Taxation in the United States the Taxation

Taxation in the United States

The taxation system of the United States of America is flawed in many ways; meanwhile there are some benefits of this system as well. The current taxation system of the United States needs to be analyzed to point out the flaws in the system. The main purpose of this paper is to discuss the current components of this system with respect to the flaws and good things about it, to discuss the problems relevant to the particular taxes and what can be done to solve these problems. Before we go on to analyze the system, it is important for us to know the components of the taxation system and the types of taxes that are imposed on the people in the country.

Overview of the Current System

The United States of America is known as a federal republic. This implies that it is composed of autonomous local and state governments. Taxes are imposed in the United States of America at each of the aforementioned government levels. The taxes that have been imposed in the country consist of income, sales, property, payroll, imports, gifts and estates along with numerous fees. In the year 2010, the taxes that were collected by the municipal, state and federal governments totaled up to 24.8% of the Gross Domestic Product. It is important to note here that the taxation system of the United States is known to be one of the most progressive tax systems in the developed or industrialized world[footnoteRef:2]. [2: U.S. Federal Individual Income Tax Rates History, 1913 -- 2011, 2011.]

The imposition of taxes is done on the gross income of the corporations as well as the individuals by the federal government, most state governments as well as some local governments. Residents and citizens have to pay taxes on worldwide income and they are also allowed a credit as far as foreign taxes are concerned. The income tax is determined by making use of the tax accounting rules and not the principles of financial accounting. Almost all income from every source is included is subjected to taxation in the United States. Due to many business expenses, the income that is taxable is reduced, although there is a limit when it comes to some business expenses. Individuals are allowed to reduce their taxable income by specific nonbusiness expenses, personal allowances that include interest on home mortgage, local and state taxes, and medical expenses, contributions to charity organizations and by other expenses that are made above specific percentages of income. On the other hand, the state rules for determination of taxable income are often different from the federal rules. The rates of federal tax vary from 10 to 39.6% of income that is taxable. Depending upon jurisdiction, the local and state tax rates vary widely from 0 to 13.30%. It should be noted here that most of the aforementioned tax rates are graduated. Generally, the state taxes are considered as one of the deductible expenses for the determination of federal tax. In this year (2013), the top most marginal tax rate for a resident of California (high-income) was 52.9%. Some specific alternative taxes may also be imposed.

It is important to note here that America is the only country in the world that imposes taxes on its nonresident citizens for their worldwide income, just in the same way and with the same rates as they tax their residents. The constitutionality of the payment of the aforementioned tax was upheld by the Court pertaining to the case of Cook v. Tait in the year 1924.

Types of Taxes

The federal as well as all the state governments impose payroll taxes. Medicare and Social Security taxes are also included in the payroll taxes and are payable by the employees as well as the employers. The combined rate of this tax is 15.3%; meanwhile it was 13.3% in the years 2012 and 2011. The Social Security tax is applicable only on the first $106,800 of income in the years 2009 through 2011. Nevertheless, benefits are only accumulated on the first $106,800 of the income. It is the duty of the employers to withhold the income taxes on the salary of the employees. Unemployment tax along with many other levies is also paid by the employers.

Most local governments impose the property taxes. Apart from that, many special purpose organizations also impose this tax based on the value of property in the fair market. School as well as other authorities are governed separately and therefore separately taxed. Generally, property tax is applicable on realty. Even though, there are some jurisdictions that tax some types of business property as well. The rates and rules of property taxes vary considerably.

Most states and come local governments impose sales tax on the price at retail sale of most products and also some services. Depending upon the different jurisdictions, the rates of sales tax vary from 0 to 16%. Moreover, the rates can also differ within a jurisdiction on the basis of specific goods or services that are taxed. The seller is the collector of the sales tax when the product is being sold, or when it is remitted in the form of use tax by purchasers of items that are taxed.

The individual mandate of the Affordable Care Act and the Patient Protection also come under the category of taxation.

