Fixing Our Country’s Economic Problems Requires a Change in Our Tax System

by Larry Goldsmith, C.P.A., J.D., C.F.F.A.

The income tax system that we grew up with is suffering from dementia; it forgot that the purpose of taxation is to fairly tax individuals and businesses to support the funding of government services.

Today, highly paid tax attorneys are retained to influence Congress to provide loop holes in the Internal Revenue Code designed to benefit large corporations and only the wealthiest members of society. Typically, these changes shift the burden to small and mid-size business and middle-class wage earners, already straining to cover the costs of a ever growing governmental budget.

I have ideas that I wish to share with you that can have a profound positive effect for our economy and our standard of living. I propose a change that will provide hope for our children to live in a country that is not in peril of financial collapse. Let me start by saying I have no political agenda and no specific axe to grind; I address these issues from a purely economic footing, ignoring all political issues.

The current system…

Under the current system, the top corporate income tax rate for “C” corporations for the tax year 2011 is set at 39% for companies earning more than $100,000. State tax corporate rates vary, but can be as high as 10%. “S” corporations are taxed at the federal level on the individual’s income tax return rather than the paying of a separate corporate income tax. Most states do have a corporate “S” corporate tax rates from 2-5%.

The federal tax rate for highly compensated individuals has been increased from 35% to 39.6%, and state individual income tax rates vary from 0-10%. In Illinois the state tax just jumped from 3% to 5%.

The US has the second highest corporate income tax rate of the 34 countries in the Organization for Economic Cooperation and Development (OECD). So the big US corporations are extremely motivated to buy legislation to limit their taxation, or create solely owned foreign corporations that earn substantial profits without having to pay the their share of corporate income taxes back home. Recently General Electric earned a 2010 profit of $14.2 billion dollars and paid no corporate income taxes to the United States because the bulk of those profits, some $9 billion, were offshore. This was the second year in a row that GE reported billions in profits yet paid no income tax. This was accomplished by getting Congress to grant GE tax credits for the products it produces while still allowing GE to leave its profits off shore. The United States lost five billion dollars of tax revenue, just from this one company this year.

If this seems unfair to you – and it should – don’t blame the corporations who are simply working the system to maximize their earnings within the law.  Blame the high corporate tax rates which force big business to go offshore and shift the burden of the tax base to the small and mid-size business owner. Though these small businesses employ the majority of the nation’s work force, they have the most difficulty obtaining bank lines of credit in tough economic markets, putting their owners at greater risk of personal bankruptcy. In fact, small business bankruptcies increased 10.4% last year. The number of businesses just closing their doors cannot even be accurately determined.

The average small business owner last year earned $100,000. They were taxed 7.65% for Medicare and social security taxes on their earnings, paid federal income taxes of 35%, plus state taxes.  Let’s say total taxes of somewhere around 46.15% on their earnings. No offshore hiding place, no huge tax relief package from the Fed.  Where’s the incentive to keep going? Many small business owners could simply close the doors, fire their employees and go to work for a corporation, with no personal risk, and keep more of their earnings – plus perhaps gain a pension and health care, something that fewer and fewer small business owners provide themselves because of liquidity and profitability issues.

The effect of our tax system…

Corporations who do pay taxes have to include a premium of approximately 35% of the cost to produce goods to cover the cost of corporate income taxes. For example; a hammer is manufactured here in the US at a cost of $10 for labor and materials. The hammer can be sold at wholesale for $30, yielding a profit of $20 to the manufacturer.  But the company needs to include $7 to pay taxes in their cost structure so that the real cost is $17. Goods produced in China by a company that pays no US taxes can save that $7 of taxes and have a competitive advantage selling goods in the US over a US manufacturer. In other words, our taxing system is hurting US competition, keeping unemployment high, and is creating an environment where the US is dependent on foreign countries.

The system is such that neither foreign companies nor U.S. companies want to follow the rules. Everyone wants to cheat. With an elevated risk of investment in the US and the tax rate so high, it is difficult to get manufacturers to build plants here. If goods in the US were manufactured with our higher labor costs but the company was not taxed, the cost of goods would be much more competitive with a country like China that has lower labor costs but higher costs to bring the goods to market in the US (primarily shipping). Assuming that the US has better quality which goods would be purchased?

