Wednesday, April 25, 2007

Flat Tax

Since we were starting a bit of a discussion on the flat tax in my previous post, I'll expound some here.

First, my shorthand in the original post left things confusing, but the phrase "flat tax" usually refers to a single rate with one single deduction. It is possible to eliminate deductions without having a single rate, and to have a single rate with a bunch of deductions, but the ideas generally go hand in hand, and it's this combination that I'm supporting.

It is true that the system of deductions is probably a bigger problem than the graduated scale. It encourages rent-seeking behavior, since it may be cheaper to lobby congress for a tax loophole than to pay the tax you would otherwise owe. Furthermore, it's a playground for the government to attempt to manipulate the market in ways that I think it is ill-suited for. (For instance, you may get a tax deduction for buying a Toyota Prius. Think that's a worthy thing for the government to encourage? Well how about a Ford Expedition? Once the gov't uses tax policy to engineer social change, everything is fair game.)

So if you get rid of the deductions, isn't that good enough? Well I'd be pretty happy, assuming we lowered tax rates across the board so that the effective tax rate didn't go up. Of course we wouldn't, though - because lowering the upper rates benefits "the rich". The graduated tax system provides ample means to engage in counter-productive class warfare. Politically, it's easy to increase taxes on the upper fraction of wage-earners, to the point where the top 10% pay 50% of taxes. If you try to scale those taxes back, you'll be accused of only helping the rich. Politically we're not interested in achieving the most economically efficient state (for whatever our goals are) but simply in what a given law does to change the status quo. This also makes it harder to reduce the size of government, since a program directed at low income people can be presented as paid for by, again, "the rich". The nasty little catch to all of this is that the tax brackets (and deductions) aren't generally indexed to inflation, so what starts out as a tax on the rich ends up punishing more and more of us as time goes on, such as with the alternative minimum tax.

Beyond the rent-seeking and the manipulation, I still don't think a graduated tax makes sense. We can argue about which tax is more "fair", but I think a flat tax results in a better use of resources. As Alan pointed out, the marginal value of a dollar earned decreases. If you increase the tax on that dollar, then you increase the difference between the value to society of the work done to earn that dollar, and the value of the compensation to the worker. People at the upper end won't want to produce as much income, which means they also won't produce that good to society. The contribution of the 200,000th dollar earned is no less than the 50,000th; there's no reason as a society for us to want someone to earn 50,000 but stop before 200,000.

To put it more clearly, a flat tax (at least the ones commonly proposed), even on income, is a "consumption tax". That is, it equally taxes all money spent on goods and services, but not that spent on capital investment. This is a good thing, since capital investment increases productivity, allowing more to be made for less, and making us all richer.

To me, the ideal tax would have a generous standard deduction - perhaps $20k for a head of household, with $5-10k for each other member, indexed to inflation. This deduction makes the tax somewhat progressive - if all your income goes to the necessities of life, you pay no tax - but you pay a flat rate on all your disposable income.

Another intriguing option is to replace the income tax with a national sales tax. In some ways I think this is a spectacular idea. It's clearly a consumption tax; it can be quite fair if, as many states do, you exempt necessities; it would even tax the underground economy, since drug dealers don't pay income tax but would pay sales tax if they wanted to buy anything (except drugs I suppose). I'd be worried that we'd end up with an income tax and a sales tax though. And that would be even worse than the system we have now.

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