As our nation is in deep discussions about raising the debt ceiling versus raising taxes, and there is much debate in Washington DC about how to fix some of our deficit problems, I often hear that the rich should be taxed more so we can balance the budget.  The well-meaning centrists will note that we should cut spending and raise taxes so that we can bridge the budget gap and get our fiscal house in order.  I would submit that the way that we are taxing people isn’t going to really raise much revenue, and certainly taxing the “rich” isn’t going to get the job done.

One caveat before I begin:  I don’t believe that we need to raise taxes on anyone.  The problem is we have overspent, not that we have under taxed.  So if I had my way, we’d do what the states are required to do, and we’d cut spending if we have shortfalls in revenue so our budget would always be balanced.  I’ll admit that the 40% cuts that would be required would probably cause mass unrest as the entitlement majority finds themselves sucking on a dry teat and now having to do something radical, like work or be responsible in order to put food on their tables, cigarette smoke in their lungs, beer in their bellies, and lottery tickets in their wallets.

However, I think it is useful to look at our structure of taxation.  We have a progressive income tax in this country (in addition to many other forms of taxation).  As you report more income, you will move from lower brackets to higher brackets as you pass certain monetary thresholds, after you take your exemptions and any deductions that you may be entitled to.  Sounds simple, right?  It isn’t, but that isn’t my point.  Who has income?  What qualifies as income? Who are all of these rich people that the nanny state can plunder from?

One common stereotype of wealthy people is rich offspring of hard working parents, living off of an enormous trust fund and doing nothing but playing golf, polo, and other such activities of the idle rich.  There may be people like this;  I’ve never met any, but I live in Mississippi at the moment, and I can’t imagine why people with wealth would want to live here.  I’m off on a tangent; the real question is do these trust fund babies have income?  In short, no.  They might have some interest or capital gains from the funds being in the bank, but they are not working and generating income.  Their income is portfolio income, and is taxed differently than earned income.  So do these rich people have income that can be tapped using our progressive income tax?  No, they don’t.  If you have accumulated a giant pile of money, and just live off of it, assuming taxes have already been paid when the money was earned, you don’t have to pay income tax as you spend it.  The “idle rich” don’t have income and so can’t fix our income problem without our actually going after their wealth, which would amount to a bill of attainder, and be constitutionally prohibited (for those of you who still care what the constitution says).

What about the wealthy investor class like Warren Buffett?  He has famously claimed that the rich don’t pay enough in taxes.  Mr. Buffett has much of his capital at risk, and is paid in return by dividends, capital gains disbursements, and the like.  These generally are classified by the IRS as capital gains, and are taxed at substantially lower rates than income.  However, this income is different because it is generated by having some capital at risk:  gains are not guaranteed and you might lose your initial capital.  (Even Warren Buffett, although he has an enviable track record.)  Wage income doesn’t have a generally negative income possibility (unless you get sued or incur some penalty or fee):  the worst thing that could happen is that you lose your job.  Investments that might generate capital gains could lose value, and you could even lose all of the money that you invested.

So how can we raise more in taxes?  I believe the simplest way would be to not tax income at all, but tax consumption instead.  When the trust fund babies spend, they would be taxed.  When the wealthy investor spends his capital gains, he would be taxed.  Such a taxation scheme would have several beneficial consequences.  First, it would eliminate the complicated and expensive record keeping required to comply with the current laws that tax income.  While notionally we are assumed to be innocent until proven guilty, when we are taxed we have to prove our innocence to the IRS by a complicated record keeping process.  We are required to submit records that we shouldn’t have to in a free society.

In addition to reducing the record keeping and improving privacy, a consumption tax would capture tax revenue from numerous people who don’t have reportable income either because they are spending already-taxed income (the “idle rich”), or because they don’t report their activities because they are illegal for some reason.  For example, I doubt many drug dealers report their incomes to the IRS, and illegal aliens also don’t typically request to pay taxes either.  It would eliminate the ever popular “just pay me in cash” scheme that many people use to avoid income taxes.

It would also tax the poor and middle class.  There are some good ideas such as the Fair Tax that would provide a rebate up to a certain level to avoid taxing the poor and making the tax system slightly progressive.

I don’t believe taxing the rich is the way to go, but if you are going to be fair about taxation, a consumption tax makes much more sense and would be more effective than the current income tax system.