The Fairest Tax

Republicans in Congress took another step toward passing tax-reform today. The bill is the typical Republican trickle-down idea, cutting taxes magically puts money back into the economy. This is a myth that doesn’t work, but that subject has been covered ad nauseum. Instead I’ll use this opportunity to talk about how we can build a fairer tax system.

You may have heard the terms “Flat Tax”, “Fair Tax”, or “national sales tax” thrown about. “Fair tax” and a national sales tax are both “consumption taxes”, meaning it’s a tax added to things you buy or use. Most states and localities have a sales tax, which is a form of this. A “Flat Tax” could be on income or an after-the-fact consumption tax. The basic idea is to greatly simplify the tax system with a single flat rate. Proponents of these tax policies claim they are fairer than our current system which, at the federal level taxes income at different rates depending on how much income a person has.

I won’t disagree that our current system needs work. The system could be vastly simplified and if we are honest, the deductions in our current system mostly benefit people who need it the least. The complexity is due more to lobbying by the tax preparation industry than it is to the type of system we use. Unfortunately a flat tax scheme really isn’t fair and again, mostly benefits the wealthy under the guise of “freedom”.

The argument says that the more one makes, the more one pays, even though the percentage stays the same. On the surface this makes sense. Person “A” makes $120,000 and person “B” makes only $24,000, in a system that taxes everyone at 10%, person “A” pays $12,000 in taxes and person “B” only pays $2400. A consumption tax would work in a similar way except the tax is based on what you spend. Person “A” spends $100,000 in a year and saves $20,000. They now pay just $10,000 in taxes. Person “B” doesn’t make as much money so they spend their entire $24,000 on necessities and thus they still spend $2400 in taxes.

In that last example you may notice a small problem. With the consumption tax the richer person is able to lower their tax bill simply by having more disposable money that isn’t required for basic needs. Fair Tax actually seeks to fix this problem by giving everyone a “prebate” which would be a monthly payment to everyone up to the poverty line. So for example if the poverty line was deemed to be $12,000 annually then everyone gets $100 a month to cover the first $1200 in tax.

An income based flat tax suffers from a similar problem and here is where we can see why a progressive tax system with multiple tax brackets makes sense. Going back to the person “A” and person “B” example, we need to look at what they spend their money on. For ease of calculation we’re going to assume these people are single, live in the United States and for now we’re going to ignore state and local sales taxes (but not property taxes because that figures into housing as I’ll explain momentarily). We’re also using averages so these numbers will be vastly different for someone living in San Francisco or New York City.

Person “A” with an income of $120,000, or a little more than twice the national household average. Receives $10,000 a month and pays:

Housing: $1500 (mortgage, insurance and property tax)
Utilities: $350 (water, gas/electric)
Infotainment: $300 (internet, tv, cell-phone)
Healthcare: $100 (employee portion of employer group ins.)
Groceries / other necessities: $250 (doesn’t include eating out)
Transportation: $700 (new car payment + gas + auto ins.)
Total necessity: $3200

Person “B” with an income of $24,000 or about twice the poverty line and a bit less than half the national household average. Receives $2000 a month and pays:

Housing: $600 (rent on 2-bed apartment)
Utilities: $300
Infotainment: $100
Healthcare: $150 (individual health-plan)
Groceries / other necessities: $200
Transportation: $550 (used car payment + gas + auto ins.)
Total necessity: $1900

Now we can see something very important. Person “A” only spends 32% of their income on stuff they need, even when they spend a bit more for nicer things. While Person “B” spends 95% of their income. If you add a 10% tax on top, Person “A” can easily absorb the $1000 they’re asked to pay but Person “B” is asked to pay $200 and they simply doesn’t have it, they have to cut somewhere else. Even with the Fair Tax idea of giving Person B an extra $100 a month, the system ensures that where they could barely save anything before, now they can’t save anything at all.

It would be better if we tax each person’s disposable income rather than the total. In the flat tax example above we’re taxing Person A’s disposable income at less than 15% but we’re taxing Person B’s disposable income at 200%! These are their effective tax rates.

