What does the Heritage Foundation have to say about potential tax reform:Study released May 10, 2011 (Part 2)

Obama’s Tax Hike: The Movie

“Saving the American Dream: The Heritage Plan to Fix the Debt, Cut Spending, and Restore Prosperity,” Heritage Foundation, May 10, 2011 by  Stuart Butler, Ph.D. , Alison Acosta Fraser and William Beachis one of the finest papers I have ever read. Over the next few days I will post portions of this paper, but I will start off with the section on tax reform.

The Details

A Unified Single Tax Rate. The Heritage tax reform plan is far more
comprehensive than previous well-known tax reform proposals. Typical of many tax
reform proposals, our plan replaces today’s individual and corporate income tax
systems and eliminates the death tax. In lieu of the current motley collection
of taxes, this plan institutes a simple, single-rate tax on individuals and
businesses. It also folds today’s federal payroll taxes financing Social
Security and Medicare into the new system, establishing a single tax rate for
all taxpayers. In addition, it replaces all federal excise taxes except those
dedicated to specific trust funds, such as the gasoline tax, which would be
retained until that tax and its associated highway program are devolved to the
states.

Tax Rate. The tax system is designed to raise a permanent revenue
stream of up to 18.5 percent of the economy as measured by GDP. With the design
characteristics of this new tax system, we estimate that the statutory
individual and business tax rate will likely eventually be between 25 percent
and about 28 percent under traditional scoring methods. This is comparable to or
significantly below the typical rate facing an individual or family today. Most
working families today are subject to a 15.3 percent payroll tax rate on wages
and salaries plus a 10 percent, 15 percent, 25 percent, or 28 percent individual
income tax rate for a combined rate of 25.3 percent, 30.3 percent, 40.3 percent,
or 43.3 percent.

A Simplified System. The basic structure of this tax plan is simple.
With its single rate, it taxes uniformly all income sources that are spent on
consumption. This means that taxable income includes all labor compensation and
all net borrowings. The net amount put aside in savings is then subtracted to
determine net taxable income. Thus, the more individuals or families save, the
lower their taxes; they pay tax on savings only when savings are used to pay for
goods and services.

However, the new tax system does not tax government transfers explicitly
associated with low-income citizens, such as welfare, health care assistance,
and similar programs. Ultimately, when the Social Security and Medicare programs
are fully reformed, the Social Security checks and premium support that seniors
receive will not be taxed either. In the Social Security and Medicare transition
periods, a portion of the benefits of some seniors will be taxed if their income
is above a certain amount, just as many seniors’ Social Security is taxed
today.

Thus, the new tax system offers individuals and families a comparable or
lower tax rate and vastly improves their savings incentives to build wealth and
ensure their own financial security. It simultaneously improves the ability of
the economy to raise wages and provide more job opportunities. And filling out
tax forms will be a lot simpler.

An Alternative Option for Savings. For some purposes, many taxpayers
today prefer to save after-tax dollars as permitted through the current-law Roth
IRA rather than paying tax when funds are withdrawn as under today’s traditional
IRA. This Roth-style alternative maintains the principle of a single incidence
of taxation but may result in further increased saving by giving savers an
additional option. To allow such accounts for those who feel they need them, the
plan permits taxpayers to contribute after-tax dollars to an account,
contributing as they choose until the account balance reaches $100,000, with a
limit of one account per adult taxpayer. The income earned on the account is
tax-free, and disbursements from the account are tax-free for any purpose.

Few Deductions or Credits. Under the Heritage tax plan, the individual
income tax has only three deductions instead of the legion of deductions under
current law:

  • Higher education. Recognizing the role of higher
    education as a form of saving and investment in human capital, a deduction is
    allowed for tuition and expenses for higher education up to the average annual
    cost at a four-year public college or university.
  • Charitable donations and other gifts. Since the tax is
    levied on consumption, gifts are not taxable until they are spent by the
    recipient. Thus, per current law, gifts to nonprofit organizations are tax
    deductible if the organization is recognized as tax-exempt for tax purposes.
    Gifts to individuals and transfers through inheritance are deductible and become
    taxable to the recipient only when spent on consumption. And there is no death
    tax.
  • Mortgage interest. As under current law, homeowners can
    deduct mortgage interest while the lender continues to be taxed on mortgage
    interest income. Homeowners are also given the option of forgoing the deduction,
    in which case the lender is not taxed on mortgage interest income and market
    pressure would encourage the lender to offer a lower mortgage interest rate.

Protections for Low-Income Working Households. Current law hits
low-income workers and others with the full weight of today’s payroll taxes,
whatever their wage and salary income may be. The Heritage tax plan folds all
payroll taxes—or FICA—into the single tax system. It then eliminates all income
tax on low-income workers through the health insurance tax credit described
above (a $3,500 nonrefundable tax credit for families and $2,000 credit for
individuals). In addition, the Earned Income Credit is retained as part of the
overall system of financial support for low-income Americans. Further, the
calculation of taxable income excludes all other cash and noncash benefits
provided by the federal government through its anti-poverty programs, such as
food stamps. The net effect is that, compared to current law, this plan provides
substantial tax relief to low-income workers and families.

Protecting Low-Income Seniors. For Medicare-eligible senior citizens,
the measure of taxable income is modified to ensure that the flat benefit
amounts for Social Security and the Medicare defined contribution are tax-free.
Thus, lower-income seniors will not be pushed back into poverty by the tax
system after Social Security and Medicare have lifted them out of poverty. As
noted earlier, during the lengthy transition period for the Heritage plan’s
Social Security reform, some seniors above certain incomes with relatively high
benefits will pay tax on part of those benefits, but they will pay less than
many do today.

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