Sunday, June 16, 2013

Auditing and the IRS

Auditing is a necessary part of accounting.

The need for auditing comes from the nature of business. A simple mistake in the books can have dire financial consequences.

This statement would be true even if there were no government and we did all transactions in gold bricks.

Supporters of the Flat Tax and Fair Tax make a claim that their tax reform proposals will end auditing and the IRS.

This is absurd.

The Fair Tax replaces personal income tax with a national sales tax. This new tax will be collected by businesses. (The Fair Tax is a business tax, not a consumption tax).

This new tax will require intense auditing by government auditors. The Flat Tax will require an auditing firm like the IRS.

The Fair Tax replaces the personal income tax with a massive new tax on business. Yes, this will reduce the audits of individuals, but it will increase the audits of businesses. The auditing of business is actually more problematic than the auditing of individuals.

For example, the IRS Scandal in the news involves the IRS targeting Conservative Groups. To gain the coveted status of a 401c non-profit corporation, groups are required to incorporate and file a tax status. The IRS delayed these applications.

The Fair Tax does not solve the root issue of the IRS Scandal. The Fair Tax will actually make things worse because it intensifies scrutiny of corporations.

The Fair Tax will create a paradigm in which people who want to do business will need to file for permission from the IRS. The IRS will scrutinize businesses as never before in US history. The IRS will give preferential treatment to the businesses they like and the businesses they don't like.

As pointed out in the post The Fair Tax will Be Unfair, States already classify businesses and charge different businesses different tax rates. Non-profit corporations are held to be sacred and often have no tax. If you look at the retail landscape, you will find that businesses are taxed at different rates. Hotels are taxed at one rate. Gas is taxed at another. Utilities pay a strange mix or taxes. In some places Domino's Pizza is taxed at a restaurant rate and Papa Murphy's pizza's are taxed as groceries. We have luxury taxes and sin taxes.

If we move from an income tax to a national sales tax, Congress will quickly develop a system with different tax rates on different types of business.

Many people in Congress dislike guns and love flowers. The National Sales Tax will give Congress a vehicle to tax guns at a higher rate than florists.

The Fair Tax will quickly devolve into a system in which each class of business has its own tax rate. The Fair Tax will intensive the auditing of businesses. The IRS, being composed of humans, will wring the businesses they dislike through more intense scrutiny than the businesses they like.


I called my tax reform proposal "The Object Tax." This proposal takes a different tact.

The reform starts with the realization that accounting and auditing are part of life.

Rather than trying to eliminate the need for accounting, the program seeks to give people a set of accounting tools that lets them take charge of the lives.

The program uses Object Design. We would pass a new abstract tax that can be implemented either as an income tax or as a service offered by a financial firm. (This will minimize disruption).

We create a tax code that financial firms can implement as a product. One implementation is a "Tax Aware Account."

A Tax Aware Account could be implemented by your local bank.

People will have the option of continue with the income tax, or they could choose to have the Tax Aware Account handle their taxes.

If a person chooses to use a Tax Aware Account, they will have their entire check deposited into their account. They will pay a progressive tax when they withdraw the money.

For example, you might have $1000 deposited into your account. When you withdraw the money, the Tax Aware Account will look up your personal progressive rate. If your rate is 20%, the program will pay a $200 tax and give you $800 in cash.

As you see we are combining the best of a progressive income tax with a consumption tax.

With the Tax Aware Account, the taxation will take place in real time at your bank. Your bank account will automatically generate a full and accurate accounting of your earnings (the money deposited into your account), the money you withdraw and the taxes paid.

The Tax Aware Accounts will still require auditing. The auditing can take place at the bank.

Most banks have accountants on staff. Banks usually do a good job of tracking money.

Banks will compete on the quality of the Tax Aware Accounts. Banks, wanting to retain customers, will have legal departments and accounting departments at the ready to defend the people using their tax aware accounts.

By embracing the fact that audits are a necessary part of accounting, I believe the best approach to tax reform involves creating individually based financial products with the tax function built into the product.

IMHO, the Fair Tax is doing our world a disservice by selling the lie that their reform will eliminate the IRS and the need to audit accounting systems. The need to audit is inherent in accounting. A better approach to Tax Reform is to create a system that gives all taxpayers access to robust, privately administered accounting systems ... as is done with the Object Tax.

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