Reform the Tax Code with a Flat Tax

I think that everyone would agree that our current tax system is a failure. It is extremely complicated, very time consuming (or expensive) to figure out what you owe, and it has too many loophole that allow legal tax evasion. In addition, the corporate tax rate is a major contributing factor in jobs leaving our shores. I propose a flat tax system, where loopholes and deductions would be minimized, and everyone would pay the same rate on all earnings, be it wages, dividends, or capital gains. Before explaining my proposal, an understanding of our current screwed-up system is necessary.

Our Current System

I am amazed at the number of times I here average, middle class people lament about the wealthy not “paying their share” and then criticize any attempt to eliminate the very system that creates that situation. Our current system is rigged to benefit the wealthy, due to high taxes on wages, and relatively low taxes on investments. Lower and middle class individuals earn most, if not all, of their wealth through wages; for the wealthy investment income is the primary form of income. And not only are the taxes low on investment income, but there are many ways to legally avoid taxes altogether. Of course, since the poor in this country are eligible for all sorts of government assistance, we have the infamous “middle class squeeze”. Compare the following tax rates:

NOTE: I am not going to chart a table showing the corporate tax rates, as they are even more confusing and screwed up than the individual’s rates. Rates range from 15-39%, although certain business must pay an additional 15%, no matter what the income level, while other business have received sweetheart deals from the government and pay no corporate taxes.

As you can see from the tables, every form of investment income (except for short term capital gains) has a lower tax rate than the rate for salaried income. On top of that, there are plenty of places for the wealthy to shelter their investments from taxes. For example, investments in municipal bonds are tax free. And while municipal bonds do not have an incredibly high return on investment, it is an excellent tax shelter for the wealthy.

What this creates is a system where it is difficult to become wealthy, but relatively easy for the wealthy to maintain their wealth. In essence, what we have is a lock on the clubhouse door. And raising taxes on investments really wouldn’t solve anything, as the wealthy would simply shift their investments around to tax shelters. And the numbers from the IRS confirm this.

A Stanford Professor and Economist, W. Kurt Hauser, has been studying the relationship between federal tax revenue and the GDP since the early 1990’s. If you look at the federal tax revenue from the 1950’s to present, the federal tax revenue has ranged from 17.9% to 20.6% of the GDP. That is quite a tight range, when you consider that the top marginal rate has ranged from 92% (1952-53) to 28% (1998-2000). In simple terms, if you want to increase federal tax revenue, you need to grow the GDP. How much growth in the GDP will take place if investors are investing in municipal bonds?

A System that Favors Economic Growth

The federal government should not discriminate the tax on earnings based on where the income came from, or what the current income level is. A flat tax would have overall lower rates with no loopholes. This would both fulfill the “equal justice under the law” principal, as well as promoting economic growth. Here is how they system would work:

• All income, no matter what the source, is taxed at a flat rate. Corporate, wages, dividends, capital gains….all the same. I would suggest a 15% rate, but that number could be adjusted as needed. It would be nice to get the GDP up and federal expenditures down so that the rate could be below 10%.
• A $15,000 personal deduction would be the only deduction (married couples filing jointly would get $30,000). We do not need to reward individuals (or corporations) with behavior that fulfills some politician’s political goal (or attempt to get reelected).
• To level the playing field and eliminate loopholes, there are no additional deductions or tax shelters, including municipal bonds. Believe me, the state and local governments need no encouragement to go into debt.
• Instead of the current 850+ tax forms, there would be two postcard-sized forms: One for salaried income and one for business/investment income. For individuals, you would basically take you gross income and subtract your personal deduction. Multiply this by the tax rate, and you have your yearly taxes. Subtract what was withheld from your paycheck, and you have your refund or the amount you owe. The business/investment form would be based on the same idea, although instead of a personal deduction, business expenses would be deducted instead.

Besides being pro-growth and the fairness of the system, simplicity is one of the great benefits of the flat tax. With such a simple system, mistakes on tax returns would be greatly diminished. As a result, the IRS would need a much smaller staff to conduct audits, and the audit process would not be the long, agonizing process it is today. In the case of individuals, it would simply be the case of a math error or typo, and would easily be fixed. Businesses would not spend as much time and money on tax prep, and business decisions would no longer be based on tax consequences.

The United States needs to reform its tax code, and it needs to do it now. I can see no better system than the flat tax.

I hope you have enjoyed this article. Please feel free to leave comments below. Be sure to stop by my blog at TheThriftyNation.com for great money-saving advice!