Flat tax

One of the more interesting discussions I had at my reunion last week was with an old friend who’s quite the successful financial analyst and hard-core libertarian.  He was perfectly willing to give ground on how fortunate he had been to achieve his present station in life (accepted the role of fortune in his family, upbringing, education, etc.), but he works awfully hard (much too hard, I would say) and was quite dismayed at the idea that he should be penalized, i.e., pay higher tax rates, than those who don’t work as hard.  I was intrigued that he gave so much ground where many libertarians would not, but felt so strongly in opposition to progressive tax rates.  It’s not like the idea of a progressive rate structure is some crazy, irrational liberal guilt approach to policy.  Rather, the marginal value to the individual of $1 is much less when that person makes $100,000/year than when they make $10,000/year.  Thus, it is more efficient to tax higher incomes at higher rates.  Obviously, my friend supports the flat tax.  It reminded me of this persuasive rebuttal of such in the American Prospect a few years ago:

The commonly stated benefits of flat tax plans are “fairness,” simplicity, and economic growth. These are plans that are usually proposed by conservatives, which might suggest to a cynical person that there is something extra for the conservatives in these plans. And there is: flat taxes would, on the whole, benefit the richest.

A simple thought experiment shows this to be the case. Suppose we replaced the current mildly graduated marginal income tax rates in the United States with the average tax rate, and then applied this average to all income groups except the poorest. Suppose we did this while holding government expenditures constant. Who would pay less under the flat tax scheme, and who would pay more? Even with all deductibles abolished (except for the basic one such plans allow) it is pretty clear that the wealthiest would benefit and the middle class would suffer. Is this part of the fairness that flat-tax believers are always touting?…

The most appealing aspect of flat-income tax schemes is undoubtedly their simplicity. Wouldn’t it be wonderful to be able to do the taxes in five minutes flat? Wouldn’t it be great to get rid of the vast bureaucracy that is the Internal Revenue Service? Of course. But simplifying the tax system is not linked to the use of flat taxes except through the advertising efforts of the conservatives. There is nothing to stop us from simplifying the current tax structure by removing all deductibles and by closing all loopholes while retaining a set of progressive tax rates. It is not the progression of the income taxes that cause the complications so deplored by the flat-taxers.

Not only are flat taxes not the only means to simplification, they are not the only way to collect taxes from the rich more efficiently. Closing the tax loopholes would work at least as well while having the advantage (for the rest of us) of larger tax payments from the wealthy.

Not that our progressive tax structure is going anywhere any time soon.  In fact, I think the evidence is quite strong that it’s not progressive enough (a post for later this week).  I’m not sure of any good polling data on this (not that I’d actually trust polls on the nature of tax rates), but I do suspect that a pretty solid majority favors progressive taxation (though, I also suspect highly susceptible to question wording effects).  I’ll try and look before my next post.  Until then, just remember that the flat tax is most definitely not all its cracked up to be.

About Steve Greene
Professor of Political Science at NC State http://faculty.chass.ncsu.edu/shgreene

3 Responses to Flat tax

  1. Mike McAuley says:

    Dr. Greene: you know I’m a pretty liberal guy, and while I certainly don’t support a pure flat tax, I do think the “FairTax” proposal has some interesting ideas that might actually make a lot of sense. For instance, I’m sure you know about the concept of a “prebate” that accompanies the FairTax proposal, the idea being that by giving families back the taxes they would spend on life necessities, the “flat” tax becomes progressive in practice. I would think that a flat sales tax, accompanied by this kind of system, might work surprisingly well. Certainly it would simplify enforcement of tax codes if only merchants had to be audited/monitored and the average American didn’t ever have to think about taxes (or have any chance to cheat the system) beyond paying for goods & services. So long as the poverty level to which the prebates are tied did a good job of tracking cost-of-living, the tax might actually be as progressive or more progressive than current tax codes, especially when you factor in all the loopholes that the rich are currently taking advantage of.

    Just so we’re clear, I’m not a definite proponent of the FairTax… any change to our tax system this dramatic would require serious scrutiny, which I haven’t yet given… I’m more just thinking out loud here & trying to get your thoughts. But as far as how the prebate would work, I’m curious to just throw out some simplified numbers and see what comes out. Let’s say the flat tax rate is 25% and the poverty level for a family of 4 is $30,000. This means that every family of 4 would receive back $7,500 a year ($625 check sent out monthly, like Social Security). So if a family of 4 brings in exactly $30,000 a year and spent every dime of it, they would pay $0 in taxes. Another hypothetical family which brings in $60,000 a year and spent every dime of it would wind up paying $7,500 in taxes (12.5%) and so on and so forth. By the time you get to a family of 4 with a net income of say, $300,000 per year, they would be paying $67,500 in taxes (22.5%) assuming they spent all of that money on goods & services. Of course, if any of these families spent less and saved/invested some of their money, their effective tax rate would go down. I assume it is a net positive for society-at-large if the savings rate goes up (and least marginally), though I’ve only got one macroeconomics course under my belt and I could be wrong about that. Lastly, of course, I’m sure the sales tax rate and poverty levels could be rejiggered to make the system revenue neutral compared to the current system, I just wanted to make the numbers easy for this armchair analysis.

    Thoughts?

    • Steve Greene says:

      There’s certainly some good ideas in here, but my understanding was that the prebate is about a flat tax on consumption, not income. I’m not at all opposed to this idea, in addition to a progressive income tax structure. For relatively lower incomes, under a few hundred K, this all seems fine, but I think it is basically inefficient from a tax policy perspective to have people making high 6 figures or millions+ and having a top marginal income rate of 25%. To fund our current government, there’s no way that doesn’t result in a net transfer to the rich.

      • Mike McAuley says:

        For most people consumption and income is very nearly the same thing. Consumption is essentially going to be income minus savings/investment… I know I read some article during the early months of this “Great Recession” that mentioned how personal savings rates had fallen to less than 1% on average in the months leading up to the collapse (the point of the article being that many households had no savings to fall back on when they started losing their jobs). However, I certainly agree that a top marginal rate of 25% is a little low (although, playing devil’s advocate, I’m not sure what tax rate the FairTaxers advocate, it might be more like 30%). I think I agree with you that a strongly progressive income tax is by and large the best system, but sometimes I wonder if the FairTaxers are on to something.

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