Flat Tax Rates vs. Marginal Tax Rates

Tommy

Just a Millennial living in the real world...

The 2020 US Election was the biggest voter turnout in US history and many people, including myself, thought it was one of the most important elections in our lifetimes. We felt it was very important because we think that the country is extremely divided and whoever controls the Legislative and Executive branches would be able to change the country for better or worse. The 2020 election is in the past and only time will tell to see where we will go as a country.

On the 2020 Illinois election ballot, there was a very important question being asked to IL residents. This very important question was to vote Yes or No for Governor Pritzker’s IL Fair Tax. In fact, it was so important that it was the first question on the ballot even over the Presidential Election. Also, Governor Pritzker and hedge fund tycoon Ken Griffin, who is also the richest person in IL, spent a combined $111 million dollars campaigning for/against the Fair Tax. The IL Fair Tax was a progressive tax to change the current income tax rate from a flat tax rate system to a marginal tax rate system.

Governor Pritzker was tried to keep his promise to “tax the rich and make them pay their fair share” and to help bridge the gap between the Illinois budget deficit. I applaud his efforts to try to cut the deficit, but I don’t think “taxing the rich” is the simple solution to the state’s problems as seen by IL population loss over the years. So that leads into my topic of what is the difference between a flat tax rate system and a marginal tax rate system. We will use the state of Illinois as a case and I will state my case for a flat tax rate system.

What is a Flat Tax Rate System?

Per Investopedia, a flat tax rate system is where the same rate is applied to every taxpayer, regardless of income bracket. The system can add deductions or exemptions, but for the simplicity sake of this blog post we won’t go that far into discussion.

Supporters of the flat tax say it simplifies the filing process and it encourages taxpayers to earn more money as they won’t be taxed at a higher rate. Critics against the flat tax say that it’s not fair to lower income levels as they are taxed the same rate as the rich.

IL is only one of 9 states who uses the flat tax for income taxes so I am in the minority. Also in a simple flat tax rate system where all personal income is taxed at one rate, the flat tax rate will be the same as your effective tax rate.

What is a Marginal Tax Rate System?

Per Investopedia, a marginal tax rate system is where taxpayers incur taxes based upon every additional dollar of earned income. So as income rises so does your marginal tax rate at different thresholds. We currently use a marginal tax rate system at the federal level, which began in 1913 and here are the marginal tax rate tables for 2020 and 2021.

Supporters of the marginal tax rate system say the system is fairer for low income earners as they are taxed a lower marginal tax rate than the wealthy. Critics against the marginal tax system say it discourages people to earn more money.

Please note, and this is very important, that your marginal tax rate is not your effective tax rate (even though the main stream media and many people gets this wrong all of the time). You have to do a separate calculation to get your effective tax rate, which is your total tax paid divided by taxable income as stated in my financial glossary post.

Why A Flat Tax Rate System?

As stated above, we use a marginal tax rate system to tax income on a federal level. I disagree with that system and I think it should be a flat tax rate system. Herman Cain, a Purdue grad and a former Republican presidential candidate in 2012 proposed his 9-9-9 Plan, which was a flat tax rate of 9% for income taxes, corporate taxes, and a national sales tax. Now I didn’t fully agree with it because of a potential decrease in tax revenue, but I thought it was a well thought out plan and a good starting base for making real change to our tax code. I truly believe that our tax code is overly complicated and it should be simplified so we can close many loopholes used for tax avoidance. Below are three reasons for why I think we should have a flat tax rate system.

The More You Work, The More Money You Earn.

As a child, I learned that if you want to be successful, whatever that is to you, then you have to work hard and earn it. As I have matured, I think that this statement is only semi-true as I think you can put in hard work and you can still fail. Nothing is guaranteed in life. Also, I don’t think that the real world is fair to everyone, which is a shame. So I will change my statement to “If you want to be successful (whatever that is), then you have to figure out how to bring value to people.” That may be bringing value to other people and/or yourself. This is not supposed to be easy. I actually consider it hard work and this is something that I am still trying to improve everyday.

I think most Americans feel the same way. And guess what? For jobs that pay hourly wages, the more hours you work the more you get paid plus overtime. I will even argue that the same is true for salaried positions too. The more value that you bring to your employer, they will hopefully recognize and reward you with a raise for the value that you bring to them. Obviously this is not guaranteed, but I think that employers should treat their employees fairly. I view the employer-employee relationship a two-lane highway. If your employer doesn’t treat you well, which sadly happens often in the US, then I would highly recommend finding a new employer that will treat you right or even better become self-employed. You, not anyone else, are responsible to take care of yourself and decide what’s best for you.

It’s every person’s choice to decide how far they want to go for their employer or how hard you want to bring value to their customers if you are self-employed. And that is something you have to decide for yourself. This is called finding your healthy work-life balance and it’s different for everyone.

Lastly, when Americans work hard, we find solutions to people’s problems through innovation. If we have zero incentive to innovate, then guess what will happen? We will be less innovative as a country. Our smartphones won’t become better, our healthcare won’t become better, and our cars that destroy the environment won’t become better… Innovation is what made the US a superpower in the world and I think we should strive to continue that for the betterment of all Americans.

The Effective Tax Rate Is The Same For All Taxpayers.

Like I said above, the flat tax rate will be the same as your effective tax rate. The effective tax rate is the important percentage because it shows exactly how much money you are paying in taxes to the government.

