Wednesday, September 11, 2013

Don't Buy The Flat Tax Arguments

A short one today. People who advocate the flat tax keep promoting the idea that this will make your taxes simple: “You can send in your taxes on a post card!” And they make claims like the flat tax will eliminate the need for the IRS. This is simply wrong.

To understand why this is wrong, you need to understand something that a lot of people don’t seem to get: concepts like “income” are not specifically defined within the tax code. They aren’t specifically defined because the moment you provide clear boundaries, people slip their income outside the boundaries of the definition.

To give you an example, assume that you define income strictly as “Any money paid in exchange for services you provide.” Sounds like it would work, right? So what happens when people stop paying “money” and instead give property. Suddenly, you can avoid paying taxes by taking “property” that can then be easily converted back into cash. Unless the IRS wants to allow this, it then needs to change the above-definition to add “money or property” or it needs to re-define “money” more broadly to include “anything of value.”

Now we have it though, right? Income is “anything of value paid in exchange for services you provide.” That works. Well, no. Now people stop paying each other for services. Instead, they give “gifts” to people who provide them with services. Again, people have escaped the income definition. Thus, again the IRS must change the definition. What if a third party pays for them? What if you value the property you give the person at $1 when its real worth if $10,000? What if you pay with an option that has a $1 value today, but $10,000 value tomorrow? Etc.

Suddenly, the thing so many people think is easy, (“After all, who doesn’t know what income is?”) turns into a multi-page definition with attached explanation and examples of what is or is not income.

This is how the tax code has grown to become what it is. From day one, people tried to find ways to avoid having their income fall under the definition of income. To fix that, the IRS issued rulings, guidance, and new definitions to catch up to these people. And with each one of these, the code grew until it all resulted in a massive, complex book which spends hundreds of pages defining what is actually income and what isn’t.

This is the problem.

And when people say, “All you do is write your income on the card, so there’s no need for the IRS,” they are speaking quite ignorantly because they don’t understand that the word “income” requires the existence of an IRS to decide what counts as income and what doesn’t. In other words, so long as we are taxing “income,” there will be a need for the IRS to decide what constitutes income.

Further, the people who advocate this have a total blind spot when it comes to deductions. They think that “deductions” are simply 3-4 numbers that you get on a 1099 or out of a tax booklet and everyone will be willing to forgo those for lower rates. They totally ignore the fact that for anyone running a business, “deductions” are ultra important because they define income.

Indeed, if we were to eliminate “deductions” for businesses, we would kill most businesses. How? Consider this. If you took in a million dollars in income through your business, but it cost you a million dollars in things like salary, rent, and supplies to make that happen, then your current tax burden is $0. That’s fair since you have $0 in profit at the end of the year. If we go with the vision promoted by the flat taxers, you would be paying 20% taxes on that million dollars in income... as you have no deductions to reduce it to “profit.” So you will pay $200,000 in taxes on $0 of profit under their system. How long will most business last paying that?

And if they respond, well, we should only tax “profit,” then all those deductions they claim should vanish reappear and your taxes are identical to what they’ve always been... except for individuals who have lost their deductions but still must face the IRS determining what constitute their income.

The flat tax argument is a delusion. It is a delusion spun by people who don’t understand how the tax system works and who are selling you a false view of reality. It is impossible to “eliminate all deductions.” It is impossible to eliminate the IRS so long as income and/or deductions exist. All a flat tax does is lower the rates and shift the tax burden around slightly. It does nothing to make taxes less complicated. It does nothing to make taxes less onerous. It does nothing to end the disincentive to hire people or to start a business.

It is not real reform.

21 comments:

AndrewPrice said...

And Bev has a new Mayor... or will soon. Sadly, it's not Weiner. :(

Anonymous said...

Very good analysis, Andrew. It doesn't seem like many people think ideas like these through, hence they ignore or gloss over the problems like the definitions and how the deductions actually keep businesses going. This definitely strengthens the case you made for the asset tax in Agenda 2016 considerably. Hopefully the book, and idea, will get a lot more traction. The more I see stuff like this and the health care issue where both sides are pushing unworkable crap, the more I feel like beating my head against a wall.

- Daniel

AndrewPrice said...

Thanks Daniel! Yeah, I wish people would think these things through rather than just jumping on them when they sound good.

A flat tax sounds great, especially with the promises of "eliminating the IRS". But it won't do anything it promises. Our income tax system is a real nightmare on every level, and all the flat tax does it shift the rates around... it solves none of the problems.

I really have come to believe that the asset tax is the best solution by far. It does what both left AND right want (which would normally seem impossible, but isn't in this case), it does it with a lower burden on almost everyone, it promotes work rather than discourages work, it doesn't create bubbles, and it's surprisingly easy. So it will never happen. :(

I know what you mean about the hitting your head against the wall. I get very frustrated whenever I watch a debate on television and I see both sides throwing unworkable, idiotic, destructive ideas at each other. This stuff isn't that hard and you would think someone on either side would finally open their eyes. But apparently not.

