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Addition by Deduction

If the tax code encouraged people to provide for themselves, we'd have a better government and a freer society.

by James Leroy Wilson
April 16, 2008

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Addition by Deduction

Revised April 18, 2008

Tax Day has come and gone. Each year, the high stress and long hours associated with income tax filing prompt many to call for a better system that is simpler, less stressful, and costs taxpayers and the government less.

But the main problem with the tax code is that government tries to do too much. This requires a high tax bill, but not everyone can pay the price, so the tax code becomes exceedingly complex to make it "fairer" and to encourage some socially beneficial behaviors over others.

Many people and organizations have come up with tax reform plans. I believe most of them would be better than what we have now, and I would prefer some of them over what I'm proposing today. But what I'm suggesting here is more moderate than scrapping the income tax. It is instead a proposal to make the income tax work for us.

The cause of America's fiscal troubles, which require a large tax bill to begin with, is that the federal government has added retirement savings, health care, education, and welfare (charity) to its obligations. And then we confuse "entitlements" with "safety net." A "safety net" program keeps people from destitution, and it shouldn't give money to people who are already well-off. In order to "save" Social Security and Medicare, they can no longer exist as "entitlement" programs and should transition into genuine safety-net programs. But this means people would have to save their own money and pay for their own medical expenses. The question is, how?

There are plans like this already: 401(k)'s and similar retirement programs, and Health Savings Accounts (which Ron Paul wants to expand), where people can reserve part of their income for health expenses. This money is withheld by employers and placed into personal accounts, and would not be taxed. I suggest expanding these programs, and adding education and charitable giving to them.

Here are features of the plan:

First, get rid of FICA taxes. FICA taxes are just a devious form of flat tax to deceive people into thinking they are contributing to separate Social Security and Medicare accounts, rather than to the federal government's general fund.

Second, allow people to withdraw from Social Security and Medicare, by getting back the money they paid in, or by transferring their money into interest-bearing bonds. These programs will remain faithful to individuals currently dependent on them, but revenues and expenditures will come from the general fund. The illusion of separate accounts and "lockboxes" will disappear. And as people drop out of the programs and current beneficiaries pass away, these programs will transform into anti-poverty programs for the truly needy, and not entitlement programs for everyone.

Third, create four classes of individual accounts: Retirement Savings, Health Savings, Education Savings, and Charitable, and allow individuals to contribute as much as they want into these accounts. The amount people put into these accounts will be up to them. In most instances, people couldn't withdraw from their retirement account until they reach retirement age, whereas the health and education accounts can be withdrawn from to pay medical bills, tuition, and other health and education expenses. And money that is not withdrawn can accrue interest. Charitable accounts, however, must be completely spent by the end of each year.

Financial institutions, medical providers, schools, and charities that want to attract customers holding these accounts would have to be registered and approved with the government to guard against waste and fraud, so that the government knows that this tax-free money is actually spent on the purposes its supposed to. Yes, this may invite government regulation. Nevertheless, the government wouldn't actually be directly be funding them, and no institution will be forced to register. Institutions that don't register, however, won't be able to receive money from these individually-controlled, tax-free accounts. For instance, a woman who wants to spend money at, say, an unregistered health professional would be free to do so, but couldn't use money from her Health Savings Account. 

Beginning with the date of enactment, people could pay off old debts from their retirement account, but not new debts acquired after enactment. People could also pay off old school loans from their education account, but not new ones as the intention is to discourage going into debt to pay for school. Medical accounts could pay for insurance and deductibles, but also could be saved for rainy days and emergencies, and accrue interest in the meantime. And the money in these accounts can be transferable and inheritable, provided they're reserved for the same uses. For instance, a husband could inherit the retirement account of a wife who dies young. If you want to help out a sick neighbor boy, you can transfer some money from your own Health Savings Account to help pay for his medical bills. Donations to schools and scholarship funds could be withdrawn from your Education Savings Account.

Individuals could then deduct all the money, up to a certain amount (I'm thinking $50,000 per household, a little more or less according to number of dependents) that they had deposited into their Retirement, Health, Education, and Charitable accounts when computing their taxable income for the year. The more people contribute to their own family's retirement, health, and education, and to causes they believe in, the lower their tax bills will be. This is because they will not be as dependent on the government, and so the government won't have to spend so much.

The fourth feature of the plan: a flat tax rate on all taxable income - I'm thinking 20%. This will greatly simplify the tax code, and save countless hours of headaches.

Here's how it would work: let's say two people earned $80,000 during the year, and each had standard IRS deductions/exemptions totaling $30,000. Person A contributed the maximum deductible amount, $50,000 total, to his Retirement, Health, Education, and Charitable accounts. Person B contributed nothing to these accounts. Person A would have no taxable income ($80,000 - $30,000 - $50,000), while Person B would pay taxes on $50,000 ($80,000 - $30,000 - $0). Assuming a flat 20% tax rate, Person A would pay no tax on $80,000 in income, whereas Person B would pay $10,000 on the same income amount - and will have saved nothing for his own education, medical expenses, or retirement.

The only taxpayers will be those already making a good income, and those who make less but don't want to bother putting their own money into their own future.

And this brings us to the last feature: Beyond this limit ($50,000 or whatever it will be), individuals will still be able to donate half their income to charity tax-free. So if Person A  making $80,000 in the example above got a raise to $200,000, only $120,000 would be taxable income. But if he gave half of that to charity, his taxable income would be down to $60,000. And he would be helping society on his own terms the way he wants, not the way bureaucrats want.

The more more people save for their own retirement, the less Social Security will be needed. Likewise, the more people provide for their own - and each other's - medical care and education, the less government support will be needed. And the more people are encouraged to give - to anti-poverty programs, substance-abuse centers, medical research, etc. - the more social progress will be made without government interference or Big Government spending.

The more civil society takes care of itself, the less government we would need. Ideally, we wouldn't need a transition from government programs to "government-approved" private institutions, but in this plan private institutions wouldn't be directly subsidized by the government, and individual choice, not bureaucrats, will decide where one's retirement, medical, educational, and charitable spending will go. Even if they are registered and regulated, private entities will still have greater incentive to be efficient and customer-friendly than the government does.

The result will be a more prosperous American public less burdened by taxes and debt. Increased savings will expand the pool of capital and lead to more production and more jobs. Moreover, government will be disinclined to waste money, as more and more people will opt to pay less in taxes and spend more on their own future and well-being. Indeed, many government programs will be judged unnecessary, and the people will clamor for ever-larger deductions and lower tax rates. People will be more generous in providing help to neighbors and in giving to charity, and fewer people will come to the government for help. The less it is burdened with retirement, health, education, and welfare, the more the federal government could focus on its Constitutional duties of defense and trade policy. Instead of Big Government, we would have better government.

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