Flat Tax Fiasco

Copyright (c) 1998, 2006 Douglas Dunn / Word Wizards communications -- all rights reserved

The simplistic "flat tax" idea is once again a topic of hot conversation in political and economic circles. While this interest is largely fueled by a spate of proposals calling themselves a "flat tax" it is important to consider the idea of the flat tax itself apart from the specific proposals, especially since NONE of the "flat tax" proposals currently being considered actually addresses the true theoretical concept of a real flat tax. The proposals are primarily offered as either recommendations for tax simplification (which is an important issue but entirely unrelated to the issue of tax rate structure, as noted later in this commentary) or are not actually flat, as also noted below.

In addition to discussing the problems with the theoretical model of a true flat tax, this commentary will also briefly discuss why current proposals are not real flat tax systems at all and also discuss the important issue of tax simplification and reform.

Flat Tax Frauds

In the U.S. Senate, Arlen Specter proposed a flat 20% tax on earned income (working people's wages), from which rich people's unearned income (capital gains, interest and dividends) would be exempt. Congressman Dick Armey supports similar legislation in the House. Former presidential candidate Steve Forbes (who has exhibited virtually no entrepreneurial innovation in his life and became wealthy by inheriting his late father's publishing empire) made as a centerpiece of his failed campaigns a flat tax scheme that salutes the idle rich (as distinguished from hard-working innovators 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 allowing those who gain wealth without working for it to avoid taxes while those who work hard for what they gain pay all the taxes). Since Forbes' plan reduces taxes on the poorest and especially favors the wealthy, but is supposed to be revenue-neutral (no loss of incoming tax revenues) once again it means the middle class working people would be the ones squeezed to make up for benefits to the rich.

In California, former Assemblyman Howard Kaloogian teamed up (unsuccessfully) with Arthur Laffer and others to introduce a similar proposal for our state. Laffer is the economics guru who inspired Ronald Reagan's "supply side economics." Starting Laffer's theories on cutting marginal tax rates on the highest incomes, Reagan developed a plan to balance the budget by cutting taxes for rich people while increasing spending, resulting in all-time record deficits paid for by the middle class and future generations, and which George Bush (senior) labeled "Voodoo Economics" when he first heard about it in 1980. The essence of Reagan's "tax cuts," which Laffer engineered, was to reduce the progressive character of federal taxes by eliminating the highest tax brackets. Middle-class and low-income working people 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." In actuality, 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 no tax will be assessed against a primary layer of income. This creates a "progressive" system with two tax brackets: zero and the top rate. Allowing this primary exemption acknowledges the need to distinguish between the differing levels of marginal utility of money, but goes from one extreme, a "zero" rate, all the way to the other extreme of the top rate in one single jump. Since they have acknowledged the need for at least one level of graduation, it makes sense to phase it in through gradual layers of progressivity, as was done during the prosperous era of the 1950s and 1960s.

Proponents of these "flat" taxes love to point out that it is unfair to charge some people a different rate than others. But under their proposals, some people would pay no tax at all and others would pay the full rate. This is supposed to be more fair?

Problems with a flat tax

The notion of a flat tax does have a certain simplistic, egalitarian appeal. But it has three main flaws: 1) It seeks to improve something that is already completely equal; 2) It forces middle-class taxpayers to subsidize the wealthy (especially those incarnations such as Forbes' that exempt "unearned" income such as the interest on his invested inheritance, so that working people would support the idle rich); and, 3) It confuses much-needed tax reform and tax simplification in defining taxable income with the unrelated issue of whether the rate applied to that income is flat or graduated. Anyone who wants to support a flat tax better run the numbers first and see how much more they're going to pay!

