What policy reforms could simplify the tax code?
Reducing the number of distinctions among economic activities and taxpayers’ personal characteristics would simplify the code, reducing both compliance costs for taxpayers and administrative costs for the government. The consequent broadening of the tax base would allow lower tax rates while maintaining revenue and also reduce economic distortions caused by taxation.
The key to tax simplification is to make fewer distinctions across economic activities and taxpayers’ personal characteristics. This would not only reduce compliance costs, but allow for simpler administration. For example, if everyone paid the same tax rate on dividends, the tax could be collected from dividend payers without having to trace who got what.
The general structure of a simple tax system would be a broad tax base with rates that are the same across different income sources or types of expenditure. Progressivity could be embodied in the rate structure (with rates rising with income, as they do now), a basic exemption amount, and the choice of tax base (income, consumption, or another measure), rather than through specific provisions that treat different levels of income and consumption differently. Universal exemptions, deductions, or credits are much simpler to administer than targeted ones.
Several fairly modest changes could make the current tax system simpler as well as fairer and more conducive to economic growth. One possible focus: the individual alternative minimum tax (AMT). To spare middle-income taxpayers who were never its target, the AMT should allow deductions for dependents and for state and local taxes. Further, all personal credits should be available against the AMT. Any new proposal that cuts regular income tax liabilities should also make conforming adjustments to the AMT so that more taxpayers are not subjected to it.
Another option would coordinate the phaseout of tax credits. Specific tax credits phase out across different income ranges, so that claiming each credit requires a separate worksheet and tax calculation. The phaseouts also create hidden taxes over the phaseout range and diminish the effectiveness of the credits by encouraging the very activities they are designed to spur.
Numerous provisions—each with its own rules—apply to the same general activity. Coordinating or consolidating these provisions could simplify taxes with little or no change in revenue or the distribution of taxes. Examples include the various provisions related to families with children (the earned income tax credit, the dependent exemption, and the child credit), tax subsidies for education (the American Opportunity and Lifetime Learning credits, and the deductibility of tuition and fees), and saving incentives (traditional individual retirement accounts, Roth IRAs, education IRAs, and Keogh plans).
Yet another simplification would tax capital gains as ordinary income in return for a reduction in top tax rates. This was the cornerstone of the 1986 deal that allowed substantial simplification of the individual income tax. Returning to this approach would massively reduce incentives to create tax shelters or to engage in complex tax planning.
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