Thoughts on Flat Taxes

Written for the RENUA flat taxes event today.

When all the little economists are in short pants, we learn the principles of public finance. Governments have to tax households and firms in order to provide services the market won’t, like libraries, street lighting, and national defense, as well as redistributing income from the rich to the poor as an aid to social solidarity. Taxes are a necessary evil. All taxes induce distortions to people’s behaviour. Some distortions, like the plastic bag tax, are clearly good. They make almost no one worse off and make lots of people better off. Recurrent taxes on property are in fact the least distortive to long run GDP per capita we have. While a site value tax would have been perfect, the LPT does a similar if suboptimal job.

Some taxes are highly distortionary, such as a very low corporation tax rate, or a very high income tax rate. These make lots of people better (and worse) off and damage important incentives. An efficient tax structure would deliver the funds to power public services with the minimum of distortions to individual and collective incentives. The theory of public finance has come around to the view that marginal taxes are not the most important thing to worry about, in information-opaque systems, the average tax rate should be relied on most heavily. The all-in tax rate for personal income tax & employee social security contributions is 52% here, relative to 46% on average across the OECD.

Perhaps more importantly, the ability to balance the average tax rate with a corruption-resistant tax structure through which taxes are collected and disbursed is a major asset of any public finance structure.  Important results have now been established showing the spread of corruption is quite badly affected by the ease with which the variables which determine the tax base can be manipulated by those in power. If we worry about the Noonan-end of the tax gathering element first, then, two principles which therefore make sense are simplicity and certainty with respect to the tax system.

None of the above is an argument for a flat tax: they are desirable elements of any taxation system. Given what we know about the Irish taxation system and its highly pro-cyclical features, we are aware that how the taxes are collected, and from whom, matters. The income tax system is really complicated by many tax credits, reliefs, exemptions and deductions. Figure 1 shows in percentage terms just where we got those taxes over the last 10 years or so. The transition to an income-tax based system by 2015 is clearly a result of large negative changes occurring elsewhere in the system, and I needn’t spend time on that for this audience. Figure 2 shows who pays these taxes, and in what quantities. Clearly there are progressive and regressive elements within our taxation structure, with the poorest households paying a whack of their income in taxes, and the richest 30% accounting for the vast bulk of the taxes we need to run the system. Only 18% of all tax payers pay the higher rate, while 45% pay the standard rate and 37% are exempt. Figure 3 shows the disjunction we have between our average and marginal tax rates by income category.

Figure 1. All taxes as % of annual total. Source: Revenue Commissioners.

The system, by the way, costs about 44 billion to run in a given year, before we think about paying interest on the national debt or other obligations. A de minimus requirement of the flat tax would be that it generates as much, or, more, in revenue, as the current system—roughly €18 billion by the 2016 forecast. But more on that in a few paragraphs.

Figure 2. All-in tax rates, by decile and source tax, ca.2010. Source: Collins 2014.

Figure 3 shows Ireland’s taxation system is pretty biased against those starting up businesses, and those in the €30,000-50,000 threshold, who get hit with the same taxation structures as those on €100,000, but without the creature comforts or access to accountants to allow them to offset these impositions. The marginal space is non-linear, while the average space is fairly curva-linear. The theory of public finance suggests that when the tax is collected only from one sector of the economy, the effects are highly distortionary and suppressive of economic activity. Differentiating who actually pays taxes and in what amounts therefore makes lots of sense purely on equity grounds.

Figure 3. Average and Marginal Taxes. Adapted from O’Connor et al (2015).

The system is a mess. Starting from scratch, you would not start here. Does a flat tax deliver large changes to the system? The advantages of a flat tax are simplicity, a constant average tax rate, and no weird threshold effects. It would be corruption resistant since, with one stroke, you would remove large chunks of the tax code to the trash bin.

A flat tax works by levying a percentage on all income above a minimum threshold. The welfare loss to the poorest households. Single people earning less than €20,000 and married couples earning more than €30,000 both are taxed at a rate less than 5%, for example, in the current system. They would clearly need to have their income taxes under a flat tax system offset using a tax credit, which drains the system some what.

The political considerations would be quite large in the calculation of where the tax credits and the rate would go.

To my mind, given the system that we have now, a move towards a flat tax rate of 35%, with quite a large basic income support of €4,000, would move the system towards a minimal distributional impact. A 23% policy would be harmful to the poorest in the current set up, with the winners here being those at the top of the income distribution.

