Using the idea of one size fits all, some have proposed a flat tax as an alternative to the present-day marginal tax system. Like the Musketeers, they propose "All for one and one for all!"
It may be that this approach would produce the most equitable result, or generate the most revenue, or would be the simplest to implement. As long as taxpayers understand the actual criteria used to determine whether this is the best approach, then I say let’s try it on for size.
But before we examine the specifics of a flat tax, let’s answer one key question. Is the earth really flat? Can a tax plan really be flatter than a pancake? Viewed through the prism of truth, does such a thing as a flat tax really exist? I think the answer is no, although I suppose such a plan could be implemented.
Even under America’s first income tax, which mandated only one tax rate, the result was not truly one rate for all. Those who earned income above a certain threshold—set at $800 by the Revenue Act of 1862—were assessed income tax at 3%. Those whose income fell below that threshold incurred no income tax liability. From my window seat, that looks like two rates (0% and 3%) not one.
Every proposal I have examined that included “flat” in its nomenclature allowed for a threshold below which no tax was assessed. Just as the revenue act of 1862 did, plans that include a threshold establish a minimum of two rates.
There is one other consideration that must be evaluated. That is the treatment of different types of income. Unless all income, earned and unearned, passive income, investment income including interest, dividends and capital gains, unless all are treated the same, such differentiation serves to create something other than one tax rate for every dollar earned. All for one and one for all!
In our confused and confusing tax system, any “flat” tax proposal that fails to address payroll taxes automatically introduces at least three additional tax rates. Those with no earned income have a 0.0% payroll tax rate; those with income below the social security threshold have a 7.65% rate; those above the threshold have a 1.45% rate. Combined with one flat income tax rate, these produce four separate rates. In an era of political spin, politicians can use the word “flat” to describe a plan that has one individual income tax rate, yet produces a variety of actual effective rates.
I have a question. Do those lines resemble anything that you can call "flat?" To put this graph into stark focus, consider two taxpayers. The first falls smack in the middle of the 2nd income bracket, earning $75,500. Under this plan, he would pay total Federal taxes of $13,947. This translates to an effective tax rate of 18.5%. Our second taxpayer earns twice as much, $151,000. His Federal tax burden totals $24,705, an effective tax rate a full 2% LESS than our first taxpayer. If we compare this result using the methodology currently employed, marginal tax rates, this second taxpayer pays a marginal rate of 14.25% on the incremental income.
Although subject to debate, supporters argue that a flat tax is fairer than a marginal-rate system. They suggest that it encourages enterprise and hard work, leading to wealth creation, because taxpayers who earn more are not penalized by paying higher marginal tax rates. They contend that a progressive tax rate punishes effort, risk taking, and entrepreneurship, blocking economic growth. The flat tax avoids this outcome by taxing every dollar at the same rate.
Opponents contend that a flat tax places an undue burden on the lower- and middle-income classes by removing deductions and expanding the tax base to include every level of income. They believe that this method is regressive and shifts the tax load onto those who are least able to pay. Perhaps, but before we can say true or false with any certainty, an agreement on the definition of burden must be reached.
If burden means the total tax paid in dollars, then those in the top quintile of income will, just as they now do, almost certainly carry the heaviest burden. If what is meant is the percentage of income paid, a final, comprehensive plan, including a tax rate, must be presented in order to assess that argument.
Proponents of a flat tax make another key argument. Because, as proposed, income from investment, including dividends, interest on savings, or capital gains, would not be taxed, they claim the suggested approach eliminates double taxation by only taxing earned income. This is seen as increasing the fairness and simplicity of the system as well as encouraging investment. Most opponents counter that exempting interest, dividends, and capital gains would create a society in which the working class would, in effect, support the idle rich.
Challengers of a flat tax argue that progressive, marginal-rate tax systems are fair because they tax disposable income (income minus expenses). While that may be true conceptually, this argument brings the entire complexity of the existing tax structure into the discussion. Which expenses are deducted from income can be a slippery slope. The foundation of the marginal-rate approach is the belief that those earning more should pay higher taxes because they have more disposable income and therefore a greater ability to pay. Some deductions or exclusions can actually reverse that result.
Unlike the Fair Tax plan, which proposes one specific rate, proponents of a flat tax have suggested several rates. Herman Cain, onetime Republican presidential candidate, once suggested a blended plan (9-9-9) which included a flat 9% individual income tax rate, a flat 9% corporate income tax rate, and a 9% sales tax rate. Governor Rick Perry, who also sought the Republican presidential nomination, suggested an optional flat rate of 20%, allowing taxpayers to opt out of the existing tax structure and pay the fixed rate. As an aside, it is not clear to me how either of these two proposals would significantly simplify our existing tax structure.
Nonetheless, contrast the tax liability assessed under the current system with one produced by a flat tax system. For this comparison, I use a tax rate of 19% and a standard deduction of $32,496 for the flat tax computations, both figures as proposed in H.R. 1040. To calculate the tax under the current code, I use the standard exemption and deduction. For these examples, I assumed all income is wage income and there is no change to existing FICA taxes.
Under the flat tax, a taxpayer earning $62,100 pays income tax of $5,625 and payroll taxes of $4,751 to produce a combined federal tax liability of $10,375 (an effective tax rate of 17%). Under current law, this same taxpayer would pay income tax of $4,256 and payroll taxes of $4,751. These two produce a total federal tax liability of $9,007. Thus, under the flat tax proposal, this taxpayer would realize a tax increase of $1,369.
Now consider a taxpayer earning $124,200. Under the flat tax plan, income tax and payroll tax would be $17,424 and $9,501, respectively. Total taxes paid come to $26,925 for an effective tax rate of 22%. Under current law, this same taxpayer would pay federal income tax approximating $15,964 and payroll taxes of $9,501. The combined total is $25,465, reflecting a tax increase of $1,460.
What is the impact of the flat tax plan on a taxpayer at an even higher level of income—say, $2 million? Using the assumptions stated before, he would pay a flat tax bill of $373,826 plus $57,498 in payroll taxes. Total federal taxes equal $431,324 for an effective tax rate of 22%. Under current law, this taxpayer would pay income tax of about $750,000 and payroll taxes of $73,248—including additional Medicare tax—for a total tax liability of $808,063. Under current law, this taxpayer would incur an effective federal tax rate equal to 40%. Under this flat tax, this taxpayer would realize $376,739 in tax savings.
As you can see, under a flat tax, total federal taxes on families with lower-middle incomes increase, taxes on the wealthiest decrease, while the tax burden for middle-income taxpayers generally increases. The tax burden increases until income rises above a level that triggers a marginal tax rate under current law that is higher than the established flat tax rate.
From that point, taxpayers realize a savings, both in terms of the percentage of income paid as well as absolute dollars. The fact is that the flat tax lowers the taxes paid in real dollars for the very highest incomes. That may or may not be economically desirable, but it is a fact. Regardless, it is difficult to consider that result to be fair, or even reasonable.
The idea of one tax rate, applied against all income, clearly offers a less complex tax system. Elimination of the various preferences and credits creates a less ambiguous, less random tax structure. Furthermore, elimination of deductions expands the tax base by bringing income into the tax base that is currently excluded.
America has just started to back away from “super sizing” drinks and fries. We should adopt that same strategy with respect to taxes and spending. Flat is not nearly as important as size. Size matters. Petite, small, medium, large, or extra large—getting the right size is flat out important.
Vaminos muchachos! No flat beer for me today. I will ask the bartender to make mine an ice-cold frosty, frothy draft.