The Case for Small Government

A Libertarian Perspective on Economic and Social Policy

April 19, 2006

Flat Taxes

Much discussion of tax reform considers a flat tax on income or consumption. I focus here on the income case.

The simplest possible flat tax imposes a constant tax rate on all income. This case is mainly of theoretical interest, since few people endorse taxing people with very low income.

A modified flat tax (MFT) therefore includes a zero bracket amount, a range over which no tax is owed. The flat rate then applies to all income above this amount. Many MFTs also eliminate various deductions, exemptions and credits, although this is separable issue from whether the tax rate structure is “flat.” And most MFTs impose a tax rate that is low relative to current top rates.

What are the pros and cons of an MFT on income compared to the current system?

One advantage is simplicity. Some improvement comes from the reduced number of rates, although this is minor given that most people let H&R Block or TurboTax calculate their taxes. Greater simplification comes from taxing all income at the same rate and eliminating deductions, exemptions, and the like.

A second advantage of an MFT is the lower tax rate on high incomes, This improves the incentive to work and save.

The negative of MFTs, according to critics, is reduced progressivity. An MFT is progressive, of course. Low income taxpayers pay zero taxes, while higher incomes taxpayers pay amounts that increase, as a fraction of income, as income rises. But critics are right that MFTs are less progressive than the current system.

Whether this aspect of MFTs is undesirable depends on one’s views about redistribution. I argued in an earlier post against redistribution except for the poor, so I do not mind the lesser progressivity of an MFT.

All in all, there is a reasonable case for a flat tax on income, subject to one key qualification: consumption is plausibly a better basis for taxation than income. Consumption taxation requires a zero tax rate on capital income, however; a flat tax on income imposes the same rate on labor income and capital income.

A future post will discuss income taxation versus consumption taxation in more detail.


At 11:01 PM, Anonymous Anonymous said...

My problem with your MFT is that going from the 0 tax rate bracket to the regular bracket has no incentive to want to get more income in the same way that the EITC can provide an incentive to want increase a person's income. Maybe there could be a way to provide an increase in the rate up to the regular bracket's rate in a similar structure as the EITC is supposed to work. Another alternative is just to have a small government in the first place where we don't have to worry all the time about insignificant problems like these.

At 8:15 AM, Blogger Brian said...

For most of U.S. history there was no income tax. Income tax only started in 1913.

Repealing the U.S. income tax is not politically feasible, but The Case for Small Government should point out that a gov't without any income tax is both possible and preferred.

At 8:20 AM, Anonymous Anonymous said...

I'd love to see a genuine flat tax. A Flat tax that is effectively progressive -- by not taxing the first X (survival) dollars of anybody's income -- and efficient (by not discriminating between allocation of capital and allowing capital to move on the merits, rather than the tax advantages).

A consumption tax is very enticing. There are a lot of wonderful aspects to a sales tax, and only one drawback. Unfortunately, that drawback renders it pretty much impossible to implement. That is, at any tax rate theoretically sufficient to be revenue neutral (a minimum requirement for political viability), a sales tax would suffer enormous evasion/avoidance activity. Practically speaking, I don't think we could raise a sales tax high enough to be revenue neutral.

That's been the experience of every country that tried a NST.

At 8:55 AM, Blogger Chris said...

The argument about the non-progressivity of flat tax is a bit misleading. If you take into account all taxes paid at local, state, and federal level you end up with a tax that is very nearly flat with the bottom 5% only paying a tax rate a couple of points below the top 5%.

If all taxes were reformed a flat tax would be easily feasible while reducing corporate welfare and the mindnumbing complexity of the current system.

At 11:09 AM, Anonymous Anonymous said...

As long as we’re speculating in fantasy land, how about a voluntary tax. Yes, I know if it’s voluntary it’s not a tax. But! What if the government published budgetary needs each year and each entity – individual, family, corporation, etc.- could then contribute to each line item as their conscience or desires dictated. If some line item didn’t get the funds to operate the obviously it’s not something the people of the nation want the gov’t spending their money on. Economic democracy

At 2:46 PM, Blogger Chris said...

Do you have a point stargeezer?

At 3:26 PM, Anonymous Anonymous said...

Only that no system of taxation that uses extortion to finance the operations of gov't can be a good system.

At 9:29 PM, Blogger Chris said...

Without taxes there can be no government. While there are certainly some that would advocate such a regime, that isn't the world that we live in.

At 8:42 AM, Blogger Malachi said...

Let's say a 25% tax kicks in at $20,000 (just naming numbers to illustrate a point). That means a person making $19,999 would never receive a raise because to make $1 more would cost him $5,000. He'd have to get a 33% raise just to keep bringing home the same amount of money.

There would be no point to an employer giving a 33% raise so they wouldn't. To give a person a 5% raise in take home money the employer would have to give them a 40% raise!

That could only be justified for promoting somebody to a different position. So, there'd be entire classes of jobs permanently stuck at an income just under the amount where the tax kicks in.

It would also take away incentive for a person to search out a second job to improve their position because their return would be so little. Same with overtime. No point working overtime if it's going to cost the worker money.

We have the same problem with the bracket system we have today but it is to a much lesser degree.

Because of these reasons, I don't see how we can have a flat tax on income that doesn't kick in until some level of income.

Either the tax has to be flat across the board or it has to be progressive.

Or is there some obvious point that I'm missing here?

At 9:07 PM, Anonymous Anonymous said...

In your example, the 25% would apply to every dollar beyond the tax-free amount (in your case 19,999$).

At 9:08 PM, Blogger Mike Huben said...

Yes, Malachai, there is an obvious misunderstanding. The increase of a progressive tax only applies to earnings above the cut-in level. So in your example, earning $1 more above the $20,000 level would result in a 25% tax of 25 cents, not $5000. So there is no gross disincentive to earn more.

Libertarians have no argument for a flat tax. The only faintly comprehensible libertarian argument for a tax that I've encountered is the Georgist single tax.

At 1:28 AM, Blogger Malachi said...

Ah! Of course.

Thank you for correcting me on that.

At 7:20 AM, Blogger Mike Huben said...

Glad to help out. It's nice to see somebody here who is self-critical enough to recognize that he might have made a mistake. Ideology (including libertarian ideology) tends to eliminate self-criticism with a battery of ready-made fallaceous excuses for dealing with counter-arguments.

One libertarian who is openly self-critical at times (when he's not in his normal public propaganda mode) is David Friedman. His The Machinery of Freedom: Chapter 41: Problems is refreshing compared to the usual libertarian polyanna drivel.

(Some may wish to say that I'm an ideologue also: I'm not. I'm an iconoclast. I argue against the libertarian position, not for any particular position. I leave that up to people to choose for themeselves when they see the errors of libertarianism.)

At 12:13 PM, Anonymous Anonymous said...

One big advantage of a flat tax is that in many cases tax can be withheld at the source without further ado. They clip 15% or whatever off your salary or interest or dividends, and then you don't have to deal with them again or file anything. That's very efficient. Of course, you need to make some kind of claim if this results in your not benefiting from the zero-bracket.

Moreover, the government doesn't need to know very much about your circumstances. The government doesn't need to know your total income or wealth to collect a flat tax.

It's quite true that the income tax is collected by means of extortion. A total lack of government would probably be worse than being a victim of extortion, so in that sense the tax is a lesser evil. However, when the government uses the money for frivolous purposes, the lesser-evil justification for using extortion cannot be made. So when the government uses funds for less essential purposes, it becomes a criminal extortioner.

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