Falling Flat

I’m sorry to tell any of you who were hoping for some change, but we will never have a flat tax system. Not a real one, at least, so just leave it alone.

I’m talking about any kind of flat tax. Flat individual income tax. Flat corporate income tax. Herman Cain’s “9-9-9” plan. It’s just not happening.

(Side note, one of the “9’s” in Cain’s plan is a national sales taxes. I’m not discussing sales tax here, but they come with their fair share of complexities. I might discuss it one of these days, but I’ll need to do more research on the issue myself.)

The desire for a flat tax is based on the myth that tax rates actually determine what people pay. If that was the case, if we were to raise the tax rate by 1% on everyone, in theory we could take everyone’s income, take one percent of that, and get what kind of money the government would rake in.

Unfortunately, that is never the case. 1% increase could bring in billions of more tax revenue. Or it could actually lower tax revenue. Lots of highly paid people run complex calculations to try to determine what it will actually bring in, but they might as well throw darts at a board for how accurate they are. For example, in the UK, preliminary results are showing that the increased tax rate is actually decreasing tax revenue, though we’ll have to wait until the end of the year to get the full story on that one.

So why does this happen? Well, lots of reasons. But one of the main things driving it all of this is taxable income.

9% income tax rate? Great! Now what are you taxing?

That’s about all I do at work: try to figure out taxable income. The tax rates are rarely even a secondary thought.

So, for example, let’s say you’re making $50,000 a year working as a crocodile hunter. You’re not going to take $50,000 x (whatever percentage here). First you have to take your above the line items. Alimony. Tuition. Health Savings Accounts, Moving Expenses. Random other stuff. That brings you down to your Adjusted Gross Income (“AGI”).

From your AGI, you then get your personal exemption, and your itemized or standard deductions, and your foreign tax credit, and your child care credit, and your self employment taxes, and your AMT (which, as some of you may recall, is how the devil torments tax accountants). It goes on and on and on and on.

I’ve talked to people who ask “what’s the big deal with these adjustments?” I believe it’s difficult for most people to understand how much of an effect these can have on your income. For the standard salaried employee, you report your W-2 income and that’s about it. But for some people these amounts can have a huge swing on what they make.

Let’s take the example of the Crocodile Hunter, assuming we have a flat  tax of 15%. That Crocodile Hunter–assuming he was divorced, had children, moved for work purposes, contributed to his health savings account, purchased a home, gave tons of money to charity, had scads of property taxes, invested in muni bonds–could potentially have zero taxable income. Effective tax rate of 0 tax/50,000 income = 0%. Last I checked, that’s below 15%. So much for a flat tax.

Or if he was single, renting, living alone, no kids, no investments, etc., he could have taxable income of $40,500, effective rate of 6,075 tax/50,000 income = 12.15%. Hmm, still below 15%.

It gets even more complicated if that Crocodile Hunter were making between about $90,000 and $125,000 (or more, depending on the deduction). As you make more, deductions start to phase out, so depending on his deductions, each dollar he makes is not only taxed without deductions, he starts to lose the deductions he was claiming when he had the lower income.

One of the managers in the office was helping a friend with his taxes last year, and because of his particular situation, he could make $20,000 more a year in income and not see a dime of it since it was all being eaten away by phased out deductions that he then had to pay in taxes. In fact, at some point in the $20,000 spectrum, if he got a raise he’d effectively be getting a pay decrease.

The real question shouldn’t be what’s the tax rate, but what tax adjustments are we going to allow. This huge list of adjustments comes from years and years of politicians trying to encourage people to do certain things and deter them from doing others. It’s easy to say “let’s get rid of all deductions,” but do you really want that? No deduction for charitable contributions? No deductions for taxes paid to other locations? No home mortgage interest deduction?

Enough people have their favorite adjustments that some are going to stick around no matter what. These deductions are also a favorite tool for politicians to pick up some quick votes. If Politician A is against all deductions, and Politician B supports charitable contributions, Pol B will get the votes of pretty much everyone working for or supporting charities, even if it is a choice between a turd sandwich and a giant douche (video). This is also part of the reason why there are more deductions than I care to count, since thousands of groups throughout the US are more than happy to vote for a politician who fights for everyone to get a deduction for their favorite cause/product/industry/etc.

For corporations, the taxable income calculation is even more complex. How else do you think GE got away without paying any taxes last year? Invest your money in the right place, you have no taxable income. By the same token, if you invest it in the wrong place, you could end up paying over that statutory tax rate.

So should we have a flat tax rate? It really doesn’t matter that much. As long as politicians have power and incentive to change taxable income, the higher the rate only means people are more willing to pay accountants to get around the rates.

 

 

DISCLAIMER: These are my opinions. Like them, hate them, I don’t really care. Just don’t rely on them as any sort of tax advice. If you want real tax advice, go pay a tax professional. We don’t work for free, you know.