Flat Tax FiascoFlat Tax Fiascoby Douglas DunnCopyright (c) 1998, 2006 Douglas Dunn/ Word Wizards communications -- allrights reservedThe simplistic "flat tax" idea is once again atopic of hot conversation in political and economic circles. Whilethis interest is largely fueled by a spate of proposals callingthemselves a "flat tax" it is important to considerthe idea of the flat tax itself apart from the specific proposals,especially since NONE of the "flat tax" proposals currentlybeing considered actually addresses the true theoretical conceptof a real flat tax. The proposals are primarily offered as eitherrecommendations for tax simplification (which is an importantissue but entirely unrelated to the issue of tax rate structure,as noted later in this commentary) or are not actually flat, asalso noted below.In addition to discussing the problems with the theoreticalmodel of a true flat tax, this commentary will also briefly discusswhy current proposals are not real flat tax systems at all andalso discuss the important issue of tax simplification and reform.Flat Tax FraudsIn the U.S. Senate, Arlen Specter proposed a flat 20% taxon earned income (working people's wages), from which rich people'sunearned income (capital gains, interest and dividends) wouldbe exempt. Congressman Dick Armey supports similar legislationin the House. Former presidential candidate Steve Forbes (whohas exhibited virtually no entrepreneurial innovation in his lifeand became wealthy by inheriting his late father's publishingempire) made as a centerpiece of his failed campaigns a flat taxscheme that salutes the idle rich (as distinguished from hard-workinginnovators or entrepreneurs who actually earned their wealth)by exempting UNEARNED income gained as a return on investment(not merely protecting the value of the principal, but allowingthose who gain wealth without working for it to avoid taxes whilethose who work hard for what they gain pay all the taxes). SinceForbes' plan reduces taxes on the poorest and especially favorsthe wealthy, but is supposed to be revenue-neutral (no loss ofincoming tax revenues) once again it means the middle class workingpeople would be the ones squeezed to make up for benefits to therich.In California, former Assemblyman Howard Kaloogian teamedup (unsuccessfully) with Arthur Laffer and others to introducea similar proposal for our state. Laffer is the economics guruwho inspired Ronald Reagan's "supply side economics."Starting Laffer's theories on cutting marginal tax rates on thehighest incomes, Reagan developed a plan to balance the budgetby cutting taxes for rich people while increasing spending, resultingin all-time record deficits paid for by the middle class and futuregenerations, and which George Bush (senior) labeled "VoodooEconomics" when he first heard about it in 1980. The essenceof Reagan's "tax cuts," which Laffer engineered, wasto reduce the progressive character of federal taxes by eliminatingthe highest tax brackets. Middle-class and low-income workingpeople never saw any substantial difference in their taxes.All of the various proposals (Specter, Armey, Forbes, Kaloogian)are fraudulent. None of them is a true "flat tax." Inactuality, each of these proposals recognizes the need for progressivity(the differing relative value of dollars at differing income levels,as discussed below) by allowing a primary exemption -- that notax will be assessed against a primary layer of income. This createsa "progressive" system with two tax brackets: zero andthe top rate. Allowing this primary exemption acknowledges theneed to distinguish between the differing levels of marginal utilityof money, but goes from one extreme, a "zero" rate,all the way to the other extreme of the top rate in one singlejump. Since they have acknowledged the need for at least one levelof graduation, it makes sense to phase it in through gradual layersof progressivity, as was done during the prosperous era of the1950s and 1960s.Proponents of these "flat" taxes love to pointout that it is unfair to charge some people a different rate thanothers. But under their proposals, some people would pay no taxat all and others would pay the full rate. This is supposed tobe more fair?Problems with a flat taxThe notion of a flat tax does have a certain simplistic,egalitarian appeal. But it has three main flaws: 1) It seeks toimprove something that is already completely equal; 2) It forcesmiddle-class taxpayers to subsidize the wealthy (especially thoseincarnations such as Forbes' that exempt "unearned"income such as the interest on his invested inheritance, so thatworking people would support the idle rich); and, 3) It confusesmuch-needed tax reform and tax simplification in defining taxableincome with the unrelated issue of whether the rate applied tothat