Update: Karl Whelan wrote on the subject of flat taxes a while ago, I missed it, his thoughts are here

Contrast this to a simple change where the USC is put in place of the current income tax structure, with a non linear pickup from 2%, 11%, 17% in rates towards the OECD average of 46%. This would yield the magic €18 billion but would of course be hugely regressive.

So here, then, is the challenge RENUA faces: it has to calibrate its flat tax to be as progressive as possible while making the system produce €18 to €20 billion or so a year. This is a technical challenge but perhaps the more difficult challenge will be explaining the taxation change to the public.

Comments

comments

Author: Stephen Kinsella

Senior Lecturer in Economics at the University of Limerick.

22 thoughts on “Thoughts on Flat Taxes”

  1. Stephen, many moons ago a flat tax/basic income scheme was analysed by Patrick Honohan.

    Honohan, P., (1987): “A Radical Reform of Social Welfare and Income Tax Evaluated”, Administration, , Vol. 34, No. 1, Spring 1987, pp. 69-87.

    As I recall, conclusion was that it was very difficult to match the then existing system in terms of revenue without a high rate of flat tax and/or a high withdrawal rate of the basic income (i.e. basic income reduces as pre-tax income increases so its not really a basic income/flat tax system at all).

  2. “Some taxes are highly distortionary, such as a very low corporation tax rate”
    This seems backwards to me. Given the relevant elasticities, surely a low corporate tax rate is much less distortionary than a high one?

    “The theory of public finance has come around to the view that marginal taxes are not the most important thing to worry about, in information-opaque systems, the average tax rate should be relied on most heavily.”
    Could you expand more on this? (Via citations, etc.)

    “The income tax system is really complicated by many tax credits, reliefs, exemptions and deductions.”
    The Irish tax system is quite good on this count. For example, the German tax system has at least 500 deductions (Dorrenberg, Peichl & Siegloch, 2015), and the US system is essentially impossible to understand.

  3. As you say the existing system is extraordinarily complex – the result of layer upon layer of tweaks executed with the prime objective being optimal political optics.

    What follows from that is the near necessity for many of payments (or you might say, “rents”) to the industry which is a direct beneficiary of the complexity – accountancy. Don’t expect this highly influential sector to have any enthusiasm for simplification.

    Also, a minor suggestion. I suspect a small number of nerds will lap this up:

    “The marginal space is non-linear, while the average space is fairly curva-linear.”

    …but wrt accessibility (and reach), if you don’t want to loose, via the jargon channel, vast swathes of non-nerds, or ex-nerds, something like this might be more useful:

    “There are dramatic and sudden shifts in marginal tax rates, while average tax rates move gradually and smoothly as incomes vary”.

  4. Prof. Madden,
    It is all quite simple. RENUA big idea of 23% flat rate requires a low/no basic income and cuts in allowances and credits to get anywhere near the current level of revenue. It also requires actual cuts in public expenditure to be budget neutral. In effect it involves redistribution from the rest of Ireland to the south side of Dublin.
    It is clever enough to get Lucinda a car with a star but will probably be negotiated to death in any deal with other parties.
    It is catchy enough to get Lucinda into a car with a star

  5. Huh? What is complex about adding more tax thresholds, in order to provide more progressive scaling of income tax? How is a flat tax superior to that?

    We want a progressive tax system, not a regressive one – and we know that even with a flat tax, people with a higher income are still going to be gaming the tax system, to pay far less than the headline tax – a good reason in itself, to add new/higher thresholds.

    Be careful with the Basic Income idea:
    That can be transformed into a business subsidy very quickly, by businesses slashing wages – and can then be used to attack welfare, by eliminating all other welfare programs, and then attacking the Basic Income program in the future – makes it a lot easier politically, to consolidate destroy welfare.

    I’m really surprised to see you supporting Renua – and promoting policies which are ultimately regressive like this, supporting shifting taxes from business and higher earners, onto the wider public.

    I know you’re taking a ‘wipe the slate clean’ type look at this, and want the Basic Income to avoid some of the regressive tendencies of the flat tax, but you need to be more careful and cynical – the basic income is a bit of a ‘trojan horse’ type policy, that can be used to backdoor some very regressive policies alongside it.

  6. Well, if this site has reached the point where it’s carrying water for the RENUA cranks then I think it’s stopped serving whatever purpose it ever did.

