A Flat Tax is not Your Friend

Be like Ukraine, Romania and Kyrgyzstan
The flat tax is back!  I'm amazed how many people tell me what a great idea this is.  I can see the charm of it.  After all, our current tax code is unwieldy and few dare calculate their own.  We hear of GE earning a $14 billion dollar profit last year and paying no taxes.  Bank of America avoided all taxes last year also.  Exxon Mobil paid nothing in 2009.  In fact, 2/3 of large American corporations do not pay income taxes.  The top tax rate of 35% should apply to them.  We assume they evaded taxes because of deductions.  That's a small part of the picture for sure.  But the bigger part is their practice of hiding income offshore, in countries such as Panama and Liberia that do not tax it.

Set your flat tax at any rate you please.  It won't fix this problem.

There are two prominent flat tax proposals on the table this election cycle:  Herman Cain's Sim City 9-9-9 plan and Rick Perry's 20% flat tax.  Let's see who the winners and losers might be.

Both would eliminate nearly all deductions.  Both would set a single income tax rate for all earners, rich or poor.  Both have been modified to accommodate the poorest Americans.

I've given considerable explanation and detail below but to spare you reading all of it, here is the summary.

The poorest Americans would see an INCREASE in taxes if a VAT or consumption tax such as Cain's 9-9-9 plan were implemented.

Middle class families would see their taxes REDUCED under both Cain's and Perry's plans.  Perry's $12,500 personal exemption would mean a family of 4 would have to make more than $50,000 to pay any taxes at all.  (On the other hand, singles or couples without children would pay higher taxes)

The top 1% would enjoy substantial SAVINGS from both plans with Cain's the most generous to them.  These savings are not primarily from the cut to the top income tax rate; they are rather from the complete elimination of taxes on capital gains, dividends and inheritance.

Corporations under Cain's plan would lose incentives to create jobs or pay workers fairly as wages could not be deducted from income.  Nevertheless, their (stateside) income would be taxed at a much lower rate:  from 35% today to 9%.  Under Perry's plan, corporations that pay taxes (of any rate) overseas could keep their income tax free in the US.  The 20% tax rate would only apply to those firms who have NOT sheltered income offshore.  Those who have would enjoy a 5% tax rate if they brought it back.  One can imagine all kinds of shenanigans to qualify for the 5% rate.

The most alarming conclusion from both of the Flat Tax proposals though is that nearly everyone (except the poor) would be paying less federal taxes.  Less revenue to the federal government will result in one of two things:  either we allow the deficit to balloon far beyond anything envisioned or projected today or we dismantle the federal government in large measure.  Highways, the military, special education programs, Social Security, Medicare, Medicaid, Homeland Security, the FBI...and so it goes.  And both plans are designed to kill or privatize Social Security.

A flat tax only benefits the wealthiest and large corporations.  Though even they will suffer if our infrastructure crumbles from lack of resources.

What Americans should want is a simplified tax structure that remains progressive (meaning lower rates for the poor; higher for the wealthy).  Eliminate all of the deductions and credits that target just one industry.  Eliminate mortgage interest deductions too and deductions for all but charitable deductions if you prefer.  Tax all of the income American companies make, regardless where they hide it.  Tax capital gains, dividends and inheritance at the same rates as income earned through the sweat of your brow. 

The tax structure today is upside down.  When highly profitable corporations like GE and Exxon Mobil pay nothing and the wealthy who make their money from investments pay less than we shmucks who make ours from going to work, the system is regressive.  Don't buy into any flat tax proposal that doesn't apply to investment income too. 

The Examples

The Poor:  For a family of 4, poverty means earning less than $22,340 per year.

Currently:  A family of 4 at the poverty level would currently pay no income taxes due to the personal exemptions for each household member plus the standard deduction.  They would pay Social Security and Medicare taxes, property taxes and sales taxes.  They might still pay state income taxes.  Final federal tax burden:  0% plus FICA

Cain's Plan:  Under Herman Cain's plan, the poor family would pay 9% or $2090 in individual taxes.  In addition, they would pay a 9% sales tax on all purchases (on top of state sales taxes).  Since the poor spend all of their money in the marketplace, neither investing nor saving, that would add another $2090 for a federal tax burden of 18%.  (Herman Cain's website)  Since Cain proposes eliminating payroll taxes (for Social Security and Medicare), our poor family would no longer pay the 7.65% FICA.  Final federal tax burden:  11.35%.  Of course, the consequence of that is no benefit after retirement.

