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What's Wrong with the Flat Tax

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All articles "recovered" written ©Mark Joseph Young, originally published on TheExaminer.com.  All other articles written ©Mark Joseph Young.  This site is part of M. J. Young Net.

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What's Wrong with the Flat Tax

During my tenure at The Examiner, I began a casual intermittent series on Taxation, completing two parts, the first, Basic Taxation:  Income Tax, hitting some of the basics of how income tax works and why, the second, Consumption Tax and the Myth of Equity, examining the complications and flaws in the oft-heard proposal that we eliminate the income tax and replace it with a massive federal sales tax, now both articles combined in the linked page.  As we then said, it is easy to get attention offering to fix the tax system, because everyone assumes that the current system unfarly overtaxes him and lets others pay less than their "fair share", and if it were fixed that would mean he pays less and someone else pays more.  Tax law is an effort to achieve this equity; deductions are called loopholes by those who see them as a way that others avoid paying their share of the tax, but as equalizers by those who by use of them save money.  We saw that the consumption tax was not more fair unless it was made as complicated, as decisions would have to be made by sellers concerning when not to collect tax, or else everyone would have to file tax returns for rebates on sales tax they did not need to pay, and in any case the poor would wind up paying a greater percentage of their income than the wealthy.

However, there is another frequently-espoused proposal for making the tax system "fair", what is called the flat tax.  In brief, it is explained that everyone will pay the same percentage of his income in taxes, usually a nice round ten percent, and there will be no deductions at all.  Both parts of this are demonstrably problematic, but that should emerge as we discuss the basics of tax rates and deductions.  To some degree, this is expanding the first of those articles, but it is doing so within the context of this special application.  (Rand Paul, pictured, is only one of those pushing for such a tax system.)


The Flat Rate

The first problem with the flat tax is the flat rate.  We discussed this in explaining the graduated rate in Basic Taxation:  Income Tax (one of the two articles previously mentioned), but to summarize, the person who makes a million dollars can afford to surrender ten percent, a hundred thousand dollars, in taxes much more than the person who earns a hundred dollars can afford to surrender ten.  For that bottom-of-the-scale earner, that ten dollars is certainly lunch or dinner, maybe twice or even thrice if he's frugal; for the millionaire, he is not going to go hungry.

Because of this, some who espouse the flat tax also include a "minimum income" point:  anyone who makes less than some defined number is exempt, pays no taxes.  Presumably if we retain the withholdings system, they would have to file to get their prepaid unowed tax payments refunded to them, but in essence they do not pay anything.

The most obvious problem with this is what we noticed in the other article, the "break point".  If the floor is twenty thousand dollars, someone who makes nineteen thousand nine hundred ninety-nine dollars keeps every penny of it, but someone who makes one more dollar and so reaches the threshold is out two thousand dollars, keeping only eighteen thousand--a very expensive dollar, and that means a very expensive raise.

That is a less obvious problem, but a very real one, and one of the reasons that it took so long to adjust the graduated income tax system.  Because of inflation, which at a low rate is an unfortunate side effect of a "hot" healthy economy and at a high rate is devastating, absolute dollar amounts do not equate to levels of effective income--indeed, even at any given moment in time the real value of a dollar (that is, in terms of what it will purchase) is greater in some parts of the country than in others, but everywhere it will buy less next year than it will this year.  That means that the person who made nineteen thousand nine hundred ninety-nine dollars this year might make twenty thousand next year, but will already have gone backwards in how much "real income" he earns (because twenty thousand one year will not buy quite as much as nineteen thousand nine hundred ninety-nine the year before) and will now have to pay tax on it.  In a sense, Congress benefits from this, because when tax rates remain fixed but incomes rise with inflation, taxpayers pay a greater percentage of income and the government winds up with greater purchasing power because its dollar income increases faster than inflation, while taxpayers are going backwards.  While that is more complicated in a graduated tax system, it is dramatic in a flat tax system with an income floor, because at the moment you hit the floor you start owing a large part of it, and suddenly have a lot less spending power for the same dollar and fewer disposable dollars for the same amount of work.  Don't expect your congressmen to raise the floor, though--your costs help balance their bloated budget.

