Tax Basics
People think taxation is a terribly mundane subject. But what makes it fascinating is that taxation, in reality, is life. If you know the position a person takes on taxes, you can tell their whole philosophy. The tax code, once you get to know it, embodies all the essence of life: greed, politics, power, goodness, charity. Everything’s in there. That’s why it’s so hard to get a simplified tax code. Life just isn’t simple. –Sheldon Cohen (former IRS commissioner)
Benjamin Franklin once promised that nothing is certain except death and taxes. That still holds true for most of us today, with the notable exception of the super-wealthy who are often able to avoid paying any income tax at all.
In this tax overview, we will teach you how our current tax system works (or rather, how it doesn’t work for many of us), along with how to create a better and fairer system through a progressive spending tax.
Where does the government get its money from?
As you learn, it is important to remember that all of the government’s revenue must come from somewhere, meaning if one person skips out on paying taxes, someone else must pay more to make up for the lost revenue. Furthermore, when the government can’t collect enough tax revenue to cover the bill, it is forced to resort to debt spending (which just means that future taxpayers are going to have to service the cost plus interest at a later point in time). Case in point: when Trump’s promised tax cuts severely limited the revenue the government would raise, the Republicans of Congress approved extraordinary debt spending.
We started by explaining Buy, Borrow, Die. This reveals just how easy it is for those born wealthy to literally never pay taxes.
So, how does the U.S. federal tax system work?
In order to understand how the full system works and eventually how to solve this, the first thing you should understand is the role that wealth plays within our tax system. Generally, there are two ways to tax wealth: when it is acquired or when it is expended.
Secondly, we need to understand what things the government taxes, known as the tax base. The income tax, which constitutes about half of all tax revenue, focuses on taxing people’s income and thus taxes the acquisition of wealth. The payroll tax taxes wages to pay for social security and Medicaid programs, raising about a third of all tax revenue. Lastly, the excise tax focuses on how people spend their wealth.
Any exceptions?
Meanwhile, certain behaviors do not get taxed because they either qualify for exemptions or tax credits. As we will discuss in a later lesson, a tax exemption is a portion of your income that is exempt from taxation, which reduces your total taxable income, which consequently lowers your tax bill. In contrast, a tax credit is a dollar-for-dollar reduction on your tax bill.
To provide an example of an exemption: employers may contribute a certain percentage of their employees’ income to the employees’ retirement accounts. Those retirement contributions are tax-exempt because the U.S. government wants to incentivize people to save for retirement (and thus decrease the number of people who will be dependent on the U.S. government during their retirement years).
How much do we tax?
The third important thing to understand is the tax rate, which is the proportion at which income is taxed. The tax rate dictates what percentage of a tax base is charged by the government. Taxes can either be charged at a:
Flat rate (the rate stays even no matter how much of something is taxed)
Progressive rate (the rate increases as more of something is being taxed)
Regressive rate (the rate decreases as more of something is taxed).
Moreover, different household makeups represent distinct taxable units and are taxed differently. This is why your tax form will ask whether you are single or married. As you will see, the current treatment of taxable units encourages marriage among the wealthy and discourages marriage among low-income individuals.
When do we tax?
Another important tax construct is timing, or when you pay a tax. During one earning and spending cycle, prepaid consumption taxes are deducted when wealth is initially earned, and postpaid consumption taxes are charged when that wealth is subsequently spent. The vast majority of a person’s tax contributions will be paid during their working years. That being said, people reap the societal benefits of their tax contributions over the course of their lives, starting with subsidized kindergarten education and ending with social security and Medicare.
After considering these basic constructs, we will spend time looking at what this system means for those living paycheck to paycheck or those saving for retirement.
Then, we address how the wealthy exploit this system to avoid paying any taxes (the preferred option) or, alternatively, to delay paying their taxes for the foreseeable future (the second best option, which leads to more money in the present). We make a case that such strategies are not smart (as Donald Trump would claim), but rather unfair because they push the burden onto the current and future working class and middle class taxpayers.
Where does this lead us?
Finally, we will conclude by presenting a simpler and fairer system in the form of a progressive spending tax. Our proposal would tax based on how much an individual spent, instead of earned, within the prior tax year. Such a tax would thus serve the same goals as the current tax system, without providing the same loopholes currently being exploited by the rich.
If this topic intrigues you, we recommend reading Fair not Flat for further discussion on Ed McCaffery's proposal for a fairer tax system, Taxing Women for more insight how the tax system affects different people differently, and his tax supplement Income Tax Law for a more legal perspective on how the system works or does not work.