July 28, 2017

Flat Tax and other Fiscal Myths – a Rebuttal

This entry is part 1 of 1 in the series Alternatives for US Federal taxation and budgeting
  • Flat Tax and other Fiscal Myths – a Rebuttal

The federal budget should certainly be balanced, and more than that, the costs of Social Security and Medicare costs and revenues should be balanced along with the rest of the budget. After all, once the Social Security fund runs dry, the government will be on the hook to make good on the promised benefits. However, the methods suggested in Alternatives for US Federal Taxation and Budgeting – Part 1 and Alternatives for US Federal Taxation and Budgeting – Part 2 are simplistic and would do little to solve the stated problem, while generating significant new problems.

The Case against a Flat Tax Reform

According to the American Association for the Advancement of Science, the federal budget for 2010 was $3.6 trillion, of which 35% was financed by debt, i.e. deficit spending. The total revenue of the federal government was $2.3 trillion in 2010, of which $1.1 trillion was from individual income tax, $2 trillion if one includes payroll taxes, and $2.2 trillion if one includes other taxes (e.g. excise, gas, estate, etc.). The Census Bureau reports that as of 2009 the total personal income in the US was just over $12 trillion.

Assuming no taxes on corporations and no deductions, a flat tax of 19.2% would be required to replace federal revenues at 2010 levels, excluding the $1.2 trillion deficit. To close that gap without cutting expenditures would raise the flat tax rate to about 30%. To achieve a 10% flat tax, even with no deduction for the poor and lower middle class, the federal budget would need to shrink by an impossible 67%!

A flat tax system is by definition regressive – i.e. the poor are required to pay far more as a fraction of their income than the rich, since capital gains provide a far larger source of wealth for the rich than it does for the poor. Addressing this, a generous per family deduction has been proposed. Enacting e.g. a $50,000 per-family deduction would reduce the tax base by about $4.4 trillion (36.7% of the $12 trillion total personal income), requiring the flat tax rate to be increased to 30.3% to match current tax revenue, or 47.4% to cover the 2010 federal deficit without reducing federal expenditures.

Even with such a family deduction, the system becomes regressive above the deduction threshold, shifting a significant portion of the tax burden from the wealthy to middle class America. To address this problem, a graduated system has been proposed, under which there would be several, gradually rising tax rates for different levels of income. While this would improve the system’s fairness, it becomes very similar to the current tax system before Congress implemented the bewildering array of deductions and credits currently part of the tax code. Enacting this reform one should anticipate that before long Congress will be pressured by various interest groups to enact a new set of special exemptions, credits and deductions that would once again make the tax code larger than most encyclopedias.

Ignoring the futility of such an exercise, one must still question the fairness of changing the rules on taxpayers who have followed existing law, making choices informed and induced by current tax codes. For example, the tens of millions of homeowners who financed their homes based on the current availability of a mortgage interest deduction would suddenly find their taxes significantly higher than planned for, making their purchase and financing decisions a retroactive financial disaster.

Grandfathering existing mortgages (as well as other current tax credits and deductions) to mitigate the disruptions one can expect from such a massive tax reform would do away with a large fraction of the fiscal benefit of the new system. In fact, some have argued 70% to 100% of that benefit would be lost, raising the question if such a drastic reform remains justified. Further, even if current mortgages are grandfathered, the fact that new mortgages would no longer offer an interest deduction would put downward pressure on home values and decrease the net worth of a majority of American families, depressing consumer confidence and likely dropping the US into another major recession, if not outright depression.

How Does One Balance the US Federal Budget?

Reducing or eliminating foreign aid would be a mere drop in the proverbial bucket next to the size of the federal deficit, while dealing a death blow to the ability of the US government to promote our national security interests abroad through judicious use of such aid. Having foreign governments beholden to us for such support provides us with leverage needed to keep oil flowing, keep secure off-shore bases and air-space use rights that allow us to project force around the globe and in general ensure our national security interests are protected. What’s more, in 2008, the total foreign aid was under $50 billion, even including efforts in Iraq and Afghanistan. Cutting this to zero would reduce our federal deficit by less than 4%. A less fictional reduction of 50% would drop that benefit below 2%.

Cutting special earmark spending is a perennial favorite of government bashers, at least until it comes out of projects that pump federal dollars into their own state. Nonetheless, such a cut would only save about $15 billion. A phrase I recently heard would describe such a cut as being the fiscal equivalent of “a bump on a pickle”.

If Congress is to balance the budget, and if increasing taxes is politically untenable, how does one go about doing so? An interesting budget-balancing exercise was suggested by David Leonhardt and Bill Marsh in the New York Times. According to the figures provided there, the following would be the cost-cutting measures in order of decreasing impact on the budget.

First and foremost, capping Medicare growth at GDP growth plus 1% per year starting 2013 would save as much as $560 billion. Raising retirement age for full Social Security benefits to 70 (from the current 67) would save another $245 billion. Third in size impact is to accelerate the drawdown of troop levels in Iraq and Afghanistan to a combined 30,000 by 2013 would save about $170 billion (this begs the question of the likely impact on national security interests, but is an instructive number). That number decreases only slightly to $150 billion if one decreases troop levels to 60,000 by 2015 instead.

The remaining options mentioned there would be unpalatable to a majority of Americans. First, we would need to reduce the size of our military (troop levels, new weapons programs and fleet sizes) and compensation for non-combat personnel, saving a total of $185 billion. Next, we would need to slow down cost of living increases to Social Security benefits, increasing de-facto income taxes, for a saving of $80 billion. We would then cut various government programs (e.g. national parks, aid to states, farm subsidies, reducing the federal workforce, capping or cutting civil service salaries, and cutting the number of government contractors) saving a total of $130 billion. Of course these cuts would impact most or all American taxpayers directly (e.g. loss of jobs, loss of contract work, etc.) and/or indirectly (e.g. increases in state income taxes to compensate for loss of federal dollars, etc.). To close the budget gap would require essentially all of the above, unless taxes are raised in one way or another.

The Bottom Line of Balancing the Federal Budget

At the end of the day, there is no escaping the bitter truth that we Americans have gotten used to having our cake and eating our (kids’) cake too. We expect the government to provide all the goodies we’ve gotten used to, but are unwilling to pay our fair share of the cost of those goodies. If cuts are needed, they should only be at someone else’s expense and preferably not in our state so our local economy (and thus our home value) doesn’t suffer. If tax reform is called for, it should move as much as possible of our personal tax burden to someone else. If tax reform is not enacted, and budget cuts remain politically impractical, the chickens will one day soon come to roost in our kids’ and grand-kids’ homes.

The so-called Flat Tax is a modern-day siren, luring unsuspecting taxpayers onto the shoals of the fiscal reality. The reality that short of impractical changes in our society and way of life, income taxes are unavoidable, and that the wealthy should (as they currently do) shoulder the lion’s share of that burden for the simple reason that they’ve been lucky or skillful enough to wrest more wealth out of our economy than their brethren. Simplifying the tax code, as attractive a proposition as it seems, merely shifts the playing pieces around without solving the underlying problem. There is no silver bullet solution to the federal deficit problem. The only solution is to balance painful cuts to government-funded services with painful increases in our tax burden, until we only pay the government for those services we, as a nation, are willing to currently fund.

Further Reading on the Flat Tax

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