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smooth · 11-24-2004, 12:02 PM

Here is an exploration of the NST issue from the other side of the aisle:

Quote:

Why Fairness Matters: Progressive Versus Flat Taxes

By Robert J. Shapiro

Editor's Note: The full text of this report is available in Adobe PDF format, only. (Requires Adobe Acrobat Reader.)

Executive Summary

Tax reform is Washington's latest answer for the discontent Americans feel with national politics and their own economic prospects. Several presidential hopefuls have promised to replace the current system with a new flat tax or a national retail sales tax, and others would substitute a new consumption-based income tax. Among the various proposals, the flat tax in particular has gained a following, probably because it purports to use tax reform to change politics as well as the economy. As we will see, its advocates claim too much. In fact, their analysis of the current tax system is often wrong. Their promise to reform politics is largely empty. And the policy would probably leave the country worse off, both socially and economically, than it is now.

The three basic measures of a sound tax system and sensible reform are simplicity, growth, and equity; none of the current reform strategies meet all of these tests. The key to the initial popularity of a flat tax is the first measure, its radical simplicity. It would abolish almost all tax deductions, credits, and exclusions in both the personal and corporate income taxes. Make no mistake, such simplification is sound economics. The less the tax code influences how people and firms consume, save, earn, and invest their income, the more efficiently America's markets can allocate the economy's resources. And by broadening the tax base, simplification allows us to raise the same revenues with lower tax rates and lower tax rates, like lower taxes, are almost always better for an economy.

The public is drawn to drastic tax simplification, however, because it sees it as an attack on the quiet arrangements and tacit corruptions that allow powerful industries and wealthy people to secure special tax treatment. Even so, the flat tax plans offered by Rep. Richard Armey or Steve Forbes would not deliver such political reform. While they would repeal scores of special provisions used today by profitable businesses and wealthy people to shelter part of their income from tax, they wouldn't end the privileged tax status of the well-heeled. That's because both plans would replace those special provisions with new and much broader tax exemptions covering all personal income derived from interest, dividends, or capital gains, and all business income used for capital investment.

Flat tax advocates defend these blanket exemptions by shifting the argument from political reform to the second measure, economic growth. Sharply progressive tax rates, they insist, discourage the most productive people from working and saving more, which in turn reduces growth for everyone. The flat tax's answer has two parts. First, it would eliminate the personal tax on income from savings and replace progressive tax rates with a single flat rate on the income from labor. Second, it would channel new savings to traditional capital investment by allowing firms to deduct the full cost of new purchases of plant and equipment.

This defense relies on faulty data and flawed economics. The data, first, refute the claim that the current federal tax burden is sharply progressive. Taking all forms of federal taxation into account personal and corporate income taxes, payroll taxes, and excise and estate taxes middle class families already pay roughly what they would under a pure flat or proportional tax, or a little less. The federal tax burden on the most affluent people is only modestly greater. Even for the richest 1 percent of Americans, more than 70 percent of the taxes they pay represent merely their proportional share of the costs of government.

Second, the 1980s demonstrated that tax cuts for various forms of personal savings and business investment have little effect on overall saving and investment rates. In 1995, despite more than $120 billion in direct tax incentives for personal saving, the U.S. personal savings rate remained less than 5 percent. And even if such tax incentives did work as flat taxers claim, that wouldn't guarantee higher national growth. Studies of what makes the U.S. economy grow have found repeatedly that technological innovation and improvements in the skills of the work force are six-to-seven times more important than business investment in plant and equipment in promoting higher growth and incomes. As a result, the flat tax growth strategy has a serious problem of scale: To achieve a permanent 1 percentage point increase in economic growth, we would have to nearly triple our current national savings rate.

In an upcoming report, the Progressive Foundation will offer a growth-oriented strategy for tax reform designed to stimulate not simply savings but economic innovation, efficiency, and productivity. In this report, we will examine and analyze the current system and the principal proposals to change it through the optic of tax equity and fairness.

