Free Money as Prebate for Flat Tax

A national sales tax is inherently flat – if people of all income levels consume the same fraction of their incomes. To make a sales tax somewhat progressive, the Fair Tax advocates call for a “prebate” to go along with their sales tax proposal. Give everyone a monthly check that roughly equals the sales tax cost to a consumer at the poverty line, and those at the poverty line pay zero tax. Those below receive a subsidy. The prebate makes a national sales tax (or a set of excise taxes such as a carbon tax) apparently progressive.

The problem comes when we take into account the fact that the very rich often spend a tiny fraction of their incomes. They can defer tax for decades. Then again, this is the case under the current system for those rich who collect capital gains vs. wages. As a bonus, the rich today pay a lower rate on their deferred gains than many wage earners pay on their wages. So maybe the Fair Tax is more progressive than the current system. Whether it would work is another matter. A sales tax at the Fair Tax level would be very tempting to dodge.

Here, we look at replacing our current maze of tax brackets and payroll taxes with a flat rate income tax with prebate (i.e., free money for all). From there, we can debate as a nation whether to stick with a tax on income or to split it into taxes on consumption and/or property. A flat income tax is an easy first step since we have the collection infrastructure already in place. Important note: the flat income tax studied here merges payroll taxes in with the Income Tax, so it is considerably more progressive than Dick Armey’s Flat Tax proposal.

The question now comes: what should the rate be, and what size monthly government check should each adult citizen receive as a prebate? To begin to answer this question, let us look at the tax rates we have today. For wage earners, the federal income tax is effectively broken into five parts: “income tax”, employee FICA, employee Medicare, employer FICA and employer Medicare. Our proposal would be to lump these all together into a single tax with one or two brackets plus a universal stipend. (For this article we will only look at a single rate. A two tier rate will be explored in a future article.) Employer and employee FICA taxes are each 6.2% of nominal income up to $106,800. Medicare is 1.45% for both employer and employee portions with no cap. See this Wikipedia page for the income tax brackets for taxable income.

The term “nominal income” is used since the employer is providing a bit beyond the nominal income by paying the employer portion of FICA and Medicare. For a wage earner below the threshold, total income is 107.65% of nominal income.

In Table 1 we have the total and marginal tax rates for a single person who takes the standard deduction and personal exemption with no other tax dodges. That is, he puts no income in a retirement account or employer provided health insurance policy, and itemized deductions fall below the standard deduction threshold. No attempt has been made to take into account Earned Income Credits or similar perturbations aimed to help poor and middle class families.

Num adults1, Num children: 0, Estimated current deduction rate 0%

Nominal Income Total Income Payroll Tax Income Tax Total Tax Average Rate % Marginal Rate %
$14500 $15609 $2219 $515 $2734 17.5 23.5
$25000 $26913 $3825 $1929 $5754 21.4 28.1
$30000 $32295 $4590 $2679 $7269 22.5 28.1
$40000 $43060 $6120 $4179 $10299 23.9 28.1
$50000 $53825 $7650 $6344 $13994 26.0 37.4
$60000 $64590 $9180 $8844 $18024 27.9 37.4
$75000 $80738 $11475 $12594 $24069 29.8 37.4
$100000 $107650 $15300 $19091 $34391 31.9 40.2
$200000 $209522 $19043 $48031 $67074 32.0 35.4
$300000 $310972 $21943 $81031 $102975 33.1 35.4
$500000 $513872 $27743 $149371 $177115 34.5 37.4
$1000000 $1021122 $42243 $324371 $366614 35.9 37.4
$2000000 $2035622 $71243 $674371 $745614 36.6 37.4
$5000000 $5079122 $158243 $1724371 $1882615 37.1 37.4

Wow! Once we factor in payroll taxes it looks like single workers making $100,000 per year are the most clobbered, with a 40% marginal rate. The effective marginal rate for the truly rich is less since they don’t pay FICA taxes on most of their earnings. (They do pay Medicare taxes.) In the first edition of this article I went on to investigate a 40% flat tax with a generous prebate.

But later, I realized that the table above is deceptive. People making professional class incomes and above don’t use the standard deduction. Several straightforward itemized deductions surpass the standard deduction, even for people who don’t use tax shelters or give to charity.

A Higher Fidelity Tax Model

For people making below $40K/individual or so, the tax model above is pretty good. Unless you give heavily to charity (which means you don’t actually receive all your nominal income), it is hard to itemize to get above the standard deduction. As incomes go up, however, itemizing makes sense even for some fairly simple lifestyles. The author lives in a state with an income tax that starts at 6%, quickly goes up to 7% and tops at nearly 8%. Living in a house worth twice one’s annual nominal income is not unusual. Mortgage interest plus property tax leads to a rate of around 6% at current interest rates if the home if the home is mostly financed. That’s close to 12% + 7% = 19% tax deduction. (Actually, we need to subtract 12% of 7% = .84% since state income tax also takes the mortage and property tax deduction, so make it 18%.) Not everyone has their home completely financed so this figure is higher than many can deduct.

