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September 15, 2005

Comments

Andrew

"The argument is that there are huge deadweight costs associated with a complex tax regime and that high marginal tax rates and tax breaks encourage non-compliance or market-distorting avoidance measures (for example, Ireland's section 23 properties) and that a simplified system makes declaring or collecting taxes easier and more transparent."

Well, you don't necessarily need a flat tax (in terms of tax rates) to make the tax system simple. All you'd have to do is eliminate all the exemptions, credits, allowances, etc. - they're what make the current system so complicated. Once you've worked out your taxable income, it's actually very easy to apply the progressive tax rates.

Now, I can see the argument for why excessively high marginal tax rates could produce incentives for high-income people not to work as hard, but that's not really a question of simplicity and transparency...

Frank McGahon

You are correct that the problem of high marginal tax rates is a slightly different one from the benefit of simplicity and transparency but it is difficult to get an optimal marginal tax rate under a progressive system and the fear is that as the high marginal rate creeps up, so does the special pleading and the temptation to cut a break here, add a relief there. A temptation it ought to be possible to avoid given a flat rate.

Andrew

"the fear is that as the high marginal rate creeps up, so does the special pleading and the temptation to cut a break here, add a relief there. A temptation it ought to be possible to avoid given a flat rate."

Is there any evidence that this actually happens, though? I mean, I find it highly counterintuitive to suppose that once every dollar of taxable income is taxed at the same rate, people will stop arguing about what counts as taxable income ("but homeowners should get a break on mortgages; and students should get a break on tuition; and you should have deductions for charitable donations" etc). But hey, stranger things have happened... I suspect it might be possible to do a study on this since some countries do have flat taxes - a cross-country comparison of political pressures for tax exemptions or something.

Frank McGahon

The problem is that with higher marginal rates, the stakes are higher and the disincentives start to bite, especially if the bands sluggishly lag inflation acting as a kind of stealth tax rise, dragging more people into those higher bands. These types of "shocks" wouldn't occur under a flat tax rate.

Andrew

"with higher marginal rates, the stakes are higher"

The stakes are higher on high-earners, yes, but not on middle- or low-earners. If we have a flat tax rate, presumably to raise the same amount of revenue, you'd have to raise rates on lower income brackets and lower rates on higher income brackets (plus or minus whatever changes you get from changed incentives; I'm not talking about efficiency from removing exemptions etc yet). Suddenly the stakes are higher on lower-middle-class types - and then they ratchet up the pressure for a mortgate interest exemption. If anything, the middle class have more votes than the rich, so one suspects the net political pressure for exemptions might even increase.

"These types of "shocks" wouldn't occur under a flat tax rate."

Well, you could design a progressive tax rate that taxes every additional dollar you earn at an infinitesimally higher tax rate, i.e. a continuous function of tax rates rather than discontinuous bands. Or just fix the inflation lag. (Though then you get into arguments over what price index to use...) Also, I'm sure you already know this, but I was confused for a long time about this so just for the benefit of anyone else reading this, if your income rises into the next higher tax bracket, it's not that everything you earn is taxed at the higher rate, it's just that every additional dollar you earn over the limit is taxed at the higher rate. So it's not *so* much of a shock.

Frank McGahon

The stakes are higher on high-earners, yes, but not on middle- or low-earners.

But a) the band inflation problem always drags lower earners into the higher rate so today it's the high earners, pretty soon it's the middle and low earners and b) many exemptions are driven by the desire of high earners to avoid high marginal tax rates. For example - the government designs an exemption for, say, urban regeneration knowing full well that there is a "market" for tax writeoffs because of high-earners paying high tax rates. But this is a really inefficient way of achieving the original goal of urban regeneration or whatever.

If we have a flat tax rate, presumably to raise the same amount of revenue, you'd have to raise rates on lower income brackets and lower rates on higher income brackets (plus or minus whatever changes you get from changed incentives; I'm not talking about efficiency from removing exemptions etc yet). Suddenly the stakes are higher on lower-middle-class types - and then they ratchet up the pressure for a mortgate interest exemption. If anything, the middle class have more votes than the rich, so one suspects the net political pressure for exemptions might even increase.

Let's just stipulate that a flat tax rate which meant that most middle earners pay more tax is not going to happen. Assuming a system was enacted which meant that the bulk of middle earners paid around the same, then the band inflation problem just disappears into the ether along with any pressure for exemptions which would have been caused by further shocks.

Well, you could design a progressive tax rate that taxes every additional dollar you earn at an infinitesimally higher tax rate, i.e. a continuous function of tax rates rather than discontinuous bands.