income is flat or graduated. Anyone who wants to supporta flat tax better run the numbers first and see how much morethey're going to pay!The Graduated Progressive Tax is FAIRA lot of people don't understand graduated taxes. They thinkif you make more money you pay a higher rate on your entire earnings,which seems unfair. Graduated progressive taxes are FAIR for threereasons: 1) they treat all taxpayers exactly the same; 2) theytreat dollars with appropriate difference based on differing levelsof marginal utility; and 3) those who receive the most benefitshould pay for the disproportionate benefit derived from the system.Let's examine each of these reasons in more detail:Graduated Progressive Tax Treats EveryTaxpayer the SameGraduated progressive taxes do treat all taxpayers equally.Every taxpayer pays the same rate on equivalent layers of income.People in higher brackets don't pay the higher rate on their entireincome, only on the portions of income in the higher layers ofmarginal income. People, not dollars, are treated equally.Simplified hypothetical example: Let's examine a hypothetical example of a true flat tax (we have to use a hypothetical example because none of the actual proposals is a true flat tax) and compare it with a simplified example of a hypothetical progressive system. Let's imagine a progressive system with three rates: 15% on the first $25,000 income layer, 28% on the next $30,000 layer (from $25,000 to $55,000) and 33% above $55,000. A person who earns $25,000 would be entirely in the first 15% layer, for a tax of $3,750. His take-home pay is $21,250. A flat 20% rate would raise the working guy's taxes by $1,250. A person earning $200,000 (the wealthiest 2% of the population) pays an exactly equal $3,750 for the first $25,000 layer. For the layer from $25,000 to $55,000 he pays the 28% tax of $8,400; and for the final $145,000 layer he pays the 33% tax of $47,850 for a total tax of $60,000. His take-home pay is $140,000 -- more than six times that of the $25,000 worker. With a flat 20% rate the investor's taxes would go down by $20,000!  Under the current proposals, the taxes for low-income workers(in the exemption level) would be substantially reduced or eliminatedaltogether, at the same time taxes for the wealthy would be greatlyreduced. The result would be one of three possible outcomes:1. Cut back government operations.Sounds good to many people but "cutting down the government"is also very simplistic. The government (at local, state and federallevels) does lots of very good and important things that haveto be handled at the public (community) level because they affectall of us. It keeps our food and medical supply system safe. Itdevelops, builds and operates a highways system and other transportationpolicies that allow people to move freely and become economicallyproductive on a scale that could not occur in the private sectoralone (have you ever tried to drive through large freeway-lesscities in third-world countries?). It operates public parks andlands on a huge scale and manages them rather efficiently forthe benefit of the people as a whole. It operates systems of lawenforcement, judicial systems and penal systems to ensure publicsafety. It operates public health and emergency systems to maintainorder during natural disasters or crises. It operates educationsystems that keep our nation technologically and economicallycompetitive, despite huge problems in sending kids into publicschools from family environments where they have been exposedto guns, drugs, poverty, abuse, or come from different culturesand languages and have a hard time keeping up with education inEnglish. It operates massive military systems to protect us frominvasion and to defend our interests worldwide. And this doesnot even include things such as job training programs to get peopleoff welfare, programs for the disabled, and Social Security orMedicare. These are massive, complex operations and they takea lot of money. If the government would shut down for just a fewdays we would all be in a panic. Is there waste, fraud and abuse?Of course there is. Much of that has to do with economies of scale,just because the government is necessarily so humonguous. Largecorporations (the famous "private sector") also arefraught with waste, fraud and corruption. Look at Enron and GlobalCrossing (and probably many more that haven't been making theheadlines). Look at the faceless corporate bureaucracies parodiedin "Dilbert" -- there is a reason that comic is so popular:it strikes a chord in the hearts of those who have to deal withthose corporate bureaucracies on a daily basis. My business isto provide communications services, and I do contract work withsmall businesses, large corporations, private nonprofit organizationsand public agencies (everything from law enforcement, courts,schools, and every kind of public agency you can imagine), eitherin preparing documents or working at their sites or other venuessuch as conferences/conventions. Small businesses are lean andmean and most efficient (not that I'm biased or anything). Largecorporations and the government are most wasteful; small publicagencies are more efficient than large bureaucracies. I note,for example, that if I am working a corporate conference or publictraining seminar, corporate hosts generally provide food, drinks,coffee, etc. (nice!) whereas public (tax-supported agencies) providewater -- not even coffee -- not as nice, but makes me feel thereis some effort to avoid being wasteful. And we do need to continueto be vigilant in watching for and rooting out waste, fraud andcorruption when they do occur (and they do).2. Return to "borrow-and-spend"deficit governments. Deficits ballooned exponentially underthe Reagan and Bush-I administrations, as taxes were cut for therich but (despite lip service of reducing the size of government)government was not reduced. The costs of deficits are paid forby the middle class in three important ways: higher inflationas their paychecks become worth less and less; paying for increasedgovernment costs for interest on public debt; and, higher costsof private borrowing when public debt takes money out of circulationthat could have been available for private lending markets andincreases the costs of loans for houses, cars, appliances andother consumer uses.3. Squeeze the middle class. If therich pay less and the poor pay less and we don't cut governmentor run deficits, then the difference is going to be made up for,you guessed it, on the backs of the middle class workers who workhard already and are the ones who really need tax relief. If we'regoing to have reforms, it should benefit the middle class, notthose who already pay the least.Graduated Progressive Tax AddressesDiffering Levels of Marginal UtilityUnder graduated, progressive rates, all people are createdequal, but not all dollars are created equal. Earnings of theworking poor (not those on welfare) go almost entirely for survivalexpenses such as food, shelter and clothing. At that level, everydollar is critical; even a small difference causes tremendouschanges in the quality of life. Those in the middle class arestill very conscious of expenses, but have much greater flexibilityin absorbing small fluctuations in income. On the other hand,a family earning $200,000 or more (wealthiest 2%) not only enjoysa higher standard in the quality of their "necessities"(better home, car and food), they also have much more discretionaryincome for recreation or investment. While no one enjoys a dipin income, a loss of ten or twenty thousand dollars is often withinthe normal fluctuation of a wealthy investor's investment portfolio,whereas that amount would be disastrous to the middle-class worker.This applies even more for those with even larger incomes, suchas those who receive multi-million dollar salaries. This principleis most obvious at the extremes: consider the effect of a flat10% on a single mother supporting her family working as a seamstressin a garment sweatshop for minimum wage ($10,000 per year) andthe effect of a flat 10% on a corporate CEO earning ten milliondollars per year. For the minimum wage seamstress, that ten percentis $1,000 -- a huge bite in the wallet for someone barely tryingto survive. For the CEO, the bite is a million dollars. Sure,that's no small amount of change, but he is left with nine milliondollars. A person can live pretty well on that amount of take-homepay. The fact is, even a tax bite of a million dollars does notreally impact the day-to-day reality of his quality of life, whichis very high. The equivalent value of each dollar (even as anequivalent percentage value rather than a fixed dollar amount)is simply less at higher levels of income, and the differing valueof each additional dollar at the top (the margin) is simply notthe same as primary marginal levels needed for bare survival.While this is most clearly seen when comparing the extremes, thesame principle applies throughout all income strata.Even some of the national proposals recognize this, andwant to exempt a primary layer from the tax system (which is whythey can not accurately be described as true flat taxes). So,since they recognize that survival dollars are different thanwealthy dollars, why go suddenly from one extreme (paying no taxes)to the other (paying the top rate). So, since they recognize thatsurvival dollars are different than wealthy dollars, why shouldwe go suddenly from one extreme (paying no taxes) all the wayto the other extreme (paying the top rate) in one single step?This is what graduated rates are all