There has been a lot of discussion on both sides in Washington these days about how to reduce the size of the US deficit. One way of doing so is "increasing revenue" or basically bringing in more taxes. One of the more left-leaning policy ideas is to tax the rich more. I'm not going to get into my feelings on the subject other than to say that an alternative theory is to implement a "flat tax" or "consumption tax."
A flat tax for those of you who don't know is basically a tax system in which there is one rate that everyone pays. Many advocates for a flat tax would like to see it implemented in a manner that basically abolishes a person's income tax and instead raises the tax everyone pays on consumption. The theory goes that everyone will pay the same rate on the stuff they buy in essence meaning that everyone pays the same amount. Rich people will naturally spend more and therefore pay more tax, but it will be "fair" because they pay the same tax rate on purchasing an item than anyone else would.
Personally, I believe the flat tax as I described about would be a good idea, but the reality of it is that a consumption tax will never get implemented. There are too many political landmines and economic traps to scrapping the system we have now and implementing a flat tax.
First, many good jobs would become obsolete if a flat tax was implemented. The IRS would not be shut down, but they would have a lot less work to do and a big chunk of the agency would have to be let go. Additionally, any income tax accountant would be out of a job creating a glut of well trained CPAs and tax preparers that would be out of a job. This would negatively impact the economy terribly as perhaps as many as a few hundred thousand good jobs would be gone.
Second, for all the big talk, Washington has no spine. This can be seen almost weekly it seems these days. The amount of fortitude it would take to get legislation passed that would completely scrap the current income tax code would be monumental as well as nigh impossible.
Thirds, there would be a major problem in terms of 401k and other retirement accounts. There is $13.3T invested into various types of retirement accounts as of 2004 according to this report. While not all of this money is in a individual retirement account such as a IRA or 401k, there is definitely trillions of dollars invested into these vehicles. Perhaps the only reason someone invests into an account they can't access until they "retire" (usually about 65) without a penalty is that they get some type of preferential tax treatment. If income tax were to be abolished, these accounts would suddenly lose a huge portion of their relative worth.
Additionally, anyone who invested into a retirement account where they paid tax on the money going in (such as a Roth IRA) are much worse off than someone that invested in a regular IRA with pre tax dollars because not only did they pay tax and the regular IRA person didn't, but the base of their entire investment was lower as well causing less growth and less compounding returns. There is no way for anyone to figure out a "fair" way to handle these issues if income tax were to be abolished.
Lastly, a flat tax will never be implemented because it actually discourages consumption (i.e. people spending money). The hit that the economy would take as a result of people saving more of their money and spending less on non-essential goods would be potentially massive. No politician or ordinary American would volunteer to push down economic growth of the country and risk a recession or even a depression caused by a significant drop in consumer spending.
Overall, I do believe a flat tax is a "fairer" way of taxation, but the reality is that it is something that will never be implemented in reality mainly due to the severe short-term to medium-term economic harm it would cause upon implementation. Let me know if you think I'm wrong!
As always, follow me on twitter @mdperovich and I look forward to reading and responding to your comments (sorry Edwin from a few weeks ago!).
Miles
I agree a flat tax is by far the fairest way, and that our government is to self interested to do anything about it. Time for a reboot.
ReplyDeleteYour successor of CC at UNC's BTC here. Two points:
ReplyDelete1) Generally, all non-Roth IRA accounts wouldn't go down in relative value (and I'd be willing to bet that 90% of retirement accounts are held in non-Roth IRA accounts <-- just speculation though). It kind of seemed that you hinted at that, but I could have misread.
2) Any countries out there that you know of using the flat tax system? It would be interesting to what extent this has changed the spending habits of consumers. IMHO, I think most people would not be savers, or rather turn into savers, owing to the fact that Americans generally save very little.
But overall, I agree with Ron Paul's flat tax policy. If America was going to implement anything this "radical", this would be the perfect time when the general public has little faith in the current policies.
Agreed on arguments (2) and (4) as to why this won't be implemented (at least in the near future). Imposing a consumption tax is probably the last thing you want to do when GDP growth rate is low, recession fears lingering and a large amount of public debt.
ReplyDeleteAs with your previous post, there isn't a right or wrong answer in terms of the preferred tax code, but it depends on society's goals. The current tax code with income brackets is intended (deliberately) to facilitate wealth distribution. In essence, extra dollars of tax revenue from the relatively rich are used to fund government services for the relatively poor. A flat tax (as the name implies) taxes all groups equally. The numerous public programs in existence is another reason why a consumption tax isn't likely to happen soon.
@Brian
ReplyDeleteYou are probably right where most of the retirement accounts are pre-tax contribution, but that still doesn't solve the issue that for all the post-tax contribution accounts there needs to be a fix. It would be a huge deal if the government suddenly says "IRA holders, you no longer have to pay tax on your contributions" because as I said, anyone using a roth would have had a much lower contribution base and would have paid more taxes.
@Edwin
Good points in that the tax is designed to be unequal - the question is really if that is the right decision to make or not. Our current tax systems creates some extremely perverse incentives for the wealthy that shouldn't be there such as owning a farm or off-shoring money to shelter it from taxes. Having a flat tax makes it more difficult for the rich to just hire the best CPA to get out of paying any tax. Instead, they now have to stomach paying more for their 3rd Benz or huge house than an average person because they can't avoid the tax on the consumption.
One could argue that a consumption tax would actually tax the rich more equitably (and more in general) which is what the current system is supposedly designed to do at least in terms of taxing the rich more.