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It is by now I believe conventional wisdom that the federal income tax is complete absurd in its myriad carve-outs, deductions, credits, penalties, etc. Without altering any other portion of the tax code (which needs altering) what would a back of the envelope calculation be for moving from the Progressive tax to a flat-rate tax, applied broadly? The current rates go from 10% (on incomes below $16,750 for couples) to 35% (on incomes above $373,650 for couples) – soon to be rising.

The IRS reports in 2007 that:

  • $8.03 trillion in adjusted gross income (this excludes about $600 billion of income on returns with no tax liability).
  • $5.94 trillion in taxable income (this excludes about $120 billion of income on returns with no tax liability).
  • $1.115 trillion in income tax received net of credits

In a world where we kept all deductions and exemptions and credits as we have today, this would imply that we could scrap the graduated system for a flat system with an 18.8% rate on taxable income with all of the loopholes, exemptions, etc.

What if we eliminated the silly exemptions and also brought all taxpayers into the system? From a justice standpoint this would seem to be desirable – we are at a point where nearly a majority of Americans can vote themselves goodies by taxing the rest of us without incurring a penny of cost themselves. Even if you favor a strong government, such a program is not healthy for a stable democracy – or revenue raising.

In order to continue to collect the $1.115 trillion in income taxes, the flat tax on all income (about $8.7 trillion) would only have to be 12.8%. You could also bet that if there was a flat tax of 12.8% with fewer exemptions, we would see property bubbles arise less frequently, we would see more income coming in to a clear and simple tax program rather than being sheltered and hidden in all manner of costly mechanisms, and we would likely see an increase in overall income because of the removal of massive inefficiencies the present graduated system inflicts on all of us.

Of course, layered on top of this are myriad payroll taxes, sales taxes, property taxes, excise taxes, estate taxes, and other fees which are not part of this calculation.

One Response to “Simplify the Tax Code”

  1. Harry says:

    Yes, the other taxes, including state income taxes.

    In Pennsylvania we have a flat tax levied on the first dollar of ordinary income. Strangely, it taxes all positive numbers, but does not permit any adjustment for any losses (“If less than zero, enter zero.”)

    But it does have the virtue of having everyone in the game, and when Ed Rendell raises income taxes by 30%, everybody making something feels it.

    Your point about people voting to get money from other people for their pleasure is well-taken. A flat tax that hit everybody equally would make everyone more mindful that money does not grow on trees. Or I should say wealth does not grow on trees, but money grows on Treasury trees.

    I am sure you would agree that income should be net income, which should allow for reasonable deduction of expenses to produce that income. These are not “loopholes” but what reasonable people can agree as the cost of doing business; and they should not be regarded as indulgences granted by our Lords in congress.

    For this reason, there must always be accounting standards, and that means something a bit more complex, if you are to be a free businessperson. If you drive a cab, you ought to be able to deduct your gas and the depreciation on your car.

    But a flat federal tax of 12.5% would no doubt cause many more cab drivers to file their first return, and would enable the rest of us not to go to extraordinary lengths to do such things like postponing or realizing capital gains, or numerous other strategies.

    I am sure you read Arthur Laffer’s piece in the Journal about the implications of the expiration of tax cuts. We are going into reverse.

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