Tax Simplification

Now that the election is over, and the fiscal cliff is looming, tax policy is back on the pundit's lips.    There is broad agreement across the political spectrum that our tax system is way to complex, often unfair and subjects government to unpredictible wild fluctuations in income.  Unfortunately, there are also tax breaks for particular interest groups spread across the political spectrum that makes changes to the system very difficult.

In generall all the proposal's I have heard don't really address the basic underlying flaw I see in the tax system that makes it so complex and convoluted.  In the 100 years since the income tax was reinstated (it had existed briefly during the time around the Civil War) the entire system has been based on drawing a distinction between invested capital and income from labor.  The theory is you don't want to tax capital because it can be invested to create jobs and wealth.  

The distinction is false to begin with because it looks backward to focus on where money came from rather than looking forward to see what the money is actually being used for in.   So a wealthy guy with lots of Capital gain can use $500,000 of his wealth for personal living expenses and pay 14% tax on that money, while a person who makes $500,000 in a year by working really hard and long hours is taxed at something like 30% or more on the full amount the income, even though he may invest $300,000 of it.

So in fact our tax system sometimes punishes money being used for investment and rewards the personal consumption of converting investment to personal use.  

What if we changed the whole underlying assumption of the tax law, allowed people to create capital accounts, and any money going into a capital account, or generated by the capital account, has no tax consequences?  Only money that comes out of the account for personal use is taxed, and it is taxed just like any other income that goes to personal expenses.  We target the tax benefit exactly on money being used for investment to reward investment and wealth creation, and target the tax on money used for personal expenses to cover the costs of government.

There could be minimal complexity with maintaining the capital account.  All the government would care about is when money goes to personal expenses.  As long as you keep pouring the income from the investment back into investment you don't have to engage in complex tax accounting.  There would have to be some rules to control the tendency of taxpayers to try to cover personal expenses with transactions in the capital account to avoid taxes, but that would be vastly simpler than the current system involving millions of pages of laws covering depreciation, deductions, characterizing income etc.

We couldn't do this overnight.  It would be way to disruptive.  So we start by allowing people to create capital accounts while we started closing loopholes and tax benefits in existing law.  The capital account would make investing vastly simpler and more efficient so over time investments would migrate into the capital account system.  Eventually we could abolish the old system without causing massive disruption in the economy.

This is not an idea that will be an easy sell in Washington.  It will take a long term, broad based effort by citizens to raise the idea to a level of credibility that a politician who values his job will be willing to sponsor it.