Fairness versus Prosperity: The Flat Tax

Americans must choose--fairness or prosperity. Certainly we can mitigate income inequality and increase levels of GDP by limiting the most egregious excesses of corporate remuneration. See my post on corporate boards acting on behalf of shareholders and limiting poorly performing CEO salaries here. However, the country must choose, as a matter of policy, high GDP growth and job creation or progressive taxation. You can't have both.

When tax rates were very progressive, in the 1950s, GDP growth was steady if unspectacular. (Source information here.) GDP really took off in the 1960s, after the top marginal tax rates went down from 92 percent to 77 percent in the 1960s. The Reagan boom was also fueled by marginal tax rate cuts, the top earners paying 50 percent. Lower tax rates also lead to greater resources for government. As the Laffer curve (below) demonstrates, when marginal tax rates are too high, people use tax avoidance (or illegal tax evasion) strategies to shield income from the IRS.

Ironically, those that want increased government spending on social programs should not be in favor of confiscatory marginal tax rates on the rich. Setting rates back up to 90 percent will put less money in government coffers.


What would happen if we did away with our ridiculously unwieldy, complicated, and wasteful progressive income tax, and replaced it with a flat tax? (See this.) Both Herman Cain and Rick Perry favor a form of flat tax. The New York Times, predictably, hates the idea. Robert Frank writes in The Problem with Flat-Tax Fever (link here) that the flat tax can be just as cumbersome as our current system if it all the usual tricks are needed to compute adjusted gross income, and the flat tax is unfair because the rich would be taxed less and the poor more. These criticisms can be easily refuted. A good flat tax is a simple tax. Add up all ones income and multiply it by a percentage, say 20 percent. There are no deductions are complications. The calculations can be completed on a postcard. Each American saves hours of time and hundreds of dollars (or more) in lost revenue computing their taxes.

Is the flat tax regressive? No, the rich pay the same percent as everyone else but they still pay more. The woman who made a million dollars pays $200,000 with a 20 percent tax rate. Joe Six Pack, bringing home $40,000, pays $8,000. The rich will still pay the lion's share of IRS inflows.

Most importantly, will the flat tax turn our economy around? Wikipedia has an excellent analysis of the pros and cons of the flat tax. (See the article here.) The article shows how the Russian Federation, Estonia, Latvia, Lithuania, Ukraine, Slovakia, Romania, Hungary, Macedonia, Albania, and Bulgaria have implemented a variation of the flat tax in order to stimulate growth. Lithuania has boasted of strong growth, though it is hard to say if the flat tax alone is most responsible. Many more countries are considering the flat tax. Should the United States give it a try? Arthur Laffer writes that the flat tax is a recipe for growth, proposed (quite ironically) by the current Democratic governor of California, Jerry Brown, in 1992. (See editorial here.)

Will the flat tax increase income inequality? Perhaps, but with unemployment stuck at high levels, our economy needs a shot of strong medicine to grow GDP and create jobs. Recessions lower inequality but also throw many of the poor out of work.Those who have been without a job for months will be hired only when expanding businesses need workers. Extreme poverty has increased in the last year. (See article here.) Our current taxation system is not working well, and the flat tax is worth a try.

Paying CEOs a Little Less--Doing Something About the Gap Between Rich and Poor

I rarely agree with the opinions of socialists and anarchists and cannot empathize with the Occupy Wall Street (OWS) movement. However, an increasing gap between the very rich and everybody else is neither economically advisable or, as it turns out, truly necessary.  We need to have some gap between rich and poor. Otherwise, people would have no incentive to work hard, be creative, and serve others, and we would become another decrepit and creaky Soviet Union or an anachronistic Cuba where the people earn $20 a month. But when the gap between rich and poor becomes too great, the poor struggle to survive and the rich have too much economic and political power. One group of the rich, CEOs of public corporations, have been improperly rewarded for performance, and their remuneration packages are ridiculously high.

I was intrigued by an article on Jewish ethics criticizing overly high CEO remuneration packages. CEO pay has escalated once again, averaging more than $10 million per year for leaders of Fortune 500 companies. Some CEOs earn their stratospheric pay, increasing the company’s value and making larger shareholders rich. However, most do not truly earn their millions, making more than 300 times their lower paid corporate employees, even when the company reports lackluster results.

Michael Dorff explains in a number of different ways the reasons boards do not limit CEO pay. In the compilation Money (pp. 45-51, edited by Elliot N. Dorf and Louis E. Newman) Dorff notes that shareholders, the company owners, have a vested interest to keep pay down to reasonable levels. Whatever is not paid out in salaries is left over for the shareholders. Shareholders, represented by the company’s Board of Directors, suffer because the Board does not act in shareholders’ interests. They completely give into the CEO’s demands for overly generous remuneration.

Members of the typical Board of Directors have an easy, high-paying job—a few meetings a year for $40,000 (or more) plus benefits. Dorff remarks that no one wants to turn down such a wonderful situation, hardly working for a lot of money and prestige. If a Board member keeps his mouth shut, he will be invited to sit on other corporate boards and make even more easy money. Management nominates the slots for open board positions, and nominees are unopposed. Who wants to give up the gravy train for criticizing a CEO’s pay package? Shareholders’ interests and the Board member’s interests are not aligned.

I suggest that public companies change the way they pick and pay Board members. Only those stockholders that own the most stock, let’s say the top fifty shareholders, should be invited to serve, and these Board members, once elected, should receive no compensation for serving. Serving on another company’s Board for pay is grounds for dismissal. Thus we have aligned the Board’s interests with the rest of the shareholders, and it is more likely that CEO pay will be based strictly on performance and the salaries will not be overly generous. What has been saved on CEO salary can be reinvested in the business or distributed directly to shareholders.

Reserving Board membership to top shareholders may make Boards less diverse. Most rich shareholders are white males. However, since the Boards will be more responsive to shareholder interest it will be worth it. Diversity is not an end in itself but a means to avoid “groupthink” and a good old boys club. Making Boards less in management’s back pocket will avoid these problems as well, leading to a more equitable distribution of the owners’ money.

Bibliography

Dorff, Elliot N. and Newman, Louis, E., Jewish Choices, Jewish Voices, Money, JPS, Philadelphia, 2008

Postscript. June 25, 2012
The New York Times bemoans the fact that corporations have not learned a lesson from the last few years, and CEO pay rose five percent on average for 2011. (See the article, C.E.O. Pay Is Rising Despite the Din here.) Yet, since corporate boards have tied pay closer to performance, and corporations are making record profits, this may not be so bad for stockholders. We will see what happens when profits decrease. Will the CEO pay go down then? Will corporations spread the wealth a bit more, giving their lower paid employees a boost?

Postscript October 20, 2012
In her Fair Game column, Gretchen Morgenson describes a study that shows that Boards are overpaying CEOs. Reasearchers Elson and Ferrere conclude that CEOs cannot "readily transfer their skills from one company to another." So CEOs will not leave simply because someone else makes more money. Boards must reign in CEO pay. In her April 7, 2013 article, The Infinity Pool of Executive Pay, Morgensen quotes an expert: "Don't expect executives to give up on their prized perks anytime soon...even if shareholders can now publicly register their displeasure."

June 2, 2013
Adam Davidson interviews Harvard Law School professor Lucian Bebchuk. "His solution is to pass laws that make it easier for shareholders to vote out boardmembers who fail to discipline underperforming chief executives."