The Graduated Progressive Tax is FAIR

A lot of people don't understand graduated taxes. They think if you make more money you pay a higher rate on your entire earnings, which seems unfair. Graduated progressive taxes are FAIR for three reasons: 1) they treat all taxpayers exactly the same; 2) they treat dollars with appropriate difference based on differing levels of marginal utility; and 3) those who receive the most benefit should pay for the disproportionate benefit derived from the system. Let's examine each of these reasons in more detail:

Graduated Progressive Tax Treats Every Taxpayer the Same

Graduated 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 entire income, only on the portions of income in the higher layers of marginal 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 eliminated altogether, at the same time taxes for the wealthy would be greatly reduced. 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 federal levels) does lots of very good and important things that have to be handled at the public (community) level because they affect all of us. It keeps our food and medical supply system safe. It develops, builds and operates a highways system and other transportation policies that allow people to move freely and become economically productive on a scale that could not occur in the private sector alone (have you ever tried to drive through large freeway-less cities in third-world countries?). It operates public parks and lands on a huge scale and manages them rather efficiently for the benefit of the people as a whole. It operates systems of law enforcement, judicial systems and penal systems to ensure public safety. It operates public health and emergency systems to maintain order during natural disasters or crises. It operates education systems that keep our nation technologically and economically competitive, despite huge problems in sending kids into public schools from family environments where they have been exposed to guns, drugs, poverty, abuse, or come from different cultures and languages and have a hard time keeping up with education in English. It operates massive military systems to protect us from invasion and to defend our interests worldwide. And this does not even include things such as job training programs to get people off welfare, programs for the disabled, and Social Security or Medicare. These are massive, complex operations and they take a lot of money. If the government would shut down for just a few days 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. Large corporations (the famous "private sector") also are fraught with waste, fraud and corruption. Look at Enron and Global Crossing (and probably many more that haven't been making the headlines). Look at the faceless corporate bureaucracies parodied in "Dilbert" -- there is a reason that comic is so popular: it strikes a chord in the hearts of those who have to deal with those corporate bureaucracies on a daily basis. My business is to provide communications services, and I do contract work with small businesses, large corporations, private nonprofit organizations and public agencies (everything from law enforcement, courts, schools, and every kind of public agency you can imagine), either in preparing documents or working at their sites or other venues such as conferences/conventions. Small businesses are lean and mean and most efficient (not that I'm biased or anything). Large corporations and the government are most wasteful; small public agencies are more efficient than large bureaucracies. I note, for example, that if I am working a corporate conference or public training seminar, corporate hosts generally provide food, drinks, coffee, etc. (nice!) whereas public (tax-supported agencies) provide water -- not even coffee -- not as nice, but makes me feel there is some effort to avoid being wasteful. And we do need to continue to be vigilant in watching for and rooting out waste, fraud and corruption when they do occur (and they do).

2. Return to "borrow-and-spend" deficit governments. Deficits ballooned exponentially under the Reagan and Bush-I administrations, as taxes were cut for the rich but (despite lip service of reducing the size of government) government was not reduced. The costs of deficits are paid for by the middle class in three important ways: higher inflation as their paychecks become worth less and less; paying for increased government costs for interest on public debt; and, higher costs of private borrowing when public debt takes money out of circulation that could have been available for private lending markets and increases the costs of loans for houses, cars, appliances and other consumer uses.

3. Squeeze the middle class. If the rich pay less and the poor pay less and we don't cut government or run deficits, then the difference is going to be made up for, you guessed it, on the backs of the middle class workers who work hard already and are the ones who really need tax relief. If we're going to have reforms, it should benefit the middle class, not those who already pay the least.

Graduated Progressive Tax Addresses Differing Levels of Marginal Utility

Under graduated, progressive rates, all people are created equal, but not all dollars are created equal. Earnings of the working poor (not those on welfare) go almost entirely for survival expenses such as food, shelter and clothing. At that level, every dollar is critical; even a small difference causes tremendous changes in the quality of life. Those in the middle class are still very conscious of expenses, but have much greater flexibility in absorbing small fluctuations in income. On the other hand, a family earning $200,000 or more (wealthiest 2%) not only enjoys a higher standard in the quality of their "necessities" (better home, car and food), they also have much more discretionary income for recreation or investment. While no one enjoys a dip in income, a loss of ten or twenty thousand dollars is often within the 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, such as those who receive multi-million dollar salaries. This principle is most obvious at the extremes: consider the effect of a flat 10% on a single mother supporting her family working as a seamstress in a garment sweatshop for minimum wage ($10,000 per year) and the effect of a flat 10% on a corporate CEO earning ten million dollars per year. For the minimum wage seamstress, that ten percent is $1,000 -- a huge bite in the wallet for someone barely trying to survive. For the CEO, the bite is a million dollars. Sure, that's no small amount of change, but he is left with nine million dollars. A person can live pretty well on that amount of take-home pay. The fact is, even a tax bite of a million dollars does not really impact the day-to-day reality of his quality of life, which is very high. The equivalent value of each dollar (even as an equivalent percentage value rather than a fixed dollar amount) is simply less at higher levels of income, and the differing value of each additional dollar at the top (the margin) is simply not the same as primary marginal levels needed for bare survival. While this is most clearly seen when comparing the extremes, the same principle applies throughout all income strata.