On the important of most kinds of good, the United States has imported custom duties and tariffs as a part of many jurisdictions. The custom duties and tariffs have to be paid before the legal import of the goods that are taxed. The rates of this tax differ from 0 to 20%, on the basis of the country of origin from where the goods are being imported and the particular goods.

Gift and estate taxes are imposed by some state governments and the federal government when property inheritance is transferred by life time donation or by will. Just like the federal income taxes, the gift and estate taxes are also applicable on the worldwide property of residents and citizens that are allowed a credit pertaining to foreign taxes.

Types of Taxpayers

As mentioned earlier, taxes can be imposed on business entities, individuals, trusts, estates or other forms of organizations. The aforementioned taxes are based on income, property, transfers, transactions, and import of goods, some business activities and on a number of other factors. Moreover, the taxes are imposed on the kind of taxpayer for whom one of such tax bases is relevant. Therefore, the property tax will be imposed on owners of real estate or other forms of property. Apart from that, some taxes, specifically income taxes might be applicable on the members of different organizations for the activities of the organizations. Thus, partners that are in a partnership are taxed individually.

With some exceptions, if a tax is imposed by one level of the government, the other level does not imply that same tax.

Tax Administration

Hundreds of tax authorities are responsible for auditing and collecting the taxes in the United States. There are three tax administrations at the federal level. As for most of the domestic federal taxes, these are administered by the Internal Revenue Service. The aforementioned organization is a part of the Department of the Treasury. Firearms, tobacco and alcohol taxes are administered by the Tobacco and Alcohol Tax and Trade Bureau, also referred to as the TTB. Custom duties and tariffs on the imported goods are administered by the United States Customs and Border Patrol. TTB is a branch of the Department of Justice. As for the Customs and Border Patrol, it is a part of the Department of Homeland Security.

The organizations of local and state administration differ considerably. Every state has to maintain its own tax authority and administration. There are some states that administer some local taxes in part or as a whole. As for most of the local governments, they maintain a tax administration department of their own or can share one with one of their neighboring local governments.

1.2 Rationale of the Study

As mentioned in the beginning of the paper, there are many flaws in the taxation system that is being employed in the United States. Since the burden of the taxation system lies on the shoulders of the general public, it is important for us to highlight the problems within the system so that they can be sorted out. The main objective of this study is to pin point the problems and flaws of the tax system in the country and then provide solutions or recommendations to solve these problems.

Part 2: What is wrong with the system?

2.1 Complexity

The United States tax system is in fact one of the world's most complicated systems. Since most Americans are aware of the fact that the tax code has become so complex that the situation seems hopeless at times, with exclusions that are worth an encyclopedia with workarounds that seem to favor that one percent and the big firms that are able to induct the best and most competent tax professionals. If an individual or a company is inefficient, the person or the organization will be required to pay higher tax rates than those that are being paid with ones that are 'efficient'. This implies that government will be generating way less revenue than it actually needs. There is another depressing consequence of the complex tax system: This system makes the people of the United States distrustful of the government and therefore these people do not tend to support the steps that are taken by the government to make the system better in any way.

2.2 The tax code is rather regressive than progressive

The Tax Foundation of the United States particularly emphasizes on the fact that the top 10% of the taxpayers gave 70.6% of the income taxes in the year 2010; meanwhile the figure was as low as 54.6% in the year 1986.

The aforementioned information might be good news for some people, but this information is incomplete. First of all, one needs to compare the income of each group when comparing their share in the taxes. For example, if the top 10% of the taxpayers pays 70.6% of the taxes and earns 70.6% of the income, then you cannot call this system a progressive one. The state and local taxes along with the payroll taxes also need to be accounted for. Since most of the states have a regressive taxation system, the general progressivity of the overall system is reduced. According to a new report that has been issued by the Citizens for Tax Justice, which is tax analysis shop, explains the whole situation. The conclusion of the report is that the tax code can still be referred to as progressive one, but not to the extent that it is significant[footnoteRef:3]. [3: Matthews. "U.S. tax code isn't as progressive as you think," 2013]

The chart below shows the distribution of the taxpayers pertaining to their income and share in the tax money.

