The Truth About the Flat Tax Proposals

Reforming the tax code One of the themes of every presidential campaign seems to be reforming the tax code. After all, it is something that most people hate to deal with, so it’s a safe subject. Some candidates are again proposing a Flat Tax. It sounds simple and most people would love something less complex.

Then there are the candidates who don’t want to repeal the entire tax code, but blame its complexity on the graduated rates and unfair deductions. That’s not the problem either. The politicians and political pundits focus on rates in an effort to distract voters from the real argument or because they simply don’t understand the economics.

The trouble with a flat tax with one rate is that it would be harmful to most Americans.

Middle and upper-middle class citizens would be paying a disproportionately high share of the tax burden compared to the extremely wealthy and people who make their living from investments would be able to shelter income and pay no taxes at all. Then you would have to add more rules and stipulations to prevent abuses, which brings us right back to where we are today; a basic idea loaded with complexity to deal with all the different ways that people make money in our economy.

Most people don’t realize that we already have an income tax code with a framework that’s very close to the flat tax theories being proposed. Our current tax code starts out by saying that all WORLDWIDE income, regardless of source, is taxable. The problem lies in how we calculate “income” and imposing a flat tax on income doesn’t solve the problem. It still leaves the question, “What is income?” unanswered. Because of the complexity of the American and global economies, our current tax code attempts to "level the playing field" by using thousands of lines of rules and regulations.

But for arguments sake, let’s assume we did change the income tax code to a single rate that states, “All income will be taxed at 20 percent.” It would be easy to apply that rule to W-2 wage earners. Just take the amount of money an employee earned in a given year (without deducting amounts paid for health care and retirement) and multiply that number by 20 percent. Done. Expensive, but done.

But how do we determine what the income is of people who don't earn their money as a W-2 employee?

That's the problem. Now more explanations have to be added to a flat tax code to specify when passive real estate investors earn income and when they don’t. You have to specify when derivative traders have earned income and when they haven’t. There are hundreds of exceptions. In fact, in the tax code and Treasury regulations there are hundreds of examples of scenarios where taxpayers don’t have an obvious income. And these scenarios have to be defined so that shrewd tax evaders and their advisors can’t shift income and create fake paper losses.

Our current system already has very extensive rules protecting taxpayers from the abuses of the dishonest, such as the carried interest provisions of the partnership tax laws, capital gains and loss rules, dozens of tax credits and itemized deductions. There are well defined examples and case law designed to protect the majority of us from being burned by the people who are willing and able to create false tax losses.

An example of these are the “at risk” and “passive activity loss” rules that are designed to block tax shelters used to generate bogus, paper losses. This is one of the most areas of the tax code that will make a tax professional tear out their hair, but it is also one of the most necessary to make our income tax system fair to those who aren’t trying to evade paying taxes. Otherwise, it would be possible to invest in numerous tax shelters and end up paying little or no income tax — providing you could afford the minimum capital contributions.

Donald Trump complains a lot about the passive activity loss rules because the law governing passive investments is intricate and confusing. But when businessmen have dozens, sometimes even hundreds of real estate and other business ventures, figuring out whether they really have generated income, or are just using these vehicles to distort their earnings, is a daunting task. It’s complicated, tedious, time-consuming, and expensive. These rules help level the playing field by preventing easy abuse.

There are currently problems with corporate inversions and the repatriation of foreign income, but that's because we have the highest corporate tax rates in the world. There are certainly an overwhelming number of itemized deductions and individual tax credits, but these can be easily fixed. These are policies that the candidates should be talking about; bringing money pouring into this country by making the U.S. one of the lowest business tax atmospheres in the world and getting rid of most of the deductions and credits. That alone would simplify our tax code by half, instead of getting rid of all the rules meant to protect us.

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