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I've Never Seen a Fair Tax

As the 2008 presidential campaign enters full swing, several candidates have proposed ways to reform the income tax. Although many of them claim that their proposals would result in a "fairer" tax system, all of them have definite winners and losers -- not all of whom match up with what the campaign rhetoric says.

The recent debate over the alternative minimum tax (AMT) has reignited tensions between upper-middle class taxpayers and the wealthy. Only a last-minute congressional patch prevented millions of taxpayers from being subject to the AMT for the first time, which could have cost some couples nearly $6,000.

What's fair?
The main problem is that any claims of fairness have to start from a particular baseline. If you think that the current low level of income taxes is preferable to the higher taxes in the 1990s, then any tax increases are unfair. On the other hand, if the tax rates of the '90s struck you as reasonable, then the tax cuts earlier in this decade threw things out of balance.

It's easy to point to the wealthy as not carrying their fair share of the tax burden. For instance, the private equity industry has been the target of many politicians, as firms like Blackstone Group (NYSE: BX  ) and Fortress Investment (NYSE: FIG  ) had to deal with the possibility of losing their 15% rate on so-called carried interest. Oil companies like ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) , which have been quite profitable lately, narrowly avoided losing tax incentives to increase exploration and production.

These arguments are compelling on the surface. Even Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) Warren Buffett has often been quoted as saying that his secretary pays higher taxes than he does -- a statement that seems ludicrous at first glance.

Looking more closely at figures about the wealthy muddies the picture. IRS statistics showed that the highest-earning 1% of taxpayers earned more than 21% of all income in 2005, the latest figures available, and made up about 34% of the nation's total net worth. They also paid 39% of all income taxes in 2005. Is that fair? Should they pay less, or more?

In addition, no solution guarantees a result that everyone would agree is more fair. Tax laws always have a strong influence on people's behavior. For instance, some believe the housing bubble may have been exacerbated by tax provisions exempting up to $500,000 in capital gains from home sales. Similarly, some point to lower rates on dividend income as bolstering the stock market over the past several years.

Alternatives to the current income tax system have the same potential for unintended consequences. For instance, taxes based on consumption tend to penalize those with lower incomes, who must spend a higher proportion of their income on necessities. And even though most consumption-tax proposals provide for a certain minimum amount of tax-free spending, it's still likely that wealthy people -- especially those who are relatively frugal -- fare better under a consumption tax than they do in a system based on income taxes.

Forget fairness
For anyone trying to build wealth, taxes are the enemy. The best way to evaluate a tax proposal objectively is by looking at how it will affect you, and what you can do to take advantage of its favorable provisions.

Currently, there are lots of incentives for people to invest. Low tax rates on dividends and capital gains let investors keep more of their returns. Tax-favored accounts like IRAs, 529 plans, and health savings accounts let you defer taxes or avoid them entirely. Things like the deduction for mortgage interest and real estate taxes still encourage home ownership. Take advantage of those opportunities to save on your taxes as long as you can -- and if those go away, there'll probably be other ways to cut your taxes.

To learn more on saving money on your taxes, find out


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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