The terms of tax fairness

Fairness in the tax system matters because tax collection depends vitally on voluntary compliance. Paying taxes is also most Americans' chief point of contact with their government, and probably their closest approximation to a common civic experience. Yet, some analysts today dismiss equity issues and, with increasing boldness, insist that regardless of their effects on fairness, all tax cuts are desirable because government's right to tax is less than fully legitimate.

Behind this disdain for tax fairness lies a critique of democracy itself. It posits that the economic choices of individuals are morally superior to the political decisions they make as a community because in some important sense people are "natural" while governments are merely "artificial." Those who make this case misunderstand markets as well as democracy. Society probably cannot maintain itself without individual property rights, but the economic activities that produce property occur within a fabric of relationships shaped by the social and political institutions that people create for themselves. Individuals exercise their economic choices, then, within associations and corporations, which are creatures of the law, and so also, of the political decisions of communities.

Without a doubt, most people don't enjoy paying taxes. But in a democracy like ours, people contribute private resources to provide the public goods they deem appropriate as a community, including helping those unable to make their way by themselves. In America, paying taxes embodies a civic relationship of mutual responsibility, and people's obligation to pay them is as legitimate as any other public duty.

Among those who do not question a citizen's obligation to pay taxes, there are two broad views of the meaning of tax fairness. Fairness under a proportional or flat tax emphasizes equality: Everyone should be subject to the same tax rules, and therefore, everyone should pay taxes at the same tax rate and bear the same relative tax burden. By contrast, fairness under a progressive tax system stresses people's different circumstances: All people should pay taxes according to their ability to do so, and therefore, the tax system should exempt the poor and apply to everyone else tax rates and relative tax burdens that increase with income.

Conservatives generally believe that a flat tax will best protect people's individual liberty, because by burdening everyone equally, it creates the broadest constituency possible for limiting government's demands on individuals. Moreover, because a truly flat tax imposes an equal economic burden on everyone, it does not affect the market's distribution of income. This provides the basic measure of a genuine proportional tax: Each person and each income group claims the same share of national income after paying taxes as it did before paying them. And this is thought to be just because, from a conservative's vantage, markets distribute income based on how hard and well people work.

On the other side of the debate, liberals generally believe that progressive taxes protect individuals better than a flat tax, by curbing concentrations of economic power that threaten the opportunity of others, and by providing poor families with the resources they need to live independently. From this vantage, people's incomes reflect not only their own efforts but also a universe of circumstances they cannot affect; therefore the market's distribution of income is not the final word on economic justice. True equality of opportunity becomes a social achievement, one that tax progressivity advances by changing the market's distribution of income. This provides the fundamental measure of a progressive tax system: After paying their taxes, those at the top are left with a smaller share of all national income than before, and those at the bottom a larger share than before.

Both approaches to fairness can claim some basis in economic theory. The economic logic for a pure flat or proportional tax rests on the basic market notion that people produce economic goods and services because they expect to reap economic benefits. All taxes reduce the benefits people receive from working and investing but, the argument goes, a flat tax should discourage work and saving the least because a system with only one tax rate will have the lowest possible top tax rate. In addition, a market will produce goods and services most efficiently when its resources are allocated through prices that directly reflect everyone's individual preferences and taxes should reflect the "prices" people would pay for the public goods provided by government. Since traditional public goods such as national security or public parks benefit everyone equally, efficiency dictates that everyone pay taxes at the same rate to finance them.

The economic theory behind progressive taxation begins by separating the tax system from the economy that provides its resources. By this view, people work and save because they need or want certain benefits. The existence of taxes does not change those needs or desires, and so should not discourage work and saving. Therefore, tax rates could reasonably rise with income without imposing additional economic costs. In addition, just as an efficient economy uses its most productive resources first, until the cost of using more of them equals the cost of using something else, so an efficient tax system should provide that all taxpayers bear an equal sacrifice. From this optic, tax rates should rise with income, so that an additional dollar of tax entails the same sacrifice by people at every income level.