A huge misconception is how US politicians and the mainstream media continue to say that the wealthy don’t pay their fair share. But that is not true. This Brookings Institute study, “Who are the rich and how might we tax them more?” even states that “The rich generally pay more of their incomes in taxes than the rest of us” and that is from the Congressional Budget Office. It also states that incomes of the top 20% rise faster than the average American household. The reason behind this is because the wealthy have more purchasing power to increase their incomes, which the study does not state. For example, let’s compare two people and they want to invest money into the stock market. Let’s say that they each make a guaranteed 10% rate of return within 1 year. Person A has $1,000,000 and Person B has $100,000 to invest. Who will make more money? Person A will make $100,000 return while Person B will make $10,000 return. Obviously, this is a big difference and is the reason why the rich get richer.

The same goes with taxes on the other side. Let’s say you have a flat tax rate of 25% for personal income. Person A makes $1,000,000 and Person B makes $100,000. Person A will pay $250,000 in taxes and Person B will pay $25,000 in taxes, but they both will have the same effective tax rate of 25%. Is that fair or not fair? You decide, but the wealthy still pay more in taxes. So in my opinion stating that the rich don’t pay their fair share is false.

Marginal Tax Rates Encourage Tax Avoidance

Please raise your hand if you want to pay the federal government more in income taxes or be forced to give your money to someone else. I will tell you that I don’t and I don’t think there are many volunteers in the room either… It’s human nature for everyone wanting to pay less in taxes. It’s like we all want to score a good deal on buying that 90-inch 100K TV that’s on sale as it makes us feel good because we saved money. Essentially, tax avoidance means saving money on taxes.

The perfect example of tax avoidance is Donald Trump and I have seen the same thing happen all of the time when I analyze personal tax returns for real estate investors and high net worth individuals due to my career in banking. With a marginal tax rate system, it encourages taxpayers to legally lower their taxable income at any cost. This is called tax avoidance not tax evasion, which is illegal, and tax evasion is how Al Capone was arrested.

I won’t go into the specific details of explaining how Donald Trump avoids income taxes for the sake of the blog post. But I have a very good idea of how he does it using legal tax loopholes. These include S-Corps/LLCs companies, shell companies, depreciation expense, Section 179 deductions, Section 1031 exchanges, net operating losses, K-1 distributions, etc. If all of those words are foreign to you it’s because the majority of Americans haven’t heard of them unless you work in finance or accounting. These are all ways that businesses can reduce their taxable income as they are written in the tax code and these are tax avoidance strategies.

What is the future outcome?

Well if I could foresee the future, I would be the richest man on earth…

The people of Illinois voted against Governor Pritzker’s Fair Tax in the 2020 election by a 55% majority and I was literally shocked as I thought it was going to pass in a landslide. I thought Pritzker’s TV ads were so much more persuasive than Griffin’s. In order to close the $8 billion budget deficit, state politicians will have to decide whether they will raise taxes elsewhere, cut budgets. or wink wink a federal government bailout where all US taxpayers will help bailout Illinois… So we shall see what tough decisions will be made in the future.

Another con against a flat tax system is that there could be a decrease in tax revenue as marginal tax rates typically bring in more tax revenue. Well my argument against a decrease in tax revenue is let’s work to improve our national deficit and decrease our national debt. A budget deficit means we are spending more money than we have, which in turn increases our national debt through the government issuing bonds to raise cash. Our national debt has skyrocketed to $27.8 trillion due to overspending for years and a decrease in tax revenue. Over the past two decades, we have seen our budget deficit widen and national debt skyrocket. Politicians on both sides of the aisle are guilty of this going back to former President Clinton.

Should we be scared or not? The World Bank performed a study back in 2013 stating that “If a country’s debt to GDP ratio exceeds 77% for an extended period, then it slows economic growth.” This has been happening to the US for over a decade as we have seen minimal GDP growth annually. Per the article, the US’ national debt to GDP ratio is 127% as of the third quarter 2020. I have some hope that our politicians will see this as a problem and curb spending, but we shall see.

As a nation, we have to prioritize what the federal government’s role should be for all Americans and where the money should be spent. Should the federal government provide our military with the best technology in the world to protect Americans from terrorists foreign and domestic? Should the government bail out fiscally irresponsible cities like Chicago? Should the government provide welfare to the needy? These are questions that politicians and voters need to decide before our country is ran into the ground. I feel that the problem is that the politicians are overpromising things to people in order to get just enough votes to get elected, which makes sense. They want to win. But that is the nasty game of politics and I think it’s hurting our nation.

A number of politicians say that we should tax personal net worths over income like Senators Elizabeth Warren and Bernie Sanders. Guess what will happen if you add a 2% wealth tax on households with more than $50 million of net worth? Well like I said above, tax avoidance is the issue and it will only get worse under those plans. The wealthy will do everything in their power to avoid that wealth tax. Also, it will be nearly impossible to value net worths unless you want to spend a ton of money and find the peoplepower to conduct audits on every American household.

So that is why I would like to see a flat tax rate system for the US. I have little hope of it happening as I don’t have any faith in Congress passing anything as it is a very radical change. The next four years under President Biden and with a Democratic-controlled Congress shall be interesting and we shall see where they will take the country.

Featured Photo by Karolina Grabowska from Pexels