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Saturday, July 28, 2007

Income Tax Thoughts

I originally wrote this article for the Ron Paul wiki, and I'm copying it here.

Ron Paul has stated that the IRS is unconstitutional and he would abolish it by executive order if he were elected president.


There are two arguments that are frequently cited for the unconstitutionality of the income tax.

Ron Paul did say that the IRS was unconstitutional. I'm not sure what is his justification.

The 16th Ammendment did not Repeal the 5th Ammendment

I believe this is the argument Ron Paul is using for the unconstitutionality of the income tax. The IRS does not have the right to demand that citizens report their income. The IRS does not have the right to demand that citizens report all economic activity. This violates the 5th Amendment. However, without the ability to force people to report their income, it's pretty impractical to collect income taxes.

Some of the IRS's most egregious violations have come against people for not reporting all their income. In particular, people who do substantial barter transactions have come under heavy pressure.

The 16th Amendment was Never Properly Ratified

This is the argument that some tax protesters make. I'm not sure if this is the argument that Ron Paul makes. I saw a post on a Ron Paul forums saying that Ron Paul supports this argument.

There also are some arguments that say that the law authorizing the income tax is incredibly complicated and vague. It doesn't clearly state anywhere that the income tax was meant to apply to individuals. However, IRS agents and tax courts have ruled that the IRS' practices are acceptable. I'm not sure if it's been appealed to the Supreme Court.

Income is not Properly Defined

This isn't an argument used by tax protesters, but I like it. The 16th amendment leaves it up to Congress to define "income". In the late 19th century and early 20th century, "income" meant investment income. In those days, income was things like stock dividends and rent collected. Income meant "passive income". Wages were separate from "income". Is it possible that people who voted for the income tax amendment thought that it was applying only to investment income and not to wages?


Abolish the Federal Reserve, Fund Government via Seignorage

If the Federal Reserve were abolished, the government could fund its activities primarily though seignorage, the printing of new money. See my posts on the Federal Reserve for more information on the injustice of the Federal Reserve System.

The economy grows by 2-4% per year, and inflation is currently 3% according to the official CPI, but actually 7-10% according to more realistic measures. If you believe the official CPI, the government could print 5-7% more money each year and spend it directly into circulation, and the average person would experience the same inflation rate they do now.

This alone would probably be more than enough to fund the government's activities. The government should reclaim the profits that currently accrue to the financial industry due to the Federal Reserve's interest rate fixing practices.

Abolish Fractional Reserve Banking, Fund Government via Seignorage

Currently, banks effectively print new money when they loan out customer deposits. The right to create money should be an exclusive perk of the government. Banks would be required to keep customer deposits segregated, invested in treasury bonds, paying customers that interest minus the bank's expenses. If fractional reserve banking were outlawed, banks would have to borrow from the government, and in turn loan that money out. Banks would borrow from the government at a slight premium to the treasury bond rate, say 0.50% more. The spread between the treasury bond yield rate and the loan rate would be seignorage income for the government. Currently, the financial industry recognizes seignorage profit whenever it creates new money via a fractional reserve loan.

The two items above should be enough to fund the government and have surpluses, without any other taxes at all.

There are still other means for the government to raise money.

Tariffs and Excise Taxes

The Constitution allows the government to collect tariffs. A tax on imported oil is an example of a tariff.

The Constitution allows excise taxes. A tax on tobacco sales is an example of an excise tax. A national sales tax would be an example of an excise tax.

However, tariffs and excise taxes cannot be a percentage of the goods sold. For example, a federal tariff or excise tax of $0.50/gallon on oil is valid. A tariff of 20% is invalid. The tax must be per quantity, not a percentage of price.

A Direct Tax Based on the Census

A direct tax of a fixed amount per person would also be a valid tax. Such a tax would be regressive. The Constitution allows each state to decide how the fixed tax per person is allocated.

Who Needs Government, Anyway?

With a fair monetary system and taxation system, big government would be unnecessary. It probably is a good idea to cut back on the government's taxation power and its size. However, there are a large number of people dependent on government subsidies, pensions, and handouts. They won't give up their perks.

The welfare state evolved to compensate for defects in the monetary system and taxation system. With a fair economic system, welfare would be unnecessary.


The Income Tax Discriminates Against Labor and in Favor of Capital

Different Tax Rates for Wage Income and Capital Gains

Ordinary wage income pays around a 25% federal income tax, plus a 15% Social Security and Medicare tax. Half the Social Security and Medicare tax is paid by your employer, but the fact that your employer has to pay it means that less money is now available for salaries. Without the employer portion of Social Security and Medicare taxes, your salary would be 7.5% higher, even though this doesn't show up as a deduction on your paycheck.

Capital gains are taxed at a rate of 5% or 15%, if it's a long-term gain. Stock dividends are also taxed at 5% or 15%. Furthermore, if a stock has appreciated in value, you don't realize the income until you actually sell it, making the effective annualized tax rate a lot lower for a long-term investor.

Social Security and Medicare taxes do not need to be paid on capital gain income and dividend income.

Labor is Assigned a Value of Zero

If I buy a stock for $50/share and later sell it for $60/share, I don't owe $60/share in capital gains. I only pay tax on the $10/share gain.

