I totally agree that flagging is a horrible idea that doesn't work. Maybe the concept of flagging is in the right place (trying to let the users balance payouts where they think they are deserved). However, I think there is too much emotional attachment with flagging.
When people are flagged there is a sense of being attacked personally. Even if the flag was just to decrease your payout, I think you can't help but feel some sense of personal attack. This causes emotions to get involved which can escalate into the wars we have seen.
I think that there should be flagging, and possibly some anonymous way to decrease payouts on people's posts. It should still deduct from you in some way (so people don't randomly flag), but it also means that people can flag feeling safe they wont be flagged just for trying to show their honest feelings.
Then again, this would have a lot of problems too...