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“Flat Red Herrings” by John Edward
John Edward, a resident of Chelmsford who earned his master’s degree at UMass Lowell and who teaches economics at Bentley University and UMass Lowell, contributes the following column.
How long does it take you to figure out how much federal tax you owe on your income? If your answer is more than a minute or two, something is seriously wrong.
Some presidential candidates have advocated one form or another of a flat tax. They say we need a flat tax to simplify filing tax returns. If you buy that argument, something is seriously wrong.
In 1913, the Sixteenth Amendment to the United States Constitution established the federal personal income tax. It was a progressive tax from the start. A progressive tax applies higher marginal tax rates to incomes above certain levels. For example, in 2010, for married filing jointly, income above $373,650 was taxed at the top rate of 35 percent.
The federal income tax used to be much more progressive. In 1981, the top tax rate was 70 percent. In 1961, it was 91 percent. Until World War II, only the top income earners paid any taxes.
Public sector economists recognize the merits of a progressive tax. First, it adheres to the principle that those with more ability to pay should pay more. Second, the last dollar earned for someone making $40,000 is a lot more valuable to that taxpayer than the last dollar earned by someone making $400,000. Third, a progressive tax upholds a sense of noblesse oblige – a noble idea to which many of the wealthy no longer feel obliged.
Advocates of a flat tax promote its simplicity. The simplicity argument is a red herring.
It is not the progressive tax rates that make filing complicated. Once you have determined your taxable income, calculating taxes owed should take about a minute. A flat tax applies the same rate to all income. That might cut the calculation to about thirty seconds.
The deductions and credits that reduce the amount of income subject to taxation are what make filing a tax return complex. On IRS Form 1040 there are thirteen lines for deductions to gross income. Then there is a separate Schedule A for itemized deductions that is thirty lines long. There are ten lines for various credits. Line 53 alone covers eleven different credits, each with its own form.
Some, like the mortgage deduction, have been around for a long time. Congress added others, like the first-time homebuyer credit, recently.
Legislators promote deductions and credits in what are often ill-advised attempts to influence behavior. For example, the federal government uses the tax code to promote home ownership. That hurt low-income households and contributed to the housing crisis.
Once taxpayers get the benefit of a deduction or credit it is difficult to get rid of it. Clever accountants find ways to take advantage of these tax provisions in ways not imagined. The government tries to encourage fuel efficiency but sometimes credits leave gaps so big you can literally drive a Hummer though them.
These benefits have a very high price. Over the last five years the federal government has foregone $290 billion in revenue by allowing estate beneficiaries to avoid capital gain taxes. The deduction for mortgage interest costs over $400 billion.
In 1976, presidential candidate Jimmy Carter said the federal tax code was “a disgrace to the human race.” As measured by the tens of thousands of pages in the U.S. tax code, it has become much more complicated since then.
It would be a disgrace to use the complexity of the tax code as an excuse to eliminate or reduce tax progressivity.
Inequality is as severe now as it was just before the Great Depression. The top 1 percent now own more in net worth than the collective wealth of the bottom 90 percent.
One cause of increasing inequality is decreasing progressivity. During just his last year in office, the tax cuts of President George W. Bush gave middle-income households roughly two thousand dollars in extra after-tax income. In contrast, for the top 1 percent, taxes decreased by an average of sixty three thousand dollars. For some, it was a lot more.
Most flat tax plans include modest exemptions for very low incomes. However, any of the flat-tax-like plans proposed by the presidential candidates would dramatically shift the tax burden on to those least able to afford it.
According to the Tax Policy Center, under Governor Rick Perry’s flat tax plan, a household earning $400,000 would get a tax reduction measured in tens of thousands of dollars per year. A married couple with two children struggling to make ends meet on $30,000 would see their taxes increase by around a thousand dollars!
According to Citizens for Tax Justice, Herman Cain’s 9-9-9 plan gives the top 1 percent tax reductions over $200,000. For the bottom 20 percent, taxes increase by over $2,000.
An honest attempt at simplification would focus on the plethora of credits and deductions that permeate the tax code. The argument that we need to eliminate progressivity for simplicity sake simply falls flat. It is a diversionary tactic in the escalation of class warfare.
