Once again Congress and the president are talking about changes to the tax code. This will lead to a demand for tax simplification, which will lead to a discussion of the flat tax.
Herman Cain's current "999" proposal includes a flat tax. It is hard to look at our federal tax code without a demand for simplification. Currently only 20 percent of tax filers submit their own taxes without help. Why shouldn't a working man or woman be able to figure out their own taxes without professional help? The reality is that the tax code is 3 inches thick, accompanied by an 18 foot stack of regulations and explanations. It is updated every year with new laws and rulings.
The discussions for simplifying the code usually focus on the flat tax. Now the flat tax may be a good idea for many reasons, but a flat tax alone will not do much to simplify our federal income tax. There are two reasons that our code is so complicated, and neither of them have to do with the calculation of tax rates: The first reason is because income is a fuzzy gray entity. The second is that the government uses the tax code to provide incentives, favors and social engineering.
If everyone was paid by a company and received a W2 at the end of the year, income calculation would be a lot simpler; however, this is not the case. Many people work for themselves and figuring income becomes complicated. A plumber or insurance salesman might own a company car or have advertising expenses which need to be deducted when figuring their income. How much depreciation can they take on their car, what if it is an exotic sports car?
A small, personal business can have the same complexities in figuring taxable income as a large company, so the tax code requires rules, definitions and processes so consistent incomes can be determined. A flat tax will do nothing to simplify this situation.
The other driver of tax complexity is the plethora of deductions and credits. These are intended to provide incentives and support for favored government programs. Usually in discussing the flat tax the idea is proposed to eliminate all deductions in return for a lower flat tax rate. But this has nothing to do with the flat tax itself. We could eliminate these deduction now.
However, these changes would be very difficult to make because they have become part of the DNA of many organizations. Charities raise money offering tax deductions for donated cars, and investors have committed funds to machinery and inventory based on these deductions. Unwinding these deductions from the institutions that have been built on the code would take time. It would also take a new found discipline in elected officials to stop using taxes for incentives and social engineering.
So what are the logical reasons for the flat tax? First, it embodies a different notion of fairness as each person pays the same rate. Second, it would probably include taxes on a broader share of the population, including some of the 50 percent of taxpayers who don't currently pay income tax. And third, the flat tax makes the actual tax rate clear to citizens, investors and economic decision makers.
And finally, given the administrative burden that our current system places on society, any framework for reworking the system has to be seriously considered. And in this rework process, the opportunities for simplification become more probable.
Richard Parsons teaches economics and finance at Westminster College in Salt Lake City. He has been controller for several Mars Inc. companies.