Anonymous said...

You'd think, all right... Until I read the book I hadn't even thought of an asset tax, but it would definitely solve a lot of problems. I guess all any of us can do is get the word out about the concept and the Agenda book. How has it been doing, BTW? I've mentioned it to some of the very few people I'll talk politics with, though I don't know if they've read it, and review-wise I'm sure you know which one is mine by now.

Regardless, I'd like to see these ideas start catching on. There's a market for them, I'm sure, if one could just get past all the fringey clutter messing things up. I'm beyond tired of this destructive culture that's consuming modern conservatism, and it's especially aggravating when, as you've pointed out here, it gives the Democrats just enough credibility to gain and keep power in areas they shouldn't.

- Daniel

AndrewPrice said...

Daniel, I think the reason you never thought of an asset tax was the same reason I never thought of it until I sat down and decided to rethink everything from scratch to write the book: it's become dogma that taxing assets is somehow socialist or immoral... even though that's nonsense.

And while I'm not conspiratorial, I can tell you that this is a line groups like the Business Roundtable (most of whom earn billions, but pay almost no taxes) have been pushing for years. Essentially, we've internalized their lobbying.

The book is doing well for a political book -- political books don't sell all that well. I'm still planning to mail off some copies, but I'm waiting for more reviews first. Thanks for the review! :)

I do think there is a huge market for these ideas, not only among the legitimate base, but among the non-voting or moderate public as well. I firmly believe that if the GOP adopted even half these ideas, they would sweep into power. But sadly, right now, they are mired in the mud. I am very tired of it too... especially the relentless idiocy.

BevfromNYC said...

Andrew, now the Real fun begins. I will give a rundown tomorrow.

tryanmax said...

I don't know what it is about deductions that is so mysterious to most people. That seems to be a term that both sides can use to stir up their voters. I guess it's the old "my deductions are fair and reasonable, but his are not."

It's also appalling to me that almost no one understands the difference b/w income and profit as it relates to business. This is a knowledge gap I uncover all the time in conversation. And, of course, b/c nobody likes to admit ignorance, people get all belligerent when you try to explain it.

I'd say we need to teach basic finance to every high-schooler, except...
1) The teachers' unions would never approve the additional workload.
2) Liberals would deride it as insensitive to low-income students.
3) Conservatives would...
a) oppose it as liberal indoctrination,
b) demand to use the Bible as the textbook, AND/OR
c) insist that is something parents should teach at home.
4) The Association of Finance Professionals would probably have something to say about it.

Individualist said...

If you want the best possible way to physically implement and working version of a flat tax the you should go to the 1986 Reagan Tax Code.

Reagan lowered the upper marginal tax rate to 28% and in so doing he got rid of 90% of loopholes from 1980 to 1986.

Reagan got rid to the capital gains exclusion since with no variance in marginal rates there is no unfairness to taxing the capital gains in one year or over 20.

He got rid of the Passive Losses and limited all those K1 partnership tax shelters that deferred income recognition.

In 1982 he got rid of the At Risk Exclusion for real estate which stopped a tax loophole where you could invest 10K in a limited partnership knowing you would lose that 10 grand but only be liable for that 10 grand per partnership agreement and yet over one to five years receive K1's stating you lost 100 grand which under Carter 70% upper marginal rates amounted to the government giving you a 70 grand check because you lost 10 grand.

Most of the complexities in the code due to accounting tricks come from loopholes being abused and finally being closed. The problem is that the government can't stop using the tax code as a social engineering experiment to force taxpayers to do what they want them to do with their money. This leads to exclusions, complexities and this benefits those wealthy enough to spend 200 an hour for a tax CPA.

The flat tax is a myth but the spirit of the flat tax is not. we can go into the code, reduce the overall tax rates and eliminate tax loopholes. This won't make the accounting on the returns any simpler but it will make it more fair. We don't do that because Uncle Sam likes telling people what to do with their money.

The Reagan tax code was abandoned with the capital gains rates. We wanted people to invest money and now the worker pays 39% while the investor pays 15%. Sure the money from the investment is taxed at 39% but that is only if the company earned it in the US and then only matters if the investor holds onto the company to earn money off dividends. If he is buying and selling the effect of that corporate tax is reduced.

BevfromNYC said...

This is a great topic. I wish there was something I could add to it. I am just going to listen and learn today.

AndrewPrice said...

Bev, Now the fun begins? LOL! Oh boy, I can't wait. :)

AndrewPrice said...

tryanmax, Teaching finance without a license. ;P

I've run into the same thing, especially on the left. They combine income and profit in their heads and they call it "makes," e.g. "They make a lot of money." Well, making money is no good if it costs you too much to make it.

