The Forbes Flat Tax

Current speculation is that Governor Rick Perry will advocate for the flat income tax plan proposed by Steve Forbes. As a flat income tax proponent myself, I am elated by this news. Perry has referred to the plan as "the most exciting tax plan since Reagan's". I couldn't agree more!

The Basics:

Forbes proposes a flat rate of 17% applied to business and personal income in excess of $36,000 per year, with very few deductions or credits. Corporate income tax, which is a double tax, would be eliminated. Capital gains tax would also be eliminated, which is sensible when one considers that capital gains are realized from investments purchased with already-taxed money. Retirement accounts would continue to recieve the same tax treatment as now.

In Forbes' own words:

The flat tax would be simple. You could fill it out on a postcard. It would be honest. It would eliminate the principal source of political corruption in Washington. It would be fair. Millions of people would be off the federal income tax rolls.

There would be no tax on Social Security. No tax on pensions. No tax on personal savings. It would zero out capital gains taxes. It would set off a boom by letting people keep more of what they earn and by lowering barriers to risk taking.

Flat income tax would also eliminate most of the estimated $140 billion annual cost of tax preparation, remove many opportunities for tax avoidance, and take most of the bite out of the IRS.

There is already broad support for flat tax principles on both sides of the aisle in Congress. Democrats want to eliminate "tax loopholes", Republicans want to lower rates. Flat income tax does both.

Eliminating deductions and credits:

On the one hand, this means no charitable contributions deduction, mortgage interest, child credits, and so forth. On the other hand, I ask the reader this: Look at your tax return for last year. Did all of the tax incentives you claimed- mortgage interest, child credit, charitable contributions, etc.- add up to $36,000? For virtually all middle-income earners, this would equate to a net reduction in federal taxes paid.

Naturally, the major public objection to this concept is the elimination of the charitable contributions deduction. The public at large believe that this deduction promotes altruistic contributions from "the wealthy" to legitimate charities. In fact, the reality of this deduction is somewhat different: Much of the money claimed in this deduction is donated to non-charitable organizations (political and quasi-political organizations, for example).

Indeed, in the book, "The Flat Tax" (which can be bought in e-book format from that link for $6.72, and I highly recommend it, even if it does contain a few left-leaning sentiments), Robert Hall and Alvin Rabushka point out the following:

There is little merit in public subsidy for organizations whose success in raising funds depends on tax deductibility rather than the intrinsic merits of their activities.

Business expenses:

Among the few deductions Forbes would retain is the deduction for business expenses- a very necessary deduction, since taxing business expenses would create a barrier to entering self-employment, and would disproportionally burden small businesses in comparison to large businesses.

The payroll tax problem:

There is one major problem with any flat tax transition: What to do with payroll taxes? Most countries (Russia, for example) which have converted to flat income tax have never addressed their payroll taxes. If payroll taxes are left unchanged here in the US, a flat tax system would pinch the middle class most:

Income below $36,000 per year would be taxed at 7.65% (payroll);

$36-102,000 (Social Security tax cap) would be taxed at 24.65% (17% + payroll);

Income over $102,000 would be taxed at 18.45% (17% + Medicare tax).

Forbes has yet to address this problem. My suggestion? Remove the income cap for Social Security tax, so that it is applied to all income.

I admit this idea has problems, but it also has one whopping big perk. As I explained in a previous post, one of the core components of wealth redistribution is to force employers to fund entitlement programs- through employer payroll taxes- from which the employer will derive no benefit. It conceals the true cost of these programs. It also creates a barrier to hiring new employees, or retaining current employees. The revenue-neutral alternative is to convert payroll taxes into an 8% flat tax on incomes- with no deductions- removing the cap on Social Security tax and eliminating employer contributions into entitlements.

In other words, it would make the "employer payroll tax holiday" permanent.

If this were instituted, tax rates would look like this (notice the miniscule difference from the figures above):

Income under $36,000 per year would be taxed at 8% (FICA);

Income over $36,000 per year would be taxed at 25% (17% plus FICA).

This idea offers another benefit: It would eliminate the tax penalty for self-employment (payment of both "halves" of payroll taxes). A person's tax rate would be the same, regardless if that person were employed or self-employed. Since it would also apply to income derived from capital gains, it would soften the objection to eliminating capital gains tax while also softening the effect taxation has on said investments.

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In comparison to Cain's "999 Plan", flat income tax is simpler, fairer, more transparent, and decidedly less risky. Flat income tax is also a tried-and-true system, which has been a rousing success in those countries which have instituted it.

In other words, it's exactly what our country needs.

UPDATE (10/25/11): Perry has announced his own tax plan.