If I sell my labor for $30/hour, I owe tax on the full $30/hour. The tax law assigns a value of $0 to my time until I have sold it.

Really, when I sell my labor for $30/hour, my time had some value to me. I should only be taxed on the difference between the intrinsic value of my time and the wages gained. You could argue that my labor had a value of $30/hour, because that's what I sold it for. Under that viewpoint, wages should not be taxed at all because I sold something and received something of equal value in return, for a net gain of $0.

For example, instead of working for $30/hour, I could have done repairs on my house, saving $10/hour I would have paid someone else. In that case, I only gained $20/hour by working instead of fixing my house myself. Consider another example. I work for $30/hour but I have to send my children to a daycare center paying $15/hour. I only gained $15/hour by working, but the full $30/hour is taxable income.

The courts have made it clear that taxing labor income is legal. I'm pointing out that this method is biased against labor.

Income Taxes Cause Inefficient Allocations of Capital

If I buy a stock for $5/share and it is now worth $50/share, I might be reluctant to sell because of the capital gains I would owe. I might be better off selling some of the stock and investing it elsewhere, but I am discouraged from doing so because of taxes.

Similarly, suppose a corporation wants to sell a factory for $100M, for which it paid only $10M years ago. It will have to pay taxes on that $90M gain. Due to the effect of taxes, the corporation might be reluctant to sell its factory. It would have sold it for $100M, but due to the tax cost it is effectively selling it for less. That factory is then denied to another business that might have used it more efficiently.

If a business loses $100M, its owners take the full $100M loss. If a business makes $100M, its owners only get to keep a fraction of the gain and the government keeps the rest. Income taxes cause businesses to be risk-adverse, because the reward for success is diminished.

Income Taxes Exacerbate the Effect of the Hidden Inflation Tax

If I invest $10,000 in a money market account for 1 year, earning 5% interest, I have to pay taxes on the $500 interest I received. For a federal tax rate of 25%, I paid $125 in taxes. My effective interest rate was only 3.75%. A lot of the interest income I received was merely compensation for inflation. Inflation is probably higher than 3.75%, so I actually lost ground relative to inflation.

If I buy a stock for $10/share and sell it 10 years later for $30/share, I owe taxes on the $20/share gain. However, during those 10 years inflation might have been 70-100%. About $7-$10/share of my gain on the stock was merely compensation for inflation. I have to pay taxes on the additional stock price gain that was merely compensation for inflation.

Further, most tax brackets are not properly indexed to inflation. The example that most people know about is the alternative minimum tax. Using the CPI to index tax brackets is wrong, because the CPI understates the true inflation rate.

Income Taxes Force People to use Dollars and Makes Barter Impractical

Even if a group of people saw the absurdity of the dollar and decided to boycott it, the income tax prevents them from doing this. People could boycott the dollar and return to a barter system.

However, the IRS demands that people performing barter transactions report the dollar-equivalent value of their transactions as income. The income tax must then be paid in dollars. The government would not accept barter as payment for income taxes.

Even if someone wanted to boycott dollars, they would not be able to do it completely because they would need to acquire dollars to pay taxes. That's why the IRS has cracked down so heavily on private communities that try to return to a barter system.

Without income taxes, the dollar would be completely worthless. People would switch to other means of conducting trade, and only acquire as many dollars they need to pay taxes.

The Dollar is Backed by Violence

Even though the dollar is inherently worthless, it is actually backed by something. Every economic activity in the US is subject to the income tax. Income taxes must be paid in dollars. This means that the dollar is effectively backed by all the economic activity in the US. The value of a dollar is thus proportional to the effectiveness of the government in collecting income taxes.

In other words, the dollar is backed by the US government's willingness to use force against its citizens, to require them to pay income taxes. The dollar is backed by the US government's willingness to invade people's privacy to make sure all economic activity is reported as taxable income.

Think of a dollar as a receipt that says "bearer may conduct $3 of economic activity", assuming a 33% income tax rate. The dollar has value because the IRS will enforce collection of the receipts. The IRS ensures that all economic activity is reported and taxed.

Dollars have value because the rules for economic activity in the US are still more favorable than the rules for economic activity in other countries. Even with the huge drag due to income taxes, the rules for commerce in the US are more favorable than in other countries. A dollar gives the bearer the right to conduct economic activity in the US, and people from other countries frequently can conduct economic activity more efficiently in the US than in their home country.

Other Constitutional means of tax collection do not require citizens to report all economic activity to the government. Under such a system, the dollar would only be backed by those activities that are taxed, and not by all economic activity.

The Income Tax Effectively Converts all Citizens into Government Slaves

The income tax means that the government gets a cut of all economic activity. Anytime someone does productive work, they must report it to the government for taxation. It is illegal to do productive work without being taxed. Income taxes require me to hand over 40% of everything I produce to the government.

It is as if every citizen is required to work 4-5 months per year directly for the government. I am given limited freedom to choose my job, because the "free market" allocates labor more efficiently than a pure slave system can. However, the requirement that I give a percentage of my productivity to the government makes me a slave. I have certain limited property rights and a limited ability to structure my savings to minimize taxes, but I am still a taxation slave.

Effectively, the income tax means that I must get permission from the government in order to work. I cannot work without giving dollars to the government. That's functionally the same as needing government permission to work.

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