Ever since I wrote The Case Against Roth 401(k), I have people telling me I’m out of my mind. They say taxes have to be higher in the future because of deficits, baby boomers retiring, higher health care costs, etc., etc.
I don’t necessarily disagree that taxes will be higher in the future. After all, the demographical trend of an aging population is clear. The entitlement programs have to be paid by taxes — the government can’t borrow an unlimited amount forever. There might be some trimming at the edges but cutting the programs dramatically is unrealistic.
However, taxes will go up does not mean that tax rates will have to go up. The decision point on Traditional vs Roth is about tax rates, not the total tax dollar amount.
How can taxes go up but tax rates don’t? By broadening the tax base, which means having the tax rates apply to more income.
Right now the government collects tax only on a portion of one’s income. Through numerous exemptions and deductions, the taxable income ends up being only a subset of one’s total income. Through tax credits, the actual tax is further reduced from the number you would normally calculate by applying the tax bracket percentages against the taxable income.
If we get rid of or limit the exemptions, deductions, and tax credits, the actual tax bracket percentages can be lowered and the government would still collect more taxes.
Exhibit A would be the recently circulated Gang of Six deficit reduction plan. Prior to the recent breakdown, the plan has received favorable opinions from both Democrats and Republicans. Some said it can get the crucial 60 votes in the Senate. The Gang of Six plan, which borrows ideas from the Fiscal Commission report, raises taxes and lowers the marginal tax brackets.
Taxes will go up does not mean tax rates will have to go up.
Would you rather have a lot of deductions and higher tax rates or fewer deductions and lower tax rates? I would much prefer the latter because it’s much less prone to gaming. You probably heard about GE paid zero federal income tax despite having reported a large profit. How? Through exemptions, deductions, and credits.
Although the Wall Street Journal would scare the public with sensational headlines like Preparing For D-Day: When Congress Takes Your Deductions, one should realize that the exemptions, deductions, and credits largely benefit the rich. If we replace those exemptions, deductions, and credits with lower tax rates, the net effect to a typical middle class family can be very small. For most people, there’s nothing to fear about losing tax deductions.