The Flat Tax Fail

There’s a growing chorus of people demanding fairness in the tax code and the popular solution is to implement a flat tax.  I’m not convinced it solves as many problems as they claim but I am convinced it will create some very substantial new ones.  Here’s why:

The first reason is the amount they generally cite, somewhere between 20-23%, which sounds great to someone in the middle class who has a starting tax rate of 15% with payroll taxes adding another 15%.  Here’s the problem: that 23% figure isn’t the actual number.  The method they use to calculate it is a bit deceptive.  For example, if you bought a pack of gum for a dollar and ended up paying the cashier $1.30, most, myself included, would say that the tax was 30%.  However, the flat tax advocates would claim that you paid a 23% tax because $1.00 is 23% less than the final cost of $1.30.  That latter calculation is how they determined the 23% rate.  The reality is that the rate would have to be closer to 30% in order to account for all the current revenue needs. 

Furthermore, with the flat tax, there would be no deductions.  The middle income person/family that would file for basic deductions like dependents and such would get none of those.  Under a flat tax, their taxes would actually go up, and probably significantly.  In 2009, the last year which tax rates are fully reported, according to the IRS the bottom 50% of the population paid an average of 1.85% of their income.  The average income in the US is $57,000 so even allowing for a $30,000 exemption (which is the new twist in the flat tax argument), there are going to be a lot of people who are going to be paying significantly more than they do now.  Those who fall into the top 25%-50% bracket only paid an average of 5.56% of their income in taxes.  Even those who fall in the top 10%-25% only paid 8.25% of their income.  In fact, it’s not until you get to the top 5% that the “23% flat tax” actually provides tax relief.  

How is this possible?

The deductions the flat tax eliminates have limitations that are exceeded by income.  For example, the home mortgage interest deduction only applies to one’s primary residence and vacation properties in which you reside for at least two weeks a year.  Therefore, you can’t declare mortgage interest deduction on more than 26 homes.  Yeah, but who owns 26 homes?  Well, someone who owns hundreds of properties doesn’t have 26 homes, but if that limitation weren’t there they could declare all of them as such.  Likewise, child tax credits, deductions for home business expenses and charitable donations also have limitations on how much they reduce tax liability.  The amount of reduction is useful to most but after that saturation point, a person just has to pay the taxes.  So people whose income is above that saturation point are the ones who will most benefit from the flat tax.  Interestingly enough, many of the flat tax plans also propose to eliminate capital gains taxes altogether so the people above the saturation point will be in position to take further advantage of the relief because a significant portion of their income often comes from investment. 

It’s true that there are a ton of deductions available in the current code but many were designed to make life’s painful experiences less so.  For example, there are tax breaks if you’re affected by natural disasters or theft.  Charities were designed to help people through these tough times but taking away the deduction for donating to charity will destroy a significant number of them.  About a third of all donations ($98 billion) in 2011 came from people giving to their local churches, so that probably won’t change regardless of the tax code.  Likewise, another $25 billion was given via bequests so that is unlikely to change either.  So what about the other 60%?   While only about 5% of all donations ($15 billion) funneling into charities comes from companies, a company’s only directive is to make money.  Giving money away is contradictory to that directive, except when giving money away saves money.  That only happens when the benefit for deductions is greater than the tax paid.  Take away the deduction and no company will donate to a charity.   Another $40 billion is donated by foundations that likewise have a significant tax incentive.   That leaves about 40% of all donations given by individuals to non-church charities.   How much less will be given without the benefit of the tax deduction is a subject of much debate, but what is certain is that the percentage of people who will still give the same amount won’t be 100%.  The number of charities has dropped 35% since 2007 and the economic struggles of the middle and lower classes during that period is the primary culprit.  It doesn’t take much imagination to suggest that charitable giving will go down further with a heavier tax burden and no tax break for giving.

Some of the commonly overlooked deductions apply to continuing education classes or personal legal bills or even for school supplies if you’re a teacher.  Taking in the full gamut of deductions available to middle-income earners, you get deductions for improving your house, increasing the resale value or making it more energy efficient.  All of these lessen the blow of large expenses that eventually improve the quality of your life.  All will be eliminated with a flat tax.

Along those same lines, the housing market will also be affected negatively by implementation of a flat tax.  Most people who own their own homes use the mortgage interest deduction on their taxes and it saves them thousands of dollars each year.  The problem isn’t the HMID; it’s in the application, allowing people to declare it on numerous homes.  Limit the deduction to only the primary residence and all of the exploitation of that loophole will end.  Those who own multiple properties will still be able to declare a deduction for the yearly depreciation of the property so it’s not like they’re getting completely shafted.  The HMID is the single biggest financial incentive to owning a house rather than just renting.  Without the HMID, home purchases and thus new home construction will take a huge hit.  Remember when the housing market tanked in 2007-08 and how much it affected the economy?  This would be worse.  

You get deductions for investing in companies that end up generating a loss, including your own.  Not all companies succeed, even ones that have good ideas.  For example, Iridium had a fantastic idea of being able to make a cell phone call literally anywhere on Earth by using satellites.  The phone they produced was kind of big but handsets would eventually become much smaller as the technology improved.  No cell phone towers needed, no bars, no zones, no nothing.  If you had an Iridium phone you could get and make a phone call anywhere on the planet.  Great idea, right?  Unfortunately, their management wasn’t up front with its shareholders about a lot of the expenses of filling our outer space with satellites as well as some other things so the business went bust.  There are literally hundreds of companies that have brilliant ideas that will benefit huge segments of the population yet will go bankrupt because they are either too far ahead of their time, or their management makes a misstep or something as simple as bad luck.  Sometimes good ideas just don’t fly.  But regardless of how good an idea is, it can’t come to fruition without investors.  Almost all companies need start-up money and the safety net of investment loss deductions encourages people to take that risk.  That’s why it’s a bit galling to me that some people think there should be no capital gains tax.  The government (read: all taxpayers) subsidizes their losses if it doesn’t work out but get stiffed if the investment makes money.  How is that fair?  But I digress… 

Here is the biggest rub: there’s no proof that a flat tax actually improves an economy.  I'm still waiting for evidence that it will be better than what we have.  Russia is the only country in the top ten largest economies that has a flat tax and its rank has been dropping. Taken in aggregate, all the countries that have a flat tax (33 of them) have a lower GDP growth (3.72% to 4.03%) than countries that don't. Iceland had a flat tax; they decided after three years it wasn't worth it.  You might wonder why you should care about Iceland, but it so happens that Iceland is a bellwether for Western economies.  It’s small enough that change happens quickly but large enough that the sample is useful.  Because of this, it has become the proving ground for many of the economic philosophies of the past 30 years. 

So here’s where we are with the flat tax: the rate its proponents cite won’t cover current revenue demand, it increases the burden on the middle class, it punishes charity, it will probably crash the housing market and, if implemented, along with the elimination of capital gains taxes, it actually lessens the tax burden on the people who are most taking advantage of the current system.  Our current code needs some fixing for sure.  For instance, why is there a deduction for owning a corporate jet?  Isn’t that a luxury?  Why are their more deductions for owning debt than there are for owning assets?  Why are credits for creating jobs the same for creating jobs overseas as they are for creating jobs here?  These things are pretty easy language fixes.  All it takes is a little political will, but certainly less than it would take to start over with a new tax code.  And there certainly would be fewer negative consequences. 

Is a flat tax simpler?  Sure.  But there’s no evidence it would be better.