By itself, economic theory cannot choose between the two cases, and hard economic evidence does not fully support either side. As near as we can tell, tax rates do affect work effort and savings, but only when the rate is very high, and then only to a modest degree. Moreover, the impact of high tax rates is even smaller when people can protect their income from these rates by claiming various deductions, exemptions, and exclusions and that's almost always the case. Yet, relatively high tax rates and tax burdens also cannot produce economic equality. Progressive taxes apply only to people's annual income, not to their accumulated wealth, and so have only modest effects on concentrations of economic power. Moreover, while high income people don't stop working or saving because their marginal tax rate is high they find ways to avoid it or live with it the transfers financed by their taxes can affect the work efforts of those receiving them. In any event, lifting tens of millions of low income people into the middle class by direct income transfers would require much higher taxes not just on the wealthy, but also on strapped middle class families.

Ultimately, progressive taxation has the better of the argument. Flat taxers may be right that it would be morally offensive to tax higher income people more heavily if differences in income reflected only how hard different people work. But income differences reflect much more than that, if only because people don't start in the same place. People are born with different talents and come to age in families, neighborhoods, and cultures with different resources to prepare them for market competition. And plain luck often plays a role.

America's wide-open markets accentuate the impact of all these factors, so that those with more ambition, self-discipline, and talent can prosper greatly. Bill Gates and his investors, for example, would not have enjoyed as great a success in other advanced countries because their markets and laws would not have provided so hospitable an environment. And once a person or family's economic success is secured, America's open markets allow them to increase the value of their wealth at a greater rate than in most other places. The economic benefits of free markets are large and obvious. But there are social costs, because our open markets and laws also produce harsher economic inequality than in other advanced countries an urgent issue today when economic inequality is increasing rapidly and for reasons that most working people can do little about.

Progressive taxes cannot undo this inequality or restore upward mobility to poor or middle class Americans not even progressive taxes to finance transfer programs. A progressive tax system, however, can protect poor and middle class families from bearing the higher tax burdens entailed in a purely flat or proportional system, and in this sense, ameliorate some of the distributional inequalities achieved through our markets but based on factors other than how hard different people work. And the additional burden of progressive taxation is a reasonable price to pay by those who in some respect start with more, for the privilege of prospering relatively more under America's laws and in her markets. Bill Gates and his investors have a responsibility to not merely bear an equal share of the burden, but a greater share because they enjoy a larger share of the benefits provided by these laws and markets.

Furthermore, when accidents of birth and luck affect people's ability to succeed through hard work, economics as well as social considerations can dictate that they receive the means and opportunity to participate more fully in the economy. At the very least, the tax burden to finance these efforts should be progressive at the bottom so that the tax system does not further impair the ability of low income people to participate. At the top, people with higher income can contribute, within limits, without harming the economy or their own basic freedom. In the end, progressive taxation can trade off the benefits of ensuring a broader distribution of opportunity against the modest costs of higher tax rates and higher tax burdens on some to finance it.

Who pays the taxes

As we will see, the current federal tax burden including the personal and corporate income taxes, payroll taxes, excise, and estate taxes is most clearly progressive at the bottom of the income ladder. The total burden is also progressive at the top, but only moderately so and much of that reflects income tax changes enacted in 1993. For the broad American middle class, the tax system is, on balance, more nearly proportional than progressive, barely affecting the share of national income held by most families. Finally, while everyone would like to pay less taxes, evidence suggests that a substantial majority of Americans would prefer a little more progressivity, so that low income families could pay a little less than they do today and very affluent families would pay a little more.

The current distribution of all forms of federal taxation can be summarized in the following five findings:

First, everyone bears some of the burden. Higher income people pay the bulk of all federal taxes mainly because they earn the bulk of all income, but even families living in poverty pay on average more than 6 percent of their income to the federal government.

Second, a family's tax burden rises most sharply as it moves up from poverty to the middle class; beyond that, the tax burden increases with income at a more modest rate. A family living on $6,000 a year pays roughly 6.4 percent of those resources in federal taxes, and as its income increases to $25,000, the share it pays in taxes nearly triples to 16.8 percent. If the same family increased its income 20-fold more, to reach $500,000, its tax burden would only double to 32.7 percent.

