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The truth about the Flat Tax

26 10 2011

We’ve heard a lot about flat taxes lately, with the GOP race heating up. The flat tax, in principle, sounds fair. After all, if we are all taxed at say, 10%, each would have a proportion equal to their income, right?

Let’s look at an example. We’ll use nice, round numbers to keep things easy to digest and assume the chosen income tax rate is 10%. The following is the breakdown for what you’d expect to pay at different income levels:

 

Basic flat tax example

Figure 1: Basic flat tax example

Pretty simple and fair, right? Maybe, but it isn’t quite that simple.

Flat taxes are based on standard income. In general, investment income is often taxed at lower rates than regular income, provided it is considered to be a qualified dividend. A qualified dividend, simplified, is a payout from an investment that is considered to be a long term investment. This lower rate varies but is typically lower than the income tax rate and is one of the reasons why some extremely wealthy Americans are able to pay lower tax rates than their less wealthy counterparts.

Most of the wealthiest Americans are company owners and heavy investors, which gives them the opportunity to choose how to route their income. For example, as a business owner, I can choose to pay myself a small salary but pay very high annual dividends, thus diverting the majority of my income to qualified dividends, which are generally taxed at a lower rate.

How’s this work? Let’s use another very simple example to illustrate. Let’s assume now that qualified dividends are taxed at a 5% interest rate and all other aspects of the prior example remain true, with the exception that the top two earners in our scenario have shifted where their revenue derives from in order to minimize taxes owed:

 

Example using dividend income.

Figure 2: Example using dividend income.

It is important to note that paying a lower tax rate doesn’t mean paying less taxes. As we see in the example above, wealthier individuals still pay more in gross taxes, however their proportion of income paid in taxes is a much lower percentage than their less wealthy counterparts, which is what Warren Buffet pointed out recently.

In short, the tax code is very complex. By diverting funds through different investment and holding strategies, accountants are able to reduce, and sometimes eliminate, taxes all together.

A flat tax could work. However, what most flat tax plans fail to account for is where the majority of income comes from. If 90% of the revenue individuals receive come from dividends, it would make sense to tax that revenue as income, not as investment payouts. But still, it isn’t that simple – for example, how should retirees that have no income except from dividends be taxed? Would it make a difference if these retirees have annual dividend payouts of only $30,000? What if their annual payout was $3,000,000? It isn’t cut and dry.

Regardless of your political orientation, don’t take any political plans at face value. When you hear a 30 second clip on the news or read 2 paragraphs you don’t have enough information to fully understand a complex and well planned change to a very complex institution.

Don’t support policies blindly. Research and understand what you are supporting.


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