3. Better Integrate Income and Social Security Taxes

A more fundamental reform would involve better integrating the income and Social Security tax systems. Much of the complexity of the current tax system results from imposing Social Security taxes on every dollar of earned income and then using the earned income credit to refund much of those taxes to low-income workers. Wouldn't it be simpler if the federal tax system simply did not collect Social Security taxes from low-income workers in the first place?

One approach would be to add standard deductions and personal exemptions to the current Social Security tax system or to allow each worker to exempt, say, the first $5,000 or $10,000 of earnings from Social Security taxes.

9

10

A more thorough approach would be to combine the individual income and Social Security taxes into a single, comprehensive income tax. Individuals with incomes below some poverty threshold would be exempt from tax, and tax rates could be increased in order to raise the same amount of revenue. In effect, there would be a single, higher-yield income tax instead of the current bifurcated tax system, and millions of low-income individuals would no longer have to file returns.

11

4. Move to a Flat Tax

Yet another approach would be to replace the current income tax with some form of "flat tax. The underlying tax base could be either income or consumption. The key is that, above a certain threshold, a single tax rate would apply. To keep the single rate low, most flat tax plans would get rid of many if not all itemized deductions. Proponents of flat taxes are fond of saying that most individuals would be able to file their tax returns on postcards.

5. Move to a Return-Free Tax System

12

Another approach would be to move toward a return-free tax system. In 1987 the IRS issued a report in which it explored the feasibility of moving to a return-free system. 13 Under the type of return-free system that the IRS envisioned in that report, most Form 1040EZ and Form 1040A filers and a few Form 1040 filers could elect to have the IRS compute their tax liabilities and prepare their returns -- some 55 million taxpayers, in all.

9

Id. at 184-86; George K. Yin & Jonathan B. Forman, Redesigning the Earned Income Tax Credit Program to Provide More Effective Assistance for the Working Poor, TAX NOTES, May 17, 1993, at 951.

13

INTERNAL REVENUE SERVICE, CURRENT FEASIBILITY OF A RETURNFREE TAX SYSTEM (1987).

For a variety of reasons, the IRS decided not to implement this system. In truth, the IRS system was not really "return-free." Rather, at a taxpayer's election, the burden of preparing the return would shift from the taxpayer to the IRS. Taxpayers would save some time filing their returns, but many would have to wait longer to get their refunds. Also, the return-free system would increase the burdens on the IRS and on employers and other filers of information documents. To generate tax returns, the IRS then estimated that it would need to timely receive, verify, and post more than 970 million wage and information documents. And the IRS estimated that it would cost over $1 billion and require about 17,000 additional staff to implement the return-free system.

Another alternative would be to move to a so-called "final withholding" tax system. Final withholding tax systems are similar to return-free systems, except that they rely more heavily on withholding. Under a final withholding system, the amount withheld from employees and other income sources is the tax, thus eliminating the need for many taxpayers to file tax returns. Over 30 foreign countries use some form of final withholding, including the United Kingdom, Japan, Germany, and Argentina.'

14

For example, in the United Kingdom, the income tax is withheld by employers under the PAYE (Pay As You Earn) final withholding system. When an individual first becomes potentially subject to tax, an initial return must be filed so that the Inland Revenue can determine how much the employer should withhold. Thereafter, individuals with simple incomes and modest earnings are normally required to make a return of income only about once every five years. In 1999-2000, about two-thirds of British taxpayers were able to avoid filing returns.

15

Would a final withholding system work in the United States? A final withholding system could significantly reduce burdens on both taxpayers and the IRS. In its analysis of the issue, the General Accounting Office concluded that most taxpayers who now file 1040EZ returns [about 20 million in 1998] and many of those who now file 1040A returns [about 26 million in 1998] could be served by a final withholding system. Most of these people no longer would have to gather information, become familiar with tax laws, or prepare and file returns. The burden on the IRS also would be greatly reduced.

16

More recently, pursuant to Section 2004(a) of the Internal Revenue Service Restructuring and Reform Act of 1998, the Secretary of the Treasury is required to develop procedures for

14 See, e.g., U.S. General Accounting Office, Internal Revenue Service Opportunities to Reduce Taxpayer Burdens Through Return-Free Filing (GAO/GGD-92-88BR) 22-33, 36 (1992).

15

Treasury Testimony at Senate Appropriations Treasury Panel Hearing on Return-free Tax Systems, 2000 TAX NOTES TODAY 73-21 (April 14, 2000) (testimony of Treasury Deputy Assistant Secretary for Tax Analysis Leonard E. Burman).

16 Treasury Testimony at Senate Appropriations Treasury Panel Hearing on Return-free Tax Systems, 2000 TAX NOTES TODAY 73-21 (April 14, 2000) (testimony of Treasury Deputy Assistant Secretary for Tax Analysis Leonard E. Burman).

17

implementing a return-free system by the year 2008. Also, early in April of 2000, the Treasury Subcommittee of the Senate Appropriations Committee held a hearing on return-free filing

18

systems. In particular, the Subcommittee considered a proposed bill by Senator Byron Dorgan (D-N.D.) that would let millions of taxpayers elect return-free filing.

