Richard A. Epstein: The case for flat taxes

Often it is said that the flat tax is passe, a posterchild of the small government movement of the 1990s.

In fact, announcements of its intellectual death are premature. The reality is that the flat tax is robust and unique, and outstrips its competitors - the head tax and the progressive tax - in fairness and efficiency.

The head tax (also known as a poll tax) is a fixed exaction on individuals that does not vary with the amount of income received.

Head taxes attract an enormous amount of well-founded popular hostility, as the Thatcher Government discovered. Under a progressive tax structure, the rate of taxation increases as taxable income increases. Marginal dollars (the last dollar earned) are subject to higher rates of tax than inframarginal dollars. How much higher is an open question.

With a flat tax the rate of taxation is constant regardless of the amount of income earned.

If everybody in society had identical social positions and income, a head tax would lose its sting. Each citizen would carry an equal burden and no single person would be unfairly disadvantaged.

But society is heterogeneous. For a person who earns little the head tax could exceed their income. Flat dues for everybody might be appropriate for country club membership, but there will be no political willingness to tolerate a taxation system along similar lines.

So the head tax can be knocked out of contention. The question then becomes: is a flat tax or a progressive tax better?

A progressive tax can have a marginal rate for the first dollar at 30 per cent and a marginal rate for the last dollar at 30.1 per cent. Alternatively, a tax also counts as progressive if it starts at zero and goes up to 100 per cent. Anyone who favours a progressive tax must decide which tax rate structure they support out of the billions that could be conjured up.

The defender of the progressive tax will point to the undisputed proposition of the diminishing marginal utility of wealth.

But it is impossible to come up with a principled, intellectual way of determining the extent of diminishing marginal utility of wealth, just as it is impossible to come up with a principled, intellectual way of setting the marginal increases in the rate of the progressive tax. Thus the task becomes a purely political matter.

Without principled argument, it is difficult to avoid a strong division of opinion and clash of wills.

Legitimacy becomes difficult to obtain or retain. The process of figuring out the optimal level of progressivity will create uncertainty and dissipate political capital that could be better spent on more productive activities.

If a government adopts a low level of progressivity - say an "almost-flat-tax" that increases from 20 to 25 per cent - the quizzical response is "why bother?". The government will not gain enough extra revenue to make it worthwhile, yet must bear the costs of the extra administrative complexity.

A person on a low income will obtain a slightly larger share of a somewhat smaller pie as the progressive tax shrinks the economy somewhat. The people at the high end of the scale will receive a smaller share of a smaller pie. This is a lose-lose situation.

Implementing a much steeper tax scale runs into a fresh set of problems. Decisions by citizens about where to set up their homes and businesses are not independent of the tax system. This is a dynamic world.

Faced with a steep progressive rate, some enterprising and better-off people will leave, depriving those left behind of their expertise and tax contributions.

Once a government has decided on a flat tax, it does not need to face periodic alterations to its form. If the government needs greater revenue it simply raises the flat rate. If it needs less, it lowers the rate. The tilt in taxation is thus taken out of the political process, reducing friction.

Another advantage of a flat tax is that the same amount will be collected by the government regardless of the taxpayer's identity, for instance, whether the employer or employee pays tax on fringe benefits.

Under a progressive tax system, who pays and when they pay become important. This leads to inefficient economic transactions designed to obtain private gains with no social benefit.

What of the argument that a progressive tax is fairer because it redistributes resources to those who need them most?

The response is that the tax system should not be the only mechanism for redistribution. First, the government should sort out the provision of public goods, then get private markets organised and regulated efficiently.

Only when these jobs are complete should it consider how many people need substantial assistance or protection. If the first two tasks have been done well, the number of people in need should shrink over time in a growing economy.

Transfers are a more efficient, powerful and comprehensive means of redistribution than progressive taxation.

Thus, a flat tax system could be coupled with a transfer system based on criteria that establish who should qualify for welfare assistance.

Yet even without that explicit mechanism, a flat tax itself brings about significant redistribution when used to fund social programmes. Those on higher incomes pay more in absolute terms but often make less use of government services.

The redistributive aspect of a flat tax is even greater when non-pecuniary income is taken into account.

Individual wealth is more comprehensive than a simple measure of individual property and money in the bank. Wealth can be thought of as the sum of hedonic pleasures and financial assets.

Hedonic pleasures include things as mundane (and vital) as good health, happy relationships, being able to laugh and enjoy life.

When somebody's income is taxed and that person is supplied with, for example, police protection, the government is not only protecting their property but also their liberty and hedonic resources, both of which fall outside the conventional tax base.

A flat tax hits financial wealth but the revenues it generates are used to protect both financial and hedonic resources. It follows, then, that redistribution will occur towards people who are relatively poor in financial terms.

A move to a low single rate of tax would not mean tax increases on low income earners. Also, they would not face higher tax rates as their incomes rose and they would share in the benefits of faster economic growth a better tax structure would generate.

When the overall questions of wealth production and wealth transfer are combined, the flat tax emerges as a powerful, durable and simple idea.

Hong Kong and Singapore are countries with "almost-flat taxes".

Russia has introduced a flat tax of 13 per cent and Estonia, Latvia, Lithuania, Serbia, Ukraine, Slovakia, Georgia and Romania all have relatively low flat taxes.

It is ironic that the flat tax is popular in former communist countries. It was Karl Marx, in his Communist Manifesto of 1848, who was among the first to call for "a heavy progressive or graduated income tax" at a time when a flat rate was the norm in the early industrialising countries.

It is no accident that every strong defender of limited government has gravitated toward the flat tax. This is true of John Locke, Adam Smith and Friedrich Hayek.

Nobody would try to put themselves in that league, but I shall cast my vote with the giants and let those who dissent find some other champion - perhaps Karl Marx.

* Richard Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago.

This article is based on a talk he gave in Auckland last year on a visit hosted by the New Zealand Business Roundtable.