The Amateur Financier

(Below is a (slightly modified) reprint of a response I wrote to a blog post by the Financial Samurai.  He was attempting to argue that fairest possible tax would be a completely flat tax, wherein everyone who earned above the poverty rate would pay 15% of their overall income.  I disagreed, and wrote a rather lengthy response detailing my qualms with his logic and his position (in a respectful manner, of course).  After finishing my nearly 1000 word response, I took a step back and looked it over and realized that with a few edits, it could stand as a post all on its own.  Below is my take on the flat tax, and why it is NOT fair.  You can read the post that inspired it over here.)

Why do I believe that a flat tax is not fair?  First, attempting to make a tax system fair is tricky, as ‘fair’ is such a subjective word. Rather than being something you can easily measure, it’s a moral judgment, which will depend on an individual’s sense of right and wrong. Depending on your feelings and beliefs, what is ‘fair’ to someone else might be completely ‘unfair’ to you.

Let’s look at an example of another ‘fair’ tax system to get a feel for this. Let’s say the government decides to replace all federal taxes with a single per capita tax, set at about $10,000 (what the government would need from each of us to meet its annual budget, by my back of envelope calculations). It’s ‘fair’ in that everyone in the country will have to pay the same amount, including you, me, Donald Trump, and the poor man on the end of the block. But, obviously our ability to pay will be very different. Someone making one million dollars a year will barely notice the ten thousand missing, someone making $50,000 will feel the loss but still have plenty of money remaining, and someone making $10,000 will watch as the government quite literally takes his whole paycheck. Even though this system would be fair (by the standard of taking an equal amount from each person), it doesn’t mean it would be an ideal tax system.

Which brings me to my next point: mathematical even-handedness isn’t the only concern when designing a tax system. If it was, I’d gladly concede that it’s hard to make a ‘fairer’ tax system than a flat tax on income from all sources. Instead, the designers of the tax system also attempt to: promote desirable behavior (which is why mortgage interest is tax deductible and why IRA accounts exist), drive financial investment (hence the lower long term capital gains tax) and maximize taxpayer utility (the ability of the after-tax income to satisfy the taxpayer’s needs).

This last point, utility, is a major reason that liberals (and for the record, I definitely lean that way, even if I don’t go so far as to call myself a liberal) support a progressive rather than a flat tax. Taking 15% of the income from a family of four earning $30,000 a year will have a much bigger negative impact on their standard of living than taking the same percentage from someone earning one million each year. Indeed, because the difference in utility between $25,500 and $28,500 is so much greater than the utility between say, $850,000 and $750,000, it makes sense to create a tax system where someone grossing $30,000 each year only pays 5% and someone earning one million pays out 25%.

This utility issue (or perhaps their own sense of ‘fairness’) is one reason why most flat tax planners include a healthy exemption or ‘negative income tax’ that offsets the tax paid by lower income taxpayers. A typical set up is having the tax set at a particular rate (let’s say 15%, to stay consistent) but only applying that tax to income above a set amount (say, $20,000). A family of four grossing $30,000, for example, would pay only $1500 (15%*$10,000) or 5% of their income in this scheme, while a family earning $100,000 would pay $12,000 ($80,000*15%), 12% of their gross income. Thus, most flat tax plans are actually progressive in nature.

You might argue that it is not FAIR that a high-earning family pays a higher percentage of their income in taxes than the lower earning family. You might further claim that both families SHOULD pay exactly the percentage in taxes (although, as already noted, no flat tax plan currently in consideration, would actually cause them to do so). But that goes back to the first point I made; what’s fair is subjective, and it depends on who is doing the judging.

I think a progressive tax (a genuinely progressive tax, without all the loopholes and tax dodges inherent in our current system) would be very fair; you are certainly entitled to disagree, and maintain that a completely flat tax is the best system. Hopefully, I’ve at least made a thought-provoking point or two about fairness and taxes.