Good luck designing, enacting and explaining that one!

Andrew

"Let's just stipulate that a flat tax rate which meant that most middle earners pay more tax is not going to happen."

But won't this lower overall tax revenue? I mean, I get that the pro-flat tax argument is that it will actually boost overall tax revenue, but I don't see how that's supposed to happen (Laffer curve and all). I suppose one might see lower overall tax revenue as a good thing, but then you have to figure out where to cut spending...

More generally - If I understand the argument about pressuring for exemptions correctly, it means that there's a direct (or sort-of-direct) relationship between amount of tax extracted and political pressure for exemptions. So if overall revenue collected remains the same, shouldn't the pressure for exemptions remain the same? (If the answer is that rich people have more power than poor people, it seems the logical conclusion would be a regressive tax system.)

"Good luck designing, enacting and explaining that one!"

Yea, I guess. I mean, in some ways it's an unnecessary complication - you'd still have inflation creep anyway, it would just be spread out over your entire income rather than on the last dollar you earned in the higher bracket. (I don't know about the math, but I'm guessing it all comes out in a wash.) The simpler solution would just be to tie the brackets to inflation. To be honest, tying brackets to inflation doesn't sound that difficult to me - going to a flat tax as a solution for it seems like using a hammer to kill a fly.

On a more general note, I can understand why someone paying 35% on his last $100,000 would put more pressure on legislators to provide exemptions than someone paying 25%, but I'm not sure this would be a significant effect empirically. Likewise, I'm not sure that if someone was taxed at the next higher rate on $1,000 that he was taxed at the lower rate for the previous year (supposing his wages rose with 2% inflation and he earned $50,000/yr), that this would make him exert significant pressure on legislators for exemptions, that he wouldn't have exerted if the brackets had risen with inflation. That is to say, it's not clear to me that the "shock" is a) psychologically significant or b) significant in inducing political pressure for exemptions.

Frank McGahon

But won't this lower overall tax revenue? I mean, I get that the pro-flat tax argument is that it will actually boost overall tax revenue,

It doesn't need to lower overall tax revenue. Remember the income tax rate is just one part of the overall tax burden. In the UK, while the income tax rate has remained unchanged, the overall tax burden per individual has increased significantly due to "stealth" taxes, many of whom are quite regressive (increased fuel taxes and the like) which necessitated this complicated system of tax credits for low earners. The more of these extra taxes and tax credit kickbacks, the more transaction and deadweight costs.

As for the pressure for exemptions, high marginal rates are a lot more noticeable when you get salary increases (by the way, the reasons bands don't follow inflation so well is that the measure of inflation in any given year is a crude approximation and might not track very closely rising salaries, plus governments afraid to raise the signal tax rate will often let the bands stagnate instead dragging more people into the upper rate), plus tax incentive schemes are great opportunities for empire building bureaucrats - it's a way of funding pet projects indirectly.

Andrew

So if the current system is progressive income tax + regressive sales/fuel/stealth/etc taxes (which may or may not come out in a wash), doesn't that mean that making the income tax flat will lead to tax regime that is overall regressive (especially if, to make up for the lost revenue caused by the flat tax, the government increases the other regressive taxes)? I can see the fairness argument for a flat tax system over a progressive tax system (though I don't agree with it) but I don't see it at all for a regressive tax system over a flat-ish tax system.

"the reasons bands don't follow inflation so well is that the measure of inflation in any given year is a crude approximation"

Well, a crude approximation is better than nothing isn't it? And it seems to me it doesn't matter if the inflation rate tracks rising salaries - what matters is that it tracks "cost of living." After all, the whole point of a progressive tax system is that if you earn more money you pay a higher tax rate; you want to track inflation just so that you're not paying a higher tax rate on a salary that's actually the same as your old salary in buying power.

"governments afraid to raise the signal tax rate will often let the bands stagnate instead dragging more people into the upper rate"

Couldn't you write an inflation-pegging measure into the tax code so that it would be automatic and make it hard for the government to stop the inflation-pegging? (If they tried to keep the bands constant, any opponents could decry them as "stealth tax hikers" or something...)

Frank McGahon

No, the idea is that a simpler, more transparent tax system ought to take in more, not less and take the pressure away from the stealth, regressive taxes. I don't think it would be much of a victory for a simple flat tax to push the tax burden onto consumption taxes which have their own distorting effects.

