August 11, 1995

August 11, 1995 | Commentary on Taxes

ED081195: A Friendly Critique Of The Flat Tax

Many people would like you to believe the flat tax is so named because it will flatten your finances. That, at least, is the intended conclusion from a flawed study recently released by the National Association of Realtors.

By eliminating personal deductions like mortgage interest payments, the study claims, the flat tax would reduce housing values in this country by upwards of 10 percent. But the study's methodology is shaky at best, and the jury on housing values is still out.

Despite the forces allied against the flat tax, tax reform momentum has grown steadily because the current tax system is so unpopular and the alternatives promise so much. The leading contender, the flat tax proposed by House Majority Leader Richard Armey, R-Texas, is easy to explain, addresses the need to increase savings and investment, and seems eminently fair to most people. House Minority Leader Richard Gephardt, D-Mo., is attempting to trump the Armey plan with a "flat tax" that sets up five tax rates to Armey's one.

But in addition to the possibility of lower housing values, the flat tax poses several other serious problems too easily dismissed by its advocates.

Businesses may be the flat tax's second biggest obstacle. By reducing the cost of compliance with the tax laws and removing uncertainties about their tax situation, the flat tax would eventually benefit businesses. However, they would see their tax burden rise by about two-thirds, on average, from around 31 percent of the total tax burden to around 50 percent. This tax increase on businesses would result from the loss of deductions for state and local taxes and for employee fringe benefits, among other things.

Though businesses will try to pass on these costs to consumers and employees -- by raising prices and trimming fringe benefits, for example -- shifting the nation's tax burden to the business community will not produce successful tax reform.

Next, the flat tax initially would raise taxes on the middle class by 20 percent. On average, a family with between $40,000 and $50,000 in adjusted gross income would see their taxes rise by about $700 -- to about $7,500. Of course, Mr. Armey's plan calls for the tax rate to decline to 17 percent in its third year, but this happy event is contingent on about $400 billion of additional spending cuts beyond what the Congress has already called for to achieve a balanced budget. Far easier said than done.

The flat tax appears also to have a major fairness problem. Consider two families. The Joneses have a combined salary of $50,000 in wages. Under the Armey flat tax, a 20 percent rate would cost this family $3,700. Now consider the Smiths, who in retirement consume every dollar of their $1 million in dividend income. Under the flat tax, the Smiths owe no tax at all because capital income is excluded from the tax base. To be sure, their dividend income was taxed at least once at the business level before they received it. But the perception would persist that a high-income family could pay no tax. Will tax fairness be defined so that individuals consuming significant amounts of capital income would pay little or no tax?

Though difficult issues, they are not impossible to resolve. Moreover, the system's advantages could well outweigh its drawbacks. The flat tax could prove a boon for the economy by eliminating a passel of convoluted tax disincentives to saving and investing. Economists will quibble over exact estimates, but there can be no question that saving and investment will improve in both the short and long run under a flat tax.

Advocates are correct to insist that the flat tax would be much simpler than the current tax system. The new system would tax only the income derived from individual labor, after allowing for personal exemptions. There would be no deductions. The flat tax would tax business' net cash income at the same rate that applies to individual income, while eliminating all the special tax provisions that penalize some businesses while benefiting others.

One big problem with the current system is that it costs from $150 billion to $300 billion annually to operate. The flat tax, by contrast, would cost about 1/15th as much once fully phased in. These cost savings are equivalent to more than a $100 billion tax cut for the American people.

No tax system is perfect, and no tax reform proposal is without flaws. In the end, the flat tax's greatest strength is that it would remove the current tax system's depressing effect on the economy. This, over time, could make up for all the problems mentioned above.

But before it can pass, the problems will have to be addressed.

This essay by J.D. Foster, Ph.D., executive director and chief economist for the Tax Foundation, is adapted from his article in the Summer 1995 issue of Policy Review, the quarterly journal of The Heritage Foundation, Washington, D.C.

About the Author

J.D. Foster, Ph.D. Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
Thomas A. Roe Institute for Economic Policy Studies

This essay by J.D. Foster, Ph.D., executive director and chief economist for the Tax Foundation, is adapted from his article in the Summer 1995 issue of Policy Review, the quarterly journal of The Heritage Foundation, Washington, D.C.