A tax reform you probably haven’t heard of

All tax systems are inherently unfair. Only if everyone paid the state for the value of the services provided (or if no one paid any taxes because the state did not exist) would it be possible to justify a particular tax schedule as morally superior to all alternatives. But neither of those regimes are realistic. After all, most government spending is meant to prevent or ameliorate severe poverty. If the beneficiaries of that government spending could afford to pay the amount of taxes that is “fair,” they would not need to receive state aid in the first place.

Suppose the government confined itself to providing basic physical security to its citizens. It is still not clear what would constitute a “fair” system. Would the salaries of the police and the cost of their equipment be split equally among all members of the population? Or do those with more property derive greater value from the security that the state provides?

So every tax system has to be somewhat arbitrary. This does not mean, however, that there are no better systems than the one we have. Today, I will present a practical alternative that is never discussed: the progressive continuous income tax.

The U.S. federal government taxes its citizens in a variety of different, complicated ways. There are marginal tax rates on arbitrarily defined tax brackets. There are deductions and refunds. There are payroll taxes (some of which only apply to those on lower incomes). There is an “alternative minimum tax.” There are taxes on interest income, dividend income, and capital gains income. To top it all off, savings are taxed through inflation.

This patchwork—to say nothing of the various exemptions and deductions that special interests have carved out for themselves—is deeply distortive. We spend valuable time and money trying to play by the rules without getting cheated instead of on things we actually want. Not only that, but we push some of our brightest minds—who could have been engineers or doctors—into professions that exist solely to help the well-to-do minimize their tax burden.

Economists have spent decades arguing for lower tax rates and fewer deductions. While sensible, these proposed reforms merely curb some of the system’s worst excesses while failing to correct its basic flaws. More radical measures, such as a simple flat tax on all earned income, have intellectual appeal but place an undue burden on the poor. That is because someone who earns $30,000 a year spends a much larger proportion of her income on the basic necessities of food and shelter than someone who earns $3,000,000.

The progressive continuous income tax combines the simplicity of the flat tax with the benefits of the current system. It works like this:

Tax owed = (Income ^ scaling factor) * tax rate

Obviously, the choice of scaling factor and tax rate are going to be arbitrary. However, this approach is far less arbitrary than the current regime, which has six arbitrarily defined income tax brackets, payroll taxes that are perversely designed to punish the middle class, and countless deductions.

To illustrate the difference between the two systems, I modeled the effective average income tax rate (including Social Security and Medicare payments) for someone who is single with no dependents and collects only the standard deductions across a range of incomes. I then compared this tax regime against the tax rates he would face under the progressive continuous income tax across a range of incomes. Moreover, I scaled the progressive continuous tax to collect the same amount of dollars as my model of the current system. The scaling factor was 1.3 and the tax rate was 0.5%. This is what the two tax schedules look like:

For those who are curious about the methodology or want to play around with different combinations of scaling factors and tax rates, you can download a copy of the spreadsheet I made here. Hint: lots of nested IF functions. Source for tax rates, bracket levels, and standard deductions was this article on Wikipedia.

As you can see, everyone who earns less than $1,000,000 in gross income would pay less under this alternative regime, while everyone who earns above that would pay slightly more. Not a bad trade, all things considered.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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