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December 31, 2011

The Truly Flat Tax

What is a flat tax? A flat tax is one in which the marginal rate, the rate on an additional dollar, is constant regardless of the level of income. It just so happens that the flat tax proposals that you hear about in the media are not truly flat. This is because they utilize a personal deduction . . . below which the marginal tax rate is zero. So the marginal rate starts at zero and then jumps up to 20% or thereabouts.

So what is a truly flat tax like? Well, imagine that a person with no income would receive a subsidy or negative tax of some amount. As this person’s income increases, his subsidy would decline 20 cents for each dollar of income increase. Then at some income level (the maximum subsidy divided by .2), there would be no subsidy and no tax either. Beyond that income level, positive taxes would be owed. Again, the rate could be 20%. Obviously, you can substitute any rate that appeals to you as long as the rate for subsidy recipients is the same as for tax payers.

How could this sort of tax policy be relevant? The answer is that it only makes sense if you get rid of all other subsidy programs. There would be no unemployment compensation, no disability payments, no food stamps, no public housing, etc. That is, there would be no in-kind subsidies at all.

Who would hate this policy? People who want to control, or try to control, the services and commodities consumed by the poor would hate it. Bureaucrats that run these subsidy programs would hate it. Lobbyists who derive their livelihood from subsidy programs would hate it. You get the idea.

Who would love this policy? The poor subsidy recipients would love it. Economists who are troubled by the implicit tax rates associated with subsidy programs that have income tests would love it.

So what should the maximum subsidy be? This is a political question. Some would say that it should be zero. Others, might say that it should be on the order of $7,000 for an individual with no income. Let’s just explore the implication of the $7,000 maximum subsidy. With a 20% marginal tax rate, the income at which subsidies stop and positive taxes start would be $35,000. Now you can see that people of various political persuasions might argue about the parameters of this tax schedule. Nevertheless, it accomplishes a lot.

This proposal shrinks government. It makes the tax rate low and explicit so that it can facilitate the upward mobility of the poor.

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