Rabushka on the flat tax

by Russ Roberts on April 23, 2007

in Podcast, Taxes

Here is Alvin Rabushka talking about the flat tax, a radical proposal for tax reform that would eliminate all deductions other than the personal exemptions and tax all income at a single rate. I was surprised to learn how popular the idea is around the world. There is little political enthusiasm right now in the United States for fundamental tax reform. Which is a shame. Wouldn’t it be wonderful if all the talented people who currently help rich people avoid taxes were instead encouraged to something productive?

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{ 28 comments }

Randy April 23, 2007 at 12:13 pm

Not to mention the talented(?) people who spend their days making or requesting modifications to the tax code.

dave smith April 23, 2007 at 12:49 pm

I think it would be terrible. All those people would be unemployed. ;)

Tom April 23, 2007 at 12:58 pm

I think a greater problem is the dead weight losses from all those business (and personal?) decisions that are made only for their tax merits.

bartman April 23, 2007 at 1:33 pm

This post conflates two issues: tax simplification and progressivity. The complicated part today is calculating what the taxable income is. The tax payable calculation is then pretty trivial, regardless of the number of brackets.

Simplifying the first part is a far more worthy and valuable goal, but too many people get bogged down on the "flat" part. A simplified (no deduction) tax code that maintains some progressivity would be an esasier sell to J.Q. Public.

Of course, I personally advocate replacing income taxes with a comprehensive sales tax, coupled with a vast reduction in the size of the state. Yes, dreaming, I know.

Mike April 23, 2007 at 2:34 pm

"I personally advocate replacing income taxes with a comprehensive sales tax"

Why advocate for taxing productive activities? Why not raising taxes on land and perhaps other natural resources and nothing else?

I am not in favor of any policy that penalizes me for working harder and investing or for enjoying the fruits of my labor.

bartman April 23, 2007 at 2:58 pm

Ceteris paribus, a sales tax is less disruptive and inefficient that pretty much any type. Taxing capital is the worst.

This is said in the framework of "if we need to have any taxes." I think the burden could be greatly (>75%) reduced, but most of the public disagrees.

Matt C. April 23, 2007 at 3:51 pm

I haven’t heard the conversation yet, but I do look forward to it.

The flat tax can be considered a progressive tax. If we take a look at a simple example, between two individuals, one who makes $20k and the other who makes $100k, with a 20% flat rate and a $10k personal exemption.

The first person would pay 20% on $10k, working out to $2k a year. That’s a 10% overall tax rate. The second person would pay 20% on $90, after the exemption, which is $18k or 18% of the salary. So as a person makes more money they will pay closer to that 20% amount. It would probably work out to be much more “equitable” than what those who advocate a progressive rate will a bunch of deductions.

As far as sales tax, it would still very costly to operate. Who would remit the taxes? Would it be the seller? Would it be the individual? Would it be paid to the states and then the states remit it to the federal government? Many who advocate for a “fair” say that the poor would not have to pay taxes because they could be reimbursed. But kind of administration would it take to work that out? Wouldn’t it become just a consuming as the current system as we have now?

Just as a tariff decreases imports, consumption would be reduced by a consumption tax. Just because people don’t have to pay income tax doesn’t mean they would work to avoid the consumption tax. A simple example is a car, in which we pay a boat load of taxes on anyways, could you imagine adding a 5% federal sales tax onto a car?

As far as I am concerned though, it doesn’t matter to me, but a tax is a tax is a tax. Either way it's still theft.

Steve Plunk April 23, 2007 at 5:23 pm

The problem with major tax reform is the creation of winners and losers. That in turn will politicize the process to the point of no one trusting the fairness of the outcome.

The status quo, for all it's faults, is at least somewhat predictable in terms of what effect it has on business and personal taxes. A flat tax or sales tax could adversely impact enough people to cause an uproar.

Honestly, who among us trust our politicians to do this right?

true dough April 23, 2007 at 6:32 pm

My computer won’t allow me to listen to the whole interview at this time, but in response to a comment…

A national sales tax is essentially a consumption tax, like the flat income tax. The difference between these two consumption-based taxes is that the flat tax is levied where money is earned, while a sales tax is levied where money is spent.

The two are similar. But, two advantages of the sales tax:
i) there’s less incentive for the expansion of the underground economy amongst the self employed and illegal work force (unless the flat tax is low enough); and ii) there would be less distortion when employer-paid fringe benefits like healthcare come into play.