There other problems with the flat tax proposal, though.



Equalizing Deductions

At the top of the United States Form 1040 income tax form you are supposed to identify your dependents--are you single, are you married, do you have kids, are there dependent adults living in your home.  There are several reasons for this, but the obvious one is that someone living alone has fewer expenses than someone supporting seven other people on one income.  Thus if Bob makes thirty thousand dollars and lives alone, that's all his.  If he gives a tenth to the government, that leaves him twenty-seven thousand dollars to support himself.  But if Bob has a wife, Mary, suddenly he is supporting two people, effectively having thirteen and a half thousand dollars for each of them.  Certainly two people living together have fewer expenses than two people living separately--they don't have to heat two houses--but contrary to the aphorism, they cannot live as cheaply as one--there has to be enough food for both, and they will both need clothes.  Then if Mary has a child, suddenly Bob earns nine thousand dollars per person, and a second child lowers it to six thousand two hundred fifty.

You might say that Mary should get a job, but it might be that Mary has a job--staying home taking care of little Eric, who was born blind.  And certainly children Eric and Cindy will be unable to obtain meaningful employement for at least several years.

The flat tax says, we don't care how many people are living off this one income.  It is all the same to us whether the money is all earned by Bob or the same amount of money is earned by Bob, Mary, Eric, and Cindy.  Of course, it does not say that exactly--after all, if we have a twenty thousand dollar "floor", and Bob earns twenty thousand while Mary, Eric, and Cindy bring in the other ten, the tax is only going to be two, not three, thousand dollars; and if no one in the house individually earns the floor, no taxes are paid from that household.  That, though, seems inequitable on its face--which is why usually we tax household income rather than individual income, and reduce the amount of income taxed by a "standard deduction" and a "dependent deduction", that the number of people who have to live on this income matters.  These thus are "equalizing deductions", deductions which account for the differences in expenses, in circumstances.  These are the most obvious ones, along with similar deductions for being blind or disabled.  They recognize that the value of the paycheck is to a large degree dependent on the circumstances into which it is paid.



Income Calculations

We have discussed this before, but let's illustrate it more clearly.  If you sell your house for one hundred thousand dollars, that is one hundred thousand dollars of income to you.

You will say that it is not, but in the strictest sense your gross income from the sale of your house is one hundred thousand dollars.  You cannot refute that.  Under a ten percent flat tax, you owe ten thousand dollars to the government.

Of course, perhaps you will argue that you bought the house for fifty thousand dollars ten years ago, and so although your income was indeed one hundred thousand dollars this year, it should be reduced by fifty thousand dollars for the original cost of the house; your actual income--what we call net income--is only fifty thousand dollars.  So you should be taxed only five thousand dollars.

On the other hand, most people who sell a house buy another house.  We need to live somewhere, so unless we are retiring to a nursing home or a rental property, or are disposing of the home of a recently deceased relative, we are really trading one house for another and using money to facilitate the trade.  But in that sense, we did not really earn any money at all.  We sold the house for more than that for which we bought it, because inflation has driven up the value of houses generally.  We cannot buy another house like this one for fifty thousand dollars; we probably cannot buy a comparable house for ninety-five thousand dollars.  Logically, to get a home equivalent to the one we just sold for one hundred thousand dollars, we will need to pay one hundred thousand dollars--we have earned nothing at all, and the fact that for a moment our one hundred thousand dollar home was turned into one hundred thousand dollars in cash before being converted to another one hundred thousand dollar home does not really change that fact.  That is why, under United States tax law, if you sell a home in which you are residing and use the money to buy, within a specified period of time, another home of comparable value in which you then reside, you are not taxed on the money you got for the sale of the home.  You are taxed on that money if you use it for some other purpose, though--and we will return to this when we discuss capital gains taxes.