Third, two groups bear lighter tax burdens than others: Elderly people pay significantly less than younger households with comparable income; and at low and moderate income levels, families with children pay less than other households. Lower taxes on families with children reflect the intended effects of the dependent's exemption and the earned income tax credit (EITC). Lower taxes on the elderly are mainly an indirect consequence of taxing much more lightly the capital income and Social Security benefits on which many elderly rely than the wages and salaries on which working families depend.

Fourth, the total federal tax burden is genuinely progressive at the bottom and at the top of the income ladder, and roughly proportional for everyone else. Relative to the current tax system, a pure flat or proportional tax system would leave poor families with 16 percent to 22 percent less to live on than they do today, and the wealthiest 1 percent with 12 percent more. For virtually everyone else, a truly flat system would raise or lower their disposable income by less than 3 percent.

*Fifth, higher income people bear all of the current costs of tax progressivity, but these costs have only moderate effects on their total income. Only families earning more than $75,000 pay more today than they would under a pure flat tax system. Even for those who earn $500,000 a year, the progressivity of the current system accounts for less than 30 percent of their taxes, and this additional burden represents less than 10 percent of their income.

Fairness and tax reform

Plans to broadly reform federal taxation, especially the flat tax and national retail sales tax proposals, would leave the system much less progressive and much less fair. Under the current arrangement, basic fairness is provided through six progressive elements. At the bottom, (1) an exemption for initial income protects poor families from income tax, and (2) the EITC, in effect, refunds part of the payroll tax and other tax payments of working poor families. For everyone else, (3) tax rates on personal income rise from 15 percent to nearly 40 percent as income increases. And for those at the top, (4) most of the value of their personal deductions is phased out; (5) federal corporate taxes affect mainly owners of capital, who are predominantly affluent; and (6) estate taxes affect only the very well-to-do.

Flat tax. The Armey and Forbes flat tax proposals would repeal four of these six elements the EITC, the graduated tax rates, the phaseout of personal deductions at the top, and estate taxes. The repeal of the EITC, in particular, would worsen the poverty of millions of working poor people and their children. However, the proposals would help many moderate income families, by expanding the current tax exemption for initial income. Yet, the benefits of this change would not be felt by many middle class taxpayers who would lose their personal deductions for mortgage interest, pension contributions, and state and local taxes.

There's no easy way for the flat tax to avoid this problem. Simply preserving the mortgage-interest deduction won't work as long as the flat tax also exempts interest income from tax. If flat taxers tried to allow people to deduct both the interest they pay and the interest income they receive, anyone could take out a second mortgage and deduct the interest cost and then invest the money and exclude the income it earns. The result would be pure tax leverage, producing taxpayer-financed transfers to those holding the greatest home equity, a revenue hemorrhage, and financial distortions as the nation's capital was channeled through second mortgages.

A pure and comprehensive flat tax system wouldn't have this problem because it would tax all income the same, whether it comes from labor or capital. And a pure proportional tax would affect the disposable income of most middle class families very little, one way or the other. The current proposals, however, cannot avoid imposing higher taxes on most middle class Americans as the original architects once noted themselves because they would not tax capital and labor the same. Instead, the Armey and Forbes plans would shift more of the total tax burden to labor, because capital would be taxed once under a business tax while wages and salaries are to be taxed twice under both the income tax and the payroll tax. The middle class has to pay more under such a system, and the wealthy much less. That's because virtually all of the income of average families come from wages and salaries, with only 6 percent to 10 percent coming from capital, while people at the top derive much less of their income from labor but 35 percent to 48 percent from the interest, dividends, and capital gains receipts exempt from personal tax under these plans.

Initially, however, the flat tax would likely depress the market value of all corporate stock, by strongly favoring new investments in plant and equipment over existing business capital. Still, by one preliminary estimate, these plans would mean at least $30 billion more in taxes paid by families in the bottom half of the income distribution, and $50 billion less in taxed paid by those in the top 20 percent.