  7. Ben,
    It is not carrying water for Renua. Read the posts. If it is doing anything it is pouring cold water all over the policy & that is being polite.

  8. “Figure 3 shows Ireland’s taxation system is pretty biased against those starting up businesses, and those in the €30,000-50,000 threshold, who get hit with the same taxation structures as those on €100,000, but without the creature comforts or access to accountants to allow them to offset these impositions.”

    A less loaded way of putting it would be: “Figure 3 shows that the system is biased in favour of those making €100,000 to €1,000,000 or more who are able to enjoy great luxury while paying tax at rates that are broadly the same as those paid by taxpayers making 1/2 to 1/20th (or less) what they make.”

    Yes, the tax system is hard on the middle class and the poor. That is not a bug, it’s a feature, for only by being hard on those groups can it achieve the goal of going absurdly easy on the very wealthy. A flat tax will only exacerbate this.

  9. @ Stephen Kinsella:
    I must take issue with you on some points:

    1.You state: “Some taxes are highly distortionary, such as a very low corporation tax rate, or a very high income tax rate. These make lots of people better (and worse) off and damage important incentives”. The distortionary effects are not a matter of the numbers affected, but also depend critically on the magnitude of effects on individuals. In the case of low corporation taxes, they are not so much a cause of distortions in the usual sense of price or output decisions of firms, but are a result of competition between tax jurisdictions for mobile activities. The treatment of debt interest in corporate tax codes may however be highly distortionary in encouraging high levels of debt as opposed to equity finance.

    2.You write about “the Irish taxation system and its highly pro-cyclical features”. Irish fiscal policy may be pro-cyclical, but this is because of changes in taxation (and public expenditure) which are quite different to the structure of the tax system, which is what I presume is at issue in this discussion.

    3. Your Figure 1 indicates an increase in the share of tax revenues coming from Income taxes and a reduction is the share of VAT and excise since 2008. This has probably increased the overall progressivity of the tax system

    4. Your Figure 2, on the incidence of tax by income decile in 2010 reproduces the apparently very regressive incidence of VAT especially for the poorest decile. This result has been questioned elsewhere largely because the reported expenditure of the lowest decile exceeds their income by an incredible 86%.

    5. You state that “The advantages of a flat tax are simplicity, a constant average tax rate, and no weird threshold effects”. The point about the constant average tax rate is surely a mistake. The marginal tax rate is constant, at least above a threshold level, with a flat tax. The average tax rate increases with income, assuming that there are basic tax credits or allowances which lower the effective average rate on lower incomes, but the details of this will depend on how tax credits are configured.

    @John B:
    You are worried that a Basic Income (maybe as part of a reform which includes a Flat Tax) might be used to attack welfare and eliminate various welfare programmes. Yes, it might be, and this could be all to the good: it could be far easier and cheaper to administer that the plethora of income supports with we have at the moment. But introducing such a system without creating losers could be very costly. It’s different when you are contemplating a Flat Tax for some economy with a primitive tax system which accounts for a low percentage of GNP.

  10. “Governments have to tax households and firms in order to provide services the market won’t, like libraries, street lighting, ”

    Not under the Tories
    Government is responsible for the NHS , payments aimed at the over 60s and defence.

  11. Flat taxes were adopted in several Eastern European countries after the fall of communism and it is easier to implement such a system when effectively establishing new structures from scratch.

    Slovakia abandoned the its flat tax system in 2013.

    A flat tax in Ireland would not result in an end to politicians and vested interests seeing the value in campaigning for tax breaks.

    The forthcoming general election will be an argy-bargy on tax breaks and rates — basically a return to typical campaigning and Kenny/Noonan cleverly avoided giving the fiscal advisory council a role on costing election manifestos as they reckon when they say Sinn Féin’s tax proposals will wreck the economy compared with their own, that they will hold the upper ground.

    This type of campaign avoids addressing issues such as the legal impediments on a delayed banking inquiry that make a joke of accountability or the failure to grow an indigenous international trading sector after 60 years of state supports despite the lowest corporate/employer social security taxes in Western Europe.

    An Irish Times report today suggests that the latest is property tax is set to be junked like the last one which expired in April 1997.

    http://www.irishtimes.com/business/economy/cantillon-a-withering-warning-on-property-tax-1.2457745

    Stephen does raise a relevant point about startups and the low marginal tax threshold.

