The Real Tax Reform Question

The real question of any tax reform should be what is taxable, not what's the tax rate.

On the Colbert Report, Ron Paul said wants to eliminate the income tax and abolish the IRS. Mike Huckabee agrees and want to have a "Fair Tax", or national sales tax.

Would every purchase really be taxable under this "fair tax"? Would a single mother on welfare have to pay 23% sales tax on baby formula? Would you have to pay sales tax on the purchase of your primary residence? The Fair Tax people say yes, but you can see how easy it would be to start saying this or that should be exempt from sales tax. And even in the current form, the tax would exempt purchases for resale and the sale of used items.

Any major tax changes will likely have some unintended consequences. Would the sale of used cars increase because of the 23% sales tax on new ones? In light of Kyoto & Bali, how would that affect pollution and carbon emission concerns? Would a black market emerge to sell items "off-book". This "fair tax" might be a boon for service & repair businesses as people may be forced to repair that old TV instead of getting the newest HD set. What would that do to our consumer/consumption based economy?

You can see it's never quite as simple as sound-bites sound. And there would have to be some enforcement, whether it's called the IRS or something else.

On the other hand, other contenders want to "keep rates low". Well again, if you're not addressing the complicated mess that is the Internal Revenue Code you really aren't addressing the real tax issue.

The reason taxes are so complicated is determining taxable income (what is taxable) is so complicated. And that's a direct result of Congress using the tax code to encourage certain behaviors it deems desirable. The reason mortgage interest is deductible is Congress decided that home-ownership is something to encourage. The reason we can exclude certain retirement plan contributions from taxable income and there is a Saver's Credit for some lower income savers is Congress deemed that saving for retirement is a good thing (oh, and businesses wanted to get out of their expensive pension plans). Same for charitable contributions, certain education expense. Investing is "good" so dividends and capitals get taxed at lower rates. Not to mention all the tax credits. Like the child tax credit, the child care credit, the hybrid car credit...

And that's just for individuals! Start looking at businesses the picture gets even more complicated. Put aside the tax loopholes for some industries. Just understanding what is or is not deductible can flummox: What is depreciation and how do I calculate it? What auto expenses can I deduct? What meals or entertainment expenses are deductible? What can I deduct for business use of my auto? What constitutes a home office? And these are just the "simple" every day questions.

So now we get those who say all income is taxable. That might work for simple individual returns, but what about businesses? Must a business pay tax on its gross revenues? Will you at least allow a deduction for cost of goods sold? If so, how do you calculate that? You can see how business would try to dump every expense into cost of goods sold to reduce their taxable income.

If not, how would the effective tax of a high margin business compare to that of a low margin business (like grocery stores)? How will that affect the mix of business in the marketplace?

And I wonder how such a change might affect the purchase of business equipment. If you could never recoup the cost of equipment, might not the service &repair businesses benefit here too?

So the next time you hear some pontificating about tax reform, remember to ask the right question: What is taxable? That's the real tax reform question. And the answer is there is no simple answer. But unfortunately, the promise of simple sells. :(

The hardest thing in the world to understand is the income tax....This is too difficult for a mathematician. It takes a philosopher. -- Albert Einstein