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Thursday, May 20, 2010

A More Just Tax, Part VIII: Determining the Exemption Level

By Norman G. Kurland, Dawn K. Brohawn, and Michael D. Greaney

In the previous posting we looked at how much income would be exempted from taxation and the potential effect this would have on personal as well as national finances. To get to that point, we used some figures that we now have to justify. The question we need to look at is how to determine the amount of income to be exempted from taxation. Difficulties start once we begin working on the figures used in the calculation.

Again we have to note that the figures used in these chapters are only a very rough approximation. They are based on data available on the web sites of the Census Bureau, Department of Education, Department of Health and Human Services, and the Office of Management and Budget. These are all "official" government numbers, but several critical categories of expenditures are not available for each year. This builds a rather serious "fudge factor" into our calculations. Fortunately what we're after is a reasonable figure on which to build specific policy recommendations, not an in-depth econometric model.

First off we have the amount of the standard exemption under a Capital Homesteading program. We begin with the official "poverty" figures supplied by the Census Bureau for 2007. These start at under $10,000 for a single individual, to just short of $20,000 for a family of four.

While these amounts may seem generous (or not) at first glance, we need to examine what they mean. Taking a family of four as our "benchmark," we begin with a poverty level of $20,000, rounded up for ease in calculation. Out of this let us take taxes, housing, and health care. To simplify the calculations, we will assume a flat 15% rate for Social Security and Medicare (on the possibly unrealistic assumption that were the money not paid by the employer, it would have been used to increase wages), $3,000, the standard deduction and exemptions for income tax, $-0-, $7,000 per capita for health care (see below), $28,000, and one-third of gross income for housing, $6,500. This gives us total expenditures of $37,500 for a family of four with a single wage earner making the poverty level income of $20,000.

The income tax takes into account the standard deduction for "married filing jointly" ($10,700), an exemption of $3,400 for each individual, and a 10% tax on adjusted gross income below $15,000. Housing is rounded down from $6,667. Despite the zero income tax and an unrealistic cost of housing, the family of four has already spent $17,500 more than it takes in, largely as the result of escalating health care costs.

Removing health care costs (for which a family at the poverty level is either not paying or simply not receiving adequate health care) leaves the family $10,500 to meet expenditures for food, clothing, transportation, utilities, education, and so on. This might — with a great deal of luck and no emergencies — be enough on which to survive, but not address a problem with which many people today are concerned: the inability of many Americans to finance adequate health care.

Per Capita Health Care Expenditures

Another problem is that removing the per capita cost of health care disguises the nature of the present crisis. Universal coverage means some form of insurance, and insurance premiums are set to cover estimated claims and the cost of administering the system. Further, a universal system could only be fair if the premiums were set at the estimated per capita expenditure for health care.

Calculating the premium for universal comprehensive health insurance presents something of a problem. The United States Census Bureau,, publishes statistics on total health care costs for every year that ends in "2" or "7," or every five years. The latest figures available when we did the original research for this series were from 2002, when the estimated population of the United States was 288,368,698. Since these figures are sufficient to illustrate the severity of the problem, we will continue to use them.

At that time, the total cost figure for "Health Care and Social Assistance" was $1,207,299,734,000, or (roughly) $1.21 trillion, including the costs of malpractice insurance, hospices, health insurance, prescription drugs, preventive care — everything — and support systems for health delivery. Backing out the reported figure of $91,412,364,000 ($91.41 billion) for "Social Assistance" (which includes such line items as day care and pre-school), leaves an adjusted figure for purely health care costs for 2002 of $1,115,887,370,000, or $1.12 trillion.

Dividing the cost by the 2002 estimated population gives a per capita health care cost for that year of $3,870, or nearly $4,000 per man, woman, and child in the United States. The "population clock" on the Census Bureau web site for July 24, 2007 gave an estimated total population for the United States as 302,426,525, which when multiplied by $3,870 gives an estimated total health care cost for the United States for 2007 as $1.17 trillion — assuming no increases. Some alarmists are predicting that health care costs will increase by 300% to 1,000% over the next five years, but without verifying their figures or explaining how they arrive at their estimates.

This would give us a rounded annual per capita cost of health care in the United States of $4,000, or an amount to pay for a per capita health insurance premium of $3,000, assuming a $1,000 deductible. While these figures seem reasonable, however, the United States Department of Health and Human Services gives a substantially larger annual per capita cost of health care. Although we were unable to verify the figures, the "Health Care Costs Fact Sheet" posted on the agency's web site states that, "In 1960 . . . health care expenditures accounted for about 5 percent of the GDP; by 2000, that figure had grown to more than 13 percent."

Raising the figure to 15%, we think we can come up with a figure that will satisfy any potential critics and be extremely conservative at the same time. Using the 2006 reported GDP of $13.25 trillion, we calculate total health care costs of $1.99 trillion, which we will round up to $2 trillion. Dividing by an estimated total population of 300 million, we arrive at an annual per capita health care cost of $6,666.67, which we round up to $7,000. We then revise our estimated per capita insurance premium to $6,000, and provide a "standard deductible" of $1,000.

