Flat tax retains progressivity

Ever since North Carolina enacted a major tax reform package in 2013, left-of-center politicians and pundits have lamented the disappearance of a progressive income tax.

The reason for their disappointment is unclear. That disappointment is especially perplexing if their goal is to ensure that taxpayers with higher incomes pay larger percentages of their income in taxes.

North Carolina’s flat tax, combined with substantial increases in the standard deduction, accomplishes that very goal.

To recap: The 2013 state tax reform package replaced the old progressive individual income tax with a single flat-rate tax. Rather than assess a tax of 6 percent, 7 percent, or 7.75 percent, depending on the level of income, North Carolina instituted one flat rate — 5.8 percent – starting in 2014. Lawmakers have continued to lower the flat rate. It drops to 5.25 percent in 2019.

They aren’t acting on a whim. Peer-reviewed academic research consistently shows that higher top marginal income tax rates have a negative impact on state economic performance.

It would be easy to look at the tax rate changes above and assume that the new system ended tax progressivity. If there’s just one tax rate, it might appear unlikely that higher earners are paying higher rates.

But that assessment ignores another change in the state income tax that accompanied the lower, flattened rate. Lawmakers substantially increased the standard deduction, or zero tax bracket. They removed much larger chunks of a taxpayer’s income from taxation.

Prior to the 2013 tax reform, single tax filers took a standard deduction of $3,000. Married couples filing jointly took a standard deduction of $6,000. The initial tax reform bumped those numbers up to $7,500 and $15,000.

And lawmakers didn’t stop there. As they have lowered the flat rate, they have continued to raise the standard deduction. This year, the deduction jumps from $8,250 to $8,750 for single filers and from $16,500 to $17,500 for married couples. In 2019, the deduction jumps again to $10,000 for single filers and $20,000 for married couples.

In the span of six years, the standard deduction will have more than tripled.

To explain how this change affects the income tax’s progressivity, let’s compare the tax bills for married couples at several different income levels. We’ll assume these couples have no children. Rules linked to child tax credits and deductions also have changed in recent years to favor lower-income taxpayers.

We’re also ignoring all other exemptions and credits that existed before and after the 2013 tax reform. Yes, those factors influence the total tax bill each taxpayer faces. But they are irrelevant to a comparison of the relative progressivity of a progressive tax code vs. a flat tax with a higher standard deduction.

It’s been useful in the past to employ the example of a bank teller earning $25,000 a year and a bank president earning $120,000. We’ll also add a corporate CEO with income of $1 million. In each case, we’re assuming a married household with a single worker.

Under the old progressive system, the 6 percent tax rate kicked in for married households as soon as they subtracted all credits and exemptions. Once taxable income hit $10,625, the rate jumped to 7 percent. The rate jumped again to 7.75 percent with taxable income above $50,000.

In our scenario, the married bank teller with no kids paid $1,223 in income tax. The effective tax rate was less than 4.9 percent. The bank president paid $8,353. The effective tax rate was less than 7 percent. The million-dollar earner paid $76,553. The effective tax rate was more than 7.6 percent.

The bank president earned 4.8 times as much as the teller and paid 6.8 times as much in taxes. The million-dollar taxpayer earned 40 times as much as the teller and paid 62 times as much in taxes.

The system was clearly progressive. Earn more money, then pay a higher percentage in taxes.

But what about the flat tax with the higher standard deduction? In 2014, the first year of the new flat-tax system, the bank teller in our scenario paid $580, with an effective tax rate of 2.3 percent. The president paid $6,090 (5 percent). The million-dollar taxpayer paid $57,130 (5.7 percent).

The bank president still earned 4.8 times as much as the teller, but now paid 10.5 times as much in taxes. The million-dollar taxpayer earned 40 times as much as the teller and paid 98.5 times as much in taxes.

Yes, this means even more progressivity under the flat tax than under the old progressive system.

Fast forward to 2017. Under current rules, the bank teller pays $412 (1.6 percent). The president pays $5,636 (4.7 percent). The million-dollar taxpayer pays $54,027 (5.4 percent).

The bank president now pays close to 14 times as much income tax as the teller. The million-dollar taxpayer pays 131 times as much.

Yep, still even more progressive.

In 2019, the teller’s tax bill drops again to $262 (1 percent). The president will pay $5,250 (4.4 percent). The million-dollar earner will pay $51,450 (5.1 percent).

The bank president will pay 20 times as much as the teller. The million-dollar earner will pay 196 times as much.

Even more progressivity.

It’s fair to point out that higher-income earners are more likely to itemize their deductions, rather than taking the standard deduction. That means they could pay tax bills smaller than the ones listed above. If that creates a progressivity problem, then the problem lies within the deductions — not the flat tax.

It’s also fair to point to credits and exemptions under the old tax system that allowed lower-income earners to shield more of their money from the tax man. Those exemptions and credits could have made the progressive system more progressive. It’s worthwhile to explore credits and exemptions that help working families without generating negative unintended consequences for the economy as a whole.

But those caveats do not erase the fact that a flat income tax rate, combined with a higher standard deduction, maintains a high degree of progressivity. Each increase in the standard deduction builds in even more progressivity.

When one taxpayer can earn 40 times as much money as another while paying nearly 200 times as much in income taxes, it’s hard to argue with a straight face that the system is skewed to his advantage.


Mitch Kokai is senior political analyst for the John Locke Foundation.

Mitch Kokai is senior political analyst for the John Locke Foundation.