Friday, December 30, 2011

The Flaw of the Flat Tax

Paying both federal and state income taxes can be an exasperating and depressing experience. It is easy to understand this dissatisfaction, especially because individuals do not know the precise destination of their tax dollars, instead watching the money vanish into a black hole riddled with waste and misappropriation. Unfortunately the black hole is not even the worst part of the tax system, yet few people seem to either realize the real problems in the tax system or care enough to do something about it.

One of the more popular suggested tax reforms is the elimination of the progressive tax system in favor of a flat tax system where all taxpayers would pay the same percentage of income. Proponents of the flat tax system sing its praises for its simplicity, what they believe as fairness and its ability to acquire more revenue for the federal government than the current progressive system due to a perceived elimination of a vast number of deductions and tax shelter tricks. However, proponents of the flat tax are either misinformed or trying to create a greater advantage for themselves with little concern for others.

Despite numerous studies concluding that flat taxes provide insufficient funds relative to the existing progressive tax system from a methodological standpoint comparing revenue gains from a flat tax system to the current progressive system is silly because the current system is so riddled with immorality and waste that almost any reform will give the appearance of a short-term increase in revenue with favorable assumptions. Therefore, if one were to be reasonable the flat tax system would need to be compared to other reforms in the progressive system and other new systems to gauge the legitimacy of its revenue collection superiority. Simply comparing one reform against the current system without comparing it against other possible reforms diminishes the authenticity of such an analysis. Such a mindset is also questionable in that it is irrational to conclude that there is only one possible alternative to an existing system or solution without careful analysis.

With regards to fairness it is easy to see why proponents of a flat tax system believe such a system is fairer to all parties than the current progressive system. The common flat tax and tax cut battle cry has frequently been ‘why should those that make more money be penalized?’ under the typically bias mindset that those who make a lot of money work harder than those who make less money. Most flat tax supporters appear to believe that the progressive tax system punishes ambition and success, which in turn may discourage individuals from being successful because the more successful they are the less they get. Of course any practical analysis instantly characterizes that complaint as complete and utter bull because first it is irrational to believe that an individual will be less motivated to acquire financial resources simply because they will have to pay more in taxes. Anyone given a choice between pursuing a career where he/she would make 25,000 dollars a year and pay 4,500 in taxes versus make 100,000 dollars and pay 34,000 dollars, would obviously selection the latter option. No reasonable person would elect to only make 20,500 dollars a year instead of 66,000 dollars a year to either ‘stick it to the man’ or because paying 34,000 dollars instead of 4,500 dollars to the government is so distressing that making a net of 45,500 dollars more is immaterial.

Proponents of a flat tax would contend that the above statement misses the point. The very fact that the disparity exists in the tax system at all is what is unfair. If these individuals feel so strongly about ‘rooting’ out unfairness then they should start promoting a communistic economic system. Capitalism is fraught with inequalities and unfairness for gone are the days where individuals can consistently achieve financial success by simply studying hard and working hard. There is indeed still the rare case where an individual pulls him/herself out of poverty to make it big, but in the modernized capitalistic system who you know and what resources you possess have a much more pronounced effect on your success than any drive to work hard. A majority of the individuals that have wealth today definitely took advantage of some of the unfair elements of capitalism to amass their fortunes. How funny it is that most individuals complain about unfair elements that are to their disadvantage, yet say nothing about unfair elements that are to their advantage.

Unfairness in capitalism and the role of the progressive and flat tax is best illustrated in an example. Consider two participants running a 400-meter dash, Runner A and Runner B where Runner A gets to start 100 meters ahead of Runner B (think of this as better connections and greater access to resources largely due to parental connections). The gun is fired, the participants run the race to the best of their ability and Runner A wins easily. Suppose then the timers elect to remove 5 seconds off of Runner B’s time closing the difference between the two times, yet still maintaining an easy victory for Runner A. Those that support a flat tax would cry foul about removing 5 seconds from Runner B’s time, but would remain silent about Runner A’s 100 meter head-start. Replacing the progressive tax with a flat tax would simply be removing one unfair element that favors the poor further stacking the deck in favor of the rich and well connected.

A more conspiracy theorist view of the flat tax could label the system itself as a fiendish negotiating tactic by the super rich. Perhaps one day the masses will realize the actual disparity in the tax rate between those who make 35,000 dollars a year versus those who make 1,000,000 dollars a year is not in their favor, but the favor of the million dollar earner due to government neutering of the IRS and tax loopholes for the rich. Such realization will result in a demand to close tax loopholes for both the individual and corporations reestablishing the genuine rate as outlined in the progressive system.

With this eventual understanding that some perceive to be inevitable, one could believe that the flat tax is just a preemptive strike to neutralize progressive tax reform. In essence although the flat tax would result in an increase in tax payment from net effective rate of the mid-teen (what most well-connected wealthy individuals pay) to something like 20% it would dramatically reduce the probability of reform within the progressive system itself that could result in a rate increase from mid-teens to 39% or even higher. So by giving up something like 4-5 percent points, the biggest benefactors of a flat tax save themselves a 20-30 percent point increase at some point in the future.

Finally the importance of the assigned tax rate in the flat tax itself deserves analysis. If the rate is too low, then the government will not be able to recoup the necessary capital required to effectively run programs for the benefit of its citizens, which would lead to the loss of certain programs or increased national debt either element would negatively affect the economy. If the rate is too high, then those in the lower portion of tax bracket in the progressive system will end up paying more and those in the higher portions of the tax bracket may end up paying less and that hardly seems to emulate the ‘fairness’ of the system, the less you make the more you pay. This single statement has deduced the reality behind the flat tax. Inherently in its purest ‘on paper’ form the flat tax is fair, but the current practice of capitalism is not. The insertion of a flat tax into an unfair system of much greater magnitude corrupts any authenticity in the flat tax. So while a flat tax may be fair in isolation, in the current economic system of the United States, it is unfair and unwarranted.

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