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Is a Flat Tax
a Good Idea? 

With April 15th still strong in our memories, our thoughts turn to income taxes and how much of our earnings go the government. Inevitably, the subject of the flat tax arises as a way to pay fewer taxes. While the concept sounds like a nice idea, in my mind it's just not a workable one.

Before we scrap our entire income tax system, let's take a look at what we have and how we got it. Under our current income tax system, we have a small number of tax rates starting at 15% and going up to 39.6%. Putting aside for a moment capital gains rates and the alternative minimum tax, individuals currently have only 5 tax rates to apply to taxable income. The problem is not with the rates themselves, but how we get the number to which we can apply those rates. This number, taxable income, is the hardest number to compute.

Of course you are saying, "That is exactly WHY we need the flat tax!" But before we get into that, let's explore how we got the tax system we have now.

Once upon a time, our tax system was very simple. Very few deductions, simple tax rates. Then some bright people in Congress got together and decided to start changing things to get people to do certain things and to NOT do certain things. Congress says buying a house is good, so they let you write off mortgage interest and taxes. We need good housing for low income people, so Congress gives you a tax break for investing in this kind of real estate. Taking money prematurely from your retirement plan is a bad thing, so Congress heavily taxes you for doing so. Every time some one comes up with a new idea, they change things.

Yes, our code started out simple and has now become completely crazy. But it got that way by design. Yes, we could scrap it all and start over again, but given enough time, we would end up right back here again. And look at all the revenue that would be lost while inventive people exploited loopholes in the simplified system.

Now for the moment, let's go ahead and assume we scrap the whole thing and agree to tax earnings at 17% (just to pick a popular number). Sound simple? Hardly.

Let's start with definitions. What is income? Let's say you work for a living and you earn $ 1,000 in the last half of December 2000, but you don't get paid until January 2001. Is it income when you EARN it or when you COLLECT it? To answer this, we have to draft a rule to determine exactly when you have to pay tax on it. Now let's assume your boss is decides to only pay you part of what he owes you. Let's assume $ 600. Again, do you pay tax on the $ 600 you collected or the $ 1000 you earned? So now we have to draft another rule.

Let's talk about corporations now. The same questions apply to them. What is income and when is it income? If I charge $ 1000 on my credit card, when does it become income to the corporation? When I pay it or when I charge it? To make matters harder, assume the corporation spends $ 400 to make the item it sold to me? When does it get to write off the cost of that item? Current tax laws try to match the income stream with the associated costs, but doing that takes rules and more rules.

Consider this as well. Many large companies generate small profit margins after paying for merchandise, labor and overhead. Grocery stores, for example, operate on a very small profit margin but survive by having a huge volume. Tax 17% of their gross sales and they will go out of business. Tax exempt organizations such as churches and civic organizations that help our needy, troubled families and many other people would cease to exist if forced to pay taxes.

My point is simply this: our current tax system is extremely convoluted, hard to deal with and completely impossible to fully understand. However, it would be pure foolishness to scrap the entire thing and go to a flat tax. It would be like throwing away your family automobile just because it is complex and returning to walking because it is simple. It might work but it wouldn't be efficient and would probably throw our whole economy into a tailspin. We should continue to work on what we have and simplify it. Over time, we have been doing this, and while we still have a long way to go, the flat tax is simply not the way to do it.