Tax reform and how to win the lottery when you file your 1040

At least once every tax season I have a client who is dumbfounded that their federal tax refund is bigger than the amount of income taxes they had withheld, and they invariably say “you mean the Internal Revenue Service will send back more than I paid in, that doesn’t make any sense!”  
Indeed, but in fact (according to a recent nonpartisan Joint Committee on Taxation report on 2009 Federal tax filings) about 30% of American taxpayers do, in fact, get back all and more of what they paid in for federal income tax.  This happens via something called “refundable tax credits,” credits that directly lower federal income taxes but are then refundable if the credit exceeds the taxpayer’s liability.  In the tax world these refundable credits are often called tax expenditures, i.e. the I.R.S. sends out a refund in excess of the money the taxpayer has actually paid in.  The growth of these refundable credits has produced this 30% of the population that gets back more than they paid in, as well as to the equally shocking 51% of Americans that pay no federal income taxes (according to the same Joint Committee  report).  These refundable credits include the much abused earned income tax credit, adoption credit, American Opportunities education credit and the new home buyer’s credit.  These credits essentially turn the Internal Revenue Service into a quasi-welfare agency for approximately 30% of American taxpayers.

So what is tax reform going to look like?  I suspect it will be modeled on the huge 1986 tax reform bill, and that can best be visualized in this way; if the tax code is a rubber ball, the reform will essentially squash the ball.  It will lower all marginal rates in exchange for eliminating special tax breaks and credits and it will broaden (flatten) the tax base.  Regardless of what one thinks about “tax breaks for the wealthy” no democracy is going to function properly if 51% of its citizens do not pay taxes and 30% see filing their taxes as akin to playing the lottery.  We certainly have poor people in this county that should not be paying taxes, but I have a hard time believing that group is 51% of US tax filers.  I also find it hard to believe that 30% of the American public needs to be collecting what amounts to welfare payments thru their tax filings (a process loaded with opportunities to manipulate income). 

While I am no fan of the Internal Revenue Service part of tax reform should be returning the Service to its proper function; the administration and collection of taxes.  It should not be a welfare agency and it should also not become the traffic cop for the national health reform (a subject for another day).  The I.R.S. should never be sending out checks in excess of what it has collected and most important more Americans have to become tax paying citizens.  I think before we even have the discussion on proper tax rates for “the rich” we desperately need to get more American’s with “skin in the game.”  A capitalist democracy demands and needs a citizenry that sees and understands the relationship between money paid in for taxes and goods and services received from the government.