Do Richer People Pay a Higher Proportion of Tax Under a Flat Tax?

[Q:] My friend and I were discussing flat tax proposals where the income tax rate is the same no matter what your income level is. I think that richer people should pay a higher proportion of their income so the flat tax is a bad idea. My friend said that even with a flat tax richer people would still pay a higher percentage of taxes because of exemptions. Is this true and what are those exemptions?

[A:] Thank you for your great question.

To first consider how much a taxpayer would pay under a flat tax system, first we have to consider a flat tax proposal. Let’s consider the proposal by Malcolm S. Forbes, Jr. from a few years back. At its core it has the two basic features:

1. A $13,000 per taxpayer basic personal exemption
2. A 17% tax rate on every dollar earned past that $13,000

Economists refer to the 17% tax rate as a marginal tax rate, as it is the percentage you have to pay when you earn an extra dollar of income.

Your concern that “richer people should pay a higher proportion of their income” is not dealing with marginal tax rates but instead with the average tax rate. Unlike the marginal tax rate, the average tax rate measures what percentage of your overall income goes to the taxman. We can see the difference with the use of an example.

Take a man who earns $20,000 a year. His marginal tax rate is 17% because if he earns an extra dollar that is the rate at which he will be charged. His average tax rate will be different, as he is exempt from paying taxes on the first $13,000 he earns. Thus he has to pay 17% on the remaining $7,000, for a tax bill of $1,190. That $1,190 represents 5.95% of his total income, for an average tax rate of 5.95%.

With the basic personal exemption, a low income taxpayer has an average tax rate which is much lower than the marginal tax rate of 17%. Here are the average tax rates for income levels above $20,000.

Average Tax Rates Under The Forbes Plan

• $30K: 9.65%
• $40K: 11.48%
• $50K: 12.58%
• $75K: 14.05%
• $100K: 14.79%
• $200K: 15.90%

Your friend was right, under a flat tax the rich do pay a higher percentage of their income in taxes than do the working poor. This is due to the impact of the basic personal exemption, which I suspect is one of the exemptions your friend was talking about. As your income increases this exemption starts to represent a smaller proportion of your income and thus loses its importance. For the exceedingly wealthy this exemption becomes almost meaningless and the average tax rate is only a shade lower than the marginal tax rate of 17%.

By examining the difference between marginal tax rates and average tax rates we see that even under a flat tax proposal the rich would still pay a higher proportion of their income in taxes.

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