Tuesday, March 8, 2016

Flat Tax = Flat Earth

Simple answers are usually the wrong answers.

I spoke before about our tax system - actually in several posts:

Deductions versus Credits, Part I

Deductions versus Credits, Part II

Deductions versus Credits, Part III
Deductions versus Credits, Part IV

And I have even written about the Flat Tax proposals - which are little more than political posturing, as there is no chance in hell of them ever passing Congress.

To the novice it seems all so confusing and daunting.   And part of this is by design.   As a friend of mine who worked at the IRS told me, the two greatest weapons they have in their arsenal are withholding and the unnatural fear people have of the IRS.

Horror stories about the IRS are spread by people who blatantly cheated on their taxes - they pooh-pooh their own malfeasance and then postulate the IRS was "unreasonable" by assessing penalties.   The agency doesn't bother to refute these stories.  If people are scared of the IRS, it makes their job easier to some extent.

The reality is, of course, that it is a horribly underfunded and understaffed agency with antiquated equipment that counts on the honesty of the public for the most part.   But that doesn't fit anyone's political narrative, so forget I said it.

I also related earlier that in Law School on the first day of "Tax Law" the professor gave us an assignment to come up with a new and better tax system.   And on the second day of class, some young College Republican would stand up, beaming with pride and propose a "flat tax" system, and act as if he had invented the wheel.

"That's a good idea," the professor would say, "how exactly would that work?"

"Well," the boy would reply, "You just tax, say 15% of everyone's gross income.  No deductions, no tax credits, no forms, you just write down how much you made and then pay 15% of that!"

"Sounds good!" the professor said, letting the boy into the trap, "But suppose you ran a business where your profit margin was only 15%?   That person would end up broke, if you taxed them on gross income, right?"

"Well," the boy said, "I guess you'd tax on net income.   You'd subtract out the business costs like labor and materials and what not and only tax the profit part."

"Congratulations, my boy!" the professor said, "You've invented the deduction!"

Of course, it didn't end there.   Since it didn't seem "fair" to pay taxes on taxes, there should be further deductions for State taxes paid, as well as local taxes and so on.   Within a few minutes, our "flat tax" proponent had muddied up his "simple" system with a host of deductions and exceptions.

"Now what about things like meals?" the professor added, "should business meals be fully deductible?  If they are, we create a loophole where people will claim their food as a deduction!"

"Well, I guess not," the boy replied, "maybe they could be partially deductible" - and so the young man kept parsing out the actual tax code we have.

"And I suppose someone making only $10,000 a year - should they pay the same tax rates as someone making a million dollars a year?" the professor asked.

"Well, I guess not" - and he invented the somewhat progressive tax system we have today.  In short order, his "flat tax" proposal grew to a complex set of deductions and marginal rates and it no longer could be written on one page of paper.

Then a young fellow named Bobby Jindal raised his hand and said, "Well, what about just a sales tax?"

That, too, seems like a swell idea at first, until you realize a few things.   First of all, a sales tax is a regressive tax, as the poor spend 100% of their income on food, clothing and shelter, and if you instituted a 15% tax, they would pay 15% of their income.   The rich, since they invest don't spend all of their money and would pay less tax.

And they also have ways of avoiding taxes.  When California tried to institute a "yacht tax" to "get after all those rich people" the very rich simply registered their yachts in nearby Mexico and then just flew to Baja to go fishing, thus killing off the marina business in Southern California.   Taxes always create unintended consequences.

Another fellow posited a property tax would be better.  And in some States in the past, all of your personal property was taxed, right down to your shoelaces.  Just trying to inventory all of your assets and calculate a tax on a used chair from year to year was a nightmare, so the municipalities used flat-rate schedules for "personal effects" based on the assessed value of your home.  Sometimes cars were also taxed - which created a disincentive to buy a new car, as the taxes would be murder for the first few years.

And as the professor noted, when people get older, they may live in a house that is "paid for" and can afford to live there, but if the property taxes were high enough, they could not afford the house.   So the fellow proposing that scheme created a set of schemes for property tax relief for the elderly and infirm.

You can see how "simple" tax schemes become very complex in short order when they collide with the real world.

As I noted, every kind of tax has some unintended consequences.  If you allow business lunch deductions, businessmen start taking their secretaries out to expensive restaurants (until the wife catches on).  You tax yachts in Southern California, they move to Mexico.   If you raise property taxes through the roof, people move to other States or property values go down.

But Congress, over the years, as also used the tax system to create intended consequences - Incentivizing people by using the tax system.  Buy an electric car?  Get a $5000 tax credit.   Buy a House?  Deduct your mortgage interest (why?  It isn't a business expense, just a personal one!).   Rent out a house?  You can depreciate the property and reduce you income taxes and convert ordinary income into capital gains.   There are all sorts of incentives, some of which work, some of which backfire - like the "free NEV" scheme that resulted from a poorly worded tax incentive that allowed people to get free golf carts, paid for by the government.