Even some of the national proposals recognize this, and want to exempt a primary layer from the tax system (which is why they can not accurately be described as true flat taxes). So, since they recognize that survival dollars are different than wealthy dollars, why go suddenly from one extreme (paying no taxes) to the other (paying the top rate). So, since they recognize that survival dollars are different than wealthy dollars, why should we go suddenly from one extreme (paying no taxes) all the way to the other extreme (paying the top rate) in one single step? This is what graduated rates are all about. Since the current proposals are supposed to be bring in the same total amount of tax revenue, if the poor are going to pay less and the rich are going to pay less, it is naturally going to fall on the middle class (as usual) to make up the difference!

In the 1950's, the tax rate for the highest income layers was much higher than now, and there were many more brackets. There were 13 brackets, and the top marginal rate was 91%, though very few people had incomes reaching into that strata and those who did only paid that percentage on the fractional portion of their income that made it into that level. Most agreed it was too high, and in the early 1960's, President John F. Kennedy proposed that it be lowered it by 25% and the proposal was actually enacted in early 1964, after his death. Yet, the economy was not burdened by excessive taxes. Those were very prosperous decades, in large part because a greater share of the burden came from those who could most afford it, while middle class working families paid lower rates (before inflation-generated "bracket creep"), leaving more disposable income for more people to pump back into the economy.

Are Progressive Taxes Socialistic?

Many of those who write to me accuse me of being a "socialist" or "communist" or worse, in the misguided belief that a robust progressive tax structure - one which every person pays the same rate on the portion of their income in the same income level (bracket) - is somehow socialistic.

Yet some of the most successful CAPITALISTS today, including Warren Buffet and Bill Gates, have openly supported progressive taxes. They both deal in businesses dependent on a broad base of middle class consumers. They understand that they have more to gain by broad-based middle class prosperity that enables the capacity for consumer demand that fuels their industries.

Or perhaps those who cry "socialist" have never heard of ADAM SMITH. For those familiar with basic economics, Adam Smith is known as the "Father of Capitalism" - the first person who articulated the concept of market-driven economics, coining the phrase about the "invisible hand" and "enlightened self interest," guiding entrepreneurs to get ahead by meeting the needs of their customers.

Here is what Adam Smith wrote in his seminal work, An Inquiry into the Nature and Causes of the Wealth of Nations, from Book V, Chapter 2, Article I:

So was Adam Smith - the "Father of Capitalism" - a communist? a socialist?

For the record, Adam Smith DIED 28 years before Karl Marx was even born.

Graduated Progressive Tax Requires those who Benefit the Most to Pay the Most

In addition to the differing value of marginal utility for money at higher levels of income, it is further true that those who are most wealthy also benefit more from all dimensions of the current system at a level far disproportionate to a simple scaled application of a flat percentage rate. Whether by our system of inheritance that permits families to pass down huge amounts of wealth to those who had no hand in its creation, or by their opportunities for access to and maneuvering through the economic system as it is (including disproportionate income levels for elites which may be thousands of times that of front-line workers who work at least as hard under less satisfying conditions), those at the highest levels of income have simply benefited disproportionately on a scale not reflect in simply applying the same rate across those larger amounts.

