From the Bluegrass Institute Scholars – It’s Tax Day 2015: Flat tax policy eliminates ‘expensive loopholes,’ lower rates for most

Schansberg

By D. Eric Schansberg, Ph.D.

We pay taxes every day. But for many people, April 15 represents “Tax Day” – the day when our income tax forms are due.

Many people file their 1040s sooner, particularly when they’re receiving refunds. They have allowed the government to keep too much of their money all year. So why should they extend the interest-free loan to the government for a few more months?

In terms of taxes on income, payroll (FICA) taxes usually impose a far-larger burden on most wage earners. But we rarely think about that tax on income because it’s not nearly as obvious to us. The taxes are withheld each pay period before we see the money; we don’t file an income tax return for FICA; and we never get a refund or pay more at the end of the year for FICA.

Beyond the two federal income taxes, most workers deal with state and local income taxes. And of course, we pay all sorts of taxes with our after-tax income as we spend it on everything from donuts to pants, cars to houses, gasoline to telephones.

The Tax Foundation has tallied all of these taxes and calculated “Tax Freedom Day” for the average person in each state. If we had to pay all of our taxes first, when would we be free from taxation?

Of course, this number would vary tremendously by individual. It varies by state as well.

For example, Louisiana is the first state to “gain its freedom” on March 30, while Connecticut is the last state – on May 9. Indiana is in the middle of the pack with a Tax Freedom Day of April 16. Thanks to its low income and its light federal-tax burden, Kentucky is early in the pack with a Tax Freedom Day of April 8.Some households reach Tax Freedom Day sooner because they have lower incomes. Our tax system is generally “progressive”, applying higher tax rates to those with higher incomes.

Other households reach Tax Freedom Day sooner because of income tax deductions.

All income is exposed to FICA taxes. But not all income is exposed to income taxes.

Some income is excused through “exemptions” (mostly related to household size) and a variety of “deductions.” Taxpayers are offered a “standard deduction,” but can benefit from “itemizing” their deductions (detailing the deductions allowed by law) if that amount is more than the “standard.”

For example, in 2014, the standard deduction for a married couple was $12,400. If a couple had itemized deductions of $13,400, their taxable income would be reduced by another $1,000. If they were in the 15 percent tax bracket, this would reduce their taxes by 15 percent of the $1,000, or $150. If their itemized deductions were only $12,000 (less than the “standard”), their taxable income and their taxes would be unchanged.So, larger deductions and larger tax rates lead to a greater advantage.

Wealthier people face higher tax rates and tend to have larger deductions. Thus, they typically gain a lot more from deductions, reducing their taxable income more so and sheltering their income from higher tax rates.

It also follows that wealthier states have much more to gain from deductions. According to the Treasury Department’s budget for 2016, the five largest tax deductions are: 1) the subsidy for tax-free health insurance and health care; 2) retirement savings; 3) state and local taxes; 4) mortgage interest and 5) charitable contributions.

Subsidies for retirement savings and charitable contributions face little controversy, so let’s focus on the other three.

The subsidy for health insurance through the firm results in a loss of $225 billion in revenue for the federal government. (The subsidy is also responsible for most of our problems in health insurance and health care, but that’s another article.) This works out to about $2,900 from the average family of four. The state and local tax deduction leads to $81 billion (more than $1,000 per family). The mortgage interest deduction leads to $54 billion (about $700 per family).

These three subsidies comprise about 20 percent of all income-tax revenues. If we got rid of these loopholes, we could lower income tax rates substantially.

In the coming year, when you hear some politicians talk about a “flat tax,” this is what they’re discussing: getting rid of expensive loopholes that largely benefit the wealthy while lowering income tax rates for everyone.

Which system would you prefer?

D. Eric Schansberg, Ph.D., is professor of economics at Indiana University Southeast, a former Libertarian candidate for Congress and a member of the Bluegrass Institute Board of Scholars. Reach him at dschansb@ius.edu. He is the author of  "Turn Neither to the Right Nor to the Left," a Christian's guide to public policy.