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Our Democracy Needs a Change in Tax Policy

Sept. 3, 2021, 8:01 AM

Employees are the backbone of our taxing system. If you are an employee, your employer withholds your taxes before you even see the money. The withheld taxes are then sent to the Internal Revenue Service throughout the year. It is automatic. It is not a voluntary tax system for employees or employers.

If you are an employer who fails to turn over the withholding taxes, watch out. The IRS will unleash its harshest collection agents against you, along with its harshest penalties. Individuals with any authority over payroll are subject to penalty until the amount of withholding taxes is paid. The trust fund recovery penalty, also known as the 100% penalty, is vigorously enforced by the IRS.

Comparatively, if you earn your money in other ways, i.e., as an independent contractor, as a partner in a partnership, as a stockholder, or as an entrepreneur, there are methods to write off expenses and largely zero out much of the income. The tax system on that segment of the population is mostly voluntary.

Going higher up the ladder of “success,” if you are wealthy enough to have substantial assets to borrow against, you can get a low-interest rate loan and live off borrowed money, avoid taxes since loan proceeds are not taxable, and then slowly pay off the loans with additional borrowed money. If structured correctly, the interest paid on the loans is deductible against other income and in turn lowers other taxes theoretically owed.

There is no downside. It is perfectly legal under the current tax code. There are no withholding taxes to worry about or IRS collection agents terrorizing you and your bank accounts. That’s a nice gig if you can get it. For the wealthy, paying taxes to the federal government becomes truly voluntary, and many voluntarily choose not to do so. See “How the Wealthiest Avoid Income Tax.”

Our current tax regime rewards behaviors that should not be rewarded, and taxes behaviors that should instead be encouraged. The taxes on savings, in addition to requiring upfront tax withholding on anyone classified as an “employee,” discourages or even makes impossible the upward climb of the middle class. At the same time, the tax code provides many loopholes so multi-millionaires and billionaires not only don’t pay taxes but are not incentivized to put their millions to work.

The funds held by the top echelon of Americans represent assets that could rebuild this country. Many of these assets sit in offshore accounts or fund private foundations and charitable donor-advised funds that are mostly dormant. There are also incentives for the wealthy to hold assets that should otherwise be sold, waiting for the step-up in basis upon death so that capital gains are minimized.

This tax structure is nonsensical and so complex that it is difficult to enforce, assuming all parties are in agreement with what the law actually requires, which is increasingly not the situation. The complexity provides much cover for mischief and gives taxpayers plausible deniability that they did not intend to defraud the government in situations in which they arguably did. Also astonishing are the situations where avoidance techniques are actually sanctioned by the law. Many avoidance techniques are perfectly legal under the current tax code. These factors deprive society of much needed resources.

The U.S. desperately needs a consumption tax, a/k/a a value-added tax (VAT). We Americans are the kings and queens of consumption, and so taxing our purchases and not our savings could revolutionize society’s value structure. Right now there is status in more and bigger “things.” Those things should have just a small percentage added as a VAT in order to establish a solid base upon which our government can operate. This would provide the federal government with a separate steady revenue stream to take the pressure off withholding taxes.

We need and expect a strong defense, roads that are pothole free, bridges and buildings that don’t fall down, a child-care system and public schools that protect and educate our children, healthcare, and a society that doesn’t let people fall through the cracks. It takes a village, but a village in which those blessed with assets and wealth from a free economy also participate in enabling the peaceful and prosperous society that has so enriched them.

The U.S. lags far behind most of its peers with regard to its tax system. More than 150 countries have a VAT, including Russia, China, Japan, and countries in the EU. More than three-quarters of the world’s population live in a country in which a VAT is collected on sales of goods and services.

Some argue that a VAT, which is essentially a national sales tax, would infringe upon state and local governments that rely on sales taxes. However, currently most states have an income tax, and that overlap does not seem to concern VAT critics.

