A Plan for Comprehensive Restructuring of How Government Raises Its Revenue

Edward J. Dodson

[This paper presented a slightly revised version of a proposal submitted to the President's Commission on Federal Tax Reform in 2004. The original version was posted to the government's website for comment]

For most of the history of the United States, the role of government at every level was relatively modest. That changed as the United States matured as a society; that is, as the safety valve of free land disappeared, as the cities became heavily populated with poor immigrants from abroad, and as decisions were made to establish a permanent military capability. As a consequence of the Second World War, there was no turning back. Our local, state and federal governments now spend over $5 trillion annually. Yet, government is not able to raise this amount of revenue via taxation and other charged fees. Bonds are issued that pass on debt to future generations of citizens. By the time the next U.S. President takes office, the federal debt will reach $10 trillion and continue to climb. At an average interest rate paid to bondholders of 5 percent, this means the federal government must raise $500 billion annually just to service this debt.

Clearly, the entire public revenue system of the United States puts the economic, social and political stability of the nation at risk. What we need is a comprehensive approach to restructuring this system to move toward a sustained period of balanced budgets fostering full employment without inflation. What follows is a set of changes that, if pursued, have the promise of achieving these crucial objectives.

DISTINGUISH BETWEEN "EARNED" AND "UNEARNED" INCOMES BY ADOPTING A GRADUATED FLAT TAX AT BOTH THE STATE AND FEDERAL LEVELS

Well over half of all households in the United States receive little or no income from passive sources, such as the ownership of stocks, bonds, mutual funds, money market funds, or investment properties. Our income tax system is neither progressive nor simple to comply with. Moving to a graduated flat tax would solve both problems. This approach, with higher rates imposed on higher ranges of income, could easily be adopted by the states as well. The structure proposed is roughly as follows:

The "graduated flat tax" would begin to tax individual incomes above the national (or state) median. Above this amount, increasing rates would be applied to higher ranges of income up to whatever maximum is required to achieve a balanced budget. Assume, for example, a national median of $50,000. Incomes greater than $50,000 up to $100,000 could be taxed at 5%; greater than $100,000 up to $250,000 at 10%; greater than $250,000 up to $500,000 at 15%; greater than $500,000 up to $1 million at 20%; greater than $1 million up to $5 million at 25%; and so on. These rates and ranges would be reviewed annually and adjusted to meet budgetary requirements. The tax rates adopted by state governments would be proportionately lower based on the state budgetary requirements.

INHERITED WEALTH

Recent data indicates that just 300,000 U.S. citizens collectively received as much income at the bottom 150 million. Much of this wealth comes from inheritance and/or income generated by passive investment of inherited financial resources. Under state and federal estate tax structures, there is no distinction made between income flows earned by investment in job-creating capital goods or from unearned rent-seeking investments.

Opponents of the estate tax have persistently tried to make the case that such taxes result in the dismantling of the nation's family-owned farms. While the historical evidence reveals that inflated land prices and excessive debt drive families from farming, there is no validity to the charge that estate taxation is a factor. A recent report by the Center for Budget and Policy Priorities indicates that only 65 farms nationwide faced any estate tax at all because of the current level of tax exemption.

Also worth noting is that half of those on the Forbes 400 list of wealthiest individuals inherited the businesses they manage or inherited substantial wealth. Out of 121 million U.S. households, only around 9 million have a net worth above $1 million. The median net worth of all households is only around $60,000. Thus, a federal estate tax that exempts even the first $1 million in value would be highly progressive.

REPLACEMENT OF U.S. GOVERNMENT BONDS WITH FULLY AMORTIZING BONDS

In conjunction with the above restructuring of the Federal income tax, the national debt can be significantly reduced over time by replacing maturing bonds with fully amortizing bonds (i.e., bonds that repay both interest and principal to bondholders). The amount required to service this debt would be included in a requirement for a balanced budget.

EMPOWER COMMUNITIES TO MOVE TO A LAND-ONLY PROPERTY TAX BASE

Land values are societally-created by aggregate pubic and private investment. A long line of economists and their predecessor political economists have argued the case for public collection of location rent as a (or even, "the") primary source of public revenue. The specifics include:

• To ensure property assessments are kept current and equitable throughout each state, the responsibility for assessment should be taken over by a state agency. Assessments by county agencies and/or local assessors are almost everywhere influenced by political interests or are simply never updated. The worst cases involve failure to reassess undeveloped or underutilized land parcels based on current market values, leading to long-term holding of land off the market for speculative gain.
  
• Gradually exempt property improvements from the tax base, so that at the end of, say, 7-10 years, all revenue raised by taxing real estate would come from the taxation of assessed land values only. This change may seem drastic but is economically very sound (rewarding property owners for developing land to its highest and best use and, by greatly reducing the financial rewards for speculating in land, result in the gradual lowering of land prices.
  
• To address concerns about displacement of long-term residents due to rising property taxes, allow homeowners to apply to have their annual tax payment capped based on some affordability formula. The unpaid amount would accrue as a lien against the property (at a modest rate of interest) to be paid at time of resale or transfer of ownership.

AND, FINALLY, WHAT ABOUT PUBLIC FUNDING FOR EDUCATION?

I would also recommend that the public funding of education be paid for by state government. As the system exists today, many higher income households with children in the public school system are subsidized by households with much lower incomes and no children. The way to address this inequity is to institute a needs-based tuition voucher system. Low income households with children would receive vouchers sufficient to cover their childrens' educational expenses, with the amount of voucher decreasing with rising household incomes.