I don't know how well these points stand up, but they seem reasonable to me. Why else favour the national sales tax over the flat tax?

true dough April 23, 2007 at 7:04 pm

I see that I should have held my breathe until I was able to hear the whole podcast. :X Rabushka addressed my second point nicely.

true dough April 23, 2007 at 7:05 pm

I see that I should have held my breath until I was able to hear the whole podcast. :X Rabushka addressed my second point nicely.

happyjuggler0 April 23, 2007 at 7:45 pm

I'm guessing it is a lot easier to persuade the populace, and the politicians and the media to adopt a flat tax when everyone is roughly equally poor. This explains why an awful lot of the former communist countries managed to do it while almost no one else has.

bartman, I think it is a fool's errand to expect lasting tax simplification with multiple tax rates. Such a situation simply begs for rent seeking to create "loopholes". The best you can do is have low rates and hope this makes such lobbying not worth it due to the relatively small gains. Check out this link, especially the answer to #2. How does one explain the virtually identical % tax takes per income group (at least for the top groups, the lower groups look to have gotten a great deal from the anti-tax movement) when the top rate pre-Reagan (i.e. the 1981 figure) top tax rate was 70%, radically higher than it is now? Answer: The much lower rate of today is a huge disincentive to engage in uneconomical tax shelters.

Python April 24, 2007 at 12:32 am

happy J.,

Thanks for the link to the Business Week article. It makes me wonder if this is another data point in the discussion of "real income growth". There is a claim that real incomes of the lower and middle classes haven't grown at all in the past 40 years or so, based on the average incomes in the bottom brackets.

To argue against that supposition we have brought up:
1) that the group that is being measured is not the same people (that is, poor people have gotten richer, but new poor people – immigrants and young – have taken their place)
2) even if real incomes have held steady look at all the things we can do with the same amount of inflation-adjusted money (TVs, microwaves, iPods, better clothing, cell phones, personal computers, air travel, etc, etc.)

And it seems a legitimate point to say that the tax rates are better also. As far as I know, the real income stats that most people quote are pre-tax. If this is true, it looks like all tax brackets below the median income level have gotten better by 4-7% just since 1981. I certainly think tax should play into the discussion. If taxes were higher now than back then you know the critics would be pointing that out as eating into the middle-class pocketbook, or some cliche like that.

Lenny April 24, 2007 at 2:36 am

I'm not particularly sophisticated on this subject but I have a hard time understanding why a sales tax is better than an income tax.
With an income tax I share a portion of my productivity and when I can no longer be very productive I cannot be taxed into the poor house.
What would an economy look like if the only tax was a flat income tax? No sales taxes, property taxes, etc, etc.

true dough April 24, 2007 at 9:36 am

Lenny, you basically have the same question as I do: how can a sales tax be better? (Although, you might have a more sophisticated understanding than me –the 2 reasons I thought up earlier are complete duds.) I found these 2 links to be helpful:

1. Daniel Mitchell argues that the flat tax is similar to the national sales tax: http://www.heritage.org/Research/Taxes/BG1134.cfm
2. In favor of the national sales tax, from the CATO Institute:
http://www.cato.org/pubs/pas/pa-272.html

Michael Sullivan April 24, 2007 at 10:01 am

1) that the group that is being measured is not the same people (that is, poor people have gotten richer, but new poor people – immigrants and young – have taken their place)

I don't really buy this argument. It works against the specific claim (that I don't generally see made) that particular individuals are worse off than they were 40 years ago. But in terms of the economy as a whole, it doesn't hold water. There were young people and immigrants in 1967 just as there are today.

If you're looking at the median income or the bottom half, or say the fourth or fifth quintile of income earners, you're looking at a similar segment of society 40 years ago as today. If young people and immigrants (and whoever else makes up the bottom 40% of income earners) don't have it any easier today than 40 years ago, I think that puts the lie to rosy depictions of our economy over the last 40 years. Basically it's been very good for a lot of people, and pretty bleh, for others.

The second objection (that cpi overstates true inflation) is much stronger. If the same "real" wage buys a much richer or easier life today than it did in 1967 no matter where you are in the income spectrum, then saying real wages are flat is just saying that growth in living standards is not faster than some arbitrary check-point rate. I think Don B's thought experiment pretty much convinces me that this second objection is true. It doesn't convince everybody though. Some people do not value the things that are far more affordable (possible!) today as much as I do.

Randy April 24, 2007 at 11:16 am

I favor just leaving the AMT alone for a couple of decades. Once most of the significant deductions have become meaningless, eliminate them.

quadrupole April 24, 2007 at 11:36 am

Lenny,
The reason a sales tax is better than a flat income tax is that it taxes only consumption, not investment. This of course begs the question as to why we would want to tax consumption and not investment.

Consumption benefits the person consuming, and no one else.
Consumption today also does nothing to expand the amount available to consume tomorrow.

