Sanity Zone 10-14-10

There have been times in the past where, during the heat of trading forum posts, our discussions have moved from purely thread related issues to economic issues. I've noticed that many have opinions on economic policy, local, national and international. When I see a topic that could use some illumination, a post here in the Sanity Zone will ensue rather than get a thread bogged down in distracting and unproductive argument. I will do my best to maintain my tradition of non-partisan, non-ideologic analysis of economic conditions and policies. Hopefully, we can have discussions on possibilities and outcomes based on both facts and known correlated behaviors of individuals and peoples. I promise not to be dry, condescending or patronizing, and I encourage constructive participation.

Recently there was a dust up over the flat tax.
Fortunately, this is an easy topic to discuss. Many people are angered over income taxes, and taxes in general, and this concept floats around during periods of slow economic activity.

Definition.
Just so we're all on the same page, a flat tax simply means that everyone pays either the same amount of tax, or the same percentage of tax. Examples of flat taxes are property taxes (% of value), sales taxes (% of total $ value purchased) and fees for things like a driver's license or registering a gun.

The proposal.
Consider a flat tax on income. This would be a single rate of tax on net personal income, where allowable deductions would be subtracted from gross income.

The Current Situation.
To keep things simple, I'm not going to address State or Local income taxes, most of those taxes are flat rate taxes or a minor tiered system similar to the Federal Income Tax.

Our current tax code has 6 tiers ( 0%, 15%, 25%, 28%, 33% and 35%), and is what as known as a Marginal Tax Rate System or a Progressive Tax System, where each additional dollar of wages may have a higher rate of taxation. Under our current system no citizen pays more than 35% for Federal tax on their last dollar earned.

There is also a provision called the Alternative Minimum Tax (AMT), which ensures that, no matter what, an individual cannot game the system with allowable deductions and pay a much lower rate of income tax. This rate is currently 26%, and would be considered a "flat tax."

There are also Capital Gains taxes, which provide for a lower rate of tax on income derived from selling long term assets, like stocks and bonds. This rate is currently 15% and would be considered a "flat tax."

While this table is simple, there are thousands of codes that describe rules for deductions and exemptions against income that could lower the net income, and thus lower federal taxes for the individual.

Analysis.
Our current system has elements of both a progressive tax system and a flat tax system. With the AMT provision, above $71K in adjusted income (filing jointly) ensures a minimum of that flat rate. The federal tax rates on marginal income are relatively simple and easy to calculate.

The complexity is in the deductions. Deductions are used to promote behaviors or activities that our culture deems valuable both in the short and long term.

Providing a deduction for a mortgage, for example, gives the family unit an incentive to own a home. This promotes building new homes (employment, increased GNP) and it promotes stability of wage earning (don't want to lose one's home). It also serves as forced savings if one chooses a traditional amortized mortgage.

Our tax deduction code has been a useful tool by our government to promote key desired behaviors. It is constantly revised based on observed behaviors. There have been times where lawmakers have created "loopholes" inadvertently, where unwanted behaviors arise as individuals shelter income through these deductions at too high a rate, or the definitions of what incomes are allowable for shelter are too broad.

Discussion

If one is attempting to have an equitable income tax system, one must balance the needs for:

1. Revenues
2. GDP Growth
3. Desire for the "American Dream", or class mobility.

Flat taxes tend to be regressive, which is code for adversely affecting lower income classes and promotes an unequal distribution of wealth. While one might argue that if we made the rate a flat 15% no matter what your income, that 15% is not created equally.

A family of 4 earning $ 50,000 would pay $ 7,500 in federal taxes. ($6,700 currently) - 55% of Americans fall near here
A family of 4 earning $1,000,000 would pay $150,000 in federal taxes. ($324,240 currently) - 1% of Americans fall near here

The argument against a flat is three fold:

1) $800 does not seem like a lot of money, but it potentially represents a major portion of discretionary income. Lower income families save at a far lower rate, have far less in reserve and far fewer opportunities to recover from an adverse event with a higher rate.

2) Even adjusting for the increased tax revenues from the poor against losing revenues from lower taxes on the rich, overall government revenues would fall, causing increased deficit spending. (we can have another discussion on this later)

3) Marginal Propensity to Consume.
Give a poor person a dollar, that person will spend it all. Through velocity (movement of that dollar in the economy) it will generate about $1.60 in GDP.
Give a rich person (over $300,000) a dollar, that person will only spend enough to generate $0.30 in GDP.

The argument for a Flat tax is that one can make it revenue neutral, that it doesn't necessarily keep poor people from saving, and that tax simplification eliminates potential frauds and inequities of deductions that favor the rich anyway. One could even exempt the lowest income classes from tax (as we currently do.) There is a theory that reducing taxes on the wealthy will make them work more to earn higher income. This has been dis-proven by empirical analysis of wages and taxation over the last 80 years. There is also a theory that the rich spend money, and that economic activity will "trickle down." Yes, it is a trickle (see above), not the gusher of economic activity proponents claim.

Conclusion

As long as western nations have as a basis of tax code the concept of upward class mobility and the desire to adjust economic activity by using the tax code to promote short and long run beneficial behaviors, there can be no "flat tax." There are no complex economies with such a tax system simply for those two reasons.

Next up - the BUSH TAX CUTS and their effects on our economy.

Thanks for reading. I look forward to your comments.