So What if We Had a Flat Tax?

Last year, the CBO released a report on historical effective tax rates. I ran through the data with an odd goal in mind. I wanted to see if I could replicate the existing tax burden with a simple flat tax.

I don’t mean to say that I’m a flat tax advocate. I simply wanted to look at what Americans actually pay and see if I could mimic the real thing with the simple rules of a flat tax.

The answer is, not really, at least not very accurately. The CBO report only gave me eight data points to work with.

Still, this type of analysis has value. In fact, there are emerging fields of study, like Chaos Theory, that look to find simple rules that lie beneath highly complex structures.

Here’s what I was able to come up with. The graph below is my Faux Flat Tax going back to 1979. The blue line follows the left scale and is the flat tax rate. The black line follows the right scale and is the standard household deduction. The deduction is in 2009 dollars.

For 2009, I came up with a tax rate of 29.81% and a deduction of $41,541. So every penny a household makes under that is completely tax free. Every penny above it is taxed at 29.81%. That includes everything—income taxes, social security, Medicare, corporate taxes, the whole shebang. And most importantly, we can abolish the IRS (wait for applause).

I realize these aren’t quite the numbers that most flat taxers have in mind, but my goal is mimicry. I took the current tax code “as is” and tried to be revenue neutral. Obviously, if I had more data points I could be more accurate.

Looking at the table does reveal some interesting information. When the two lines rise, the tax code becomes more progressive (higher taxes on the rich and less on the poor). When both lines fall, the reverse happens.

What I find interesting is that despite using just eight data points, there seems to be some continuity through the years. So even if I had much more data, I think this is a reasonable approximation of what a clear-the-table flat tax would look like.

Notice, for example, how the two lines tended to track each other somewhat for most of the 1980s and early 90s. So there was some method to the madness. The relationship only broke down over the past few years as we’ve seen larger deductions and lower tax rates. The big spike in deductions near the end represents the effect of the payroll tax holiday.

One of the drawbacks of my flat tax is no matter how impressive my R-square is (.9994 in 2009), any small deviation can be rather unpleasant for certain taxpayers. That’s the messiness of using a simple model to replace a complex one. The flat tax doesn’t quite capture the right “bend” of the current tax burden. For example, under my flat tax, households making $93,800 would have a tax hike of more than $1,400. I don’t think they would be terribly impressed by my stab at being revenue neutral.

As a general rule, my flat tax is close to the current burden but it tends to be slightly more progressive. The major reason is due to social insurance taxes. Since so many lower-income workers are completely exempt from any taxation under my theoretical flat tax, it’s made up for with higher taxes at the upper end.

Let me explain how I got my numbers. I apologize but this is going to get mathy. In the data files of the CBO report, Tab 1 has the effective tax rates and Tab 3 has the pre-tax income for eight subsections; the lowest four income quintiles, plus four subsections for the top quintile (percentiles 81 to 90, 91 to 95, 96 to 99 and the Top 1%).

If you run a scatter plot with the X-axis being the eight income points and the Y-axis being the tax paid (income times effective tax rate), you get this:

That’s for 2009. Using the trend line function, I added a linear trend line and the linear equation is also included. In the equation, y = mx + b, m is our flat tax rate and b/m is the deduction. As you can see, that’s how I got 29.81%.

Here’s the Flat Tax Data I used for the computations. Columns B through I have the household incomes for the eight groups (note that the definition for household income changed in 1986), columns J through Q have the taxes paid and columns R through Y have the effective tax rates.

On lines 35 to 66, I list the flat tax info. Column B has the tax rate by using the SLOPE function. On Column C, I get the deduction by using the INTERCEPT function.

Posted by Eddy Elfenbein on April 9th, 2013 at 10:24 am

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