National sales tax. A national retail sales tax has an even more troubling effect on tax fairness. This approach would repeal all six progressive elements in the present tax system: Along with eliminating the EITC, graduated tax rates, the deduction phaseout, and estate taxes, the plan also would repeal business taxes and the exemption for initial income. Further, it would create an unlimited tax deduction for new saving and investment, favoring those with high income, since poor and middle class families have to consume much larger shares of their income. The only progressive feature of a sales tax approach is an implicit tax on existing wealth, since people would pay the tax whenever they sold an existing asset and spent the proceeds. By one preliminary estimate, such a proposal would more than double the effective tax burden on the poor and substantially raise the burden on middle class families, while providing enormous tax relief to wealthy families.

Under the flat tax or a national sales tax, for the first time in American history the tax system would redistribute income towards wealthy people. Families at the top of the income scale could claim a larger share of all national income after paying their taxes, so that the tax system would actually reinforce the country's growing inequalities in income.

USA tax. Of all the current major reform proposals, only the Unlimited Savings Allowance (USA) tax plan of Sens. Sam Nunn and Pete Domenici would have little adverse effect on fairness. This plan would exempt new saving and investment from federal income tax, including all inheritances, but it also would preserve the EITC, graduated tax rates, business taxes, and a substantial exemption for initial income. While including some modest simplification, especially for the corporate tax, the plan retains personal deductions for mortgage interest and charitable contributions and creates a new deduction for college tuition. It also would offset some of the regressive effect of its exemption for new net saving and investment by providing workers a new tax credit equal to their payroll tax payments. In addition, it would create the same kind of implicit tax on existing wealth as a sales tax. Nevertheless, in order to maintain roughly the same progressivity as exists today, the proposal requires higher tax rates than those imposed currently on income which is not saved or invested.

Robert J. Shapiro is the director of economic studies of the Progressive Foundation and vice president of the Progressive Policy Institute.

---http://www.ppionline.org/ndol/print.cfm?contentid=1398

KMA,

do you see why Manx and myself understand the NST to be a regressive taxation structure?
Do you agree with us?

The article you provided doesn't dispute the regressive nature of the NST, but rather attempts to patch it to reduce the regressivity within it. It's important to note who the audience of that position paper is directed toward. The assumption made before the model was created is that someone is paying too much tax. So the model attempts to answer the question of how do we reduce the tax burden on that particular payer and implement a more fair system.

The attempt is not to reduce taxes for everyone. I didn't see it in that paper, but hopefully CATO didn't say it would--because that would put them in a pretty untenable situation. I was surprised when you asked how this would negatively affect the middle class. Restructuring the tax burden is not going to lower taxation for everyone; instead it will move that burden around because it is a discussion on where, not whether, the burden should fall.

When I say something like that study came from CATO or this one comes from the Progressive Center, I'm not asserting one should reject one in favor of the other based on that information. But one must evaluate the assumptions the authors are operating under and who their target audience is. Neither the CATO position nor the Progressive Center's position is attempting to solve an objective problem. They are both trying to solve a problem for their respective audiences.

Without knowing your specific income situation, I can only guess whether you are the intended audience of the CATO Institute. Have you taken all your receipts from the past ten years (including housing

)? That average would give you a more clear picture of your expected burden. But if you don't have those figures, at least roughly figure the past few years before deciding that you wouldn't be economically harmed by this shift.

If you find that you are not, it's important to realize that the goal of this position is to reduce the tax burden on the wealthy. If your taxes are reduced and/or remain stable, but the wealthy taxpayers' burden is reduced, then we need to add a new phenomenon into the equation: where does the government make up lost revenue.

The historical answer has been to increase fees. So this means that if you like to go to national parks or go gaming or other recreational activities, you might pay $60 dollars for your fishing license instead of $24. Park entrance rises from $10 to $30 per day, for example. These costs need to be figured into your share of the burden of the cost of government services.

Another part that needs to be figured is how state's will receive money. Will they charge a per usage fee for police assistance, or will they just raise overall rates?

Now, it's important to watch where the position claims loss of revenue is going to come from. They may claim that there will be no loss of revenue. That is, maybe the market will produce enough to make up for the loss. But we can look at the historical record to interrogate the probability of that. The important thing to note is whether the position gives a good enough account of where the increase is going to come from. Even if the position believes the market will make up for the decrease, it ought to provide an alternative scenario in case the market doesn't adjust or provide enough. If it doesn't, why not?