Others argue that a VAT is regressive in nature, and so much of the burden would fall on those who live paycheck to paycheck because more of their paychecks are consumed through the purchase of necessities. However, this argument falls apart if those same lower income individuals and families are exempted from paying other taxes, including income taxes. Also, food and other essentials are generally exempt from a VAT.

Before new tax legislation is enacted, Congress and Treasury need to do a better job of measuring the incentives created by the legislation, and the social conduct that will be the result of said legislation. The most aggressive lobbyists should not be rewarded with tax breaks for their clients. It is a known fact that businesses and individuals make many decisions based upon tax implications. Hiring more lobbyists should not be one of them.

Home ownership is encouraged and subsidized through use of the home mortgage interest deduction available to individuals. Businesses are encouraged to buy assets that can be depreciated, in order to take advantage of depreciation deductions when in fact, some assets are actually increasing in value. Businesses are also encouraged to defer taxes through “like-kind exchanges” when the buildings “exchanged” are not really “like-kind” and the gains are theoretically deferred, unless the owner dies and gives his or her heirs the asset with a stepped-up basis. (The biggest tax-dodge.)

The result is that assets are not fully utilized but rather sometimes put on mothballs, waiting for someone to die so that the asset can be sold with the adjusted basis stepped up to fair market value on the date of death, and minimal taxable gain as a result. In addition, corporations are still incentivized to locate their headquarters and assets offshore, and the U.S. version of oligarchs are incentivized to structure their businesses to take advantage of the many loopholes available.

Another tax avoidance scheme—perfectly legal—is for an individual with appreciated assets to set up a private foundation or donor-advised fund and “donate” the appreciated assets to the charitable entity, thereby obtaining a charitable deduction to offset other income. The charitable entity can then generally sell the asset with no taxes owed by either the donor or the charity. The resulting funds are available for charitable use by a wide range of charities doing a wide range of activities.

However, only 5% is required annually to be distributed by private foundations to charities, including non-operating donor-advised funds. There are no distribution requirements for donor-advised funds. The distributions are at the discretion of the board of directors, and/or donor, which can also provide employment and security for family members if structured correctly. (There is an excise tax for those in private foundations that engage in self-dealing, but there are many legal methods to avoid it.)

The IRS reported in its FY 2022 Congressional Budget Report, Publication 4450, that 1.8 million exempt organizations report $4.5 trillion in assets. Donor-advised funds make up a reported $140 billion of that amount. Legislation was introduced on June 9, 2021, by Senator Angus King (I-Maine) and Senator Charles Grassley (R-Iowa), which would impose distribution requirements for donor-advised funds so that more funds are currently utilized. In S. 1981, private foundations would not be able to fulfill their 5% distribution requirements by donating to donor-advised-funds. This would help activate more funds for current charitable use, although more reforms are needed.

The burden for the day-to-day expenses of society falls largely on employees subject to withholding taxes, i.e., the shrinking middle class. Tax revenue received by the U.S. Treasury Department in 2020 was overwhelmingly from income tax withholdings, including both income taxes and payroll taxes, i.e., Social Security and Medicare. In 2020, the Treasury received $1.6 trillion (47%) from individual income taxes and $1.3 trillion (37%) from payroll taxes. The total percentage of revenue from individual wage-earners is $2.9 trillion or 84% of annual receipts of the U.S. government. Most of that amount is collected through withholding at the source by employers.

The U.S. places substantially more reliance on taxing sweat equity than on taxing dormant equity. As the Trump Organization recently discovered, violating employment tax laws may work for a while, but ultimately the tax authorities will discover the fraud and pursue this sacrosanct source of tax revenue.

A VAT could shift the emphasis from a taxation system that taxes services to a taxation system that taxes consumption. If all business entities are required to collect and pay periodic payments for every purchase of goods to make their widgets, provide their employees with office space, or fund expensive cars, vacations, and homes, the emphasis may shift to become a bit more balanced between wage-earners, corporations, and the top 0.1%.

