May 25, 1995 | Backgrounder on Taxes
Legislation to dismantle the current tax code and replace it with a simple, 17 percent flat tax triggered immediate and strong support when introduced last year by now-House Majority Leader Richard Armey (R-TX). Newspaper columnists said that, among other things, this "revolutionary reform" would eliminate a "Rube Goldberg tax code."1 In the view of taxpayer groups, "this legislation would unleash enormous economic growth and greatly increase personal freedom"2 while "eliminat[ing] the long-time bias in the current tax code against saving and investment."3 And Representative Armey has received thousands of letters of support from people all across the country. In short, millions of Americans know the current system is burdensome, unfair, unworkable, and beyond repair.
A flat tax is more than popular, however; it is economically sound. If enacted, for instance, it would:
America's tax system is a major reason for Americans' widespread distrust of politicians. Taxpayers know they can spend their money more wisely than bureaucrats and lawmakers, who seem reflexively to raise taxes at every opportunity. The tax burden in America is now at an all-time high, and economists estimate that this causes both economic growth and job creation to suffer.
But this animosity is driven by more than opposition to an ever-growing tax burden and concerns about lost jobs and lower wages. Most Americans see the tax code as bewilderingly complicated, with laws and regulations written for the benefit of special interests rather than ordinary citizens. Families and businesses must pay huge amounts to comply with this code, but even this does not ensure an audit-proof tax return. Tax lawyers and accountants admit that some provisions of today's tax law are so complex that it is impossible to know whether returns are filed correctly.
Congress could solve most of these problems by adopting a flat tax, taxing income at a low, single rate and, with the exception of a family allowance, eliminating the current labyrinth of rates, deductions, credits, and exemptions. No income tax ever promoted economic growth, but a flat tax at least would penalize work, savings, and investment far less than the current tax code.
Unfortunately, while tax experts across the political spectrum have been attracted to the flat tax, politicians have not been as receptive. A flat tax would undermine their ability to use the tax code to finance new spending, to grant favors to powerful interests, and to generate contributions from those seeking to change or preserve specific features of the tax code. Now, however, thanks to the sweeping changes in Congress wrought by last November's elections and the voters' demand for simplicity and fairness, a historic opportunity exists for radical reform of America's tax system.
What is a Flat Tax?
While no two of the several flat tax proposals advanced over the years have been identical, they usually are based on the proposal developed about fifteen years ago by Stanford University economists Alvin Rabushka and Robert Hall. Among the key features of a Hall/Rabushka-style flat tax are:
While they share certain core principles, however, flat tax proposals are not identical. The Armey proposal, for instance, calls for a very generous family allowance.13 Others include smaller personal allowances, a feature which allows the tax rate to be dropped even further. Another major issue is whether a flat tax also should be a tax cut. The Armey proposal would reduce government revenues (according to static estimates). Others, like the Specter bill, would collect the same amount of revenue.
Other differences involve the tax treatment of business. All flat tax proposals based on the Hall/Rabushka model, such as Armey's, address the many anti-growth features of the corporate income tax. In theory, however, a flat tax could be designed that applies only to the personal income tax. The Social Security and Medicare payroll taxes, which together are the equivalent of a 15.3 percent income tax for most Americans, are yet another unresolved issue. Unlike the income tax, the Social Security portion of the payroll tax (12.4 percent) is levied only on the first $61,600 of income. The Medicare portion (2.9 percent) applies to all wage and salary income. Hall/Rabushka-based flat taxes do not attempt to tackle the special problems of these retirement programs, though it would be possible to design a flat tax which incorporated payroll taxes.
In addition, there are proposals that move in the direction of a flat tax but, for various reasons (usually political), do not satisfy all three core criteria. Some retain a "progressive" rate structure, penalizing those who contribute most to the economy's growth14; others retain some deductions, usually for fear of offending a powerful constituency15; and still others would continue to double-tax savings and investment. Such proposals generally are an improvement over the status quo, but they clearly would not have the positive impact on jobs and wages that a true flat tax would have.
More important, these attempts to find a "middle ground" lack the political appeal of a genuine flat tax. One reason the flat tax is so popular is that it breaks the special-interest logjam by reversing the notion that the tax code should be used to reward some groups while penalizing others. But allowing politicians to continue choosing winners and losers also allows tax lawyers and lobbyists to retain power and influence. Even worse, because of budget deficit concerns, retaining special provisions in the tax code almost inevitably results in tax rates that are higher than they would be under a true flat tax. These halfway steps also undermine the goal of simplicity, since every surviving credit, deduction, and exemption means longer and more complex tax forms. For these reasons, more "moderate" flat tax proposals most likely would fuel cynicism among ordinary Americans and generate far less support than more radical plans.