By way of contrast, investment today benefits both the investor (capital) but also the workers (labor). Labors share of economic growth generated by investment is in the 50% range (ie, if I invest a dollar, and it produces 10 cents more in GDP next year, 5 cents is captured by the investor, and 5 cents by the workers who's productivity is improved). So investment both benefits people other than the investor and expands the amount available to consume tomorrow.

So everytime you tax away a dollar that would otherwise be invested, you hurt not only the investor, but also the workers who would have benefited from that investment. In addition you reduce the amount that would have been available to consume in the future.

When you tax away a dollar of consumption, you reduce only the consumption today of the individual it was taxed away from.

A reasonable objection, which you have raised, is to say: "OK, but we deem a minimum level of consumption to be necessary, and if someone is poor, your taxation prevents them from being able to afford that minimum level of consumption."

This is why, in the only national sales tax bill in Congress (HR 2525, the FairTax) they have a 'prebate' that rebates to households the amount of tax they would pay if they spent up to the poverty line for a household of their size, essentially untaxing what is deemed to be the basic necessary level of consumption.

bjartur April 24, 2007 at 12:10 pm

Keeping money in the private sector isn't productive?! Please explain.

David White April 24, 2007 at 12:13 pm

What has gone unaddressed if the fact that all tax "reform" is "revenue neutral." That is, none of plans address the real problem — out-of-control government spending — that will be our ruin if it isn't reined in:

http://mwhodges.home.att.net/fed_budget.htm

In fact, the only meaningful reform is the one that would reform Rome-on-the-Potomac out of existence.

David Z April 24, 2007 at 12:42 pm

"When you tax away a dollar of consumption, you reduce only the consumption today of the individual it was taxed away from."

Except for the income, rent, etc., for which the dollar of consumption might otherwise have paid. Any tax on consumption devolves into a tax on income.

Nadia April 24, 2007 at 2:16 pm

To me it appears that taxing consumption will be equivalent to taxing the rate of return on investment. The decreased rate of return will lead to a decrease in marginal value product. Time-preference of individuals would artificially look as if it were lower but there would be no additional inflow of investment. Without tax, a decrease in time-preference leads to an increase in saving-investment, to a lower rate of return and increased productivity. But when taxing consumption, the decreased rate of return (and marginal value product) will lead to a reduction of investment and lowering of productivity. Marginal investors will be pushed out of the market. So investment is still taxed. And as someone said above all taxes are theft no matter what because of interconnectedness of saving, production and consumption.

Please leave feedback if you think this doesn't make sense. I am really just learning, but with great interest. So feedback is appreciated.

Nadia

Python April 25, 2007 at 1:53 am

Michael,

I think you are looking at the claim differently than I am. When "commentators" say that real incomes are not rising, they leave the reader with the impression that individuals are "treading water" or "trying to keep up". But this is clearly not the case.

When you say that there were young people in 1967 you miss the point. They are different people. Young people start with little, get part-time jobs, get educated, get raises, change jobs, save money, and generally move up. If you don't believe that think of the counter example: Were the people who are now in the top 20% also in the top 20% 15 years ago? Of course not.

(http://en.wikipedia.org/wiki/Household_income_in_the_United_States)
Read the Age of Household section.

Read http://www.jewishworldreview.com/cols/sowell020700.asp

The young people now are still below median, just as they were back then, but that has absolutely nothing to do with how much the "average" person in America is doing.

Suppose there are 3 people who live in Sullivanland, each having different incomes. Assume that no one gets raises, only cost of living adjustments (if they did get raises than the hypothesis is blown already). A new Sullivan is born. When she gets her VERY FIRST job where will she rank amongst the other 3? But wait, no one gets raises, only cost of living adjustments. She must stay at that rank her entire life.

But, on average, people do get raises above the rate of inflation over their lives. So, how can the average person only be holding steady? They are not holding steady, the low income people as a group are holding steady, but their members get replaced by new people every year.

"Basically it's been very good for a lot of people, and pretty bleh, for others." Yes, it has been very good for most people, because most people pass the median household income line at some point in their lives, and above the median household income line incomes have been growing much faster than inflation. (See Wiki article).

If you stayed in your exact income bracket your whole life, you might feel the "bleh" but most people fortunately do not stay there. Taken from Sowell article: "An absolute majority of the people who were in the bottom 20 percent in 1975 have also been in the top 20 percent at some time since then."

Dr Dan H. April 25, 2007 at 5:49 am

OK, let's look at this argument from another angle: what is the basic purpose of a tax in the first place?

