Ah, but we're not done yet. There is the not so small issue of the payroll tax, which currently stands at 15.3 percent. Although we are told that workers who pay this tax are contributing to their Social Security and Medicare benefits, in fact all the money is spent the very minute it comes in the door. If each of us were saving for our own retirement, we would need to put aside only half that much. Instead workers are paying 15.3 percent of every paycheck — not for themselves, but for someone else's benefits.
Moreover, unlike the income tax, the payroll tax is actually very regressive. That's because we only pay it on the first $110,000 of income. All income above that level gets off scot free. If we integrate the income and payroll tax, we're now looking at about a 20 percent tax on all income. That's a double tithe. And we're not done yet.
There are three other things to consider.
First, as I wrote in a previous post, it's in everyone's self-interest to have a tax system that makes the economy larger, rather than smaller. When people save and invest they are benefitting the rest of us. When they consume, they are benefitting themselves. That's why it makes sense to only tax that part of people's income that they consume. Practically this means that people would pay the flat tax on all income, minus the dollars they invest.
Second, we have a huge imbalance in our federal finances and it is probably unrealistic to think that the problem can be solved without some increase in the tax burden.
Finally, there is the whole question of whether this type of reform unduly benefits the wealthy at the expense of low and moderate income families. To deal with this objection, some flat tax advocates (Dick Armey, Steve Forbes, etc.) include a generous standard deduction for everyone. Advocates of a national sales tax include a generous rebate for everyone. Sometime back, my colleague Larry Kotlikoff and I decided that this approach gives away too much money to people who don't need it (e.g., Warren Buffett) while leaving important social goals unmet.
As an alternative, we proposed a generous rebate to the bottom third of taxpayers to solve other social problems. For example, to get one-half the rebate, low-income families would have to produce proof of health insurance. This would encourage millions of people who qualify to enroll in Medicaid or in their employer's health plan. Barring that, families could apply the tax rebate to health insurance they purchase on their own. We propose making the other half contingent on proof of a pension, an IRA, a 401(k) or some other savings account.
So instead of national health insurance and more government spending on the elderly, we would use our flat-tax proposal to urge people to solve these problems on their own.
We called our proposal a "progressive flat tax." The reason: under our flat tax the rich would bear more of the tax burden than they currently do.
So where does that leave us? With a flat tax rate of about 28%. Interestingly this is the rate Ronald Reagan left us with as part of tax reform in 1988.