Similarly, if you are a green grocer running his own solo operation, at the beginning of the day you have shelves full of fresh fruits and vegetables and a stack of invoices due to farmers or middlemen who provided them, and at the end of the day you have empty shelves, a full cash drawer, and those invoices to be paid.  Strictly speaking, however much cash is in the drawer is your income before deductions.  If you collected ten thousand dollars in cash, that's your income, and you now owe a thousand dollars in taxes.  Of course, you also owe however much you agreed to pay for all those fruits and vegetables in the first place--could easily be nine thousand dollars, and that means you have no money at the end of the day.  We don't think that's a fair way to run things.  Rather, you should be allowed to deduct the money you pay for your stock from the total receipts, and so count your income as the difference.

What the "no deductions" clause fails to grasp is that there are a thousand things exactly like this, things that are "deductions" precisely because you cannot make any money without spending some of it.  The grocer has to have a place from which to sell his goods, and that means either rent or mortgage and taxes, repairs and maintenance, plus utilities.  He needs supplies to keep the store clean, light bulbs.  In some places he needs salt for the ice in front of the door, poison to discourage vermin.  He probably has to print signs, maybe circulars, and he might decide it is cost effective to buy advertising in local newspapers or broadcast outlets.  And it isn't just the independent businessman who needs these things.  Nurses, hairdressers, and waitstaff often need special clothes for the job.  Teachers and others need supplies, paper and pens and other stationary department items, plus books and materials.  Some jobs require the employee to travel from site to site, such as visiting nurses, sales representatives, construction safety inspectors, and who pays for the transportation?  "No deductions" literally means that the money you spend to be able to do your job as required comes out of your pocket, and you pay tax on it despite the fact that you never had a choice as to whether to spend it.

There is thus an entire category of "deductions" that are a necessary part of the process of calculating your real "net pay", how much you earned after you paid all the costs necessary for earning it.  Without that, some jobs would be too expensive, or the prices of some products--such as fresh fruits and vegetables--would rise drastically.



Public Policy Deductions

Of course, someone will say, "We don't mean those kinds of deductions; we mean the deductions that are there to reduce the amount of tax some people pay on the money they do earn."  Indeed, the tax code is full of deductions that have nothing to do with how many mouths you are feeding or what it costs to make the money you get.  A lot of those are about public policy.

Here's an obvious one.  The United States has a dangerous dependency on foreign oil.  It hurts our economy some, and it makes us vulnerable to the manipulations of a handful of nations known as the Organization of Petroleum Exporting Countries--OPEC.  The government sees clear advantages in promoting ways to produce energy that do not use imported petroleum.  There is also a significant secondary air and water quality problem connected to the use of fossil fuels generally, including coal--a Tragedy of the Commons problem, because pollution that is dumped in the air or the water is a cost of energy production that is paid for in health care costs and public works cleanup projects, not by the energy producers or consumers directly.  That means even though fossil fuel energy production is a problem, it is also economically cheaper for people to use such fuels, and there is a strong disincentive to use other methods of energy production because of the cost differences.  Thus our tax codes include deductions for investments in alternative energy--whether installing solar panels on your roof or building a wind farm or doing research on tidal turbines.  These expenditures are often not costs of doing business, or if they are they are usually greater than the costs of using traditional energy--but we want people to do this.  So we create an economic incentive by allowing deductions for such expenses, because if paying for solar panels saves you money on your taxes, it might just make it economically sensible to do that.

There are many such deductions in the tax code.  Indeed, the deduction for dependent children we previously mentioned is in part there to encourage people to have children by reducing the expense of raising them.  Mortgage interest deductions exist to make it ecomonically better to buy a home, and so encourage new home construction and support jobs in the construction trades.  Anything done by private charitable organizations to help the poor is that much less work for the government, so we give deductions for contributions to such organizations.  We also give deductions for political contributions, because we want people to be involved in the political process.  We want people to be able to support themselves in their retirement, so we offer deductions for payments into certain retirement savings accounts.  These are all examples of deductions which exist in order to influence behavior, to induce taxpayers to use their money in ways that the government prefers.