Further, those who are wealthiest benefit the most from the system because they simply own and control a disproportionate share of the assets that are protected by that system, through its legal systems of civil and contractual laws which are enforced more to their favor by law enforcement, civil legal proceedings, and the military system that protects from foreign invasion. Those who are richest simply are favored. They can buy advantage in access to the legal system (civil or criminal) from which the poorest are simply shut out and they are better protected by law enforcement. In wealthy neighborhoods, one can call the police and get a reasonable response just because someone is playing their music too loud, while a poor but honest resident in a drug-infested ghetto who is surrounded by major felonies and direct constant exposure to damage will barely get the slightest attention from law enforcement when they call to report gunshots near their residences. Additionally, those who benefit the most from our system of commerce are the ones who disproportionately benefit from the system of public works (infrastructure for highways, bridges, urban roadways, satellites and communication systems) that make it possible. Those who benefit the most for these things should be the ones who contribute the most to support them.

Tax Rates and Stimulating Investment to Create Wealth (and Jobs)

Some have complained that higher marginal rates act as a deterrent to the kind of wealth creation that trickles down to working people in the form of more jobs. Again, this is not an issue because the higher marginal rates only apply to the higher levels of income; all taxpayers still pay exactly the same rates on equivalent layers of income. Morever, this widely-believed fallacy simply fails to grasp the true nature of wealth (or job) creation which is based on the faulty view that if you give tax breaks to the rich, or otherwise put more money into the pockets of those who already have the most, that they will use it to create jobs. While it is primarily the wealthy who invest the capital needed to create more wealth (and jobs), jobs are not created just because people have money. If they just have money, and that's all, they'll just keep it or spend it on themselves, as they always have done in the past. Jobs are not created as acts of charity for working people that the wealthy elites don't even have personal acquaintance with. Jobs (and broad-based wealth) are created when those in a position to administer productive resources see a demand for goods to be produced. And if they see such a demand, they will generate the increased production -- create new jobs -- whether or not they have the money on hand -- even if they have to raise money by borrowing the necessary capital for financing. If the general public, which is made up far ore by working people than by the wealthy elite, does not have discretionary income to spend on products, the broad-based demand needed to stimulate wealth creation (and job creation) is inhibited. It has more to do with creating a broad base of demand than by making sure rich people have enough money. This concept is discussed in much more depth on my economics web page, at:
http://www.wordwiz72.com/econ.html

Simplification and reform

There are legitimate gripes about the tax system, but they have little to do with the graduated rate structure. We need more progressivity, not less, and real -- not superficial -- reforms, such as:

1. Close loopholes: We need to close loopholes that the rich use to avoid paying taxes on the portions of income in the higher levels. The real complexity in filling out forms and schedules at tax time is not in calculating the final tax, but in determining what "income" is, with all the exemptions, deductions and other loopholes. However, this is a separate issue from the question of what rate or schedule should be applied to whatever income is calculated. If we want to 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 such areas of reform and simplification.

2. Property and Business Taxes: If we want California to be more attractive to middle-class working people and businesses, we need to make property taxes and business taxes more progressive. A family buying an owner-occupied residence in the low 100,000's should pay little or no property taxes while those with multi-million dollar mansions or large commercial landlords should pay higher rates for amounts in excess of the first layer. If we want to attract job-producing capital investment, business tax rates should favor small and startup companies, while industrial giants should pay higher rates on the higher portions of their net incomes.

Eliminating Deductions

One "reform" that is often suggested in the interest of "tax simplification," and which (again) sounds simplistically appealing, is the idea of "eliminating all deductions." The basic concept of deductions is based on determining what one's actual income is. For example, consider two working guys. They're both plumbers. They both receive checks throughout the year paid to them which total $100,000. The first guy is an employee. He works 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 from a handful of corporate clients who report their payments to him on 1099's). He hires a secretary to schedule his appointments and pays her $30,000. He buys a truck for $25,000. He spends $5,000 more on tools. Is it really fair to say there will be NO deductions? The issue should not be to eliminate all deductions, but to isolate legitimate ones and separate them from welfare for the rich.

It is foolish to think that a scheme to raise taxes on the middle class, while lowering them for rich people and avoiding any 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 aspects of 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 noted below, specific analysis of economic issues can be found in the commentary "Economic Justice and Fairness" by the same author, at:
http://www.wordwiz72.com/econ.html.

Copyright (c) 1998, 2006 Douglas Dunn / Word Wizards communications

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