The basic purpose is, I think, to fund the activities of the State. The State in turn should confine its activities to providing those services which it is uniquely suited to providing, and ONLY those services; it is not supposed to be a source of employment for legions of unemployable incompetents, nor should it be larger than the minimum needed to do the job.

So, the best way to tax is to take a cut of money earned by the population, in such a way that the very poor are not touched.

Taxes also should cost very little to collect and be almost impossible to dodge; in these goals extreme simplicity is your friend (think flat tax, and similar tax rates for all taxes).

The model one Gordon Brown has built in Britain is pretty much a blueprint for how not to do it; extreme marginal taxation of the poor, hideously complicated tax structures, an uncontrolled money supply and assorted windfall taxes all combine to depress economic activity, both at the personal level (why work harder when Grabber Gordon will only nick more of it off you?) and at the corporate level (Make a big profit and have Kleptomaniac Gordon help himself to a big slice).

Paul C April 25, 2007 at 9:10 am

My preferred system of flat tax (given the necessary evil of taxation) is as follows.

The proposed combined income and payroll flat tax of 25% (for the US) could be implemented as an opt-in tax. Most people would be better off under the flat tax, so self-interest would ensure a high take-up.

The removal of all allowances (apart from the personal allowance) is an essential part of the simplification to achieve a flat tax.

One other feature of a flat tax is the way you choose to implement the "presonal allowance". It is actually better to pay out a "personal allowance equivalent" to all registered citizens – say 25% of $10,000. This gives the unwaged, and very low earners a negative tax rate – beat that for "progressiveness"!

As this also results in all earnings being taxed at the flat 25% rate – any employer just has to deduct the 25% from the pay of all employees registered for the flat tax. This avoids complexities in the actual collection of tax at source, as having two part-time, or even several casual jobs each paying different wages, would not affect the rate of tax deducted by the employer.

Company taxation is best implemented as the 25% tax rate on all share dividends. Profits retained (and invested in growth of the company) not being taxed.

Objectivist April 25, 2007 at 1:52 pm

Any tax system one puts into place will distort the economy and cause dislocations. Thus, one needs to find a system that minimizes these dislocations, while at the same time providing ample funding for necessary public goods (the fact that federal, state and local governments do things way beyond the realm of public goods like defense, property laws, the federal reserve, streamlining of consumer information etc., is another story).

It would appear to me that a poll tax on people who are employed would be the optimal choice. After a fixed amount of money, say $1000 is paid, then there are no other payments, at least to the Federal government. Granted that there would still remain tax evasion issues, although the far greater simplicity and fairness of the poll tax would make such evasion much less than it is now.

A poll tax would force the government to stop spending money for no reason, since if there were a current poll tax, it would be $20000 per employed worker in the US, and thats for the federal government alone.

Whats there not to like?

The Truth of It December 25, 2007 at 12:46 am

As to consumption vs. income, this is an issue I have not explored very much and don't consider my openion to be completly formulted. However, a flat tax is not the answer and here is why.

Lets look at the numbers and judge equality from there.

Say you have three people in an economy with a 10% flat tax.

Person 1 makes $10,000/year, for an after-tax take home of $9,000.00
Person 2 makes $100,000/year, for an after-tax take home of $90,000.00
Person 3 makes $1,000,000/year, for an after-tax take home of $900,000.00

The fallacy of a flat tax lies in the assumption that differences aforementioned are fair. Given that the rich have the opportunity to live modestly – in theory as poor as those who make $10,000/year if not more realistically be that of person 2 or somewhere in between person 1 & 2 – the person 3’s lifestyle could be entirely unaffected. Alternatively, taking a way $1,000/year from person 1 would effectively be a critical tax which would, and by no means unavoidably given the economics of American, largely negatively impact the individual and their family.

Since the rich could simply modify their lifestyle, or not, and the poor would be scraping to make up for lost income this type of tax would, by definition, not be fair.

This tax is usually proposed with an exemption for the poor; however, the dynamics work the same regardless. Since the cost of goods and services stays constant for each income level the effective buying power of the rich is negligibly effected by the tax in comparison to even to the upper class. When considering the difference between person 2 and person 3 it is not remarkable to note that taking away $10,000 from person 2 could be a large portion of the tuition for their child college while taking away $100,000 from person 3 would still leave them with $900,000 and only effect their child’s tuition if their values were greatly misappropriated.

Look to reason, for within the gaps of our understandings lie the foundations of oppression. Unless you are in the top 1%, perhaps even so, this is a bad option that will inevitably result in class struggles great enough to walk the edge of revolution. This is not a lasting nor within the graces of civility.

The Truth of It December 25, 2007 at 12:50 am

*opinion

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