Since the advent of the income tax, the wealthy - who stand to gain the most - have been determine to avoid or, if necessarily, evade it. As they have adopted new strategies, Congress has responded by wising up and closing loopholes. Today, the legal loopholes for wage earners have closed and the only thing that remains is a big, gaping wormhole that takes the wealthiest sliver of Americans straight to tax heaven, where they owe literally nothing.

Fortunately, the two next steps for Congress in closing legal loopholes is clear; (1) allow an unlimited deduction for savings, and (2) tax debt when it is taken. This would convert our current income tax system into a consumption tax system, which could target a taxpayer’s spending rather than their earnings. This would take pressure off the lower classes by including the wealthiest Americans in the tax base, encourage saving behavior and long-term financial health in the middle class, improve the efficiency of a taxes across a taxpayers entire lifetime, and help taxpayers make more economic decisions when taking debt by factoring the entire cost into the debt instead of hiding it until they are paying their debt back with after-tax money.

How the Rich Pay No Taxes

We describe this system in greater depth here, where you can see how it is akin to a simple magic trick; you would think that it is complicated, but the only part that required skill was picking your parents to have a lot of money. If it seems incredulous that something so simple could actually be practiced, then remember that Warren Buffet pays less taxes than his secretary and Larry Ellison has a $10 Billion line of credit; while we don’t know the reason, it will at least have the effect of allowing him to avoid taxes on $10 Billion of his income.

How The Working Class Pay Lots of Taxes

The taxes have to come from somewhere. If the rich aren’t paying them, as we established above, then that means everybody else is paying more to compensate. It is said that taxes are the price of civilization - so it seems unfair that the rich can skate by without paying while everyone else bears the burden for them.

Taxing Wealth

In order to ultimately understand how our tax system works and why the solution is actually as simple as described above, you should think about the two common ways of thinking about wealth. Ultimately,

Sources of Income = Saving + Spending (or Consumption)

Right now, the tax system raises over 80% of its revenue through two taxes; the Income Tax and the Payroll Tax. Both of these fall on sources in the left side of the wealth equation. The Income Tax accounts for all income, or the entirety of the left side, and raises somewhat more money than the Payroll Tax, which only accounts for money earned through wages. The first several ten-thousand-dollars earned for a taxpayer face a higher rate from the Payroll Tax than the income tax and, for this reason, most Americans face a greater burden from the Payroll Tax than the Income Tax.

The trick to understanding how the wealthiest Americans avoid income taxes entirely lies in what we don’t tax. We don’t tax appreciation of assets until they are actually sold even though it is unequivocally income and, when a person dies, we throw out that appreciation and give it to the inheritor without any taxes. This heavily favors the wealthy because it means they can earn money their entire life without paying taxes on it, then pass it along to their children who can sell it and never pay taxes on it (or do it again for their children). If a person does need to sell their appreciated assets before they die, then they are blessed with a lower “capital gains” rate - so even if a rich person has to pay taxes, they get to pay less!

For Income Taxes, on the right side of the equation, Congress also defers taxes on retirement savings until those savings are spent, up to $19,000 per year. Very few Americans save more than that and most save much, much less. (by some counts, nearly a third of Americans have less than $5,000 saved for retirement total) That means that almost all Americans are taxed on their income, less their savings, which means for almost all Americans, the current income tax is already identical to a consumption tax.

For Payroll Taxes, there are no deductions. Every cent earned is taxed. But you are lucky if you are rich enough not to earn your money through a paycheck - that means that none of your income is wages and is therefore ignored by this 15% tax.

How Much Is Taxed?

Tax Rates are poorly understood. The Income Tax includes a progressive rate structure, so it increases with an increasing amount of income. But this does not mean that the tax on all of an income suddenly rises, it means the rate on your next dollar of income rises. Each bracket is like a bucket; when the bucket fills with income, further income moves into the next bucket, until it fills. Each bucket has a certain percent that is taxed, but it only taxes the money in that bucket. This means that a person never actually pays taxes on their entire income as high as their tax rate, but the more they earn, the closer it is.

The Payroll Tax features a regressive income. The rate is about 15% until about $130,000, at which point further income is taxed at about 3%. Another reason it is good to make a lot of money.

Because most people earn their entire income through wages, those two taxes should be added up to determine the progressiveness of our taxes. Doing so reveals an interesting observation; although conservatives decry the income tax as sharply progressive, most Americans pay a pretty flat tax rate around 40%. (except those who earn their money through capital gains, i.e., the rich, because the capital gains rate peaks at 20%, or half that of the working class)

Hidden Taxes

There is also a certain type of taxes that are hidden, because they are not shown to us as consumers. Half of the Payroll Tax is “paid by your employer” and is hidden to you in your paycheck, even though you are the one losing money for it. The gasoline tax is hidden because it is paid by gasoline companies and then they charge you a higher oil price to compensate.

Taxes on your debt are hidden, because you will not know them until you are later paying back your debt with after-tax dollars. This can lead to uneconomical decisions and people taking debt that they cannot actually afford to take because they don’t realize that it will actually cost them about 40% more in “income” than they expected it would. Taxing debt when it is taken, instead, would enable them to make that decision more clearly and would be more efficient because it would tax based on their consumption. It would also make it impossible for rich people to avoid taxes on their income because the debt they must take to do so would be taxed.

The Better Way

Fortunately, as stated at the beginning, there is a better way to tax! All that is required is two straightforward changes in the current income tax; (1) allowing unlimited deductions for savings, and (2) taxing debt when it is taken rather than when it is paid back.