Mind you, with less than five percentage points separating the top and bottom tax brackets (see
), we would be perilously close to flat-tax territory, with all the controversy that inevitably excites, philosophical, metaphysical and, er, semantical.
Always clever Declan at Crawling Across the Ocean cleverly argues that "flat-tax" advocates are in fact advocates of a two-rate structure -- since flat-tax models typically provide for an initial tax-free allowance of several thousand dollars -- and are thus hypocritical, duplicitous or worse. When you hear people advocating for a flat tax I recommend asking them two questions: 1) Do you mean a flat tax or a two bracket tax? When they admit that it is really a two-bracket plan they support you can ask: 2) Why are two brackets better than five?
Thus, to Declan, when the state abstains from taxing the first $x-thousand in earnings, it is really taxing them at a rate of 0%.You can go a long way with this kind of thinking. If the tax the state does not collect on the income people earn is a tax, so, reasonably, is the tax the state does not collect on the income they don't earn. And what about the tax that is never collected on the earnings of people who don't exist?
At any rate, the answer to Declan's question is as follows. The point of a flat tax is not to have a single rate of tax -- or two -- but to have as low a top marginal rate of tax as possible, since marginal rates -- the rate you pay on the next dollar of income earned -- are what affect people's decisions.
Suppose you need an 8% rate of return on an investment after tax to persuade you to part with your money. At a 50% marginal tax rate, the investment would have to earn 16% before tax to get the green light. Whereas at a 20% tax rate, it would only have to earn 10%. Cut the marginal tax rate from 50% to 20%, and all those investments paying returns of between 10% and 16% become economic, where previously they would not have been.
All right. But what about social equality? Doesn't a flat tax mean abandoning progressivity -- the notion that rich people should pay higher rates of tax than poor people, since, as Declan points out, a dollar of income is worth more to a poor person at the margin than it is to a rich person? The answer is that a flat tax is a progressive tax, thanks to that very tax-free allowance that Declan finds so contradictory. There are, that is, two ways to achieve progressivity. We can tax each additional slice of income at higher and higher marginal rates, in the traditional manner. Or we can tax a higher and higher proportion of income at the same rate.
Suppose the first $10,000 of income is exempt, with every dollar taxed at 20% above that. If you earn $20,000 gross, you pay tax on half that amount, for an effective rate of tax of 10% (1/2 x 20%). If you earn $100,000, on the other hand, you pay tax on 90% of your income. So you pay 18% of your income in tax, nearly twice the rate you'd pay at $20K.
I realize we're talking average rates of tax rather than marginal, and granted, this does not achieve the finely modulated gradations that Declan's utilitarian analysis would demand, in which each additional dollar is taxed at a higher rate to reflect its deemed utility to the recipient. But marginal analysis is itself of declining marginal utility, the further you rise above subsistence. An extra dollar of income is clearly of greater value at $10,000 than it is at $100,000. But between $90,000 and $100,000? Who cares?
The case for progressivity, it seems to me, is less rooted in the notion that we should extract as much as we can from the rich -- tax 'em till the utilitarian pips squeak -- than it is in the idea that people should pay tax only on their discretionary income, ie income above that required for the necessities of life. It's a bedrock principle of taxation that it should be based on ability to pay, and ability to pay is clearly related to the discretionary principle: you can't pay tax with money you need to feed and clothe yourself. That's the point of that initial allowance. You take the basic necessities out of the equation, depending on your assessment of where "necessity" leaves off and "discretion" kicks in: whether it's $10,000, or $20,000, or something else again is a political question, involving prevailing norms of an "acceptable" standard of living. If you didn't do that, a flat tax would indeed be regressive. In effect, you'd be taxing those on low incomes at a higher rate than the rich.
To complete the picture, you'd also want to pay people a "negative income tax" below the threshold, to ensure that no one had less than a decent minimum to live on. Though they go by different names, this is conceptually identical to a guaranteed minimum income. You can either pay people a lump sum, then tax them on every dollar they earn above that -- in effect, "clawing back" the original payment -- or you can pay them a supplement that declines as earned income rises. But the intent in either case is the same -- indeed, the same as with the flat tax: to keep marginal tax rates as low as possible. Right now, thanks to various federal and provincial "clawbacks" of benefits, people on low incomes often pay the highest effective marginal rates of tax, which presumably Declan and I can both agree is crazy.
CODA: This is of more than theoretical interest. Next week's federal budget is likely to include a "working-income supplement" as bruited in previous budgets and as called for by every economist since Milton Friedman, who invented the idea.
last.fm
3/31/2007
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