Want a fair tax system? Get the steamroller!

In all the recent uproar about taxes and people paying a "fair share," nobody is talking about Alvin Rabushka, and we think that is a tremendous oversight.

Dr. Rabushka is a political scientist and the David and Joan Traitel Senior Fellow at the Hoover Institute at Stanford University. Along with economist Robert Hall, he is the author of numerous books about the flat tax, which he has championed since the early 1980s.

We would challenge all the politicians arguing about the tax code, on both sides of the aisle, to read through the book The Flat Tax by Hall and Rabushka. We would advise all investors to do the same.

Right now in the US, we have one faction saying "millionaires need to pay their fair share" and another faction saying raising tax rates on the upper brackets and on capital gains is not a good idea "in a fragile economy" (as if it is a good idea at other times). We believe that to really get everyone to pay their fair share, and to do it in a way that actually helps the economy, policymakers should enact a flat tax that taxes everything and does so at a low flat rate, and that in doing so they should entirely do away with all of the deductions that special interest groups and social engineers have introduced over the years.

The benefits of such a flat tax policy are enormous. As Hall and Rabushka write:
Our flat tax solves many tax problems that have challenged academics and politicians for years: it eliminates double taxation; it improves capital formation; it correctly defines the tax base; it provides true simplification; it dramatically improves incentives; it removes millions of low-income households from the tax net; it lowers the costs of compliance; it puts a serious dent in tax cheating; it even reduces the adversarial stance of the Internal Revenue Service toward tax payers. 4.
The argument for the simplicity of the flat tax is incontrovertible. For example, if lawmakers decided that 18% of income was going to be collected, they could get to that number by a simple 18% flat tax or by a complicated system of brackets and deductions which charged higher than 18% on some earners but gave back deductions and credits to various groups for various activities, which ended up netting the government about 18%, although by a much more circuitous route. As a taxpayer, if you earned $100,000 of income in a year and were going to end up paying about $18,000 in taxes, would you rather do that with a postcard-sized tax return under the flat tax, or would you rather do it through a 40-page tax return that took hours of your time or hours of work by your accountant (charged to you)?

While nobody disputes the simplicity of the flat tax versus the current system, Hall and Rabushka note that many reject the flat tax on the basis of "fairness." However, they present extensive evidence that the flat tax is eminently fair, despite the criticisms often leveled against it. In fact, as argued in this chapter from their book exploring the concept of "fairness," the authors explain why the flat tax is far more "fair" than the current system (or any other practicable taxation system).

They point out that by almost any traditional definition of fairness, the flat tax is fair, except for a relatively new understanding of "fairness" that developed during the twentieth century among "politicians and intellectuals" who redefined it to mean "redistributing income" to "attain their egalitarian goals" (42-43). Aside from the philosophical and ethical problems with this new definition, Hall and Rabushka point out that attempts to redistribute wealth via higher tax rates on higher earners don't work very well in practice either: "Despite attempts to equalize after-tax incomes through steeply graduated tax rates, one Congress after another has riddled the tax code with hundreds of loopholes that permit some millionaires to pay no income taxes whatsoever and some high earners to pay low taxes" (43).

We would also add that philosophically, we disagree with Robert Hall and Alvin Rabushka over the idea in the quotation above that the flat tax should remove "millions of low-income households from the tax net." Their flat tax plan calls for no tax on those earning up to a certain minimum amount, after which the flat tax would kick in. We believe that there is moral hazard involved with excluding any group of voters from the tax system entirely, and believe that the tax rate should truly be low, flat, and the same for everyone.

Not only do all the complexities of the tax code waste time, money and energy for filers every year, and not only are they "not fair" in that they end up allowing some people to get away with paying less than others in similar circumstances and with similar incomes, but they have another huge problem that's not always well understood, which is that they encourage massive misallocation of capital, also known as malinvestment. By privileging various types of investment through the tax code, lawmakers encourage capital investment to go where it otherwise may not.

For example, real estate enjoys tremendous tax benefits in the US: many kinds of mortgage interest expenses are tax deductible, and sales of real estate property can be rolled into other "like kind" real estate investments without being taxed in between. In contrast, proceeds from selling shares in one company cannot typically be rolled into shares of another "like kind" corporation without being taxed in between. Similarly, insurance products and annuities enjoy different tax benefits. All of these tax loopholes and deductions encourage investors to commit more capital to those types of instruments than they would otherwise do, and this can lead to gross misallocations of capital, such as the real estate bubble that imploded with great collateral damage from 2007 to 2009.

(As an aside, we might ask Warren Buffett why -- if he is so keen on increasing "fairness" in the tax code -- he doesn't agitate to remove the inequitable tax loopholes that have been afforded to the insurance industry over the years in the United States).

A simple, low flat tax -- accompanied by the elimination of all the deductions and loopholes that politicians of both parties have enacted on behalf of lobbyists and favored industries over the decades -- would have a tremendous positive benefit on the US economy.

We are under no illusions as to the likelihood of such a commonsense solution ever being enacted. However, we believe it is important to go on record as supporting the flat tax as the most pro-growth policy that lawmakers could possibly introduce. With awareness growing of the problems inherent in the current abominable tax system, we can only hope that at some point more people will start listening to Alvin Rabushka.