Per Capita Education Expenditures

Education is another area of concern. Without a good education within the reach of people of moderate means, the United States faces the creation of an extremely stratified society, divided into an educated elite and a large mass of unemployable unskilled workers. More importantly, without a grounding in the ability to learn and think, creativity dries up, as it has in many respects already as institutions of higher learning have been transformed into job training centers, distributing the necessary admission ticket to a "good job." We should now calculate the per capita expenditure for education by taking the total amount spent on education reported for 2003 ($857,354,109,000) and dividing it by the total population. This gives us $2,857.85.

This we round to an even $3,000. We must be aware, however, that not everyone may spend this much on education each year — or this little. We can, however, qualify such things as savings for education and payment of student loans (both principal and interest) by including them as expenditures and allowing an unlimited carryback and carryforward of any expenditures or savings in excess of the annual deduction. If a taxpayer neither expends nor saves any funds in any form for education, of course, there will be no deduction for education.

Per Capita Capital Homestead Tax Deferral

This brings us to an estimated level of expenditure for a family of four living in poverty of $49,500. This can be reduced slightly by taking out the $3,000 for Social Security and Medicare, but that only lowers it to $46,500. Assuming only the dependents are being educated cuts it still further to $40,500. This is a little better, but it is still more than twice the official poverty level! There is also no provision for food, clothing, transportation, or anything other than shelter, health care, and limited education. There is no provision for saving, which is the backbone of the Capital Homesteading program.

Removing Social Security and Medicare from the list of expenditures requires that we replace these programs with some other mechanism whereby people can save and invest for retirement. The Capital Homestead deferral for payments of principal and a deduction for interest on securities acquisition loans must be instituted. This is merely an extension of the tax principles to encourage workers to accumulate a significant capital estate for meeting their retirement needs through leveraged Employee Stock Ownership Plans.

The annual amount put into an individual's Capital Homestead Account should not be a fixed, limited amount each year, but a "lifetime deferral." This would be set by a maximum amount that the Capital Homestead Act would allow to be accumulated tax-free. (More accurately, it would not be "tax-free" but "tax-deferred," being taxable to the recipient in the event of a liquidation of all or part of a Capital Homestead accumulation, due to death, use of the accumulation for consumption, or a desire to live in complete poverty.)

Thus, the amount of Capital Homestead lifetime deferral would be determined by whether or not the maximum tax deferred amount had been accumulated and maintained as of a valuation date to be determined by statute each year, or some acceptable form of averaging. If an individual had not used any part of his or her lifetime deduction, and the Capital Homestead accumulation was set at $1 million, that individual could use it up all in one year by putting $1 million into the tax-sheltered Capital Homestead account. If the investments turned out to do poorly and the value of the account declined by, say, 25%, the next year that individual would be eligible for a deferral of up to $250,000 plus interest that could be deducted to bring his or her account up to the tax deferred maximum.

Practically speaking, however, most people wouldn't be able to put $1 million into their Capital Homestead accounts at one time. Assuming that everybody lives to be 100 years old, and everybody puts in exactly 1/100 of the total lifetime deferral each year, we end up with an average per capita Homestead deferral of $10,000.

Further, it may not be expedient or even "politically salable" to limit the annual amount of capital formation financed via Capital Homesteading Accounts. There is an estimated $2 trillion of new capital formation each year, at the current slow rate of growth. When divided into the estimated population of 300 million, this gives per capita capital formation in the amount of $6,667. We round this up to $7,000 for ease in calculation. By age 65, someone born just as Capital Homesteading was enacted, and assuming absolutely no acceleration in economic growth or return on investment (highly unlikely), would accumulate a capital stake of $450,000 generating taxable income of nearly $60,000 annually — of which $30,000 would be exempt under the single rate tax — and the "Capital Homesteader" would have received net dividend pre-tax income from birth to age 65 of more than $1.8 million.

If we assume that the economy will grow at a slightly faster rate, we can increase the Capital Homestead accumulation so that it equals the somewhat more realistic average per capita amount of $10,000 per year. Factoring in this additional $3,000 we get a total accumulation by age 65 of nearly $650,000, annual pre-tax capital income of over $85,000, and net dividend income from birth to age 65 of more than $2.5 million.

Some people might be tempted to suggest that with the increased capital income, economic growth could be speeded up if people didn't spend everything on consumption, but saved a substantial portion. Cutting consumption in order to save, however, would have a detrimental effect on the financial feasibility of the investments, as Dr. Harold Moulton pointed out:
When the managers of modern business corporations contemplate the expansion of capital goods they are forced to consider whether such capital will be profitable. They must begin to pay interest upon borrowed funds immediately and they must hold out the hope of relatively early dividends on stock investments. To be sure, there are certain types of speculative enterprise in which capital will be risked for considerable periods of time in the hope of large ultimate profits; but, in the main, returns have to be in prospect relatively soon.