Why a Flat Tax is Fair
Perhaps the most common argument against a flat tax is that it would not be "fair." This assumes that the tax code should impose increasingly steep rates on people as their income rises. More specifically, a so-called progressive rate structure facilitates far more income redistribution than is possible under a single-rate system. As will be discussed in further detail later, the economic consequences of this approach are severe and have been demonstrated in many studies. Even leaving the broad economic argument aside, however, the redistributionist approach fails any reasonable test of morality and is fiscally counterproductive.
"Progressive" taxation is discriminatory
The central tenet of a progressive tax is that the government has a right to larger shares of an individual's income as his income rises. But traditional notions of fairness suggest the law should treat citizens equally, and penalizing those with higher incomes violates this principle. As John McCulloch, an early student of taxation, warned, "The moment you abandon... the cardinal principle of exacting from all individuals the same proportion of their income... you are at sea without rudder or compass, and there is no amount of injustice or folly you may not commit." 16 Those favoring high, confiscatory tax rates sometimes argue that well-to-do taxpayers received so much from society that it is only proper that government seize bigger portions of their income and use the money to benefit the less fortunate. This approach presents several fundamental problems.
First, in the private sector, income is earned by offering others something of value. Employers pay workers because they produce; consumers buy products because they value them. Without government coercion, income is earned by offering something to society, not by taking something from society.
The redistributionist credo, by contrast, holds that income is earned at the expense of others in society. This assumes income is a fixed pie and that any additional income earned by one individual somehow comes out of the pockets of everyone else. As the chart above shows, however, earnings for all income groups tend to rise and fall in unison. Incomes for all groups, including the poor, rose substantially during the Reagan years when tax rates were reduced. They did not perform strongly during the Carter, Bush, and Clinton years when high-tax policies were enacted.
Second, advocates of high tax rates often claim that government
spending somehow helps the economy in general or the poor in
particular. As discussed previously, however, study after study
shows that higher levels of government spending are associated with
weaker, not stronger, economic growth. Even programs designed to
help the less fortunate, such as welfare and food stamps, seem to
conditions for the poor by trapping them in a cycle of
dependence on government.17 As the adjacent chart shows,
large amounts of welfare spending have not lowered the poverty
Third, studies have shown that high tax rates can backfire by discouraging work, savings, and investment, thereby reducing taxable income and depending on the tax rate causing revenues to stagnate or fall.18 According to this principle, popularly known as the Laffer curve, when tax rates reach certain levels, total tax revenue will fall. Despite attacks by politicians and journalists, the theory is valid. Imposing a 100 percent tax on income above a certain level, for example, almost certainly would yield no additional revenue, since people no longer would have any incentive to earn money above that amount. Conversely, the government would collect no money if tax rates were zero. The only question (bearing in mind that the revenue maximizing tax rate is not the same as the growth maximizing tax rate) is whether tax rates are so high that government loses potential revenue.
Unfortunately, official government projections are of limited use when attempting to calculate the "revenue-neutral" rate under a flat tax, since tax estimators in the Administration and in Congress assume that taxes have no impact on the economy19. Most Americans would find it hard to believe that government ignores economic effects in calculating revenue, but consider the experience of Senator Bob Packwood (R-OR). In 1989, as ranking Republican on the Senate Finance Committee, he asked the Joint Committee on Taxation (JCT) to estimate what would happen if the government confiscated all income above $200,000 per year. The JCT projected that such a tax would raise $104 billion in 1989, $204 billion in 1990, $232 billion in 1991, $263 billion in 1992, and $299 billion in 1993. As Senator Packwood remarked, the Joint Committee's estimate "assume[d] people will work if they have to pay all their money to the Government. They will work forever and pay all their money to the Government when clearly anyone in their right mind will not."20
This blunder was only a theoretical exercise, but it demonstrates the enormous shortcomings of its methodology. Unfortunately, it is this methodology that drives the JCT estimates that Congress uses when considering alternative tax proposals, and the results can be very costly, as many cases have demonstrated.21 Capital gains estimates in the late 1980s that were off by more than 100 percent were used to kill a capital gains tax reduction that could have eased the economic hardship afflicting the nation during the Bush Administration.22 The large tax increase of 1990 was approved in part because lawmakers were told it would balance the budget. Instead, revenues came in below the tax collection estimates made before the tax increase was enacted.23 Over the years, because of static revenue estimating procedures, the JCT has seriously overestimated revenues from such changes as the windfall profits tax, the corporate income tax after the 1986 Tax Reform Act, and the 1990 Luxury Tax on yachts.24 Ironically, the Clinton Administration admitted the flaws of static scoring during the debate on the General Agreement on Tariffs and Trade (GATT), arguing correctly that revenues generated by higher economic growth would more than offset tax cuts in the trade legislation.