Perry's Plan:  Rick Perry's proposal would levy a 20% tax on everyone, but with $12,500 personal exemptions, enough to keep our poor family from paying any income taxes.  (Rick Perry's website) Perry would privatize Social Security but there's little detail to allow us to project consequences for families.  Final federal tax burden:  0% plus whatever FICA would be.

Taxes on the poor would go up under Cain's plan and remain the same (zero) under Perry's.

The Middle Class:  A family of 4 earning $63,000 (national average)

Currently:  This middle class family paid federal income taxes of $9600 or 15% after taking typical deductions and exemptions.  As an average family, they paid another $126 in capital gains taxes and $727 in dividend taxes.  Final federal tax burden:  17% plus FICA.

Cain's Plan:  The middle class family can only deduct charitable contributions; the rest is taxed at 9%.  Assuming $1000 for charity, their income tax would be $5580.  Additionally, they would pay the 9% VAT on their purchases, estimated at 40% of income or $2268 per year.  All taxes on capital gains, dividends and inheritance would be eliminated.  Final federal tax burden:  12% (no FICA)

Perry's Plan:  Included in the 20% flat tax are the remaining deductions of home mortgage interest, state and local taxes and charitable contributions.  With $50,000 in individual exemptions ($12,500 x 4), the rest would be swallowed in deductions, leaving the Middle Class family also with little to no federal income taxes.  All taxes on capital gains, dividends and inheritance would be eliminated.  Final federal tax burden:  0-3% plus whatever privatized FICA costs.

Taxes on the middle class would go down under both plans.

The Top 1%:  There are 1.4 million households earning $1.3 trillion dollars.  Average:  $1 million per household.

Currently:  This group all itemize with deductions for this family in the $400,000 range plus $14,600 for individual exemptions for a family of 4.  Federal income taxes on a million dollars in wages would be $178,000.  But this group make most of their money from capital gains, dividends and inheritance.  This family's average capital gains earnings would be $276,000 taxed at 15% ($41,000) and dividend earnings would be $130,000 per year also taxed at 15% (19,000).  Inheritance currently is tax free.  Nice if you get a bunch.  Final federal tax burden:  17% plus FICA. (Notice that in spite of the higher tax bracket on wages, the wealthiest pay about the same rates as the middle class due to very low taxes on capital gains and dividends).

Cain's Plan:  With just a 9% flat tax and only deductions for charitable contributions (estimate of $10,000) and no other deductions, this wealthy family would pay 9% on earned income but would pay no taxes on capital gains, dividends or inheritance.  Total income taxes would be $81,900 on $1.4 million in income (including capital gains and dividends).  Their VAT taxes would be a smaller part of income as well, since $100,000 would be a high estimate of annual purchases for this family.  Final Federal tax burden: 7% plus FICA

Perry's Plan:  Perry's 20% flat tax also does not include any taxes on capital gains or dividends.  Individual exemptions of $12,500 per person exempts $50,000 for this family of four.  Deductions for mortgage interest, charitable deductions and state and local taxes remain, allowing perhaps half of their current itemized deductions or $200,000.  That leaves $750,000 taxable income of the total $1.4 million in actual income with $150,000 to pay.  Final Federal tax burden: 10.5% plus FICA

The Top 1% would pay lower taxes under both Cain's and Perry's tax schemes.

Corporate Taxes

Currently:  Corporations pay income taxes on their net income:  gross income minus expenses such as wages, equipment, cost of goods sold and depreciation.  They only pay on the income claimed in the US.  Income sheltered overseas is free from US taxes. 

Cain's Plan:  Cain's 9% business tax would tax "Gross income less all purchases from other U.S. located businesses, all capital investment, and net exports."  Wages paid would not be deductible for businesses.  Essentially, economists have dubbed Cain's business tax as another version of a consumption tax, with the tax passed on to consumers.  Creating jobs and paying workers are not considered a value in Cain's plan.  Nothing in Cain's plan corrects the problem of income hidden overseas.  Tax savings for those corporations who do keep their accounts stateside would be substantial but cannot be calculated for a typical business without years of scrutinizing corporate spreadsheets.

Perry's Plan:  Perry would tax net corporate income (undefined) at 20% UNLESS a corporation paid some level of taxes in another country (then it pays nothing) or UNLESS it had previously sheltered income offshore and agreed to bring it back (then it pays just 5%).  The devil would be in the details naturally but one can imagine the acrobatics businesses could do to move money offshore and then back again to qualify for the meager 5% tax rate.  It appears that again capital gains and dividends would be untaxed, a boon particularly for the financial sector.