How to Solve America's Tax Nightmare

David Arky for Newsweek

Most Americans spend dozens, if not hundreds, of hours attempting, not always successfully, to do their tax returns. We spend almost $30 billion paying accountants to fill out the complicated forms, and by some estimates we devote $110 billion of our own labor just keeping track of all the necessary records and paperwork. Americans pay about 85 percent of the taxes they owe, better than in most countries, but the shortfall is still a drain on the Treasury (and the rich seem to find a way to avoid taxes legally). Is this costly, demoralizing struggle between the IRS and the rest of us really necessary?

The short answer is no. There is a way to relieve almost all Americans of the annual April 15 nightmare. What's more, it's a necessary first step toward a plan to cut the looming federal deficit. The time is right for thoroughgoing tax reform—a true clean slate—that will bring in more revenue while giving the public a greater sense of fairness. The reforms we propose will even allow most people to take home more pay than they do now.

The place to start is to cut almost everyone's payroll and income taxes by half. Yes, you read that right. Cut most tax rates, which now run from 10 to 39 percent, by half. All individual taxes would be collected through company withholding taxes on compensation (salary, bonus, deferred payments, etc.) and investment income (dividends, interest, capital gains, rents) to individuals. The very rich—those making more than $2 million a year—would still pay a top tax rate of 30 percent on earned income. The rate on investment income would be 15 percent. The result: individuals would not have to file tax returns, most Americans would take home more pay than they do now, the tax base would be broadened, and the AMT—the alternative minimum tax, which sweeps up more taxpayers every year—would be eliminated.

Too good to be true? There's no free lunch. The revenue lost to the government—roughly half of all personal federal taxes—has to come from someplace else. The best fix is to eliminate all deductions and exemptions for individual taxpayers—all those tax breaks that were intended to promote economic activity or serve worthy social goals but have ended up creating myriad unfair outcomes. It's true that the wealthiest 1 percent currently pays about 18 percent of all taxes. Still, thanks to clever tax dodges, the top 400 income earners pay an average tax rate of 16.6 percent; megabillionaire Warren Buffett notes that his secretary pays a higher tax rate than he does.

Deductions are costly to the federal Treasury—siphoning off between a fifth and a quarter of all revenue. Wipe them out and we will have restored a significant percentage of the money lost by cutting income-tax rates. Where does the rest come from? A 12 percent tax on consumer goods, collected in increments as they are produced and sold, would raise $600 billion, more than closing the gap.

Some will argue that a consumption tax would raise prices, maybe even unleash inflation, and hurt the economy. Many economists, however, believe that a modest value-added tax (VAT) can actually boost the economy in the long run. It encourages saving and investing over consumption and debt—the twin habits that helped push the country into the Great Recession of 2008. Though savings rates are going up, we are still "unwinding" our personal debts and have a way to go. We can put more money in people's pockets by lowering income taxes but encourage saving and investment with a consumption tax.

This basic version of the Clean Slate Plan is revenue-neutral—it neither raises nor lowers the total amount of taxes flowing into the Treasury—but it can be adjusted to deal with changing economic conditions. (Precise predictions are impossible because changing tax rates can alter economic behavior in ways that are hard to predict.) If the government wants to give the economy a quick boost in a downturn, the VAT rates can be lowered. But if we need to raise revenue (and over the long run, we surely do), they can be adjusted upward.

This is where the Clean Slate Plan really promises to do some good for the country and for the future of our children and grandchildren. For some time, Americans have refused to pay for the services they get from government. Last year we paid federal taxes amounting to about 15 percent of the nation's economy. But the government spent or paid out in benefits close to 25 percent of GDP. We had to borrow the difference. The total federal debt keeps growing. It's about half the size of the economy now, high though not horrendous by historical standards. But as the baby boomers age and the costs of caring for them go up, our debt will very shortly mushroom to the sort of levels seen in Greece.

Will there be rioting in the streets as we slash benefits? Or will we inflate our way out like some banana republic, impoverishing people on fixed incomes? Clearly we have to do something about the federal deficit. We might be able to grow our way out—but very few economists believe this. Almost everyone, even politicians in moments of off-the-record candor, agree that we'll have to cut spending and raise taxes, probably in equal measure. There will have to be a compromise: Democrats will have to bend on their unwillingness to cut spending, and Republicans will have to give on their refusal to increase taxes. Setting the VAT at 15 percent rather than 12 percent, for instance, would produce an extra $150 billion or so a year in revenue. The beauty of the Clean Slate is that it offers a simple way to boost revenue that is fair, open, and progressive—and gets the IRS out of people's lives.

The rich will not be soaked, but they may actually have to pay higher tax rates than their secretaries; the special interests will squawk and protest. There may have to be some adjustments—the poor and the very old may need at least partial reimbursement for the VAT they pay, and possibly there should be pretax exemptions for individual savings, like the 401(k). Charitable deductions could be handled the same way. Of course, if exceptions are made for savings plans and charity, the tax rates will have to be adjusted upward—marginal income-tax rates might be cut by a third, instead of half. But such exceptions should be kept to a minimum in order to create a truly clean slate.

Yes, lawmakers will want to protect their favorite interest groups. But at a time when the public is boiling with rage against incumbents, agreeing to lower income taxes for most people while removing the IRS from Americans' lives—and at the same time creating a system that is obviously fair and open while helping government to pay its debts—well, that doesn't sound like a bad way for politicians to win votes.

How and why the plan will work:

Isn't the VAT too hard on low-income people?

The VAT can be made more progressive by either exempting necessities or paying rebates to low-income people. The Clean Slate overall is more progressive than the present system because there are no deductions against investment income, and people with very high compensation don't enjoy the same big tax breaks others get. It is fairer overall because there are no tax shelters and higher compliance.

Won't there be a lot of tax evasion?
There will be less evasion. The IRS says 15 percent of tax revenue is now lost to underreporting, excess deductions, and nonfiling. That is $350 billion and growing. The VAT will catch some of those losses because it applies to all purchases. Strict withholding on investment income and compensation will eliminate more losses. The Tax Policy Center estimates that a simple withholding system allows about 5 percent evasion, while a simple self-reporting system can allow 50 percent evasion. The Clean Slate would move evasion rates closer to 5 percent from the current 15 percent because it is a withholding system and collects VAT on sales.

Won't there be winners and losers?
Yes, but overall fairness will improve and the system will be simple and understandable.

What about corporations and proprietorships?
There is no change to their tax system. Individuals conducting businesses with more than $35,000 of business revenue would be taxed like all other businesses, just as they are now.

How do companies set withholding rates if the payees have several jobs or change jobs?
The IRS now collects payment information from all sources with respect to each person. The IRS can add them up and notify each company what the withholding rate is for each person based on the total.

How do companies withhold on capital gains if they don't have the tax basis?
Many companies, like banks and brokers, already have the basis information. In other cases the company would have to get it from the seller. If the seller does not supply it, the full amount is taxed so there is every reason to provide the tax basis to the company for withholding purposes.

How do you tax a transaction when one individual pays another and no one fits the business definition for filing?
Some taxes would be missed. The VAT would pick up some of that when the money is spent.

Libbey is a lawyer in Minneapolis. Thomas is editor at large at NEWSWEEK. They were assisted by Susan Tanaka of the Peterson Foundation. For more information, contact