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6 reasons why a flat tax is not a good idea

A recent report on how the rich are able to take advantage of the U.S. tax code to keep their bills lower has (re)generated a lot of talk about replacing our current system.

Flat tax steamroller_Drew-Sherman_lonegan-cartoonThat's easier said than done, but lots is still being said about the options. One of the more popular replacement proposals is a flat tax.

As I noted last week at my other tax blog, several Republicans who want to be their party's 2016 presidential candidate support some sort of flat tax. Essentially, they want to scrap our current system employing seven progressive tax rates and enact one tax rate to be paid by all regardless of their amount of income.  

Retired neurosurgeon Ben Carson wants a 14.9 percent rate, Texas Sen. Ted Cruz prefers 10 percent, Kentucky Sen. Rand Paul calls for 14.5 percent and former Pennsylvania Sen. Rick Santorum has selected 20 percent.

While one rate for all has a certain appeal, our existing multiple progressive tax rates are fairer. And that's just one of six reasons, discussed in more detail below, why a flat tax isn't a good idea.

1. The lone tax rate tends to be lower than current wealthy filers' rates.
For the most part, the single rate proposed by the GOP candidates is much lower than the tax rates that currently apply to them, both on ordinary income and capital gains. When the rich earn regular income, a lot of it is potentially taxed at 39.6 percent. So in the ordinary tax rate comparison, they'd be paying rates at half or less than their current top taxes.

Only Santorum's rate is close, with his 20 percent proposal being equal to the current capital gains taxes the wealthy pay. But his flat-tax plan wouldn't include the 3.8 percent net investment income tax, or NIIT, that's now added to wealthier investors' tax bills, so the rich, who rely on a lot of investment earnings, still would do a little bit better.

Most of us far-from-wealthy taxpayers, however, wouldn't see that much of a drop in our tax rates. In fact, we could pay a tad more.

Under our progressive system, the first chunk of our earnings is taxed at 10 percent -- for 2015 taxes that must be filed by this April, that lowest rate applies to income up to $9,225 for single taxpayers; up to $13,150 for heads of households; and up to $18,450 for married couples filing jointly. If the flat rate is higher than 10 percent, then taxpayers would pay more on the amount of their earnings now taxed at that level.

Even under the best flat-tax scenarios, a single flat rate offers no or minimal relief from current progressive rates for many lower income earners.

2. High-income earners face a smaller bite into their disposable income.
When you don't make a lot of money, you tend to need almost every cent to pay for life's necessities -- rent or mortgage, groceries, utilities, a car to get to work, gas to go into the car. The list goes on and on. And there's not a lot of leftover income for extravagances, so every dollar counts.

Rich folks, however, do have a lot of so-called disposable income to spend as they want, not just as they need.

That scenario applies to taxes, too. A 10 percent tax on $30,000 takes a larger chunk of income from that lower-wage taxpayer than 10 percent does from a millionaire. The 30 grand taxpayer would be left with $27,000. The $1 million taxpayer's $100,000 IRS bill would still leave him $900,000.

3. Beware the embedded national sales tax.
While we hear a lot about the flat tax, some proposals <<cough, Cruz, cough, Paul, cough>> also include a component that is much like the Value Added Tax, or VAT, that's in place across Europe. A VAT essentially is a sales tax where the tax is collected in stages from each producer on the supply chain rather than all at once from retailers. This pushes up the price of the goods that consumers eventually pay.

Those added production costs are harder for lower-income earners to cover. As with the single income tax rate, the VAT-increased prices take a larger percentage of a poor or middle-class family's income than they take of a rich family's income. And poorer families tend to put more of their income toward consumption of, as noted in point #2, necessary items.

4. Flat tax proposals aren't necessarily simple.
A major argument for getting rid of our current tax system and replacing it with a flat tax is that it would be easier. Yeah, right. Theoretically, that could happen. But taxes happen in real, not conjectural, life.

As noted in point #3, some politicians are muddying their flat tax waters with things like a VAT. And the other inequities for lower income taxpayers have prompted formulators of most of the current flat tax plans to keep some earnings thresholds and tax credits.

To help out lower wage earners cope with flat tax costs, most proposals include retention of tax breaks like the child tax credit and the Earned Income Tax Credit, or EITC.

Other plans would keep additional popular tax deductions, such as the mortgage interest write-off (used predominantly by higher-income earners) and the charitable donation deduction (again, a favorite of the wealthy).

If you're going to start adding things that you're getting rid of back, then it's not a flat or simple tax system.

5. Dealing with the debt.
When a flat tax erases the existing taxes now collected on higher income taxpayers, the money has to be made up somewhere or the national deficit grows.

You remember the deficit? It used to be a big political, particularly Republican, bugaboo. But flat taxers say it's not that big a deal. The single lower tax rate revenue losses, they say, will be made up by closing all the loopholes. Except, as noted in point #4 above, some of the loopholes, including some costly ones (EITC, mortgage interest write-off), will be put back.

During the Oct. 28, 2015, Republican presidential candidates' debate, CNBC's Becky Quick noted that Carson's proposal alone would leave a roughly $1 trillion hole in the federal budget. That analysis was confirmed by the fact-checking website Politifact.

6. A flat tax won't eliminate the Internal Revenue Service.
One of the arguments for a flat tax that always makes me chuckle laugh out loud is the idea that if we go to one rate, we can just shut the IRS' doors. Really? Really?

Uncle Sam will still be getting flat tax payments. That means that he'll still need a federal agency to take care of that collection. Sure, the process will change and theoretically (see #4 for my warning about this concept) we wouldn't need as large an agency.

But for all you I-just-hate-the-IRS-because-IRS folks, you're still going to have to pay your flat tax to someone within the U.S. government. Except that you won't, because we're not going to get a flat tax any time soon. 

For all its flaws, a progressive tax system still works better than any flat tax plans.

That's not to say that our current tax system doesn't need improvement. It does. And I'm hopeful that with some of the steps taken late last year, like making some tax provisions that were temporary under the extenders a permanent part of the tax code, lawmakers will take a serious look at tax reform in 2017 if not in the 2016 election year.

Rich taxpayers working the system: Until then, we'll have to put up with, as I noted over at Bankrate Taxes Blog last week, the reality that rich taxpayers tend to be rewarded under our current tax system.

The rich essentially have their own private tax system, according to the New York Times article cited earlier in this post. They've achieved this status because (1) they can afford to hire the best and brightest tax attorneys and accountants to work the current code to their advantage and (2) they support lawmakers and politicians who write the tax laws that they are able to manipulate.

Again, this needs to change. But not to a flat tax system.

Bankrate Taxes Blog logoAlso over at Bankrate last week, I looked at how an IRS security breach is still slowing down access to tax transcripts. That's a problem especially for students and their parents looking to get financial aid for upcoming college classes.

I usually post my additional tax thoughts at Bankrate on Tuesday and Thursday and then feature them the following weekend here at the ol' blog. Last week, however, in order to wrap things up a bit earlier so I could work on my New Year's Eve party plans, I posted on Wednesday, Dec. 30, instead of Thursday, Dec. 31.

OK, maybe I posted early because I found an item of interest on the 30th. The hubby and I didn't go out to a New Year's Eve party, opting instead to pop the cork on a bottle sparkling wine we'd had for a while.

Careful readers, however, have probably already noted a gap in my December Bankrate blogging. I took Christmas week off at Bankrate. But I'm back in the dual blogging routine as the New Year begins. And although it's January, next week will be the start of my weekly reports on my 2016 Bankrate tax thoughts.

Here's to a fun new year of tax activity at both blogs!

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