The last 80% of the income distribution shows that the people pay less than their share of income, but not significantly less. Moreover, the 20th through 60th percentiles get to have a bigger break as compared to the people who are a part of the poorest 20%. In other words, it will not be wrong to say that there is a bias in the tax code for the middle-class over the lower class.

Even though the richest Americans have to pay more than what is their share of income pertaining to taxes, the margins are not any significant. The top one percent of the taxpayers pay around 24% of the overall taxes, but on the other hand they earn 21.9% of all the money.

Generally, the American taxation system is considered to be one the most progressive ones in the developed and industrialized world, most social democracies including Germany, Sweden and France have a significantly regressive system that relies heavily on the value-added taxes. Yet again, the pay-outs of United States are not very progressive and therefor the government tries to decrease the injustice through the taxation system and therefore transfers way less than some of the aforementioned countries.

2.3 Tax Expenditure with respect to Fairness

The spending that is done through the federal tax code is rather a stealthy one. Some analysts claim that the code has been slated with "tax expenditures," which include many programs, out of which many of them are worthy, devised to promote policies pertaining to the departments of homeownership, retirement savings and education. However, there are two main problems with this kind of approach.

First of all, this approach is devoid of any accountability and transparency. Since the direct spending programs are continuously reviewed, the spending that is done as a part of the tax system is rather a silent one. Once a preference is made a part of the code, chances are high that it will remain in the place unless it is dislodged.

Secondly, the accomplishment of a social policy by making use of the tax expenditures has a tendency to award most of the help to the people need it the least. According to a new report that has been issued by the Annie E. Casey and the Corporation for Enterprise Development, the federal asset-building budget worth of $400 billion that should include subsidies to buy homes, save money for education or make a plan for retirement is in fact upside down. Instead of decreasing the inequality that exists with respect to the income, the tax expenditure approach reinforces it. The people that belong to the group of low-income households do not make enough earnings so that they can itemize deductions and therefore they do not get any benefit from the tax system. As for a middle-class household that earns around $50,000 every year in fact receive benefits worth of less than $500 from the property taxes and investment income and from tax breaks for mortgages, according to the report.

Something is definitely not right with the taxation system. It is true that higher-income households also pay higher rates of taxes and have a greater share in the overall taxes. However, the benefit that they receive is disproportionate; the benefit is even bigger than their share in the tax. According to the report, "Since the overall share of the tax code for the top 1% of the taxpayers was 27.7% in the year 2005, their share of gross benefits with respect to asset policies in the same year were more than 45%."

In the years to come, the financial pressure will require the analysts to look at the tax code closely. This analysis should include thoughtful consideration of the current subsidies and whether or not they are sensible and have been sensible allocated. Particularly, research needs to be done pertaining to the existing deductions and whether they should be restructured as credits or should be marginalized.

2.4 Ineffectiveness

Studies have demonstrated how the taxpayers have to fact the complexity of the taxes that is resulting in the rise in compliance costs. The people have to fill numerous number of tax forms with long instructions and the returns of the taxes are being cluttered with special breaks and credits. The number of tax breaks with respect to energy and education has increased in the last ten years. Unfortunately, the political stimulus for social engineering has given rise to a mess in the tax code and has resulted in a rise in inequities among the general public of America. There are four ways in which the complexity of the tax system results in its ineffectiveness. First of all, the annual compliance costs of almost $265 billion have been created because of the activities related to learning tax rules and record keeping. The increase in the complexity of the system has resulted in the brightest minds of the nation getting caught up in the tax industry and in the planning of taxes and designing tax shelters along with the battle that constantly goes on with the Internal Revenue Service. Efficient economic decision making is also impeded by the complexity of the system. The complex rules for capital gains, depreciation along with other items make it hard for the businesses to make decisions about mergers, investments and acquisitions. As for the individuals, the complexity of the tax system confuses the people and they find it quite hard to make important life decisions like starting a new business or planning for retirement. According to survey that was conducted in 2005, two thirds of all the taxpayers were unable to answer basic questions pertaining to the tax rules that imposed on education incentives, homes sales, retirement savings etc.[footnoteRef:4]. [4: Effective tax rates: income, payroll, corporate and estate taxes combined, 2013]

