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Income System With A Fair Tax System Economics Essay

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Published: Mon, 5 Dec 2016

That issue is taxation. Why does this topic merit so much attention so frequently. The answer is much more simple than the topic itself and it is that every individual residing in the United States is affected by taxation. Even those we tend to think of as non-tax paying individuals, like children, illegal immigrants, and the unemployed are affected. For example, a child buying a toy at a department store must still pay tax on the purchase in the form of a sales tax. Similarly, there are hidden costs found buried in the prices of nearly all consumer goods. This concept of hidden costs will be addressed several times later in this writing; however, the point to be made is that no one is left untouched by taxation.

These individuals affected by taxation share a common objective – pay as little in taxes as possible. The general feeling held by individuals regarding taxation is that of resentment. The United States is after all a democracy – so why have taxes if the majority of citizens do not wish to pay them? Well, nearly all Americans can concede that a government is necessary to maintain order, justice and security and a government requires revenue by which to finance its activities. The main source of revenue for the government comes from taxes. In the case of the United States, the majority of government revenue is derived from taxes collected on income, both personal and business.

Consequently most Americans can agree that taxation is necessary. However, this does not mean that we, as a country, are restricted to the system currently in place. Especially, when there are so many causes of complaint concerning the income tax system. As of November 2012, an internet search on Google for the key words “tax reform” yields over 290 million results. This fact portrays clearly the frequency and degree to which tax reform is discussed and debated (Google). According to a recent poll by the Tax Foundation, it was found that 80% of Americans believe that the income tax system needs to undergo significant changes or be overhauled completely (Tax Foundation). To entirely understand all of the problems with our current system it is necessary to review some background information about the income tax system itself. Below is a brief historical account for the implementation of the income tax and the current shortcomings of the system.

America has not always had a federal income tax. The first income tax on the people of the United States was enacted in 1861 as a plan to raise emergency funds for the Civil War. Prior to 1861, government revenue was derived primarily from customs duties and excise taxes. The income tax set up in 1861 was intended only as a temporary means of raising capital and was set to expire in 1871. However, government officials wanted to make it permanent. An income tax system was being used when, in 1895, the Supreme Court declared in the famous case Pollock v. Farmers Loan and Trust Company, that an income tax was unconstitutional. The basis for this violation was found in Article I, Section 9 of the United States Constitution which states: “No capitation, or other direct, tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken.” This clause basically states that according to the Constitution at that time, the income tax was to be apportioned among the states in proportion to their populations. This methodology would be inefficient and difficult to administer because it would mean that taxpayers would be charged different tax rates depending on their state of residency. (Anderson, Kramer & Pope) It became clear to lawmakers that some sort of amendment would be needed to allow for an income tax system to be implemented.

In February of 1913, the Sixteenth Amendment was passed by Congress and signed into law by President Woodrow Wilson. The Sixteenth Amendment states: “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” This amendment resulted in the formulation of the Revenue Act of 1913. This document was only 16 pages long and it imposed a flat tax of 1% on the net income of corporations and a tax of 1%-7% on individual income depending on income levels. However, there was an exemption for single individuals of $3,000 ($4,000 for married couples) and this was higher than the income of most individuals in 1913. In actuality, less than 0.5% of the U.S. population had to file personal income tax returns at the onset of the income tax system. (Anderson, Kramer & Pope)

A lot has changed since 1913. The once 16 page long tax code has grown to be

54,846 pages with more than 8.4 million words (CCH Standard Federal Tax Reporter,

2003). Now nearly every working American must file an income tax return every year by

April 15th. The process of filing income tax returns can be complicated for many people especially the lower and middle classes. The upper income level individuals can afford to pay professionals to prepare their taxes, while the lower class, in which illiteracy and poor education are more common, is generally left with no choice but to try to prepare their own taxes. This process can be very difficult due to the complexity of the tax code.

Filing your federal income tax returns takes time as well as money. New regulations come out yearly and filers must make sure they have read the updated information in order to comply with the code. Then there are the penalties for filing late or not paying a sufficient amount of money. Accountants who specialize in taxation are able to assist their clients in finding loopholes in the tax code that allow taxpayers to take larger deductions or claim less income. So in effect, the wealthy are able to decrease their tax while the poor are not. There are several options available to help remedy the various problems with the tax system.

The first option is to alter the existing tax system in such a way that it can be simplified and less costly. There are obvious problems with this option however. To say that a tax code of such great length can be simplified is illogical. The reason it has grown to be as lengthy as it is today is that there are so many topics to cover and with new loopholes being discovered the IRS must update the code to account for these accordingly. Even if the code could be simplified, chances are it would just grow longer again. Similarly, if the system remains as complicated as it is, compliance costs cannot be expected to go down. Rather they will likely go up since new regulations are added each year and it continuously becomes harder to adhere to the statutes.

