A simple, potentially low controversy proposal for tax reform (expanded standardized deductions)

2012 March 16
by Daniel Lakeland

Tax reform is one of my typical hobby horses, and I've been thinking a lot about it of course because not only is Tax Day on its way (the day after my youngest son's birthday!) but also the timeline just ran out on our family's Flexible Spending Account (FSA) so we were thinking of what things we could do to spend some extra money in a useful way.

The Problem:

The FSA is an example of a well-meaning government program gone wrong. It's an account where you can put pre-tax money, but you have to spend it on a restricted set of allowable medical related expenses, you have to document the validity of those expenses, and you lose any unspent money at the end of the year (it goes to the government). This reduces the cost of healthcare, but encourages people to over-spend on these specifically allowable items vs other things that might be a better use of your money (like for example an improved healthcare plan, as you can not use the money for premiums, or a gym membership or whatever).

A complicated solution:

I've previously advocated for a single account, like a combination FSA/HSA/IRA/Education/401k account. My name for it was HCSA I think, the "Human Capital Savings Account". You'd be allowed to put some large fraction of GDP/capita into this account each year. You could invest the money in investment vehicles like stocks, bonds, real estate trusts, mutual funds, and exchange traded funds (just like an IRA), with no capital gains taxes, and you could spend the money on a whole host of things that we consider to be good for people to spend money on (things that improve the public good). Examples would be education, health insurance premiums, healthcare expenses, maintenance of a primary home, childcare, and after "retirement age" you could simply take the money out for living expenses, like an IRA.

A simpler proposal:

Now, I still think that the HCSA is a great idea, but it does involve a fair amount of administrative costs. Here's a simpler proposal that should work well and could compliment reform of the many-different-tax-advantaged-accounts system we have.

Let's get some of the Census Bureau and other governmental statistical groups together, and have them estimate what it costs for a family of N adults and K children to achieve a "basic level of healthy welfare" and measure this as a fraction of GDP/capita each year. This "basic level of healthy welfare" means that these people in this hypothetical average family have:

  1. A healthy diet, including fruits, vegetables, fish, meat, grains, the whole "balanced diet". And not luxury organic produce necessarily, but certainly fresh ingredients, not just a series of frozen meals and starchy sugary snacks.
  2. Coverage of transportation costs to and from work for a primary earner, either in terms of public transportation or in terms of a typical commuter vehicle and associated fuel and insurance.
  3. A healthy but minimal level of housing, with no pest infestations, leaky plumbing, mold, or over-crowded bedrooms, but also not luxury penthouse condos, just a simple standard that includes electricity, heating and cooling to avoid health effects of extreme weather, and sufficient square footage and access to bathroom facilities that the conditions are conducive to human dignity and health for both the adults and children living in the household.
  4. Some typical tradeoff between a second income and the cost of childcare. Then depending on whether the household has one or two incomes there would be an allowance for childcare expenses. In this case I think we should use the cost of organized pre-schools since they are well known to provide a good public benefit (pre-school children do better in school for at least the first several years).
  5. The cost of some sort of basic health insurance providing emergency hospitalization care, immunizations and pediatric care, and access to a primary care physician through at least local "urgent care" type clinics, including a family co-insurance deductible of say 10% of GDP/capita per year (currently around $5k or so).
  6. Education expenses including the cost of paying property taxes and other taxes used to fund public schools, as well as the cost of a public university education divided over say a 40 year savings and repayment period.

Ok, so based on the above general description, and a bunch of political wrangling, we come up with some measure of the cost of "basic healthy living" in the US. This is substantially more than the "poverty level" currently calculated, and yet should still be an absolute measure based on a set of important goods and services, not simply a certain quantile of income or the like.

Now let's say for a family of 2 adults and 2 children, this comes out currently to (I'm guessing) say $40,000 per year. We simply eliminate all specialized tax deductions, and we allow for this family of 4 to simply deduct $40k from their income and pay taxes only on the amount that exceeds this basic level. Obviously for families of different sizes we need different deductions, so we'd have a formula or table depending on your household size. There would be regional differences of course, but I wouldn't argue in favor of regional scaling. We should simply average over those, under the assumption that if it's more expensive to live where you live then it's probably in part due to greater amenities in that area than average for example.

But this deduction is likely to be substantially more than the current standard deduction. The standard deduction for a family of two working parents with two children in 2011 is $11,600 for married filing jointly. The federal poverty level for a family of 4 is $22,350, so my guess of $40k is for this more improved  "healthy living" standard (which includes healthcare and savings for education and all sorts of things that the poverty level is not intended to measure).

For income above and beyond this "basic level" we simply set a flat tax rate that achieves the needed tax income (say it's around 15% of total GDP or so for the US budget, something like that) so perhaps we need to have a marginal tax rate of 25-35% for income above the threshold.

A flat tax above a threshold provides an easy calculation, avoids a lot of administrative hassle, doesn't significantly skew behavior in strange ways (such as the mortgage interest deduction being partially to blame for the housing bubble) and treats everyone similarly, and yet does not have the "regressive" problem of taxing those who earn very little so much that taxes eat significantly into their ability to provide for a healthy family. Most of the tax revenue would come from income that was going to be used by households to consume "non-essentials", exactly the kind of taxation that economic theory says we should prefer.

An even further step, negative taxation:

The next step, potentially more controversial, would be to take this threshold and add a  "negative taxation" which would give you as a payment from the government some fraction of the amount that you fell below the threshold. So for example for every dollar over the threshold you might be taxed say 30% but for every dollar below the threshold maybe you receive a payment of 30%. I personally think that would be a better way of dealing with poverty than our current system of crazy specialized welfare programs, but let's take things one step at a time.

This reform could be combined with the previously mentioned HCSA concept by allowing an additional smaller amount (say 10 to 20% of GDP/capita or currently $5 to $10k) to be placed into these HCSA accounts encouraging savings for retirement and unexpected expenses above and beyond the "basic expenses" that our census bureau and soforth had determined. Those taking advantage of the HCSA would of course need to deal with the additional administrative costs of such a program, but the core concept of ensuring that people have enough income after taxes to maintain a healthy and basic standard of living would be simplified through the new standard deduction procedure.

 

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