Thirdly, invasion of privacy on behalf of the government is also promoted because of the complexity of the system. All the special breaks of the code are enforced, including housing and education, by IRS after hunting for volumes of forms and documentation. Moreover, since the capital income is treated in a complex manner under the income tax, the Internal Revenue Service has to gain access to a wide range of personal financial information. On the other hand, under a flat tax that is based on consumptions, tax would be imposed on the capital income at the business level, which would result in decreased privacy invasion and simplified personal finances. Finally, frequent errors are caused by the taxpayers and the Internal Revenue Service because of the unclear and complex rules of the tax system. On the other hand, they also make the matters worse for non-compliance with the law. According to a recent report, the gap between actually paid taxes and federal taxes that are owed is almost $345 billion every year.

Complexity along with high tax rates have resulted in avoidance of taxes by many people, as was also seen in the Enron scandal. As for the businesses, either the corporate income tax should be dislodged or at least should be replaced with a tax system that is low-rate cash-flow in nature.

Part 3: Recommendations

Incremental reforms are basically the reforms that could be made to the current tax system of the country to make it an even better tax system. These reforms aim at making adjustments to the current system so that the process is made simpler, leaves less of an adverse effect on the behavior of the taxpayers or shifts the distribution of burdens of taxes.

Since the nature of the tax system is very complicated, the imposition of the individual income tax results in increased cost on the taxpayers, who have to spend their time and money in preparing and filing tax returns. On the other hand, the Internal Revenue Service also has to spend a great deal of time and money to audit those returns and the organization also has to deal with the numerous mistakes that have been made by the taxpayers because of the complexity of the system. If steps are taken to simplify the system of income tax, cost could be reduced significantly for the Internal Revenue Service as well as the taxpayers[footnoteRef:5]. [5: Edwards. "Options for Tax Reform," 2005]

3.1 Eliminate or align income limits and phase-outs

There are many features of the tax code that are denied to some of the higher-income taxpayers. Some these features also phase out over different varieties of income. However, it should be noted here that the aforementioned features make the system of tax returns much more complicated. Therefore, multiple worksheets are required to make calculations for the taxable income, credits and deductions. For instance, there is a reduction of $1,000 per-child tax by the tax code by 5% of adjusted gross income, also referred to as AGI of more than $110,000 as for married couples, and $75,000 for single parents. As the AGI increases from $15,000 to $43,000 the percentage for the share of expenses allowed for a child as well as dependent care decreases from 35% to 20%. As for the single taxpayers that have an AGI of more than $55,000 may not get their interest deducted that they pay on student loans. Once these restrictions are eliminated, the system of tax filing would become much more simple, however most of the benefits would go to the taxpayers with higher income. If the aforementioned income limits are retained but are set at similar or at the same levels, as for the related activities at least, the complexity of the tax system would be reduced and the benefits would also go to the taxpayers with moderate as well as low incomes and not just the taxpayers with higher income. On the other hand, nevertheless, if numerous benefits phased out over the similar income range, unacceptable levels could be reached by the effective marginal tax rates in that particular range.

3.2 Reduction of Tax Distortion

Simplifying the tax system should be coupled with reducing the distortions in the tax system and increasing the economic growth. There are three ways in which the efficiency of the tax code can be reduced. First of all, the tax rules that discriminate between the business structures and industries should be eliminated from the system. Investment of all types should face similar low marginal tax rate. This would make it possible for the markets to divert the resources towards the production of highest-value products and therefore increase the output of the nation. The figure below shows that there is no relationship between the top marginal growth rates and the GDP.