A progressive tax system tries to fix this problem by creating tax brackets. Now a common misconception of tax brackets is that if I make $1 more than the amount of a particular bracket that suddenly all my income is taxed at that rate. That is not how it works. Instead each “bracket” of income is taxed at that bracket’s rate, so even if I’m Person A making $10,000 a month, the poverty line amount is not taxed and the necessity amount is taxed very little. Here’s an example, it doesn’t use real tax rates because they change and they’re more complex than this. (the main difference is that the bottom tax rate is still 10% but you apply deductions which effectively removes it).

Bracket |    1    |     2     |     3     |     4     |     5     
Income  |$0 - $12k|$12k - $24k|$24k - $48k|$48k - $96k|$96k - $192k 
Percent |   0%    |     5%    |    10%    |    20%    |    40% 
Person A|   $0    |   $600    |   $2400   |   $9600   |   $9600
Person B|   $0    |   $600    |     $0    |     $0    |    $0

In this scenario Person A now pays $22,200 in taxes annually. The effective tax rate on their disposable income is now about 28% while we lowered the effective rate on Person B to about 25%. The effective percentages are now much closer and much more fair.

In a progressive system rather than muck too much with the rates, it’s actually better if create a spectrum of rates from 0% all the way to 99% (for those making billions of dollars) and add more tax brackets. Adding more brackets even helps Person A because they get a tax break on that money where you insert a new bracket. The basic idea is you want to make everyone’s effective rate as equal as possible without preventing those people from saving.

Unfortunately the tax reform plan in Congress seeks to reduce the number of tax brackets taking us toward a flat tax. This is why opponents of it say it’s such a huge windfall for the wealthiest Americans. Most of their income is already in the top bracket, the percentage of which will be reduced and more of their income will fall under that lower rate. Some of the middle rates will go down but the bottom rate will go up and the income level expanded.

Say in our chart above we decided to combine brackets 2 and 3 and charge everyone 8% on $12k to $48k of their income. Right now Person A pays $3000 a year on that part of their income and Person B just the $600 since they only make enough to pay 5% on their whole income. By combining the bracket and averaging out the rate we give Person A a small break, they now pay $2880. But Person B now pays $960. Person A doesn’t really care, it’s a modest break that’s paid for twice over by Person B, who is again squeezed. Obviously a single tax bracket makes this infinitely worse.

So what about the consumption tax? I showed above how those essentially suffer from the same problems. Flat tax proponents argue you can control your own effective rate, if you want to be taxed less you simply spend less. I’ve shown above that someone with so little income has a very hard time spending less because all of their income ends up going to necessities. It isn’t much of a choice.

Now in my fictional examples I’ve ignored deductions because in my perfect world of good tax policy, they aren’t needed. Okay, really it’s because the math is hard enough as it is when we’re explaining the concepts. Deductions matter when it comes to the real world because state level taxes aren’t going away. Most states charge their own sales and income taxes which can be deducted from a person’s total income. Let’s look at Person B again. Under the current system they can tell the IRS they already spent 5% ($1200) in a state income tax. The IRS then calculates their income at $22,800 rather than the $24,000 before. If the rates are like my chart above then Person B is going to reduce their tax down to $510 from the $600 they owed before. (well they’re getting killed by their state but the point stands). In a consumption tax scenario, not only are they going to pay a percentage on everything they buy, they don’t get a break on the state’s percentage either.

The Fair Tax folks in particular employ some other magical thinking, in that the government can also save money by eliminating bureaucracy, particularly the IRS, and that tax cheating will also go away. I’ll address the tax-cheating first. Perhaps the Fair-Tax people having been living under a rock, and under this rock there are no business people who offer to let you pay in cash for about an 8% discount. This happens all the time and it would be rampant under such a system. Secondly, I can’t imagine a scenario where businesses won’t get tax breaks on business expenses. (I mean there’s going to have to be some bureaucracy at the business level to collect these taxes right?). Business owners then just buy things as business expenses for their own personal use. This happens all the time as well. Cheating will happen, as such eliminating the IRS is a pipe dream. At the very least you’re going to have a new agency with a new name that does the same thing because someone has to be tasked with collecting the tax at the business level and there has to be some enforcement method.

In the end the fairest tax is an income tax (including on capital gains!). More tax brackets, fewer deductions. Target an equal rate on disposable income, and while we’re at it let’s get rid of the tax prep “industry”.