about. Since the currentproposals are supposed to be bring in the same total amount oftax revenue, if the poor are going to pay less and the rich aregoing to pay less, it is naturally going to fall on the middleclass (as usual) to make up the difference!In the 1950's, the tax rate for the highest income layerswas much higher than now, and there were many more brackets. Therewere 13 brackets, and the top marginal rate was 91%, though veryfew people had incomes reaching into that strata and those whodid only paid that percentage on the fractional portion of theirincome that made it into that level. Most agreed it was too high,and in the early 1960's, President John F. Kennedy proposed thatit be lowered it by 25% and the proposal was actually enactedin early 1964, after his death. Yet, the economy was not burdenedby excessive taxes. Those were very prosperous decades, in largepart because a greater share of the burden came from those whocould most afford it, while middle class working families paidlower rates (before inflation-generated "bracket creep"),leaving more disposable income for more people to pump back intothe economy.Graduated Progressive Tax Requires thosewho Benefit the Most to Pay the MostIn addition to the differing value of marginal utility formoney at higher levels of income, it is further true that thosewho are most wealthy also benefit more from all dimensions ofthe current system at a level far disproportionate to a simplescaled application of a flat percentage rate. Whether by our systemof inheritance that permits families to pass down huge amountsof wealth to those who had no hand in its creation, or by theiropportunities for access to and maneuvering through the economicsystem as it is (including disproportionate income levels forelites which may be thousands of times that of front-line workerswho work at least as hard under less satisfying conditions), thoseat the highest levels of income have simply benefited disproportionatelyon a scale not reflect in simply applying the same rate acrossthose larger amounts.Further, those who are wealthiest benefit the most fromthe system because they simply own and control a disproportionateshare of the assets that are protected by that system, throughits legal systems of civil and contractual laws which are enforcedmore to their favor by law enforcement, civil legal proceedings,and the military system that protects from foreign invasion. Thosewho are richest simply are favored. They can buy advantage inaccess to the legal system (civil or criminal) from which thepoorest are simply shut out and they are better protected by lawenforcement. In wealthy neighborhoods, one can call the policeand get a reasonable response just because someone is playingtheir music too loud, while a poor but honest resident in a drug-infestedghetto who is surrounded by major felonies and direct constantexposure to damage will barely get the slightest attention fromlaw enforcement when they call to report gunshots near their residences.Additionally, those who benefit the most from our system of commerceare the ones who disproportionately benefit from the system ofpublic works (infrastructure for highways, bridges, urban roadways,satellites and communication systems) that make it possible. Thosewho benefit the most for these things should be the ones who contributethe most to support them.Tax Rates and Stimulating Investmentto Create Wealth (and Jobs)Some have complained that higher marginal rates act as adeterrent to the kind of wealth creation that trickles down toworking people in the form of more jobs. Again, this is not anissue because the higher marginal rates only apply to the higherlevels of income; all taxpayers still pay exactly the same rateson equivalent layers of income. Morever, this widely-believedfallacy simply fails to grasp the true nature of wealth (or job)creation which is based on the faulty view that if you give taxbreaks to the rich, or otherwise put more money into the pocketsof those who already have the most, that they will use it to createjobs. While it is primarily the wealthy who invest the capitalneeded to create more wealth (and jobs), jobs are not createdjust because people have money. If they just have money, and that'sall, they'll just keep it or spend it on themselves, as they alwayshave done in the past. Jobs are not created as acts of charityfor working people that the wealthy elites don't even have personalacquaintance with. Jobs (and broad-based wealth) are created whenthose in a position to administer productive resources see a demandfor goods to be produced. And if they see such a demand, theywill generate the increased production -- create new jobs -- whetheror not they have the money on hand -- even if they have to raisemoney by borrowing the necessary