Recent evidence confirms the negative impact of high tax rates on revenues. The 1993 Clinton tax increase was supposed to make the "rich" pay more by imposing the largest income tax rate increase since Herbert Hoover's in 1930. Yet, according to Administration budget figures, individual income tax revenues have been growing much more slowly than other tax revenues. These figures are an early sign that this increase in the income tax rate will not raise the $114 billion in new revenue the Administration predicted. What makes the figures even more surprising is that they include money generated by the retroactive and thus unavoidable tax increase on 1993 income (due on April 15, 1994). The fact that income tax revenues in 1994 were still 30 percent below the growth rates for all other revenues is particularly significant.
Not surprisingly, the punitive Clinton tax increase caused rich people to report less taxable income in 1993, as the chart illustrates. The cause of this drop tax shelters, reduced work effort, evasion is not yet clear. Whatever the cause, the entire economy suffers.
Given what happened in the 1980s, however, the failure of the Clinton tax hike should be no surprise. Critics charged that the Reagan tax cuts were a "giveaway to the rich," but government figures show that upper-income taxpayers paid a significantly larger share of the income tax burden after their tax rates were reduced. Simply stated, lower tax rates encouraged substantial income growth and reduced incentives to shelter and underreport income, and the result was a large increase in taxable income which generated substantial amounts of new revenue for the government even though actual tax rates were lower.
Advantages of a Flat Tax
There are two principal arguments for a flat tax: growth and simplicity. Economists are attracted to the idea because the current tax system reduces growth, destroys jobs, and lowers incomes. While it would not eliminate this damaging impact, a flat tax would boost the economy's performance when compared with the present tax code. For many Americans, however, the most persuasive argument for a flat tax is that the complicated documents and instruction manuals they must struggle to decipher every April would be replaced by a simple postcard-size form. This radical reform appeals to citizens who not only resent the time and expense of their own tax forms, but also suspect that the existing maze of credits, deductions, and exemptions gives a special advantage to those with political power and the money to afford tax accountants.
The Complexity Problem with the
By penalizing work, savings, and investment, the income tax has slowed economic growth and lowered living standards significantly. This economic damage is compounded by a tax code that imposes very high costs on those who try to follow the law. As categorized in James L. Payne's comprehensive Costly Returns: The Burdens of the U.S. Tax System, these costs include:25
According to Payne, today's tax code imposes 24.4 cents of compliance costs for every dollar of taxes raised.26 The Tax Foundation puts the cost at 15.2 cents27, though even this means the tax code imposes $192 billion of compliance costs. Testifying before a congressional committee, one economist stated, "If an enemy power bent on destroying our nation were somehow given the opportunity to devise our tax code with a goal of sapping the nation of its economic vitality... it could do little better than adopt our current Internal Revenue Code."28 A professor of tax law declared, "The United States now has the most complex tax laws in the history of civilization."29
While every tax system imposes compliance costs, a simple flat tax would sharply reduce these ancillary costs. As illustrated, the Armey proposal would allow all taxpayers, from the teenager flipping hamburgers to the General Motors Corporation, to submit their returns on a postcard-sized form.30 The original tax code was only 14 pages long, and tax forms were simple one-page documents31. Today's tax code has swelled to 3,458 pages.32 Moreover, the IRS receives more than 1 billion form 1099s every year as part of the government's cumbersome efforts to track income from interest, dividends, and other forms of business income.33 With a flat tax, this burden disappears. The effect would restore the simplicity of the original income tax.