A lot of people think these kinds of incentives are wrong, and to some extent, they have a point.  When the government uses the carrot-and-stick approach of tax credits and deductions, it is no better than the Soviet Command Economy -with all its faults.   It is somewhat better in that a person can ignore tax incentives if the market is screaming otherwise.   $5000 off an electric car is nice, but not enough of an incentive for most of us to go out and buy one.

The other problem with incentives is that they are like a drug - once you are hooked, it is damn hard to get off.   For example, if you went to a "flat tax" tomorrow and got rid of the home mortgage interest deduction, many people would lose their homes, as the deduction brought down the price of the home to make it affordable.

On the other side of the coin, as I have noted before, these deductions are a sop to the middle class.   The man buying a $500,000 house has more to deduct in interest to offset his 25% marginal rate.  The man living in the $100,000 house has far less to deduct and it doesn't affect his taxes as much as he is only in the 15% bracket.  The 401(k) and IRA has a similar effect - which is why we offer the poor a tax credit to save.

The flat-tax proponents like to blather on about how many pages there are in the tax code, and stack up books and say, "See, no one can figure this stuff out!" and act like this sort of thing applies to you and me.  However, 90% of the tax code (maybe 99%) is irrelevant to individuals.   Entire sections on tax credits for farmers or widget production are complex and difficult to understand, but if you are a W-2 wage slave, they never will apply to you.  So when Senator Klaghorn stacks up tax code books on this desk on C-SPAN, he is basically lying to you and you should never take the word of liars.

The biggest problem with a "flat tax" is that even if you could somehow come up with one, it would represent a huge tax increase for people in the 15% bracket ($80,000 combined income and under) and a huge tax cut for those in the higher brackets (making $360,000 a year).  Right now, if you are living below the poverty line you basically pay no taxes.   We would be taking away 15% of the income from people who need it the most.

Now, you might say, "OK, fine, have a cutoff for people below the poverty line" - but now your flat tax is not flat anymore.  You see how complicated this gets in a real hurry.
Estimates so far indicate such a tax would be at least 25% which would be a big tax increase for the poor, many of whom pay no taxes.  This would be a huge burden on the elderly, who often pay no taxes.  It would be a huge cheat to those who saved in their IRA or 401(k) who were promised they could withdraw the money later in life at a lower tax rate.

It would be a huge blow to homeowners who were counting on a home mortgage interest deduction.

A lot of poor people would end up destitute.  A lot of rich people would have their taxes cut nearly in half.

If you want to raise your taxes so people with yachts can have bigger yachts, go ahead.

But the reality is, "deductions" are there for a reason, as are marginal rates.   And speaking of which, our highest marginal rate is about 39.5% which sounds like a lot, but is less than the 50% my Dad paid, or the 90% people paid during the Eisenhower era.  Our tax system is already pretty generous, compared to other industrialized countries.  I am not sure making it "flat" makes it any better - it just gives the top earners a big bonus, and takes away money from the bottom.

As for complexity of the system, again for the average wage-earner, filling out a 1040 is not all that hard.  And you can, for a modest fee, use websites like TurboTax to calculate and file your taxes.   The problem, I think, that people have is that there is this vague uncertainty in the back of their minds that they are paying too much in taxes as compared to their neighbor - or that they are paying too little and will be audited.   It is a matter of uncertainty and fear at work.

Calculating the exact amount owed is not an exact science.   No two accountants will come up with the same tax bill, except in very simple cases (in which you don't need an accountant).   Even the IRS rounds off anything under a dollar these days.   They are not so concerned that you overpaid or underpaid by $100 than that you failed to disclosed $100,000 in income.   And in fact, things like the "standard deduction" are really nothing more than a Scientific Wild-Assed Guess as to how much you pay in sales taxes and other taxes, to deduct from your income.   And the "personal exemption"?  A totally made-up number.

To be sure, when your finances get complicated, you may need an accountant.  When I was running my practice and had two Subchapter-S corps to file papers on, it was a lot easier to have an accountant to handle payroll, quarterly filings, and annual returns.   I realized quite quickly how much a pain-in-the-ass it was to be an employer and got out of the game.   Today, my taxes are much simpler, although chasing down 1099 forms can be a pain.   But it is not all that hard to do my taxes on Turbotax.

So the "complexity" argument is somewhat specious.  And it is a way that the very rich are using the poor and middle-class (who have tax anxiety and trouble filling out forms) to hoodwink them into pushing for a tax system that blatantly favors the very rich.

And for what?   Because filling out government forms is hard?

Flat Tax = Flat Earth.   Makes about as much sense.