Now the ability to earn interest or profits on new capital depends directly upon the ability to sell the goods which that new capital will produce, and this depends, in the main, upon an expansion in the aggregate demand of the people for consumption goods. A particular corporation may, to be sure, construct new plant and equipment in the face of a declining aggregate demand from consumers, hoping by lower costs and price concessions to take business away from competitors, whose capital will thereby be rendered obsolete; but if the aggregate capital supply of a nation is to be steadily increased it is necessary that the demand for consumption goods expand in rough proportion to the increase in the supply of capital. (Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 29.)
For this reason it is important to point out that we do not recommend cutting consumption in order to accumulate savings. This is especially relevant at the initiation of a Capital Homesteading program when people in general lack adequate means of meeting their ordinary consumption needs. Most people, already unable to meet common domestic needs adequately, could not easily reduce consumption in order to achieve savings in addition to the "future" savings made possible through Capital Homesteading.

Note, however, that the $7,000 per capita credit allocation reflects a "slow growth economy." As incomes rise, consumer effective demand will increase rapidly, providing the incentive to form additional new capital as well as the increased consumer demand necessary to sustain the new capital formation. It is not unrealistic to assume that within five years the amount of per capita investment through Capital Homesteading would rise to $10,000 or more. It would only require a permanent increase in effective consumer demand of 43% — less than 10% per year. This 10% increase in effective demand would very easily be realized from the nearly 40 million Americans currently living in officially recognized poverty, while unofficial poverty would doubtless add a substantial amount of sustainable effective demand as Capital Homesteading income became available.

Calculating the Single Tax Rate

According to the United States Bureau of Economic Analysis, (National Economic Accounts: Gross Domestic Product (GDP) "Current-dollar and 'real' GDP") the Gross Domestic Product (GDP) of the United States in 2007 was $13.8 trillion. This amount is substantiated by figures supplied by the United Nations, which reported per capita U.S. GDP at $46,000. When multiplied by the estimated U.S. population of 300 million, we get the same figure: $13.8 trillion — suggesting that the UN accepted the figure supplied by the U.S. Bureau of Economic Analysis.

Now we need to come up with a reasonable figure for government expenditures per year. According to the Office of Management and Budget the estimated annual federal budget before the current rapid increase in bailout and stimulus spending was $3 trillion, of which $2 trillion consisted of entitlements. We calculated above that a typical family of four would need on a per capita basis $46,500 to cover housing, education, and health care. As this leaves nothing for food, clothing, transportation, or anything else, we will assume that entitlements make up the difference. To this we will add $3,500 to allow for whatever was otherwise unaccounted for. We are fully aware that this last is unrealistic, but we need some basis for arriving at a standard exemption figure.

We therefore tentatively determine that the standard exemption for a non-dependent individual should be $50,000, while that for a dependent individual should be $25,000, neither of which includes $10,000 for Capital Homesteading. This is because, while the Capital Homesteading amount is treated as an exemption, it is actually a deferral. Assets sold or otherwise distributed from a Capital Homestead Account will be fully taxable as ordinary income to the recipient.

It is anticipated that Capital Homesteading Accumulations will largely be disbursed through inheritance on the death of the homesteader, and that, in the early stages, taxpayers who have accumulated wealth will take full advantage of the $1 million deferral immediately. These tend to be older individuals. Upon their deaths, the full Homestead accumulation will be taxed as ordinary income to the heirs, unless included in the heirs' Capital Homestead Account(s), but will not be included in GDP.

Thus, the amounts not taxed under Capital Homesteading should constitute a "wash" with respect to the tax base. Further, since the ability to deduct contributions to foundations from personal income will no longer exist, tax revenues should dramatically increase for a generation as a result of the loss of this tax shelter. In order to be as conservative as possible, however, the Capital Homestead deferral will be considered a dollar-for-dollar wash without regard to anticipated tax revenues from inheritance being treated as ordinary income.

Unfortunately, using these figures and assuming that half the population qualifies as dependent, we get a tax rate of more than 117%. Obviously, we set the exemptions too high. You cannot tax more than 100%. The logical alternative is to lower the exemptions. Using $30,000 for a non-dependent and $20,000 for a dependent, we get a tax rate of just under 50%. (Taxable GDP of $6.3 trillion divided by federal budget of $3 trillion.)

A tax of half your income? This looks pretty grim for CESJ's Capital Homesteading reforms. Let's look more carefully at these numbers, however. Realizing that self-employed individuals making below $30,000 per year at the present time can pay an effective tax rate of almost 40% makes the figure slightly more palatable. Are these rather stark figures, however, significantly worse than current tax rates applied to income reduced, as at present, by a token exemption and deductions insufficient to shelter enough income to provide for common domestic needs adequately?