    In the US most startups are funded not by venture capital but by personal savings, bank loans and credit cards. It’s likely the same in Ireland.

    An interesting example of the use of entrepreneurs to support a tax cut that has been demanded by lobby groups such as Ibec and others in recent years, is the demand for a cut in the 33% capital gains tax rate (CGT).

    One argument is that it is an disincentive for people to risk being an entrepreneur — this argument of course is made by folk who would never leave their 9 to 5 jobs because an individual who decides on becoming an entrepreneur based on the tax that would apply if he or she sold the imagined business, should save the hassle and remain as a wage slave.

    Michael Noonan has made changes to the CGT rules in the last two budgets and there is one further campaign in 2016 to get the rate down to the same level as in the UK.

    Despite the very low business taxes there is always some gripe to make and demand for more.

    The Examiner reports today on Renua’s mini-conference in Dublin on Monday.

    http://www.irishexaminer.com/ireland/renuas-plan-for-a-23-flat-income-tax-rate-very-welcome-says-economist-and-tax-experts-370262.html

    A director at the Irish Tax Institute, said: “The number one issue in terms of attracting talent and investment to Ireland is personal taxation” — no mention of the incentive of a 30% discount on income and benefits above €75,000 per annum when hiring an individual from overseas.

    Another individual says “from the view of the tech sector Ireland has missed the boat. They’re going to London instead of Dublin.”

    This is bullshit.

    In the US in recent times a survey of founders of the fastest growing companies in the country found that tax had been a low priority for them in selecting the city in which they were based.

    It’s hardly a surprise that they had worked/lived in the cities at least 2 years before they had launched their businesses — it’s challenging enough to start a business but to do so in a city where you arrive as a stranger with no local connections is a ridiculous fantasy.

    Ireland is a low-tax country with a tax wedge at the 8th lowest of the 34 member countries of the OECD:

    http://www.finfacts.ie/Irish_finance_news/articleDetail.php?Ireland-a-low-tax-country-Kenny-wants-radical-income-tax-cuts-272

  12. The Big 4 accountancy firms, whose bread and butter is translation of tax gibberish into English, will never countenance flat taxes.

  13. The OECD defines taxes as follow.

    “Taxes are compulsory, unrequited payments to general government. They are unrequited in the sense that benefits provided by government to taxpayers are not normally in proportion to their payments. The OECD methodology classifies a tax according to its base: income, profits and capital gains; payroll; property; goods and services; and other taxes. Compulsory social security contributions paid to general government are also treated as taxes, and are classified under a separate heading.”

    The key word is “unrequited”. Taxes levels in Ireland are low because the level of benefits is low. The taxes levied on income are also highly progressive.

    If a way forward is being sought, the focus must be on getting a better balance between taxes and benefits. Taxpayers will accept a much higher level of taxation if they feel they are getting a fair crack of the whip in terms of the services provided. The Scandinavian countries are the best example, notably because, despite the quite different approaches in terms of the detail, they end up with the same level of public acceptance, no doubt also because of the qualification that the level of both services and taxation is posited on the necessary economic growth.

    The Irish income tax system as such is probably one of the most straightforward anywhere in the EU and the level of efficiency in collecting taxes is very high. In terms of the point where the value of services provided is lower than the taxes paid, however, the rough cut-off point is, apparently, at around the income seventh income decile. The disadvantages of the system in terms of fairness with regard to education, health care and pensions are, however, enormous for the lowest income deciles.

    It is clearly the overall balance that matters. As the “squeezed middle” discovered from the sudden collapse of the economy, it was, and remains, very shaky.

    It seems that a majority wish this situation to continue, if the stalls being set out by the main traditional political groupings are any guide.

  14. @docm

    “The Irish income tax system as such is probably one of the most straightforward anywhere in the EU”

    Really!

    I’m not sure anyone, with broad interests, could have a really detailed knowledge of every tax regime in the EU – doing it for one or two is quite an accomplishment. In absolute terms it is messy and unnecessarily complex and littered with historic quirks.

  15. Stephen how can we talk about the need for change in the tax system without first examining the Pretax income distribution. Ireland’s income distribution before tax is one on the most unequal in the OECD. We are alongside the UK and the US and completely out of whack with most of Europe.
    This is the context all discussion should begin from.

    Strangely it doesn’t seem to figure in any of your graphs above.

    What Ireland does do, to bring it back into line with the EU is that we have a fairly progressive tax system.

