The Flat-Tax Fantasy, Part 2

April 24th, 2010 by Potato

There’s some interesting discussion taking place over at Larry McDonald’s blog on the flat-tax issue.

Larry asked:

“But does a flat tax necessarily entail a higher tax burden for lower income persons and/or less public service?”

I don’t have a source for you, but the math is fairly simple. If we’re to avoid less public service, then the total tax revenue has to be the same as it is right now, however that gets distributed.

Then you have three basic options for how to set a flat tax:

First, a true flat tax of X% (say, ~20%) from your very first dollar of income. Obviously, there are people right now who are very low income and pay no tax, and under this new system they would be paying tax, and the people at the top would pay less tax (so the total revenue is the same).

That goes against the progressive sensibilities of many people, so the next suggestion is to add a floor. Then you have two variables to play with: how high to set the floor, and what tax rate to set.

Now, assume that for the very, very wealthy, their total tax rate approaches the top tax bracket (if you’re making $20 million, the first $127k at a lower tax bracket is virtually meaningless).

So, if you set the tax rate to be less than the current highest marginal rate (29% federal), and set some middling tax floor ($20k, whatever), then the very wealthy will still pay less tax, so again if the total tax grab is constant, that must mean that someone lower down is paying more, but this time that’s likely to be the upper-middle class rather than the very bottom of the income distribution.

Then the only way to make sure that you’re not moving the tax burden down the income strata with a flat tax is to set the flat tax rate higher than the current highest marginal tax rate, and then have a fairly high tax floor — but I don’t think I’ve ever heard a flat-tax proponent suggest that version.

I’m in this deep, so what the hell, let’s put some actual numbers to this. I quickly looked up what the distribution of incomes is, and plugged that into excel. I know I probably shouldn’t worry about the 0.01% of Canadians who make more than $3 million when trying to figure out a tax system for most of us, but I decided to try to come close for the sake of argument. Now, this is not quite exact because it doesn’t take into account the various deductions available which will definitely skew the results — this is just taking the incomes listed from Stats Can (which are in ranges — I took the middle of the range and called it close enough), and applying the progressive tax brackets to them to find a current tax burden, and then examining different flat tax schemes to see how they fare.

So, using this model, we find that:

To get the same total revenue with one flat tax (from the first dollar on), the average rate would have to be about 14.5% (a bit higher in real life since I don’t quite add up to the same actual total tax revenue as the government pulls in with this model).

If we set a low floor, at $5.3k, a 16% tax rate gets us about the same total revenue. However, the tax burden is shifted quite dramatically towards the lower income bins. This chart should get the point across:

A graph of change in tax rate vs income

If we want to use a 22% tax rate, currently the second bracket ($41-$82k of income), the floor can be set at $15.8k, and we see that the very poor pay no tax (no change from current), those close to the floor pay a little less (those with incomes up to $27.5k), the middle class people ($30-$85k) pay more, while the very rich (over $85k) pay less.

The current top tax bracket of 29% lets us set a floor of about $24.5k, and even all the super-rich bastards pay at least the same (though those at $42.5k would start paying more, with $47.5k being enough to make the difference more than 1%, while those millionaires have a fractional percent difference because as I hinted earlier, their tax rate approaches 29%; deductions, off-shore tax fraud/evasion, and sheltering aside).

A graph of change in tax rate vs income

If we want to move the floor up to say $35k (the current average income) and really flip the flat tax idea around on the rich, then the flat tax has to be about 40.5%, and only those with incomes over $65k would be worse off than they are today (though as you can imagine, the difference would be quite dramatic since there’s a lot of slack to make up in a thin slice of population).

So you can see why I’m against a flat tax: it benefits the well-to-do in almost every incarnation — even when you set the flat tax rate at the current highest marginal rate so that the very rich pay at least the same, you still end up taxing the upper middle class (those below the ultra-rich) even more. And that is not the version championed by the likes of the Fraser Institute — they’d want one with a tax rate closer to 15-20%, which tends to shift the tax burden down to the poor and middle class. I like the progressive tax system, so if I were to make changes, I’d pull out the Ontario Health Premium, and add in another tax bracket on $1 million+. Yes, it only affects a very select few (<1% of the population), but there is definitely a big difference in your ability to pay tax between $200k and $2M.

You can have a look at my work in excel yourself, check me for errors, get more up-to-date or better resolution stats for the model, etc, right here.

Federal tax brackets: (plus basic personal exemption of $10k)
Incomes, from Stats Can, and highest few slices from the daily (also, a simpler breakdown from HRSDC).
In my very rough excel spreadsheet, I got about $140 trillion billion for income tax revenue — I figured it would understate things because the stats can data doesn’t even go to the highest tax brackets. I also probably had an overstatement because I was having tax come off even the very low income people at 15%. Then I added in a $1.5k credit to everyone and it looked more realistic, but brought the revenue down to about $100 trillion billion. So, to try to more closely model the actual case, I added a $125k income bracket for which I have no source data — the population at $100k was fudged to get the total tax revenue to come out close! I also assumed that some 10% of those millionaires making over $3M/year would be over $10M, though that didn’t have much of an effect (not enough people). The actual numbers: says that there is $133.7 trillion billion of revenue from income taxes (in 2005, which is when the income data is from). One other source of error may be that I looked up the 2009 tax rates, but have 2005 income/tax revenue data.

Edit: I made a billions/trillions error above. The spreadsheet looks like it was ok, it was just my words that failed. Also, another handy link on spending breakdown.

One Response to “The Flat-Tax Fantasy, Part 2”

  1. Marianne O Says:

    Wow, you put a lot of work into this. Impressive examples.