Individual entrepreneurs are faced with the same dilemma:

1.  Do they start businesses and employ workers or do they get a good paying job?
2. Do they risk bankruptcy in a down economy or get a safe job where they can shut off the office phone at 5 P.M?
3. Do they cheat on their income taxes or pay every last dime knowing that the fat cats do not pay taxes?
4. Do they leave the country and create wealth in a tax friendly environment?

What is the answer…?

Like Dorothy, I wish there was an all knowing being who could solve these problems. Looking to Washington for acceptable solutions is, unfortunately, a vain hope. Most politicians have never owned a successful business or worked in a business to earn a living, and have little practical insight into the ramifications of the legislation they propose. Now, I may not be a wizard, but as an accountant and a lawyer with many years experience helping companies survive I have some idea of what can work and what can’t.  Here are my ideas. They are rough, they require financial verifications, and one must consider the cost of implementation.  But I believe that, properly executed, these steps would dramatically improve the current situation.

The answer, in a nutshell, is to adopt a consumer-based tax system with some modifications.  Here’s the Larry Goldsmith Six Step Plan:

1. A Flat Tax On Income for 5 Years — There would be a flat 10% individual income tax and no corporate income taxes. The hope is that with increased consumption taxes being produced, the flat individual income taxes can be abated in time. There is an argument that consumption taxes hurt the poor. My belief is that this type of tax will increase blue collar labor, improving the job prospects for the poor and allow for increased income. Secondly, the goods purchased will cost less, therefore benefiting the poor’s purchasing power.

My personal fear is that elected officials believe that they can’t get reelected if they cannot point to spending that they influenced. If there are too many tax dollars collected then there may be a temptation to spend it. So with that said, I believe the personal tax rate should be for no more than five years and renewable only if there is a legitimate need.

1. All business “S” corporation profits will be subject to an 8% combined social security and Medicare tax that will be matched by the employer. This tax will be unlimited, meaning that if a corporation earns $1 million, the 8% tax will apply to the entire $1 million.Increasing the taxing basis will solve some of the ongoing Medicare and social security financial problems. As a note, Congress has borrowed $2.5 trillion from the social security system. In fact, last year Congress borrowed $103 billion from the social security system for their spending projects. There must be hand cuffs on these monies to prevent Congress from exercising their spending ways.
2.  There would be a 30% Federal sales tax on the end user on all goods, regardless of country of manufacture. A shirt made in South Carolina, costing $50 today, exclusive of state taxes, would now cost $38 due to the elimination of corporate income tax.  Adding the new Federal Sales tax of $12 would bring the retail price of the shirt back to $50.  But it would now be competitively priced, because the new tax would apply to all goods, regardless of where they were manufactured.

1. Goods manufactured for foreign consumption would be less expensive because there will be no taxes placed on these goods. However, U.S. workers and companies will have manufactured these goods, and they will now have disposable income to spend as they wish on goods and equipment that will create tax revenue for the government. US companies will no longer have a need to keep money offshore along with their financial resources.
2. There will be a lower tax rate – say 5% – for food and a 10% tax on rentals units. This is so that lower income workers will not be without food and a place to live for their families. However, while my plan calls for a lower tax on food, I would tax liquor, high calorie snack food, and high calorie drinks at the higher rate because of proven health concerns. This will also impact the overall cost of healthcare, further reducing national expenditure.
3. Optional considerations are; a tax on all worker’s pay of 10% that would fund health insurance. The government will cover the less fortunate in our society with a competitive and subsidized HMO plan. Participation would be on the same basis as food stamps and the criteria will be financial need. The worker merely is required to pay 10% of their wages to participate. All other workers will be able to purchase plans based on ability to pay.

And… that’s about it.  There are other areas not addressed, such as life insurance, gambling, and foreign earned income, which would also need to be considered.  But this simple plan would solve many problems, including unreported revenue; now there would be no incentive to cheat because taxes are paid for goods or services purchased. Goods purchased would carry tax stamps or bar coded stamps to ensure compliance.

The United States had $14.7 trillion of gross national product in 2008. This simple tax structure will create jobs, increase government tax revenues and will create a fair tax.

Your thoughts?