Problems with a "flat tax" on income

Whenever taxation is discussed, someone inevitably will posit "What we need is a 10% flat tax on all income, no exclusions, no deductions..." or a close facsimile of this statement.

More famous people like Steven Forbes and more recently Herman Cain, with his "999" plan,  have advocated some variation on this theme. My problem with Forbes-like "flat tax" and even Cain's 999 plan is that it does not eliminate the income tax compliance costs (and sheer invasiveness) for individuals or corporations nor does it effectively reduce the complexity of the tax code.

A “flat tax” sounds nice. All your income taxed at one flat rate. What could be simpler? But a flat tax simply removes the progressive structure (different rates for different income levels and/or types of income). This has two problems. First, much of the tax code exists simply to define what constitutes "income". Second, if anything is deductible, such as charitable donations, then much of the tax code will continue to be required to define exactly how this should work. Mountains of paperwork and 10s of thousands of pages of tax code will be involved in defining what is deductible, etc. just as it does today. Armies of accountants and attorneys and IRS agents will remain in place.

If you want to say "All income is taxable income" that's fine. But it probably won't work.  The current tax code recognizes that not every penny that lands in your pocket represents "income". For pretty good reasons, the tax code endeavors to distinguish between gross income, net income (adjusted gross income) and taxable income (AGI less deductions).

As an example, if every penny that lands in your hands is taxable, then when Grandma gives little Johnny a birthday card with $10 in it, Johnny must file a tax return and account for that $10, and Grandma may be required to file a correspond 1099MISC to document that she transferred monies to Johnny. Failure to do so on either party's part obviously is tax evasion and a clear failure to comply with the tax code. If this situation is undesirable, then exclusions must be written and further, the definition of “gift” must be codified so as to avoid certain abuses that would inevitably occur.

Now consider the nature of a gift exclusion that allows small amounts to be gifted without a need to report as income on the part of the recipient (or file a 1099MISC). First, how small is small? $10, $100, $1000, is that indexed to inflation? Can Grandma give $1000 *and* Grandpa give $1000 each? How often can a gift be given? Or is the limit a cumulative annual amount? If it's $10, then lots of people will have to file 1099 and cause way more work than it's worth. If it's $1000, a lot of people will start black-marketing "gifts": e.g. maybe I can convince my boss to "gift" me the maximum amount every year? Etc. Etc.

If I loaned $750 to someone, who paid me back $1000 (i.e. repay $750 and pay $250 in interest), the $1000 check is not all income to me right? Income in this case would be $250, the interest paid, the other $750 is simply returning my money.  What if I loaned my brother $5000, with a contract, interest payment and everything, then 5 years later decide that he doesn't have to pay it back? Is that a gift? Have I violated the gifting rules? Is that loan income to him? Is it a loss for me? Can I use it to offset other income? Etc. Etc.

What about a lottery winner, say $1000 on scratch off. Surely that's all income? But current tax law says that if he spent $750 buying tickets, the net gambling income is only $250. It cost $750 to "earn" $250. What if he won $1000 but lost $10,000? Current tax law says too bad on $9000, but he owes no tax on the $1000 winnings. Current tax law looks at your gambling income as if you were playing a long poker game: win or lose hands during the game, doesn't matter, what matters is what you have at the end of the game (tax year).

If my house burns down and the insurance company writes me a check for $100,000 is that income? What if the insurance pays more than I paid for the house? But what if it pays less than the house is worth?

More rules will be needed to clarify these situations too. That’s just defining “income”…and those are the easy examples.

If anything is deductible, say charitable donations, then another mountain of pages are required to spell out exactly how the deduction works, valuations to be used, etc. It’s easy enough to track cash donations (but current tax code has a lot of rules on those too, e.g. my donation to my alma mater is 80% deductible if I buy season football tickets, but 100% if I don’t). What is my deduction for used stuff given to Goodwill? Fiar market value? How is that determined? What valuation should be used for the Monet painting someone inherited from their grandfather’s estate when they donate it to a museum?

Think of the pages and pages of rules needed to define these elements, and the record-keeping needed to comply.

Unless you really mean a flat tax applies to all income regardless of source and nothing is deductible, then defining the various things that constitute gross income, net income, and taxable income will consume a large portion of the tax code and will continue to chew us up in compliance overhead. Futher even if you do mean all income, including Grandma's $10 gift to little Johnny bear in mind the thousands of 1099MISC forms that will need to be filed. The benefit of a “flat tax” in this situation is negligible.

Individuals spend more than 6 billion hours doing their personal taxes (at minimum wage that's more than $40B, at $25/hr that's $150B) resulting in about $2T in revenues. The corporate tax code is far, far worse. Corporations spend around $300B just complying with the corporate tax code, to generate approximately $300-500B in revenues.

A half-trillion dollars spent just figuring out how much taxes are owed? To collect about $2.5T?

For every $1 it takes in as tax revenue, the government forces the economy to produce $1.20 and produce reams of paperwork to track, report, and justify the taxes owed and paid. That's hugely, grossly inefficient, not to mention invasive and a huge drag on the productivity of the economy.

A "flat tax" does nothing (or virtually nothing) to correct this situation.