Flat Tax: 1. A tax alleged to be so simple it can be filed on a postcard, thus removing all the fun and benefit of developing tax expertise and therefore rendering the concept all but impossible to enact. 2. An effort by the well-to-do to shift the burden of taxes to the middle and lower classes, where it doubtlessly belongs because they don’t have enough sense to become rich so they can afford their own accountants.
Billy Hamilton: The Devil’s Dictionary of Taxation
The top marginal rate was reduced to 25% in the early 1920s, enough time to tilt the distribution of wealth to its tipping point by the end of the decade and assisting in the Great Depression.
Although today’s rate of 35% is mild in comparison, we can be sure there are enough loopholes (such as having hedge fund managers eligible for the 15% capital gain tax break) that the effective rate may be just about the same. The well-heeled have had a lot of years to get their lobbyists to insert favors into the code.
In addition to the low marginal rate and loopholes reducing tax revenue from the rich, there is an effect on salaries themselves – corporations would be a lot less likely to provide exhorbitant salaries if they knew Uncle Sam would get the majority of the excess.
A simple, progressive tax structure would be a benefit to the economy, as well as helping reduce the federal deficit.
To John’s original point though – once a law is in place, it becomes very hard to get rid of it. Tax incentives/disincentives are created to alter the behavior of “The Market”. From here, entire industries thrive or die based on these rules.
Many middle-class people count the mortgage interest deduction as a huge part of any tax savings. If you’re mortgaged to the maximum conventional-wisdom of 28% pre-tax income…in the first few years where you are making little headway on your principal, having over a quarter of your income exempt from a 30%ish tax rate is around 9% of your income back. Not pocket change.
While it might at first seem simple to legislate that the deduction will not be continued for any new mortgages, doing that would still disincentivize more people from taking on new mortgages. This would cool the market further, dissolving remaining home equity, or pushing people further underwater. Perhaps the fairest thing is to gradually reduce the deduction every year?
All the intelligent conversations I’ve had with enlightened conservatives and other flat tax advocates are based on a premise that the first so many dollars of income should be tax free in order to accommodate fairness to those of modest means. Observing that fully half of filers pay no federal tax as it is, the premise would seem to be a fair one that’s in line with current practice. Let’s say the first fifty is free. There should be no problem for everyone to pay the same marginal rate on the rest. It can also be observed that high-income filers today often pay a lower marginal rate than the middle class, so, in reality, a flat tax would actually increase the marginal rate wealthy filers are paying.
We need to abolish the loopholes by which wealthy people with lawyers avoid paying their fair share. There’s no more straightforward way to do it than a flat tax with no deductions or loopholes, which allows everyone a reasonable base of tax-free earnings after which the tax is levied. “Liberals” who oppose this idea are standing in the way of a fair idea.
What Kad said.
And, every tax has social consequences.
The flat tax is the sword to cut the Gordian knot. It will result in some unemployment, as accountants and lawyers will no longer find work sorting through, as Mr John Edwards points out, the thousands of pages of the tax code. On the other hand, perhaps their talents could then be applied to creating useful jobs to employ others.
Regards — Cliff
All the praise for a “simple” flat tax without any deductions or credits ignores the fact that the most contentious issue in tax law is “what constitutes income?”. That army of lawyers and accountants you want to put out of business will still have full employment from the wealthiest whose true income is ambiguous and not a simple number on a W-2.
And hoping for a tax code free of all deductions and loopholes is delusional given the current state of national politics. There’s to much money involved to hold out any hope of a result that’s not skewed towards those who employ the lobbyists and fund the re-election campaigns. Remember Ronald Reagan’s “Tax Simplification Act of 1986”? Rather than simplify anything, that about doubled the size of the tax code. It’s a fantasy to expect a different result today.
So you won’t be advocating world peace either, Dick? ;-)
I am not sure why kad barma decided to apply a label, but I am willing to run with it.
“Conservatives” continue to promote this red herring by ignoring two basic facts.
One, every flat tax proposal, including kad barma’s, is considerably less progressive than
what we have now (which is considerably less progressive than what we had when the economy was much healthier).
Two, getting rid of all the deductions, and the tax rate schedule, are orthogonal from an implementation perspective. We can still have tax returns on a postcard with a progressive tax.
I agree with Corey that while deductions often have unintended consequences, completely eliminating them immediately would as well. I would support a phaseout of the mortgage interest deduction over time, but there must be a limit on the deduction. There is no good reason to subsidize million dollar homes.