American Taxation

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So what is next? One might hope, given the fate of Presidents Carter, Bush, and Clinton, that the nation has heard the last of Karl Marx’s prescription for dealing with the inequities of the European economy of the 1840s. Even as early as the Wilson administration, which put the income tax in place, it was known that in a country with democratic politics and a capitalist economy, high marginal rates are counterproductive at best and perverse at worst. They simply do not achieve their purpose in the real world. Yet some current proposals would do no more than simplify the present system, leaving it open to sliding back into higher rates and more loopholes, as it did in 1990 and 1993.

WHAT ARE THE ALTERNATIVES? SOME ADVOCATE ELIM inating the two income taxes altogether and substituting sales taxes. The value-added tax (VAT), popular in Europe, taxes goods and services at every level of production, and these taxes are then built into the retail price, which is not taxed directly. There are two disadvantages. The VAT is complicated and requires a lot of accounting, which violates Adam Smith’s fourth principle of taxation, and the tax is hidden, making it easier for politicians to raise it without full public consensus.

A national sales tax would not be hidden, but being a consumption tax (the VAT is too), it would not tax much of the incomes of the very rich and thus would be inherently regressive. It has the very same drawback as the nineteenthcentury tax system of tariffs and excises, violating Smith’s first principle.

What’s left is the flat tax, which taxes every dime earned above a personal exemption, allowing no deductions, credits, or other complications whatever. Furthermore, it integrates the corporate and personal income tax systems, thus taxing all income but taxing it only once, while preventing the rich from using the interaction of the two systems for their own advantage. Because there are no complications, both individuals and companies alike can theoretically fill out their income taxes on the back of a postcard. And because there are no deductions, politicians cannot hide social and economic engineering or political favors in the tax code, where they don’t belong. History clearly shows that deductions and credits are to politicians what cocktails are to alcoholics: It is a lot easier for them to refuse the first than the second.

There are two main criticisms of the flat tax. The first is that it is, well, flat. There is no progressivity. But that is not actually true. The marginal rate—the tax on the next dollar of income earned—is indeed flat. But it should be; otherwise the rich man is more discouraged than the poor man from earning that dollar. The government cannot tax a dollar that has not been earned. What is not flat is the effective tax rate, the amount of total income that is taken in taxes.

To illustrate simply, assume a $10,000 personal exemption and a 20 percent tax rate on all income above that amount. Under those conditions a family of four would have a zero percent effective tax rate at an income of $40,000, but a 4 percent rate at $50,000. At $100,000 the rate is 12 percent, and at $1,000,000 it is 19.2 percent. Thus, with a flat tax, you know that however much you are paying, the guy down the block who is making more money is paying not only more taxes but a higher percentage of his income in taxes for the privilege of living in this country. Today you only know that he probably has a better tax accountant.

The other criticism is that the flat tax would hit the middle class harder than it would the rich, compared with the present system. But this is true only if one compares the flat tax with today’s personal income tax. It must be compared with both the personal and the corporate income taxes to get a true picture.

Corporations, after all, are only wealth-making machines created for the benefit of their stockholders, not separate economic entities, as the left has often portrayed them for a hundred years. As William Howard Taft understood in the first decade of this century, to tax a corporation is to tax its stockholders. And the flat tax would tax them much as it taxes individuals. In other words, no deductions beyond the direct cost of doing business.

Although this is only a personal opinion, I believe that the flat tax would move massive amounts of money out of tax shelters and unproductive assets and into fully taxed income-producing activities, while freeing billions of manhours for useful labor. The effect on the economy as a whole would be vastly positive.

And it would finally achieve what this country has so long sought. It would, for the first time, force the rich to pay their fair share.