Rand Paul's Flat Tax

Recently, the republican presidential candidate, Rand Paul, put forward a flat-tax proposal for the American economy. Now, I have nothing against Rand Paul and infact I have liked Rand Paul and his ideas on various topics. But when it comes to his tax policies, I remain skeptical.

He recently introduced a proposal to tax everyone at 14.5%. His proposal was also to eliminate the payroll tax (that currently funds Social Security, Medicare and Medicaid). There will not be a separate capital gains tax and everything – individual income tax and business tax – will be taxed at 14.5%.

Now, this looks like a lot of savings for everyone participating in the economy. This is going to put thousands of more dollars each year in the pockets of everyone. I am a big fan of less taxes (who isn’t?), but I am also a big fan of reducing gross inequality in the economy. More importantly, I want to make sure that there is sustainable demand in the economy for decades to come – because if you lose the consumer market, then you lose the economy.

At first, this tax proposal looks very attractive – leaving a lot of money with the individuals rather than with the government. And I would be willing to spend my money myself rather than allowing the government to spend my money. And above all, this is deemed as a “fair tax” as every individual will contribute the same percentage of their taxable income rather than the government re-distributing it from the rich to the poor through various tax structures. So it does seem fair.  But if you take a step back from all these attractions and concentrate on the larger picture – where in the coming years, you will have to sustain demand from the middle-income people - this plan looks a little less attractive to me.

Today, one of the biggest economic malaise in the world is gross income inequality. And the U.S. is not exempted from that.  Setting aside for a minute the $15,000 individual exemption (or $50,000 exemption for a family of four) and mortgage-interest deduction that Rand's plan envisages, let’s concentrate on a simple case – a case of two individuals – named John and Mark - (and let’s start from year one), where John earns $100,000 the first year and Mark earns $1,000,000 the first year. To keep things simple, let’s say that both individuals increase their yearly income by 2% and let us also put aside any state and local taxes. 

So at the end of the first year, after paying 14.5% in taxes, John would have a disposable income of $85,500 whereas Mark would have a disposable income of $855,000. So that states that Mark has 10 times more cash left in hand than John at the end of the first year. If you continue this for the next ten years, where every year John and Mark get a 2% increment to their salary/income, at the end of the 10^th year, John would have had a disposable income of $100,890 for the 10^th year, whereas Mark would have had a disposable income of $2,394,000 during his 10^th year. Now that translates into Mark having 23.73 times more cash in hand than John at the end of the 10^th year.

Now, let’s not kid ourselves in saying that a person with millions of dollars in income would grow his net-worth at the same rate as that of a person who earns in the low hundreds of thousands. He, for sure, will grow at a faster rate. And let’s not kid ourselves by not taking inflation into account – which would eat up a large part of the additional disposable income obtained by the massive cut in taxes across the board. And when inflation occurs, Mark, who is guaranteed to own assets at that point, will see his assets’ worth going up in value, whereas John would increasingly find it difficult to buy those assets – thereby once again creating a gross inequality in the standard of living.

Moreover, to balance the budget (which Rand says he will), massive cuts in public services will have to take place. Though I am not much of a fan myself these days on government provided services and the debt they incur, it is no doubt that these massive cuts in the public services will cause a considerable re-structuring in the economy and I am afraid that that re-structuring will occur on the backs of the middle-income and low-income people – thereby once again, giving a smooth ride to the high-income people and a bumpy ride to the middle and low-income people. Now tell me how is that fair?

Even in today’s tax structure (setting aside all deductions, state and local taxes for simplicity), at the end of the 10^th year, Mark, who would have paid a federal tax rate of 39.6% vs John’s 28%, would have had 17.66 times more cash in hand than John. And Rand Paul’s flat tax would have increased that 17.66 number to 23.73. So the bottom line is – I am skeptical about Rand’s tax plans being able to address effectively the economic ills in the society – both now and in the decades to come.

If Rand or someone comes up with a multi-tiered flat tax system, I would be willing to consider and study its effects. But this one-tiered flat tax system proposed by Rand doesn’t impress me. Sorry Rand Paul!