What is a Rational Tax Policy?

The last few posts have been for the purpose of establishing a foundation for a discussion of what a rational tax policy would be and then to proceed with such criteria to examine the tax policies of the Presidential candidates McCain and Obama. It is not possible to evaluate the soundness of their policies without thinking about the proper purpose for taxes and the least harmful ways to impose them upon the people.

First, the amount of tax money needed to operate a government should generally be determined by which derivative functions it can legitimately pursue as compatible with its fundamental function of protecting the right to life, liberty, and the pursuit of happiness of the individual. If our federal government carried out its work consistent with this constraint, the total federal budget would certainly be less than 40% of what it is now. This would allow huge tax reductions. Both state and local government functions are probably just about as bloated with respect to this purpose.

Second, all government budgets should generally be balanced, with tax income equaling government expenditures. Under severe depressions and during a life-threatening war, the last of which was WWII, government deficits are reasonable.

Third, taxes are not to be used to punish people who are either making high incomes, or who do not wish to buy a home, or who do not wish to install a photovoltaic panel on their rooftop, or who smoke or drink alcoholic beverages. Taxes are not to be used for social engineering purposes, since there is no way to do this which will not derive some people of their right to life, liberty, and the pursuit of their happiness.

Fourth, having satisfied the above conditions, taxes should be levied such that the economy as a whole will be able to sustain a maximal growth rate. The fundamental reason for this is based on the observation several posts ago that personal compensation income, including benefits, has been approximately fixed at 70% of national income for about the last 40 years. People across all income levels see their income grow as the national income grows. Thus, if you hold the best interests of anyone, poor or wealthy, at heart, the way to best improve their lives without doing actual harm to anyone else, is to establish policies which allow everyone the freedom to contribute to the growth of the economy. Putting excessively high marginal tax rates on the wealthy simply discourages them from working an additional hour they would otherwise have chosen to work. Or, it causes them to invest their income in a bigger home instead of more efficient machinery for their factory. With less efficient machinery, they cannot hire more employees or they have to fire employees, because a factory in China is making similar items for less. Or similarly, they invest their money in municipal bonds for the tax deduction, but what municipal activity grows the economy as well as their equipment investment would or as their hiring a new worker and providing him training so he can become productive?

Fifth, taxes should be simple and so straightforward that every voter knows very well how much he is paying in taxes each year. From this standpoint, pretending that an employer is paying half of the total Social Security and Medicare taxes is wrong. It is also wrong to tax corporations, because all of the taxes they pay are passed on to individuals in ways much too complicated for anyone to figure out. Ultimately only individuals pay taxes, so the tax should be levied on them directly so they can be aware of what the cost of government is to them. They must be in a position to determine whether the value of government programs equals their cost. Taxes are the equivalent to prices in the free market for government. In the free market each consumer decides which products and services and how much of each product or service he will buy based on his needs, desires, and prices. The voter should be doing the same with respect to government, albeit government limited by the principle of protecting individual rights, and the cost of government, which is given by taxes.

Personal exemptions on income taxes should be based on the cost of a person having sufficient, but just sufficient, means to feed, clothe, and house themself. No other tax exemptions should exist except qualifying medical expenses, which would not include certain types of cosmetic surgery, for example. This deduction should include the cost of medical insurance. This keeps income taxes fair and simple. The tax rate applied to taxable income should be the same for everyone. Programs such as Social Security and Medicare should be phased out since they are not a proper function of government and their functions should be handled by private industries, such as investments and insurance.

Unfortunately, governments have caused many incredible distortions of the free market with their tax policies of the past and present. People have bought homes eagerly of a size more than adequate to their needs in order to have some tax relief. Ending the home mortgage interest deduction would cause a collapse of the housing market. This is admittedly not an easy problem to solve. But, a drastic cut in the cost of governments as they retract to the size they should be, will allow those with homes to at least not be hit with a tax increase due to losing their deduction for the mortgage interest paid. Over time, a great reduction in the size of government and of taxes, will allow the economy to grow so much faster that people will want larger homes due to their greatly increased wealth. So, how do we get to no mortgage interest deduction from here without collapsing the value of homes on the market? Clearly, the deduction will have to be phased out slowly as the size of government is decreased. In year 1, 97% of the mortgage interest could be deducted, then in year 2 the deduction would be 94% of it, until 33 years down the road, there would be no such deduction. This schedule should be viewed as unchangeable by Congress so that everyone can calculate out the consequences of buying a home with a given size mortgage and not have to worry about arbitrary Congressional tampering with their biggest investment decision. Probably the same should be done with the deduction for state and local income taxes. This gives people a fairly long period to re-adjust their decisions on which states and local areas they will live in. These are long-term commitments that need to be made as a sacred covenant on the part of the government toward the people.

