LSAT 72, RC Passage 4, Flat Tax (Comparative), LSATHacks

This is an explanation for passage 4 of LSAT preptest 72, the June 2014 LSAT – the comparative passage. The passages are about taxation. The first passage discusses the advantages of having a flat tax. The second passage argues that progressive taxes are better than flat taxes, because flat taxes are unfair.

This section has paragraph summaries and an analysis of the passage, links to the explanations for the questions are below.

Paragraph Summaries

Passage A

1. A flat tax with no deductions seems to work in Estonia.
2. Some say flat taxes are unfair. Some believe that flat taxes will tax the rich less than our current progressive systems do. 
3. But flat taxes can have thresholds below which no taxes are paid. Also, normal tax systems have deductions. High income earners usually end up paying about as much under a flat tax.

Passage B

1. It’s a myth that you pay more on your existing income by moving to a higher tax bracket. Progressive taxes treat people equally. (See analysis for detailed discussion.)
2. The poorer you are, the more useful an extra dollar is.
3. Some flat taxes exempt the poor. That means you jump from no taxes to the highest bracket instantly. Middle class people will pay more from a flat tax.

Analysis

Passage A has muddled logic. There are a few issues we need to disentangle to consider flat taxes. I’m going to start with an overview of taxation. I’ll talk about the passages themselves once I clarify the issues. 

Flat vs. progressive taxes

In the United States and most of the Western world, taxes are progressive. This is often misunderstood. Let’s say you earn $50,000. 

Here’s how a progressive system might tax your $50,000:

First $10,000: 0%

$20,000 after that: 20%

$20,000 after that: 30%

Anything above $50,000: 40%

People often think that you can lose money by increasing your income and moving to the next taxation level. This is false. Whether you earn $50,000 or $1,000,000, your first $50,000 are treated the same. Everyone pays no tax on the first $10,000 of income.

So under the system I described, someone with $50,000 pays $10,000 tax. They pay zero on the first $10,000, $4,000 on the next $20,000 (at a 20% rate) and $6,000 on the next $20,000 (at a 30% rate). 

So their average tax rate is 20%. On their last $20,000 they paid a tax rate of 30%, but they had a lower rate on lower income so that dragged down the average. 

The marginal tax rate is 40%. That means that any income over $50,000 is taxed at 40%. 

So if someone earns $60,000, they pay $10,000 on the first $50,000 (as I calculated above) and then an additional $4,000 on the remaining $10,000, which is the 40% marginal rate. 

So their total taxes are $14,000 and their average tax rate is 23.3%. Their marginal rate is still 40%.

Who pays more with a flat tax?

Confused yet? This is actually still a simple tax system. I haven’t introduced deductions, which come in the next section. But first, let’s look at a flat tax.

Let’s say a flat tax exempts the first $10,000 of income. You pay no tax on that money. And then you pay 25% on the remaining income, no matter how much you earn.

How much tax does someone earning $50,000 pay? Their first $10,000 is exempt, so they pay 25% tax on the remaining $40,000, which is $10,000.

So under my flat tax system, a $50,000 earner pays exactly the same. 

What about someone earning $60,000? They pay the same $10,000 as someone earning $50,000, plus an additional $2,500, which is 25% of their extra $10,000. So they pay $12,500 total. Which is less than they paid before.

Who pays more under a flat tax? Someone earning $30,000 or less will pay more under this system. Someone rich will pay much, much less. 

Now, you can fiddle the numbers by changing the rates or by increasing the exemption, but generally the poor pay more under a flat tax, average earners pay about the same, and the rich pay less. But the more money you were getting from the rich, the more you’d have to raise taxes on the poor and middle incomes to make up for the lost money from the wealthy. 

Passage A skirts this issue of progressive taxation almost entirely. Instead, they focus on deductions. 

Tax deductions and simplified tax codes

When you pay taxes, you can reduce the amount you pay by claiming deductions. For instance, in America, you can reduce your taxes if you paid interest on a mortgage.

In Canada, I can get a tax deduction if I take public transit and buy a monthly pass. There are deductions for all kinds of things. Governments love deductions because they make governments look good, and because deductions don’t cost money directly.

But a large number of deductions make the tax code more complex. America has a vast number of deductions, far more than Canada. This is the reason your tax returns are complicated. Canadian taxes, for a regular employee, are incredibly simple and can be finished in an hour or two. 

In passage A, the flat tax removed all deductions. This has the effect of considerably simplifying the tax code. This is, generally, a good thing. Economists of all persuasions tend to agree on this point.

This is also the reason a flat tax might gain more from the rich. Tax deductions tend to be better for the wealthy. They have complex enough financial affairs that they can take advantage of them, and they can also afford an accountant who will find all the deductions that can benefit them.

What Estonia Did

So Estonia’s tax reform really did two things. It made the tax system “flat” – there is one rate for everyone. And it also removed all deductions, simplifying the tax code. 

These two changes are often proposed together, but they don’t have to go together. 

Here lies the confusion of passage A. The author argues for a “flat” tax system, but their evidence is based mainly on the benefits of a “simplified” tax system that has no deductions.

Estonia may well have succeeded with their new tax system, but we don’t know if it’s because it’s flat or simplified. 

Passage B has a clearer view of what a flat tax system might do. If the rich pay less, it will be the middle that makes up the difference. 

Passage A does have a good point about tax evasion. The more taxes you levy on the rich, the more likely they are to try to avoid them (often legally, though certainly not always). So making a simple, flat tax system may actually have the effect in practice of raising more money from the rich even if in theory a progressive system would get more. 

Passage B would be stronger if it addressed this practical issue. Mind you, it’s difficult to discuss since we have little real world experience of flat taxes.

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