provisions for industries and companies that distort investment and the economy.
Income Taxes
Since it will be very difficult to hide income under Free Money, the argument that black markets will grow as marginal rates grow will not apply. Thus, Smart Tax will rely to a substantial degree on progressive income taxes for government revenue, eliminating regressive taxes such as payroll tax, and not implementing proposals such as the regressive Federal Sales Tax or Federal Value Added Tax.
Concentrating the bulk of government revenue in a single, easily understood (after reforms!) system will also make the social conversation about the optimal size of government more realistic. Seeing the cost of government in one number, combined with strong limits on deficient finance (see below) should make citizens consider more carefully the costs and benefits of government programs.
Equal Taxation from All Sources
Today we have higher levels of taxation for income from labor, than we do on income from capital. Under Smart Tax all income from all sources will be taxed at the same rates.
A single Layer of Taxation
Today most large corporations are subject to two level taxations, once at the corporate level and then again for distributed profits, like dividends, at the individual level (if taxable).
Under Smart Tax all Legal Entities will function the way S Corporations and LLCs work today: all profits and losses will pass through any intervening hierarchy of Legal Entities to the Persons who are the beneficial owners.
The allocation of a Person’s share of Legal Entity profits will be considered taxable income while a share of losses will be deductible from taxable income.
Benefits of a Single Layer of Taxation
The existence today of two layers of taxation: corporate and individual, results in vast distortions in investment decision making. It is also a strong force for corporate gigantism since it is more tax efficient to retain earning and do acquisitions rather than returning profits to investors.
Single layer also eliminates the current more favorable tax treatment of debt investments in businesses versus equity investments. Equity investments create firms that are much more robust than an equivalent amount of debt.
Capital Gains
Under Smart Tax, capital gains will be taxed the same as any other income, after indexing for inflation.
Historically, capital gains rates have usually, though not always, been lower than those on ordinary income. The main argument for that differential has been that during times of high inflation, much of what appears to be a capital gain is merely the effect of inflation. In the low-inflation era of the last 20 years, instead of treating capital gains income fairly, this has resulted in vastly lower real tax rates on capital gains than on labor income.
Tax experts have generally agreed that indexing of capital gains to inflation but taxing them thereafter at ordinary income rates would be a better way to address the reality of inflation-deemed-gain. In the past, indexing every transaction has been considered too complex and expensive to do. Under the Free Money system, however, all the data is already collected in such a way that will make the indexing of capital gains simple, accurate, and automatic.
Dividends
Currently dividends are also taxed at a much lower rate than labor income. One rationale is that since the earning were already taxed at the corporate level, taxing them again as ordinary income would be excessive double taxation.
Since Smart Tax eliminates the double taxation issue via flowing through all profits to Persons, the chief argument for lower tax rates for dividends goes away. Thus under Smart Tax dividends be effectively taxed at the same rate as labor income.
Charitable Entities
A special subclass of Legal Entities: “Charitable Entities” would subsume our current classes of not-for-profit entities such as churches, schools, associations, cultural, institutions etc.
Donations to Charitable Entities would not be deductible from income for tax purposes.
Each Charitable Entity will be required to have a Board of Trustees who will, for tax purposes, be considered to be equal “owners” of the Legal Entity. To the degree that their charitable expenditures in a year equal or exceed their receipts they would remain untaxed. If, however, the receipts of a Charitable Entity exceeded their charitable expenditures, then the excess would be deemed income and would flow down to the “owners” as taxable income.
Charitable Entities could choose to apply income beyond the cost of charitable activities in a given year to an endowment fund, for the purpose of future charitable activities, rather than have it be deemed “income” for tax purposes. Excess funds could only be added to the endowment until the endowment is 20X the previous year’s charitable expenditures.
There would be a minimum requirement of a 5% payout from endowment funds. Any short-fall of disbursement would be deemed income, and passed down to the owners for taxation purposes. And of course, the payout from endowment would be deemed “receipts” to the Charitable Entity.
No Non-Taxable Money Pools
Today’s IRAs, 401Ks, certain kinds of trusts, “whole life” insurance policies, “variable annuities”, etc., are pools of money that are not subject to taxation in the current period on their gains. While some benefit from these schemes goes to lower income individuals, the vast bulk of the benefit goes to those in higher income classes who would likely save anyway.
Under Free Money and Smart Tax income from all pools of money will be subject to taxation in the current period. See “Investment Income Deduction” below for the way Free Money provides incentives for young people, and low and moderate income people to save and invest.
Deductions
The current tax code is unbelievably complex and grossly unfair because it has been stuffed with deductions from taxable income in thousands of different categories. These deductions result in distortions of investment and business. The total of such deductions today is thought to be in the range of 6.5% of GDP or $1 trillion.
Under Smart Tax there will be only one deduction:
Investment Income Deduction
To replace the benefits of IRAs, 401Ks etc in a way better targeted to low and middle income Persons, investment income up $650,000 lifetime will be tax free. After the tax free $650,000, additional investment income from all sources will be treated as ordinary income.
Capital Investment
Expenditures for capital equipment will be expensed in the period purchased. This will provide a substantial incentive for the creation of valuable capital, while also reflecting the reality that in the modern economy most capital purchases are obsolete long before they wear out.
Current tax regulations for capitalization and depreciation of intellectual property will be eliminated. They will be expensed like the purchase of capital equipment.
Estate Tax
Smart Tax would not have an estate tax per se. Rather RECEIPTS from estates would be taxable to their recipients.
There would be a $750,000 lifetime exemption. After that, receipt of bequests would be taxed at 75%.
Tax Rates
Actual tax rates for various income levels will be at the discretion of Congress, except that ALL income earners must pay some income tax. It can be as low as 1% but it is a critical component of social cohesion that all earners are part of paying for our government.
Since large “first dollar” taxes on income such as payroll taxes will have been eliminated, the “everybody pays some income tax” would be less burdensome on low income earners than the current system.
Rates ought to be much lower than today since eliminating deductions will make almost $1 trillion taxable, and the transparency of the Free Money system ought to result in a massive reduction of the estimated $1.3 trillion of tax avoidance happening currently.
Other Taxes
While the goal will be to get the bulk of government revenue from progressive income taxes, some other taxes may remain on the books such as “sin taxes” for alcohol and tobacco; import duties (though the goal should be to minimize or eliminate them over time).
Other classes of taxes that may remain are excise taxes aimed at financing the infrastructure or services for a relatively narrow class of users. For example: taxes on hunting equipment and ammunition to fund federal wildlife management.
Since the benefits accrue broadly, including to non-users, It is preferable that general infrastructure such as roads and airports, which today are funded substantial part by fuel excise taxes, be funded by the income tax.