The tax laws are only the tip of the iceberg. Internal Revenue
Service regulations, supposedly written to clarify ambiguities in
the tax code, are nearly six times the length of the actual tax
law.34 To put this in perspective, federal tax laws and
regulations are more than six and one-half times longer than the
King James Bible.35 Unfortunately, length is not matched
Compliance Costs of the Personal Income Tax
Most individuals are painfully familiar with the peculiarities of the personal income tax. They wade through the maze of forms and instructions or pay professionals to do the job for them. Studies show that Americans spend between 1.6 billion and 2.1 billion hours each year complying with the personal income tax.36 In dollar terms, this represents an annual burden of between $51 billion and $65 billion37, with compliance costs falling most heavily on small businesses and the self-employed, thereby ensuring that entrepreneurship is penalized.38
What do taxpayers get for their time and effort? All too often, they get wrong answers. Each year, for example, People magazine used to send tax information about a hypothetical family to 50 different tax preparers, and each year virtually every one came up with a different estimate of the family's tax bill most of them missing the right figure by a wide margin.39 They could have called the IRS for advice, but a 1987 General Accounting Office survey found IRS officials giving taxpayers the wrong information 47 percent of the time.40 This survey was conducted just after a major tax reform, and accuracy presumably has improved as IRS staff have absorbed its intricacies. Nonetheless, the fact that professionals both inside and outside of government have so much trouble with the law argues compellingly for a simple flat tax.
Compliance Costs of the Corporate Income Tax
The personal income tax code is relatively simple when compared with the laws driving the corporate tax system. According to Payne, American businesses devote more than 3.6 billion hours to tax compliance every year41, in addition to which compliance costs actually may exceed the total raised by the corporate income tax. One recent study estimated that these costs exceeded revenues by $40 billion, while another found them to be as much as 75 percent of revenues.42 Small corporations, those with assets of $1 million or less (90 percent of U.S. corporations), are especially victimized with compliance costs of $382 for every $100 raised.43
Like individual taxpayers, businesses may have no way of knowing
whether the information they put on their tax returns is accurate.
Provisions like depreciation, alternate minimum tax, uniform
capitalization, economic performance rules, transfer pricing, and
allocation rules all add to the complexity of corporate taxes and
help explain why businesses spend 3.6 billion hours a year trying
to figure out their tax bills. Worst of all are the provisions
affecting U.S. corporations that do business overseas. As one
executive has remarked, the "forms are so complex they defy
interpretation and result in noncompetitive cost
Many people in America and around the world choose to evade taxes by operating in the underground economy.46 By its very nature, the underground economy is difficult to measure. Scholars have come up with estimates ranging from a low of 4.5 percent of official U.S. economic output to a high of 27 percent.47 High tax rates and complexity contribute to a decision to operate outside the law48, but a great deal of the underground economy is the result of government decisions to impose criminal penalties on drugs, gambling, and prostitution. Income from such activity would not be disclosed whatever the tax rate, and this makes it more difficult to estimate the tax-induced economic losses from the underground economy.49
Costs of Taxation Incurred by Government
A complex tax system with high marginal rates also imposes costs on government. The annual cost of operating the Internal Revenue Service, for instance, is expected to reach almost $10 billion in 1995, and other government agencies also have tax-related divisions which add about $3.5 billion to the total. All told, according to one study, the federal government will employ more than 136,000 people and spend more than $13.7 billion enforcing the tax code in 1995.50 While considerably less than the costs borne by the private sector, these figures would drop significantly under a simplified flat tax.
The Economic Argument for a Flat Tax
There are two ways to increase a nation's economic output or rate of growth. In simple terms, Americans must work more or work more productively. Thus, economic growth depends on some combination of:
Why High Tax Rates Discourage
Taxes on labor discourage work by reducing the benefits (after-tax income) individuals receive from offering their labor to employers. In the language of economists, taxes reduce the "price" of leisure relative to work, so when taxes and other government policies make work less attractive by reducing take-home pay, many individuals choose either not to work or to cut back the number of hours they work.
This can take many forms. Economic research indicates that taxes have a strong impact on whether people work,53 particularly people with low incomes whose welfare benefits often result in higher after-tax "income" than they can earn by holding a job.54 Taxes also reduce incentives for those who do choose to work, causing a decline in hours worked and, in the case of high taxes, the willingness to work overtime (at least three strikes in recent months were against additional overtime).55 Excessive taxation also discourages second jobs, since workers often find that the additional after-tax income is not enough to offset the leisure time sacrificed. Appendix 1 lists several studies that document the impact of taxes on the decision to work.
Even though studies confirm the relationship, the idea that marginal tax rates profoundly influence individual incentives is not immediately obvious to many Americans. They recognize that businesses must watch the bottom line and thus understand how higher taxes depress wages and cost jobs, but they think about their own lives and conclude that a shift up or down in marginal tax rates probably will not mean dramatic change. Most Americans, after all, do not take second jobs in response to lower tax rates.56 Nor are many workers likely to refuse overtime just because they rise. How, then, will lower marginal tax rates encourage economic growth?
