Tuesday, August 7, 2007

Flat on the Flat Tax

This Week, in the Republican debates in Iowa, candidates clammored to line up behind some version of a flat tax. Here is a brief overview of the progressive marginal system: The tax system in the United States is to progressivly increase the tax rate on marginal income earned as your income increases. The idea is to tax at a rate at which increases as one's ability to pay increases. Takehome income never goes down when you move into a higher marginal bracket. This is best illustrated by example: If the marginal tax is 10% on the first $ 20,000 earned and 20% on the income between $20,001 and $40,000, then someone earning $20,000 exactly pays $2,000 in taxes (and takes home $18,000). Someone earning $20,001 pays: 0.1*20,000 + 0.2*1 = $2,000.20 (and takes home $18,000.80). The reasons for this tax philosophy, and the debate over alternative tax systems comes down to a debate over what "fairness" means. A flat tax can be considered "fair" in the sense that everyone pays taxes in the same proportion to their earned income. There may be small gains in efficiency and growth depending on the net burden of the new flat tax rate on consumption and savings (taxes will decline for some, but may increase for others). But, a progressive tax is "fair" in the sense that it promotes a more equitable distribution of income on the "ability to pay" principle.

Senator Brownback, one this year's greatest advocates of the Flat Tax's proponents said, "It will create economic growth." "That's why 16 countries have already gone to a flat tax." While the merits of a flat tax can be debated, let's look at the "16 countries." They are: Albania, Estonia, Georgia, Guernsey, Kazakhstan, Iceland, Iraq, Kyrgyzstan, Latvia, Lithuania, Macedonia, Mongolia, Montenegro, Mauritius, Romania, Russia, Serbia, Slovakia, and Ukraine. (Note: there are 19 countries.) The underlying reason for moving to a flat tax for most of these countries was to obtain more revenue for the government and reduce the government's deficit. The reason that the flat tax was argued to be effective in achieving this end is that it was viewed that a simplification of the tax system and a reduction of the tax rate would invite the informal sector of the economy above ground, and lead to more accurate and complete reporting of income, not as an endorsement of Supply Side theories. In this regard, we should be skeptical of Mr. Brownback's motives and ask whether he supports a flat tax because he promotes pro-growth policies, or if he realizes the need to broaden the tax base to support bloated deficits, and that the most apt way to do this would be to shift the burden of taxation from the rich to the poor.

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