capital for financing. If thegeneral public, which is made up far ore by working people thanby the wealthy elite, does not have discretionary income to spendon products, the broad-based demand needed to stimulate wealthcreation (and job creation) is inhibited. It has more to do withcreating a broad base of demand than by making sure rich peoplehave enough money. This concept is discussed in much more depthon my economics web page, at:http://www.wordwiz72.com/econ.htmlSimplification and reformThere are legitimate gripes about the tax system, but theyhave little to do with the graduated rate structure. We need moreprogressivity, not less, and real -- not superficial -- reforms,such as:1. Close loopholes: We need to closeloopholes that the rich use to avoid paying taxes on the portionsof income in the higher levels. The real complexity in fillingout forms and schedules at tax time is not in calculating thefinal tax, but in determining what "income" is, withall the exemptions, deductions and other loopholes. However, thisis a separate issue from the question of what rate or scheduleshould be applied to whatever income is calculated. If we wantto get the government off people's backs in the area of tax reform,we have to lead the way in "Taxpayer Bill of Rights"issues, eliminating taxpayer compliance statistical super-audits(or at least compensating those who participate) and other suchareas of reform and simplification.2. Property and Business Taxes: Ifwe want California to be more attractive to middle-class workingpeople and businesses, we need to make property taxes and businesstaxes more progressive. A family buying an owner-occupied residencein the low 100,000's should pay little or no property taxes whilethose with multi-million dollar mansions or large commercial landlordsshould pay higher rates for amounts in excess of the first layer.If we want to attract job-producing capital investment, businesstax rates should favor small and startup companies, while industrialgiants should pay higher rates on the higher portions of theirnet incomes.Eliminating DeductionsOne "reform" that is often suggested in the interestof "tax simplification," and which (again) sounds simplisticallyappealing, is the idea of "eliminating all deductions."The basic concept of deductions is based on determining what one'sactual income is. For example, consider two working guys. They'reboth plumbers. They both receive checks throughout the year paidto them which total $100,000. The first guy is an employee. Heworks for a company that has a scheduler who sets his appointments,and provides him with a truck and tools. The second guy is self-employed(sole proprietorship, and let's say most of his income is froma handful of corporate clients who report their payments to himon 1099's). He hires a secretary to schedule his appointmentsand pays her $30,000. He buys a truck for $25,000. He spends $5,000more on tools. Is it really fair to say there will be NO deductions?The issue should not be to eliminate all deductions, but to isolatelegitimate ones and separate them from welfare for the rich.It is foolish to think that a scheme to raise taxes on themiddle class, while lowering them for rich people and avoidingany real tax simplification or reform, is in any way fair or equal.There is much tax reform that is needed. Let's build on the aspectsof our tax system that are fair, reform the areas where needed,and address real issues in an equitable manner.In addition to other books and articles by the author notedbelow, specific analysis of economic issues can be found in thecommentary "Economic Justice and Fairness" by the sameauthor, at:http://www.wordwiz72.com/econ.html.Copyright (c) 1998, 2006 Douglas Dunn/ Word Wizards communicationsWe welcome FEEDBACK! Send e-mail feedback to: feedback.Please note, be sure to BEGINthe TITLE of your e-mail reply with the word "FEEDBACK"to avoid having your e-mail deleted unread with all the otherjunk e-mail that is mass deleted, and mention which commentaryyou are responding to, for example: "Feedback flat tax."PLEASE NOTE: WE DO NOT ACCEPT OR OPEN ANYE-MAILS WITH ATTACHED FILES.More Articles:Check out additional articlesby Douglas Dunn now available as FREE DOWNLOADS -- with additionalarticles being added regularly, each one an adaptation of thosethat have been published in mainstream newspapers and magazines[more articles].Books by DouglasDunn (click on book titles for descriptions of books and orderinginformation):--Dazhan.--Extro-Dynamics.Books written by Douglas Dunn mayalso be ordered online through Barnesand Noble, Borders.comand/or Amazon.com.Also availablethrough other retail bookstores (if not in stock may be "specialordered").Return to Word Wizards home page |
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