It turns out that high tax rates have a particularly pronounced effect at the upper end of the income scale. Unlike most citizens, the "rich" have significant control over the timing and composition of their income. As seen in the chart on page 9, "rich" taxpayers receive most of their income from investments and business activity.57
Whether wealthy taxpayers are small businesses or investors,
their relative lack of dependence on wage and salary income means
they have far more ability to alter their economic behavior and
protect their income when changes in tax rates alter incentives.
For small businesses, any increase in tax rates lessens the ability
to hire workers or retain earnings for expansion. Because of the
direct effect taxes have on their generally smaller profit margins,
small businesses are even more sensitive to changes in the tax code
than large corporations are.
Many well-to-do taxpayers, of course, receive a large portion of their incomes from dividends, interest, capital gains, and other types of investments or passive business earnings. As with most other Americans, they seek to realize the largest possible return on their investments and to protect as much of their wealth and income from the government as possible. In a survey conducted by Prince & Associates, a Connecticut financial consulting firm, 89 percent of 311 high-income business owners were found to be "extremely interested" in "tax minimization strategies."58
One significant advantage these taxpayers have over most other Americans is the ability to retain the services of highly qualified tax lawyers, accountants, and investment advisors, each of whom supposedly can generate the highest after-tax return for clients. Needless to say, increases in marginal tax rates reduce the attractiveness of many investments. This encourages tax professionals and their clients to focus on sheltering income, reducing tax code earnings, placing assets overseas, and otherwise avoiding taxes. Consider the following:
Municipal bonds are exempt from federal tax
In a Wall Street Journal report on the growth of these bonds in the aftermath of Clinton's record tax increase59, a member of one billionaire family noted, "A wealthy New York City resident is looking at a combined city, state, and federal rate of nearly 50 percent. So you've got to buy municipal bonds. You've got to. A long-dated muni yielding 5.5 percent is equal to a 10.53 percent yield on a taxable [U.S.] government bond."60 Rather than reduce the budget deficit, as politicians claim, high tax rates merely drive wealthy investors into tax-free municipal bonds and other shelters. The federal government does not collect new tax revenues, and overall tax collections may well fall. In addition, there is real damage to the economy as driving investors out of productive private-sector investments and into buying the debt of state and local government undermines economic growth, resulting in less job creation and stagnating incomes.
This anecdotal evidence that people respond to tax changes by acting to protect their earnings and change their behavior is supported by government data. Monthly personal income data from the Commerce Department, for example, show that income jumped sharply at the end of 1992 and fell just as dramatically in early 1993. The reason: the widely expected Clinton tax increase. Taxpayers with any discretion over when they received earnings shifted income from 1993 to 1992 to limit the additional amount taken by the government.
Not surprisingly, monthly tax collection figures echo these data. Taxpayers with modest earnings pay most of their income taxes in the form of amounts withheld from their paychecks throughout the year. Wealthy individuals and businesses, however, because most of their income is not subject to withholding, are legally obligated to make quarterly payments. Most of these payments are made routinely in the months they are due, but this pattern changed dramatically in 1993, when January's share of the payments was more than 70 percent higher than the average January share for the previous 15 years. This is significant, because January 1993 was the month quarterly payments for the last three months of 1992 were due. Well-to-do taxpayers shifted large portions of their income to 1992 because of widespread anticipation that the incoming Clinton Administration would increase marginal tax rates.
These quarterly payment figures underscore that small businesses and rich taxpayers can and do alter the timing and composition of their income to protect their earnings. One prominent example is the First Lady of the United States. Hillary Rodham Clinton elected to take her partner's share of earnings at the Rose Law Firm on December 31, 1992, rather than at the beginning of the following year as she had in previous years. Perhaps Mrs. Clinton, like other smart taxpayers, suspected the new President might propose higher tax rates and did what she could to minimize her family's tax liability. If she did, as the following examples indicate, she was not alone.
Why High Tax Rates Discourage Savings and
Taxes on savings and investment harm the economy by reducing capital formation, the process by which the quality and quantity of equipment, tools, and technology available to workers are increased, thereby raising their productivity.67 Since salaries and wages are linked closely to productivity, the only way to raise the income of workers permanently assuming no change in their skills is through savings and investment. Simply put, workers are paid on the basis of what they produce, and giving them better tools allows them to produce more.