    Most of the Tax changes or new ones introduced since the Government took office have been going against that trend. The Water Tax is regressive The Increase in Vat is Regressive.

    Why are we giving Renua the benifit of the Doubt?
    Their agenda is clear. They are a Party of the 1%.
    They want to increase the net take home pay of those at the top by increasing the tax burden on those at the bottom.
    They dont pretend to be doing this to invest in public services. They want to do it to increase the income inequality.

    As john B mentioned why would you not increase the number of tax thresholds if you wanted to be more progressive.

    Renua dont want that. They want people in the 1% to pay the same effective tax rate as someone on the Average industrial wage.

    I notice they have decided to add a tax free allowance called Graduated basic income as it was completely obvious how regressive their flat tax was.
    However it is then hard to see how you can call it a flat tax.

    The Flat tax would reduce the tax that needed to be paid by those at the very top. In your figure 2 we can see people currently pay about 40 % Who is going to take up that massive slack? The less well off of course.

    It is well known that people in the lower quintiles spend more of their disposable income in the real economy. Those at the top save more but Renua expect us to believe that shifting more income to those at the top will result in an increase in spending in the economy?

  16. BTW what figure 3 seems to show is that if you earn over 80K the average tax rate is virtually flat already.

  17. Id like to know what an economically literate audience think of Renuas Flat Tax verbiage contained on their website.

    Some corkers in here!
    I for one welcome our new conservative overlords.

    “6. Is Flat Tax Progressive?

    Firstly, a flat tax is the progressive tax system in insofar as the rich do in fact pay a lot more in tax than the poor in absolute terms. The abolition of reliefs and loopholes means that if you earn more money, you pay more tax. There are no more special arrangements for the wealthy.

    RENUA Ireland also does not accept the premise that a progressive tax system must involve graduated tax bands. We believe in everyone paying their fair share, which is what a flat tax achieves.

    Secondly, under our flat tax at low incomes, the average rate of tax paid by the poor is much lower than the average rate of tax paid by middle and higher income earners, owing to the basic income support included in our model.

    Thirdly, a flat tax will incentivise work and reduce the burden owed to the state to the extent that it can create real and lasting economic growth, which will benefit all. By contrast under our current system the political Left prioritise an ideological commitment to punishing the wealthy at the expense of delivering real economic opportunity to working people.

    We must not fall into the trap of disregarding the practical benefit of this proposal by focusing on theoretical and ideological hang-ups.

    7. How does a flat tax affect the most vulnerable in society?

    A flat tax liberates the most vulnerable in society by increasing consumption, increasing wealth and providing a real incentive for people to get off social welfare, seek out a job and become economically self-reliant.

    Not only are welfare-driven poverty traps eradicated under a flat tax, but minimum wage earners will be much better off by taking on additional hours of overtime, or moving from part-time to full-time work.

    What our proposal does is offer a simple way to organically increase economic growth in the short, medium and longer term. Additionally, in the short-term the transition to a flat tax will provide an economic stimulus of over €3bn into the domestic economy (over a full fiscal year). People will feel the reduction in their weekly or monthly payslips and help commence the process of driving domestic growth on the high street and elsewhere.

    A flat tax benefits everyone at lower income levels by creating the opportunity to work for everyone who wants to work.

    It will damage the black market by making people more tax compliant.

    It will reduce the number of capital-owners who locate and pay taxes overseas to avoid our punitive rates of tax here, and it will free up Irish people’s income, thereby increasing our rate of consumption.

    As a society, we believe in, and defend vigorously, a flat tax of 12.5% on corporations. It works, it is simple, it is straightforward, and the flat tax variant of this should be applied to our personal incomes.”

  18. IMO…

    Taking something rather complex… and making it simple is not sustainable in the long term.

    That is because it is human nature to take the simple concept / idea / formula and remake it as complex again.

    If all the tax rates / levies / charges / contributions are rolled into one tax rate…. within a 10 years various ministers ( pandering to populism) will slowly start to reintroduce extra levies and taxes.

    One example….. anybody remember the Health Contribution Levy… introduced by Ms Mary Harney?

    Introduced as a temporary measure to help the HSE…. doubled some years later…. various tweaks to relief rates, rolled into the USC…. and no doubt will be re-introduced again at some time in the future.

    Classic management strategy… how do you get away with having never brought a project to successful completion?

    Ans = Every few years give the project a different name.

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