Most of the deductions to which people object are usually "public policy deductions", deductions which exist to promote or subsidize certain desireable behaviors.  The issue, though, becomes whether we want the government subsidizing such behaviors.  People usually have children because they want to or they didn't intend to, not because there are tax benefits.  People who install alternative energy systems will in the long term save money on their energy bills.  We might not think people who contribute to charities or political organizations should be able to treat that money as if they never earned it.  However, no matter who we are, there are almost certainly some public policy deductions we approve, and others we disfavor, and we probably no more want to eliminate all of them than keep all of them.  "No deductions" means they all go, and the government stops using tax benefits to influence citizen behavior.  Some will think that a fundamentally good outcome--that the government should not be trying to influence behavior but should leave that to free market forces, religion, and politicians.  However, in the wealth of such programs, most people find at least a few that they would retain, and we have a hard time agreeing on which few.



Capital Gains Tax

There is an issue in the flat tax proposal that appeals to some people because of the existence of what are called capital gains taxes.  In essence, if you profit from the sale of stock you pay a smaller percentage of that profit than you do on labor or sales or similar forms of income.  This strikes some people as unfair--but the fact is that doing otherwise is also unfair, for reasons that are not necessarily obvious on their face.  But to see them we should return to the example of the house.

You bought the house ten years ago for fifty thousand dollars, and sold it this year for one hundred thousand dollars.  Assume we agree that you did not thereby earn one hundred thousand dollars, but you did earn fifty thousand.  When did you earn it?

Arguably you earned it just now, when you sold the house.  However, just as arguably, you earned it gradually over ten years.  Thus in a sense you earned an average of five thousand dollars per year on the increased value of your house.  Of course, it did not increase value in a linear fashion; it rose a certain percentage each year, and the percentage changed from one year to the next.  So your house might have been worth fifty-two thousand after the first year, fifty-nine after the second, sixty after the third, then sixty-five, sixty-nine, seventy-three, and so on, increasing by what seems random values each year--and that means each of those years your net worth increased, you had income in the amount that the value of your house rose.  Of course, we could not tax you on that, partly because it would have been very difficult to determine just how much your house was worth without actually selling it, and partly because even though you might have "earned" five thousand dollars in the increased value of your house in a specified year, you did not have any cash in hand for it.  If that was your only "income" that year, you would have had no cash with which to pay the tax unless you sold the house--not a desirable outcome.

Note, too, that if you are not earning the minimum taxable amount in wages and other income sources, this value increase of your house becomes a difficult factor.  Some years it might put you over the floor, and you would have to pay tax on all your income because of it; some years it would not do so, and you would not be charged.  But the year you sell it, it automatically means you earned fifty thousand dollars and have to pay tax on all of it, even though you might not have had to pay tax on some of it in the years that you actually accrued it.  You are paying tax on money you might have earned in years in which you would not have paid tax.

There is something of the same problem with stocks and bonds.  Certainly in some cases people buy and sell these in the short term, earning money on fast turnaround, and in that case it rather obviously is income.  On the other hand, many people--probably the majority of those who invest in the stock market, including pension funds and unions and other working class institutions--buy a stock for its long-term value, and sell it after holding it for years.  It might have tripled in value over that time, but it did not do so overnight.  The earnings were accrued over time, and, like the house, ought to be treated as not earned all at once.

That could require some very complicated calculations, but we simplify the system by taxing the profits from such sales at a lower rate.  The logic is that if you received this money as it accrued it would have been less income, a lower bracket, possibly below the level of taxable income entirely, so we treat it as if it were averaged over time, and tax it accordingly.

Besides, stocks and bonds are in essence loans made to companies to help them do business and create jobs and product.  That's conduct we want to encourage, so it also falls under the public policy section.



Corporate Tax

As an undercurrent to all this, you sometimes hear that corporations do not pay enough taxes.  It seems as if they are earning millions, some of them perhaps billions, of dollars, but somehow they wind up paying nothing to the government.  We think that they are cheating, getting away with not paying tax.