Social Security should also be phased out. The proposals to allow young people to invest a part of the present 12.4% in private investments is the way to go here. The part they are allowed to invest will increase over the years. On the other side, people are living much longer now and are much more healthy and generally can more easily find jobs which are not backbreaking than was the case when the Social Security system was begun. This means that people should be expected to work longer before drawing Social Security benefits. They have no right to draw more in benefits than younger people can afford to pay out in taxes. They voted over and over again for this Ponzi scheme, knowing full well that private investments would have provided them a much better retirement. So, benefits given out should not be extravagant. There should be consequences for choosing to do stupid things!

Similarly, Medicare should be phased out. This can also be handled in a very similar manner as with Social Security.

Corporate taxes as mentioned are simply passed on to individuals in many complex ways. If they were eliminated, then American corporations would be much better able to compete in the world economy. Prices for many goods and services would drop, corporations could make wise business decisions without having to worry about disrupting tax issues, they would export more goods abroad, they would hire more people and pay them better salaries, and they would invest more in equipment modernization and personnel training. There would be a serious resulting boost to the economy as a whole. At the least, corporate taxes should be as low as capital gains taxes, since the role of a corporation is largely one of making capital gains.

Capital gains are taxed without regard to the effects of inflation and without regard for the fact that defering the use of money for a period of time has an interest rate associated with it which should not be taxed for sure. So, what part should be taxed? This becomes complicated. Frankly, it is too complicated, so it is best to set this rate low and just be happy that with a low rate on capital gains, the economy is going to grow at a higher rate and in the end everyone benefits from getting their 70% share of the bigger economy. The capital gains rate should be considerably lower than the tax rates paid by the middle class on income at least. This gives the middle class incentive to invest and recognizes that capital gains are not corrected for deferred use of the money and for inflation. Of course inflation is supposed to vanish as governments learn to live within the much smaller budgets needed to fulfill their legitimate functions.

The Death Tax, which causes governments to dance upon the grave of the recently deceased, while they rip what remains out of the heart of grieving relatives and destroy businesses, whether farms or small manufacturing, retail, and services companies. This allows government to deprive employees, who may already have a struggle to keep the business going without the guidance of the owner, of a job. What sound government tax policy this is! This death tax is clearly all about punishing people who spent a lifetime building wealth and commonly providing many others with jobs. This is envy of the worst kind run amok. Sometimes it is claimed that relatives have not earned the income of an inheritance, therefore the government should keep them from getting it. This is not always true. Often family members have played a major role in helping to build a family business. Besides, if they are undeserving, they will commonly lose the inheritance soon enough. In any case, the on-going business and the wealth assets will be taxed into the future in the normal ways, so governments will get their income. Such businesses as do survive the death of the owner will often generate far more taxes over time than will a business sold in a fire-sale in order to pay inheritance taxes. The death tax is a clear example of political tom-foolery. We citizens who accept this disgrace are the Toms made fools of.

Now, I am not unrealistic enough to believe that this entire goal of returning government to its legitimate functions and thereby reducing its size is going to be accomplished in this upcoming election cycle. First, the people have to become committed to the essential principle of government limited to the purpose of protecting individual life, liberty, and the pursuit of happiness. Given that this will not happen soon, it is still advisable to judge the tax policies of politicians on your rational goals, rather than as a cost-free promise of Christmas gifts all year long, as many voters do.

Politicians will always skew their tax plans in a direction designed to win enough votes to be elected to public office. Some count on the electorate being absolutely uninformed about the economy, business, and of course the function of government. Some are in love with class warfare and play on people's envy for those who might have more worldly goods and income than they do. They know that few voters have even read the Constitution. They know that few voters have read much history and tried to learn its lessons over the ages. They count on voters only seeing the first and most obvious effect of any law, including any tax law. They describe the economy as a pie of fixed size, simply to be cut up in different ways. They count on being able to fool most of the people most of the time. And, they have a long track record of showing that they are masters at doing so! They almost never get voted out of Congressional office until they wish to leave. Yet, most of them vote for bills which are clearly not in the best interest of the people and are certainly not limited to functions necessary to protect individual life, liberty, and the pursuit of happiness. They are masters at using the tax code to manipulate one group of people against other groups of people and give out favors to those they want campaign donations from and whose vote they want.

Still, there are sometimes politicians whose tax plans are more fair and more likely to encourage the growth of the economy than are the plans of the completely committed socialists and demagogues. There are politicians who are counting a bit less on the ignorance of the mass of voters. There are some politicians whose time-horizon is a bit further out than that of others. I will try to judge the plans, as best they are known, of the candidates for the presidency. I will also try to assess the commitment of each based on his prior commitments and his prior votes.