There is a proposal for a tax such as this in existence already. It is called the

FairTax and is being pushed by the Americans for Fair Taxation, a nonprofit organization. Their proposal is a sales tax of 23%. Initially this rate seems rather high. However, when examined more closely you can see that it really is not high at all. All businesses know that when they are selling goods, they have to make the price high enough that it covers their costs. Costs to businesses include everything from utilities, to labor, to income taxes. With income taxes out of the way, costs for business will decrease dramatically. The result is lower prices and less hidden costs for the consumer to pay. The $300 billion paid for compliance will be saved. Much of that $300 billion is paid by corporations since their tax returns are so much more complicated than individuals’ therefore resulting in even greater business savings and less costs to be passed on to the consumer. In his book, America’s Best Kept Secret: FairTax, Ale Ose states that really Americans are already paying the FairTax. He indicates that by implementing the FairTax prices will drop by about 22% and it is on these reduced prices that the FairTax is applied (Ose). The savings do not end there.

Since the FairTax abolishes the payroll tax, you will not have to pay the 7.65% tax that comes out of your paycheck. Also, the matching 7.65% that the employer pays will be retained by your employer and more than likely most if not all of these savings will be used to raise wages. Of course, this begs the question: How will we fund retirements? The FairTax does not take any stance on Social Security reform, and in fact, Social Security can continue to be funded under the FairTax simply by allocating a percentage of the total revenue to the Social Security program. Conversely, if Americans decide that the Social Security program should be scrapped, the rate can be decreased and retirement funding may become privatized. In regards to the percentage of tax revenue allocated to retirement savings or Social Security, the FairTax has offered no fixed amount. This amount may be determined by Congress when the time comes.

Additionally, it may be pointed out that if Social Security is discontinued, the population can be slowly removed from it by a gradually decreasing percentage of funds being allocated to the program. Also, if it is considered that most Americans fall into the 15% income tax bracket, this savings of 15% of your income plus the 7.65% not withheld from your paycheck, yields savings of 22.65%. Also, not to be forgotten, no one has to pay the income tax. Another bonus provided by the FairTax is that there is a rebate provided for essential goods and services. These items are taxed to begin with because there will be standards set up to indicate how much a certain sized household needs to spend on necessities and that money will be sent out monthly. This accounts for the fact that rich people will likely spend more money on groceries than poor people. However, families of the same size should be spending roughly the same amount on true necessities; therefore, any amounts spent over the rebate amount are not reimbursed because they are viewed as unnecessary. In effect, this means that families with different consumption standards will still be receiving equal rebates. Families with higher consumption standards generally are better off financially and therefore, the amount they spend on “necessities” over the rebate is taxed. This concept is in part what makes the national retail sales tax progressive. Those with higher spending habits, pay more in taxes due to the wherewithal-to-pay principle.

A common question stemming from the above information is: with all these savings from the FairTax, is it possible that the FairTax generates as much revenue as the income tax system? The answer is yes. The proposed rate of 23% is what will be required to raise the amount of revenue currently generated. Considering that under the income tax system, 20% of revenue generated is wasted on compliance costs, it is safe to say that the present method of taxation is inefficient. The FairTax requires one thing – that businesses submit the federal sales taxes received to the federal government. This process is not difficult for most businesses as most already deal with a similar process for state sales taxes. Advocates of the FairTax will continue to gain the support of others, and someday if it does get passed into law, there will be some costs, but also a great deal of benefits.

The FairTax will eliminate filing tax returns and the huge costs associated with filing. Individuals will get to keep 100% of their paychecks. No one will ever owe taxes to the government, which means the government can put less effort into collection. A switch to FairTax could cut compliance costs for federal revenue by as much as 95% (Volunteer). Loopholes can be closed and everyone will pay their fair share of taxes. Poor families will not end up having to pay any taxes and the wealthy will never pay more than 23%, or if the rate changes they will never pay more than the new amount. The consumption tax base is an even better one than income. Pre-tax prices will actually decrease because there will be no need to hide certain taxes in the selling price. It benefit’s the U.S. in foreign trade. This is because imported goods are subject to the consumption tax but our exported goods are not. Also in the long-term, the projected growth rate after the first year of the FairTax is 10.5%, a staggering number.

Imagine if you turned on the news tonight and discovered that Congress had changed the tax system, effective immediately. It would be cause for mass confusion and chaos. For tax reform to happen, it is my belief that it must first be decided that tax reform will happen that way it can be discussed as an upcoming event rather than something that is only remotely plausible. The forming of this committee would be a great first step. Unfortunately, this bill was never passed into law and must be reintroduced.

In conclusion, there are many benefits to the implementation of the FairTax and these benefits outweigh the costs. There will not be any long-term damages from making the switch but there will be long-term benefits. The collection of taxes will be made much easier, on both the part of the government and the taxpayer. If not the FairTax, the U.S. should consider other forms of a national retail sales tax, or simply make adjustments to the FairTax if they see fit. One thing seems to be obvious, and that is that Americans are unhappy with our current system of taxation. If our government is any sort of democracy, then it needs to stop turning a deaf ear to the concerns of its people.


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