How to fix: The US tax system

In the 1950s, the top tax rate for the wealthiest Americans was an astonishing 91%. Things are saner now, or at least they sound that way, with the maximum tax rate down to just 35% of earned income.

Here's the problem, though: The income this brings in isn't enough for our government to pay its bills or provide basic services -- educating our children, defending against outside attacks, and keeping our roads and bridges from falling apart. Video: 'Taxes are not high enough'

Federal budget deficits have led to a crippling burden of hidden cost increases elsewhere in our lives -- in both higher property taxes and spiking tuition bills, for instance, as state and local governments scramble to replace vanishing federal support.

And as the national debt has doubled over the past six years, to more than $9 trillion, the dollar has lost more than a third of its value against the euro and the British pound. If further declines cause China and other foreign lenders to lose their appetite for U.S. debt, it could eventually limit the government's ability to finance its operations with debt. That in turn would force a hike in interest rates to make that debt more attractive as an investment -- and that means costlier mortgages, car loans and credit cards for the middle class.

It's time to fix our tax system. What follows are some of the reforms that would help us work our way back to fiscal health and avoid a crisis for the middle class.

Simplify, simplify, simplify. Tax law has become such a hodgepodge of arcane deductions that not even an M.B.A. can figure it out -- and nobody puts much faith in its fairness. Loopholes exist for the middle class as well as the rich, but without either specialized know-how or hired tax help, working stiffs often end up paying more than they should.

One proposal now before Congress would collapse individual tax brackets from six down to three and put it all on a one-page form, while preserving some middle-class tax breaks -- for home-mortgage interest, child care, health and education savings and retirement, for instance.

Stop tinkering with tax law year after year. Doing favors helps elected officials win campaign contributions. But it corrupts the system, usually at the expense of the middle class. Video: Why politicians cut taxes

Annual patches and sunset provisions also make it impossible to plan ahead. Hoping to avoid estate taxes? Better die in 2010, when the estate tax drops to zero. But then on Jan. 1, 2011, it jumps back up as high as 60%. That should make for an interesting New Year's Eve.

Get rid of the alternative minimum tax. The AMT started out in the 1970s as a way to keep the rich from taking advantage of too many loopholes. But today, "because of poor design, millionaires are actually less likely to owe AMT than middle-income people with kids," says Len Burman, director of the Tax Policy Center. He calls the AMT "just a horrible way to make tax policy," leaving taxpayers in a state of perpetual uncertainty. Video: What is the AMT?

For example, the tax credit for buying a hybrid vehicle may be worth $3,000 or nothing -- and you probably won't know which until your tax accountant tells you next spring whether you got caught by the AMT. Burman would eliminate the AMT and pay for it in a way that accomplishes the AMT's original purpose -- a 4% surtax on adjusted gross income over $200,000 for a couple and $100,000 for an individual. The surtax has the political advantage of still leaving the top tax rate half a point below what it was before the tax cuts of 2001. But because it would apply to adjusted gross income, before deductions, it would actually bring in more revenue. Graph: Who's hit by the AMT?

Rethink the tax break on capital gains. The potential for abuse became apparent this year when private-investment-fund managers -- in some cases earning hundreds of millions of dollars a year -- made the news by taking the 15% capital gains tax rate on what looks to everybody else like ordinary income, taxable at 35%. But Eric Schoenberg says special treatment for capital gains doesn't make sense in the first place. Video: Should the rich pay more?

Schoenberg was born into a wealthy family, and he earned another fortune as managing director of Broadview International, a boutique investment bank. At age 45, he finds working for an income no longer makes much sense to him. He now teaches the psychology of money part time at Columbia University, and because he lives largely on dividends and capital gains, "I pay a lower rate of tax than the administrative assistant in my department."

Warren Buffett, the world's third-richest person, recently lambasted a tax system that in 2006 let him pay a lower tax rate on his $46 million in earnings than one of his secretaries paid on her $60,000 income. Schoenberg would tax capital gains and dividends like wages. But to avoid double taxation, corporations could deduct dividends the way they now deduct interest on debt.

Dump some deductions now considered sacred. Charitable contributions would be a good place to start. Giving to cure AIDS or malaria is one thing, says billionaire investor William H. Gross, but "a $30 million gift to a concert hall is not philanthropy; it is a Napoleonic coronation." And the rest of us pay for it: The charity deduction cost the U.S. Treasury $40 billion in 2006.

Subsidizing philanthropy can actually make inequality worse, says Stanford political scientist Rob Reich. He cites the example of a wealthy California suburb that raised $4,300 per student for its local schools one year, while schools in nearby poor neighborhoods managed to raise just $27 per student.

Eliminating the deduction would cause a short-term hit for charities. But overall giving has gone up even when deductions have gone down. Good causes and strong convictions will keep the money flowing, says Reich.

Cut corporate taxes. Proposed legislation would reduce corporate taxes from 35% to 30.5%. How to pay for it? Thin out the rat's nest of loopholes and deductions that now allow some companies to get away tax-free.

Let the last round of upper-income tax cuts expire. Nobody's talking about reviving

the punitive rates of the 1950s. But even some rich people argue that the pendulum has swung too far.

Schoenberg would revert to the 39.6% top rate that prevailed until 2001. It's scheduled to happen anyway in 2011, and critics say good riddance: Skewing the tax system to favor the rich already has produced the worst economic inequality since the Depression, and threatens to divide the country on class grounds. Responsible Wealth, a network of 700 rich people, argues that going back to a more progressive tax code -- meaning higher rates on top incomes -- will encourage "widespread prosperity" in place of the growing class divide.

Continue to tax a person's inheritance. Robert L. Crandall -- who made a fortune (and a reputation as a ferocious competitor) when he was CEO of American Airlines -- argues for an inheritance tax up to 50%, with the first $5 million or $10 million of an estate exempted.

"We don't want to have an aristocratic class and a class of serfs," says Crandall. "We don't want to have people who can't live a decent life because, despite being willing to work, they make so little money that they can't support a family. That's not the way America ought to be. And it's not the way America was when I grew up."

Crandall admits that wealthy friends often balk at the idea of giving back more of the money they worked hard to earn. He answers this way: "You were smart, you worked hard . . . terrific! But you're also really lucky . . . lucky to get a good education, lucky to live in the richest country in the history of the world. Do you think you'd have earned the same amount if you were born and raised in Poland? Or Yugoslavia? Or the Ukraine? I don't think so."

Crandall doesn't claim to have made many converts. But, he says, "it makes for interesting dinner

conversations." And it's better to talk about it now, he says, than realize too late that taxes are the price we pay for civilization.

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Published Dec. 28, 2007