The way a VAT works is that a low-percentage tax is applied at each stage of the manufacturing process. The later stages of manufacturing add on to that tax based upon the increasing value of the product. The later-stage manufacturer receives a credit for all VAT payments already remitted to the VAT authorities on that product. It would not only apply to manufacturers, but also business entities.

Senator Ben Cardin (D-Md.) has introduced S. 5031 entitled “Progressive Consumption Tax of 2020.” It not only imposes a fairly traditional VAT but provides income tax exemptions of $100,000 for married taxpayers and $50,000 for single taxpayers. It also provides rebates to offset the loss of various credits, such as the earned income tax credit. The deductions for charitable donations, state and local taxes, and mortgage interest deductions are preserved.

Tax rates for those with taxable incomes above the exemption amounts are proposed at three brackets, depending upon income level, of 15%, 25%, and 28%. This would effectively assist both the middle class and lower-income workers to be able to better provide for their families and their own basic needs. The consumption taxes that most families and individuals would pay on goods should be more than offset by their exemption from paying income taxes, along with rebates for the lowest income brackets.

Tax legislation in the House of Representatives has also been introduced. The bill, H.R. 25, is entitled the “Fair Tax Act of 2021,” introduced by Rep. Earl Carter (R-Ga.). This legislation proposes a VAT, which would completely replace the income tax, payroll taxes, and estate and gift taxes. Thus, the burden on middle-income wage earners would be removed, with a focus on consumption rather than wages.

Another option that could be enacted to supplement a VAT and/or income tax is a financial transactions tax (FTT), which taxes each trade of stocks, bonds and derivatives. An FTT would also provide the added benefit of discouraging high-frequency trading. A typical FTT is a progressive tax that would have little practical impact on the middle class. While middle-class stock ownership exists, it is mostly held in mutual funds and stock investment vehicles with infrequent trading. Individual retirement accounts and 401K retirement accounts are not typically the source of high-frequency trading.

The recent out-of-control trading of GameStop, egged on by the Robinhood app and Reddit, artificially raising the value of the stock beyond any realistic market evaluation, would be discouraged. An FTT would make that type of speculative trading more expensive for the trader with benefits to the federal fisc. Volatility would presumably be diminished, and the market more stable, which would benefit all investors. Senator Bernie Sanders (I-Vt.) proposed the “Tax on Wall Street Speculation Act,” S. 1283, imposing a tax on financial transactions. Rep. Barbara Lee (D-Calif.) simultaneously introduced almost identical FTT legislation in the House. See H.R. 2735.

Bitcoin and other crypto currencies could also be subject to a transaction tax. This has the benefit of discouraging the popularity and volatility of Bitcoin by treating it as a real commodity subject to tax. Taxing something as elusive a concept as Bitcoin and Dogecoin, utilized as international currency by cyber-criminals seeking ransoms, has positive societal impact as well.

The Internal Revenue Code of 1986, as amended in the past 34 years, has become an albatross on the backs of employees and employers subject to withholding, while providing a labyrinth of exclusions, exceptions, and deferrals for those free of withholding and “income” taxes. Without change, the middle class will sink and the billionaires will continue to soar into space. Not a great outcome for those of us who hope for continued peace and prosperity in this corner of the world. In the opinion of this tax attorney with experience on both sides of the issues, change is needed and it cannot come too soon.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Nancy Ortmeyer Kuhn is a Director at Jackson & Campbell, P.C. in Washington, D.C. and is chair of the Tax Group. Nancy’s legal practice focuses on litigation and federal tax matters. She was a law clerk at the U.S. Tax Court for two years and then a litigator in Chief Counsel’s office of the Internal Revenue Service for approximately nine years. Nancy then switched sides and represents taxpayers before the Internal Revenue Service, the Tax Court and District Courts. In addition, she handles general litigation matters in various state and federal courts. She is an active member of the Women’s Bar Association of the District of Columbia and is a founding board member of 131 & Counting, a nonprofit organization celebrating women in elective office.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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