As for deductions, yeah, people really are ignorant about how those work, and that leaves a lot of room for demagoguery. A classic example is how liberals scream about "deductions to send jobs overseas." There's actually no such thing. What they are talking about is that you can deduct regular business expenses no matter where they are incurred (including relocation costs). So if you open a plant in Mexico, you can deduct those expenses from your income the same way you could if the plant was in Texas.

AndrewPrice said...

Indi, I agree completely.

As you say, the flat tax is a myth, but the idea of a simpler, more fair income tax is not. To me, that means that so long as we are taxing income, what we should be working toward eliminating the loopholes put into the code by Congress (like incentives to use ethanol or open a factory to make rum in Puerto Rico), eliminating the "creative" deductions (like the tax shelters), and generally trying to simplify the whole thing.

Right now, people like Warren Buffett love to advocate higher taxes because he doesn't pay those. He knows where to hide his money, how to structure his businesses, and where to get the special treatment he needs from Uncle Sam to pay almost nothing. Just as shocking was GE reporting record profits (not income) and paying $0 in taxes because of incentives and shifting their income overseas and the such.

Ultimately though, I really think we need to get away from taxing income and start taxing assets. I outline the whole thing in my book and it just makes amazing sense once you actually think about it.

AndrewPrice said...

Thanks Bev! I think this is a good thing to point out because people have the wrong idea about what a flat tax would do. I prefer the idea of a single rate, but it's no panacea at all.

Koshcat said...

I was talking with my tax planner/investment adviser recently. He feels that the tax code becomes so bloated that it needs to be overhauled every few decades and we are past due. Correct me if I'm wrong but I believe Kennedy did it then Reagan. We are due. I'm sure from an IRS standpoint they would agree as simpler codes are easier to understand and enforce.

What irritates me about the republican leadership as the recent IRS scandal makes it prime to present an overhaul. Obama's deficit reduction team recommended it as well. What the hell are they waiting for? If they wait too long the public won't care.

I read the Fairtax book and I liked that idea as well. It would eliminate deductions that companies take but they take these out of taxes due. Since there wouldn't be any taxes due there is no need. It would increase the cost of everything although they argue that it would change only minimally as taxes paid are essentially incorporated into everything you buy.

At this point, though, I still favor the asset tax although the arguments will be over the value of an asset. Government likes to play games here as well; Colorado being a good example.

Tennessee Jed said...

too tired to add much today, but good discussion. Kosh, I liked the Fairtax book as well, though it's been a long time since I read it, but as I recall, your analysis of the argument was on point. And yes, opponents of asset tax would argue about fair valuation of assets. Kind of like with your house. What is the true value? What you paid? Replacement cost new? Assessed? Market value??

AndrewPrice said...

Koshcat, Yes, every so often we give the tax code a good shakedown and we are do for another overhaul. But it doesn't change much for average people, it mainly changes things for high earners. And I think that right now they are pretty happy with the tax code, so there isn't any push for change at the top. Similarly, the bottom doesn't pay taxes. So that leaves the middle and they've been convinced to cling for dear life to their deductions, so they are afraid to make changes as well.

On the Republicans, I think the problem is that when Boehner tried to go down this path by suggesting we eliminate a lot of deductions in exchange for lower rates, his right flank went insane and screamed that eliminating any deduction or subsidy would be treated as a tax hike. The lesson there was that it wasn't worth the effort to make any changes at the moment.

I'm not a fan of the Fair Tax. I haven't studied it fully, but it seems very complicated, very open to manipulation (even more than the present code), and like it would upend our economy with a huge shock when the price of everything shot up dramatically overnight. It also doesn't change the disincentive to work in the income tax.

As for valuations, we fight those battles already, but the mechanisms for valuing things are already in place and function well for the most part. There will always be battles when it comes to taxation.

AndrewPrice said...

Jed, The value would be fair market value, nothing else makes sense. That's what assets are always taxes on (unless it's a hidden sales tax) because that is what you could get out of it today if you had to get rid of it. Assessments are meant to be a proxy for FMV.

Koshcat said...

What Colorado pulled a couple of years ago was when the real-estate market crashed the dems passed a law freezing the asset value of your home. In essence, they maintained the tax revenue. Many of us felt that it was essentially a tax increase which all tax increases must go to the people as a referendum. The left wing state supreme court didn't see it this way (go figure).

AndrewPrice said...

Koshcat, Right... and that stunk. In this case though, I think it would be harder to do that, because we are talking about a national law, plus we would hopefully be smart enough to write the words "fair market value" in the law.

As an aside, I'm thrilled that those two yahoos got recalled! :D

T-Rav said...

Yeah, congratulations on the recall successes, Andrew! The caterwauling from Democrats today was very schadenfreude-tastic. :-)

AndrewPrice said...

It was pretty sweet, especially after how nasty they tried to make the campaign.

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