As for stealth taxes and passive tax rises by band stagnation -unfortunately, and the British experience with stealth taxes attests to this, so long as the signal rate stays unchanged you won't be blamed for raising taxes. Here in Ireland, we had the band stagnation problem and it didn't cause have as much grief for the government as a tax rise would have. Plus we have seen a far greater proportion not just more poeple) of people paying tax at the higher rate than, say, seven years ago, so even before the band stagnation they were still lagging behind salary increases.

Andrew

"the idea is that a simpler, more transparent tax system ought to take in more, not less"

Okay, but is it really true that a flat income tax rate generates more revenue than a progressive income tax if rates are lower overall (as it seems they must be if you're not raising rates on most middle earners while therefore lowering rates on high earners)? For the purposes of this question, I'm not talking about eliminating complicated exemptions and all that, but just about the progressive tax rates (since we originally got onto this topic when I queried whether flat-tax-induced higher tax rates on lower middle class types wouldn't increase political pressure for lower-middle-class-targeted tax exemptions to compensate for reduced political pressure for upper-class-targeted tax exemption, and you replied that realistically speaking a flat tax would not increase tax rates on middle earners).

Frank McGahon

For the purposes of this question, I'm not talking about eliminating complicated exemptions and all that, but just about the progressive tax rates

The argument is that you can't divorce the exemptions. Sure the idea might be to get rid of the exemptions and retain the progressive structure and if rates were lower overall, this would certainly be an improvement. But the flat rate does avoid the band inflation and higher marginal rate problems. But, and this is the bit that perplexes me about the gut opposition to flat taxes: Why the obsession with ensuring (or trying to ensure) that the rich pay a greater proportion of their income as opposed to simply paying more in absolute terms? I mean, a "flat" tax is still progressive, as you get richer you pay more tax whatever way you look at it.

By the way, on the political pressure argument, I'd be reluctant to make sweeping statements on this, but if political pressure for exemptions and breaks is as a result of particular disincentives thrown up by high marginal rates or band inflation (and it is seen as "cheaper" in the short term to throw an exemption here and a break there) then the same type of pressure shouldn't apply if there are no bands and no higher marginal rate.

I should say my own position is that the complex tax code incurs huge deadweight losses and involves an significant degree of wasteful micromanaging of the economy (for example: encouraging things you don't really need to encourage, childcare, housing, etc.) plus higher marginal rates are, in my view, a bad idea, punishing/disincentivising enterprise. The best way I can see to get rid of these problems is a simplified flat tax system.

Now, note that in staking this particular position I've said nothing about how high the overall tax take should be. My own view happens to be that it should be an awful lot less but this is a separate argument as to how it is collected. The point is that someone who supported a bigger government than I do, could still support a flat rate for the same reasons - waste and disincentives.

Andrew

"Why the obsession with ensuring (or trying to ensure) that the rich pay a greater proportion of their income as opposed to simply paying more in absolute terms?"

Here's just some guesswork - left-liberals generally have a commitment to some sort of social redistribution, maybe based on something like Rawls' difference principle. Progressive tax rates could be seen as a means toward this end - a less-obvious way of taking money from the rich and giving it to the poor. Perhaps the reason this seems to become elevated to an end in itself is that one could make the judgment that it's a very easy and effective means of social redistribution, and seems more effective (or at least more politically feasible) than having a flat tax and then giving the money disproportionately to poor people through welfare programs and so on.

If I were to be convinced of value of flat tax rates, it would have to be (I think) along this effectiveness (ie waste and disincentives) argument - that a flat tax would actually generate more revenue than a progressive tax and we'd thus have more money to better the condition of the poor, and moreover that this is an easier, more effective, and more politically feasible means to the end of social redistribution than the current system. So I'd agree with you that it's wrong to see a progressive tax as an end in itself - it should be a means to an end, and if there were a better means to that end, I'd go for it.

Frank McGahon

I think your last paragraph sums up what I'm getting at - there's no a priori reason for a left-liberal to reject flat taxes. It's certainly worth being cautious and I can even understand a certain amount of suspicion. It may turn out to be right that the flat tax wouldn't prove a more efficient method of collecting taxes. The only way to find out for sure is to try it. Which, by the way, is why I'm in favour of radical devolution of power - I see no reason why there can't be differing tax regimes within a country, even one as small as Ireland - "radical" ideas such as this can be attempted and if it works in one region, another can adopt it. Competition between similar regions should suffice to ascertain something like an optimal tax regime.

The reason, I wrote this in the first place was that my impression of some anti-flat tax arguments, particularly Hutton's piece is that this is a visceral reaction, (all this "batty idea" stuff) that for many of those of his generation on the left there is a strong commitment to the means above all, over the ends.

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