Anyway, it is safe to say that for those in the professional class, an itemization between 15% and 20% is typical. For those make real wealth, some of the itemized deductions phase out, but people at this high income level make use of more complicated tax shelters. So, let’s run the numbers assuming a 15% itemization rate and see what we get (with lower income people still taking the standard deduction):

Num adults1, Num children: 0, Estimated current deduction rate 15%

Nominal Income Total Income Payroll Tax Income Tax Total Tax Average Rate % Marginal Rate %
$14500 $15609 $2219 $515 $2734 17.5 23.5
$25000 $26913 $3825 $1929 $5754 21.4 28.1
$30000 $32295 $4590 $2679 $7269 22.5 28.1
$40000 $43060 $6120 $4134 $10254 23.8 26.1
$50000 $53825 $7650 $5894 $13544 25.2 34.0
$60000 $64590 $9180 $8019 $17199 26.6 34.0
$75000 $80738 $11475 $11206 $22681 28.1 34.0
$100000 $107650 $15300 $16519 $31819 29.6 34.0
$200000 $209522 $19043 $40287 $59330 28.3 26.3
$300000 $310972 $21943 $68062 $90005 28.9 30.5
$500000 $513872 $27743 $125116 $152860 29.7 32.2
$1000000 $1021122 $42243 $273866 $316109 31.0 32.2
$2000000 $2035622 $71243 $571366 $642609 31.6 32.2
$5000000 $5079122 $158243 $1463866 $1622110 31.9 32.2

For individuals, we still have marginal rates peaking near $100K/year, but now at 34% instead of over 40%. For high incomes the effective top rate is 32%. It looks like a simple flat tax of 30% instead of 40% might just work. For families we have:

Num adults2, Num children: 2, Estimated current deduction rate 15%

Nominal Income Total Income Payroll Tax Income Tax Total Tax Average Rate % Marginal Rate %
$14500 $15609 $2219 $0 $2219 14.2 14.2
$25000 $26913 $3825 $0 $3825 14.2 14.2
$30000 $32295 $4590 $400 $4990 15.5 23.5
$40000 $43060 $6120 $1400 $7520 17.5 23.5
$50000 $53825 $7650 $2763 $10413 19.3 28.1
$60000 $64590 $9180 $4263 $13443 20.8 28.1
$75000 $80738 $11475 $6513 $17988 22.3 28.1
$100000 $107650 $15300 $9963 $25263 23.5 34.0
$200000 $215300 $30600 $31756 $62356 29.0 36.3
$300000 $317593 $35186 $57113 $92299 29.1 30.5
$500000 $520493 $40986 $113948 $154934 29.8 32.2
$1000000 $1027743 $55486 $262698 $318184 31.0 32.2
$2000000 $2042243 $84486 $560198 $644684 31.6 32.2
$5000000 $5085743 $171486 $1452698 $1624184 31.9 32.2

Do note that this table does not account for either the Earned Income Credit or the latest child credits. Exemptions for dependents, however, are included. I have since produced a higher fidelity tax model and applied it to 2015 tax rate for a revised flat tax plan.

Flat Tax Options

Now that we have a rough idea of what the effective income tax is after combining “income” tax with the four payroll taxes, let’s compare it with a very simple flat income tax with a prebate. (A prebate is simply a rebate for net taxpayers.) In the table below we have nominal income and the tax collected under the current system followed by several pairs of columns. The first of each column is the amount of flat tax collected at the stated percentage. Note that this is a percentage of total income, not nominal income—no more headaches figuring out employer vs. employee fractions. The second of each pair is the amount we would need to rebate in order to match the current tax system (still not taking into account child credits or earned income credits). If we set our prebate higher than the figure in this column, then people at this income levels get a tax cut (or outright subsidy if the prebate exceeds the previous column). If we set the prebate less, then taxpayers at this income level get a tax hike.

Let’s give it a try:

Num adults1, Num children: 0, Estimated current deduction rate 15%

Nominal Income Total Tax Flat Tax @25% Prebate to Match @25% Flat Tax @30% Prebate to Match @30% Flat Tax @35% Prebate to Match @35% Flat Tax @40% Prebate to Match @40%
$14500 $2734 $3902 $1169 $4683 $1949 $5463 $2730 $6244 $3510
$25000 $5754 $6728 $974 $8074 $2320 $9419 $3666 $10765 $5011
$30000 $7269 $8074 $805 $9689 $2420 $11303 $4035 $12918 $5649
$40000 $10254 $10765 $511 $12918 $2664 $15071 $4817 $17224 $6970
$50000 $13544 $13456 $-88 $16148 $2604 $18839 $5295 $21530 $7986
$60000 $17199 $16148 $-1051 $19377 $2178 $22607 $5408 $25836 $8637
$75000 $22681 $20184 $-2497 $24221 $1540 $28258 $5577 $32295 $9614
$100000 $31819 $26913 $-4906 $32295 $476 $37678 $5859 $43060 $11241
$200000 $59330 $52380 $-6950 $62856 $3526 $73333 $14002 $83809 $24478
$300000 $90005 $77743 $-12263 $93291 $3286 $108840 $18835 $124389 $34383
$500000 $152860 $128468 $-24392 $154162 $1302 $179855 $26996 $205549 $52689
$1000000 $316109 $255280 $-60829 $306337 $-9773 $357393 $41283 $408449 $92339
$2000000 $642609 $508905 $-133704 $610687 $-31923 $712468 $69858 $814249 $171639
$5000000 $1622110 $1269780 $-352329 $1523737 $-98373 $1777693 $155583 $2031649 $409539

(For couples and families see Appendix A.)

At 30%, the prebate to match column is reasonably flat for everyone below a half million dollars or so. A $3000/year prebate would be a tax cut for nearly everyone, and an actual subsidy for those living on fulltime minimum wage and below. It does appear to be a tax cut for the very wealthy, but if we have this rate applied to capital gains and dividends, as well as close some of the fancier loopholes, this could actually be a small tax increase for the wealthy. For a family of four we have:

Num adults2, Num children: 2, Estimated current deduction rate 15%

Nominal Income Total Tax Flat Tax @25% Prebate to Match @25% Flat Tax @30% Prebate to Match @30% Flat Tax @35% Prebate to Match @35% Flat Tax @40% Prebate to Match @40%
$14500 $2219 $3902 $842 $4683 $1232 $5463 $1622 $6244 $2013
$25000 $3825 $6728 $1452 $8074 $2124 $9419 $2797 $10765 $3470
$30000 $4990 $8074 $1542 $9689 $2349 $11303 $3157 $12918 $3964
$40000 $7520 $10765 $1623 $12918 $2699 $15071 $3776 $17224 $4852
$50000 $10413 $13456 $1522 $16148 $2868 $18839 $4213 $21530 $5559
$60000 $13443 $16148 $1353 $19377 $2967 $22607 $4582 $25836 $6197
$75000 $17988 $20184 $1098 $24221 $3117 $28258 $5135 $32295 $7154
$100000 $25263 $26913 $825 $32295 $3516 $37678 $6208 $43060 $8899
$200000 $62356 $53825 $-4265 $64590 $1117 $75355 $6500 $86120 $11882
$300000 $92299 $79398 $-6451 $95278 $1489 $111158 $9429 $127037 $17369
$500000 $154934 $130123 $-12406 $156148 $607 $182173 $13619 $208197 $26631
$1000000 $318184 $256936 $-30624 $308323 $-4931 $359710 $20763 $411097 $46456
$2000000 $644684 $510561 $-67062 $612673 $-16006 $714785 $35050 $816897 $86106
$5000000 $1624184 $1271436 $-176374 $1525723 $-49231 $1780010 $77913 $2034297 $205056

28% was the top tax bracket under Reagan’s tax simplification of 1986. So a 30% flat tax might just be acceptable to Republicans. As for Democrats, this plan is more progressive than the 1986 plan as we have eliminated the regressive payroll taxes (which went up in 1986).

30% is a nice and easy number to calculate. Multiply by 3 and move the decimal point one notch to the left. We could eliminate the tax tables! And 30% is low enough that members of welfare class have plenty of incentive to work. A dollar of effort yields 70 cents extra cash.

If we want to eliminate most poverty, we’ll need more than $3000/year of free money for the poor. At 30% rate this would yield a substantial tax cut for workers all the way up into the professional class. But some would say this is a good thing. Many political thinkers bemoan the growing gap between the professional class and the truly rich. A tax cut for the professional class, which doesn’t require tying up money in retirement accounts, excessive health insurance, etc. would allow members of this class to accumulate more equity capital. We might experience a boom in new small businesses.

But could we afford a larger prebate? That would require a study by a think tank or the Congressional Budget Office, followed by actual experiment. Another possibility would be a two-tier tax, with 30% for working class up through professional class, and a higher tax on the truly rich. Employers could still simply send 30% to the IRS and the IRS could send a bill to those who owe more. This keeps payroll computations simple. We’ll look at this possibility in a future article.

Another possibility would be clawback of the more generous prebate. This is the solution Charles Murray gives in his book. Doing so raises the effective marginal income tax rate for some low income wage earners, while still lowering their total tax rates. Maybe we need he clawback to be generous enough with our prebate so we can replace welfare without draconian taxes on the rich. Or maybe we should have a higher flat rate with generous prebate so we can reduce the gap between the middle class and the rich. The answer to these questions depends on your underlying values. Conservatives and liberals are likely to differ on the matter. Herein, we humbly present information to allow each faction to make a more informed decision.