APPENDIX

19

The two tables in this Appendix show that hardly any low-income workers will owe federal taxes for the year 2001. At the outset, Table 1 compares the 2001 federal tax thresholds and poverty income guidelines for unmarried individuals and for married couples."

20

Consider a family of four consisting of a married couple and two children. Row 1 of Table 1 shows that this family unit's poverty income guideline for 2001 is $17,650.11

17 Rossotti Testimony at Senate Appropriations Treasury Panel Hearing on Return-free Tax Systems, 2000 TAX NOTES TODAY 73-22 (April 14, 2000) (testimony of Commissioner of Internal Revenue Charles O. Rossotti).

(2000).

18

Amy Hamilton, IRS Helps Dorgan Develop Return-free Plan, 87 TAX NOTES 335

19 Senator Dorgan=s bill was subsequently introduced as S. 3087, 106th Cong., 2d Sess. (2000), 146 CONGRESSIONAL RECORD S8948-49 (daily ed. Sept. 21, 2000) (statement of Sen. Dorgan).

20

The table reflects the assumptions that all family income consists of wages or salaries earned by a single worker, that families of two or more include a married couple (rather than an unmarried head of household with one or more dependents), that all family members are under age 65 and not blind, that all family units are eligible for the earned income credit, and that all children qualify for the child tax credit. Also, only the employee's portion of Social Security taxes is considered.

21 U.S. Department of Health & Human Services, supra note 4.

TABLE 1. POVERTY LEVELS AND NET FEDERAL TAX THRESHOLDS AFTER TAX CREDITS IN 2001, BY FAMILY SIZE, UNMARRIED INDIVIDUALS AND

Row 2 of Table 1 shows the simple income tax thresholds for family units of different sizes. These are determined by summing each family unit's standard deduction and its personal exemptions. For 2001, a married couple with two children can file a joint tax return and claim a $7,600 standard deduction and four $2,900 personal exemptions.22 Consequently, the couple will not have to pay any income tax unless its income exceeds its $19,200 simple income tax threshold ($19,200 = $7,600 + 4 x $2,900).

Row 3 of Table 1 shows each family unit's income tax threshold after taking into account the effects of the earned income credit23 and the child tax credit. For example, for 2001, a

22 Rev. Proc. 2001-13, supra note 3.

23

24

Internal Revenue Code (I.R.C.) '32. The earned income credit is a refundable credit available to certain low- and moderate-income workers.

For 2001, childless individuals between the ages of 25 and 65 are entitled to an earned income credit of up to $364. The credit is computed as 7.65 percent of the first $4,760 of earned income. The maximum credit is reduced by 7.65 percent of earned income (or adjusted gross

typical married couple with two young children can claim an earned income credit of up to $4,008 and two child tax credits of up to $500. Consequently, taking into account their earned income and child tax credits, a typical married couple with two children will not actually owe any income tax until its income exceeds $29,520.

25

On the other hand, because the Social Security tax system has no standard deductions or personal exemptions, family units must pay Social Security taxes starting with their first dollar of

income, if greater) in excess of $5,950 and is entirely phased out at $10,710 of income. Rev. Proc. 2001-13, supra note 3.

Individuals with one qualifying child are entitled to an earned income credit of up to $2,428. The credit is computed as 34 percent of the first $7,140 of earned income. The maximum credit is reduced by 15.98 percent of earned income (or adjusted gross income, if greater) in excess of $13,090 and is entirely phased out at $28,281 of income. Id.

Finally, individuals with two or more qualifying children are entitled to an earned income credit of up to $4,008. The credit is computed as 40 percent of the first $10,020 of earned income. The maximum credit is reduced by 21.06 percent of earned income (or adjusted gross income, if greater) in excess of $13,090 and is entirely phased out at $32,121 of income. Id.

24 I.R.C. '24. The child tax credit is available to individuals with dependent children under the age of 17. For 2001, the credit is $500 for each qualifying child. The credit begins to phase out when modified adjusted gross income (AGI) reaches $110,000 for joint filers, $55,000 for married couples filing separately, and $75,000 for unmarried individuals.

The child tax credit is generally nonrefundable; however, a portion of the credit may be treated as refundable if a taxpayer has three or more qualifying children and the taxpayer's Social Security taxes exceed any earned income credit that is claimed. This is referred to as the "additional credit for families with three or more children." I.R.C. ' 24(d). A portion of the nonrefundable child tax credit may also be treated as refundable if a taxpayer (irrespective of the number of qualifying children) claims an earned income credit in excess of Social Security taxes paid. This is referred to as the "supplemental" child credit. I.R.C. ' 32(n).

25 Algebraically, each computation in Row 3 involved determining the appropriate equation for computing each family unit's income tax liability after its earned income and child tax credits and solving for the income level at which that income tax liability is equal to zero.

For example, for 2001, for a married couple with two children with income (I) in excess of its $19,200 simple income tax threshold but less than the $32,121 level at which its earned income credit is fully phased out, the couple's income tax liability (T) can be determined by the following formula:

T = .15 x (I- $19,200) - ($4,008 - .2106 x [I- $13,090]) - (2 x $500).

Setting T equal to zero and solving for I shows that the couple's income tax threshold after the earned income and child tax credits is $29,520.