However, the very idea that a corporation has to pay tax at all might be challenged.  The issue is a matter of what a corporation is.  In some ways it is a person, and it gets treated as a person; but it is also a conglomerate of many persons who also are treated as persons, and we need to understand in what ways it is and is not a person.

Let's go back to the grocer.  Presumably he has a cash register, or something like it, in his store.  Every time someone pays him, he puts the money in the cash register, sometimes giving them change from it.  He probably also dips into the cash register to pay the operating expenses--everything from invoices for stock to rent on the building.  At the end of the day, what is left in the register is his.

Or is it?

Bear with me on this for a moment.  What if we treated the cash register as a taxpayer?  That is, the store is itself a person, who has income from the money paid for groceries and deductions for the costs of doing business.  At the end of the day, the cash register, the store, pays the grocer, the owner and operator of the store.  But if we want to think about it this way, the store could itself be a taxpayer, and we could tax the store for its income, and then tax the grocer for his income paid to him out of the cash register.  We then taxed that money twice.

The government certainly likes that idea--the more often you can tax the same dollar, the more of that dollar winds up in government coffers to spend on government projects.  But for an independent businessman like that grocer, he--and we--would say that this is absolutely ridiculous.  The store is not a taxpayer; it is only a tool through which the grocer earns his money.  And in a sole proprietorship, that is how it works.  The money the store earns is the owner's income, and the owner pays tax on it.

However, for some reason, we treat corporations differently--and they are not different.  That is, the primary difference is that instead of one owner who at the end of the day gets his income out of the cash drawer and pays taxes on it, we have dozens, hundreds, maybe thousands who split the money between them.  The similarities go beyond that--the grocer decides how much money to leave in the drawer, and deducts the moneys spent to keep the business running from the total so it does not count as his income; the stockholders appoint someone to make those decisions, but in essence the money that goes into running the business never reaches them and does not count as their income, and the money that does not reach them is invested in the business.  Taxing a corporation and then taxing its stockholders on their corporate income is exactly like taxing the cash register and then taxing the grocer on the same money.  The corporation is nothing more than the cash register, the store owned by the stockholders through which they earn their money.

There are, of course, differences--sort of.  Most stockholders do not work for the companies they own, and most individual proprietors do.  However, some stockholders are employees and managers of their companies, and some independent business owners hire people to run the business while they limit themselves to deciding who gets that responsibility.  The only significant difference between a stockholder and a business owner is in liability:  if an individual proprietorship goes into debt or is sued, the owner has to pay out of his own personal resources even if it drives him into bankruptcy; if a corporation goes into debt or is sued, liability ends when the corporation is bankrupt, and the stockholders are protected.  That is partly because the owners are not directly running the company and the degree to which control is shared makes it very difficult for them to have any responsible input into specific corporate decisions, and the managers who make those decisions frequently are not shareholders and so have no ownership rights in the company.  This is so much the case that there is a legal term, "piercing the corporate veil", which is invoked when a court determines that the major stockholders in a corporation had sufficient control as to be responsible for the debts or liabilities of the company, and particularly when they used that control to strip the corporation of its assets leaving it bankrupt and themselves wealthy so that creditors and plaintiffs could not recover from the bankrupt company.  That, though, is a very weak argument for taxing the corporation and the stockholder also.

Thus the idea that corporations should be taxed at all is mostly based on the possibility that someone would keep his income on the corporate books and pay himself from it slowly, to reduce his tax debt--something which happens anyway, particularly with smaller corporations, and which is probably unavoidable for the form.  So the argument that corporations are not paying enough in taxes is an argument that people who own businesses should be taxed twice on the same money, once when it goes into the cash register and again when it comes out.  If the government insisted on taxing you when you received your paycheck and again when you cashed it, you would object strenuously.  How is this different?

We might have more on explaining taxation in the future, but this should help many people immensely in understanding what is wrong with the rhetoric of those who propose supposed quick-fix solutions to our tax structure problems.



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