The level of capital formation largely explains why workers in
the United States, Germany, and Japan earn more than workers in
Brazil, India, and Nigeria. Similarly, workers in America today
earn more than their parents because of net investment (increases
in the capital stock). As a result, they are more productive,
generating more output per hour of labor.
An ideal tax system does not penalize or subsidize particular economic choices. Unfortunately, one of the most destructive elements of the current income tax is the multiple taxation of savings and investment. Just as savings, dividend, business, and other forms of investment income are penalized by the personal income tax, capital formation is hindered by corporate income, capital gains, estate, and gift taxes, by depreciation tax provisions, and by the corporate alternative minimum tax.
Appendix 2 reveals ample evidence that taxes significantly reduce savings and investment. This is important, of course, because reduced levels of capital formation translate into reduced levels of income.
Why Capital Formation Matters
Economists of all persuasions recognize the relationship between investment and wages. Paul Samuelson, for example, a Nobel Laureate economist who endorsed Bill Clinton for President, has written:
What happens to the wage rate now that each person works with more capital goods? Because each worker has more capital to work with, his or her marginal product rises. Therefore, the competitive real wage rises as workers become worth more to capitalists and meet with spirited bidding up of their market wage rates. 68
Another example is taken from a 1991 report on economic growth prepared by the staff of the Joint Committee on Taxation, then controlled by the Democrats:
When an economy's rate of net investment (gross investment less depreciation)69 increases, the economy's stock of capital increases. A larger capital stock permits a fixed amount of labor to produce more goods and services. The larger a country's capital stock, the more productive its workers and, generally, the higher its real wages and salaries. Thus, increases in investment tend to cause future increases in a nation's standard of living.70
According to a 1989 report on economic growth published by the Congressional Research Service,
Capital deepening has been and will likely continue to be a central force for accelerating growth and potential output over the medium term. But as we have seen, a permanent increase in the long-term rate of growth will hinge on the United States ability to increase the pace of technical advance and innovation. However, both of these routes to faster growth will be contingent upon the ability to increase the level of investment spending more spending for capital equipment and more spending for research and development. To finance higher investment will, in turn, require that Americans raise the national rate of savings.71
Critics of this analysis complain that it is nothing more than "trickle-down" economics that relies on tax cuts for the "rich" to boost wages. Such rhetoric may be useful politically, but it cannot change economic reality, as economist John Shoven has explained:
The mechanism of raising real wages by stimulating investment is sometimes derisively referred to as "trickle-down" economics. But regardless of the label used, no one doubts that the primary mechanism for raising the return to work is providing each worker with better and more numerous tools. One can wonder about the length of time it takes for such a policy of increasing saving and investments to have a pronounced effect on wages, but I know of no one who doubts the correctness of the underlying mechanism. In fact, most economists would state the only way to increase real wages in the long run is through extra investments per worker.72
The following example illustrates why savings and investment suffer in the current tax climate. A taxpayer has $100 of income and must decide what to do with it. He can consume the $100, spending it on food, vacations, clothing, haircuts, or some other product or service, in which case (with the exception of possible sales taxes) he will receive close to $100 in goods and services for his money. Or he can invest in the stock of a start-up company with the potential to provide new jobs to the community and produce goods that consumers desire. If the company succeeds, the investor most likely will profit. If it fails, he will lose his $100.
In this case, the investment bears fruit and yields a 10 percent rate of return, enabling the company to produce $10 of annual income for every $100 invested. Under the current tax code, 34 percent is skimmed off to pay the corporate income tax, leaving only $6.60 out of the original $10. This $6.60 then goes to the investor as a dividend. But there are other taxes. Depending on the investor's income, the personal income tax will take as much as 39.6 percent of his $6.60, leaving him with less than $4.00 of annual income from a "successful" $100 investment. In addition, he may face applicable state and local income taxes.
Finally, if the investor ever decides to sell the stock, he will be hit by one of the highest capital gains taxes in the industrialized world, and what little income he eventually receives from saving and from having taken the risk of investing most probably will be subject to sales tax when he spends it. To add insult to injury, successful entrepreneurs who try to accumulate an estate to pass on to their children are penalized by inheritance taxes which can confiscate 55 percent of a deceased's assets.
Thanks to the tax code, a fortunate investor one who actually earns money on his investments may have to send more than half his earnings to the government, not to mention having already paid taxes on the money used for the investment in the first place. Thus, government tax policy has created a very tilted playing field. By punishing saving and investment, the tax code encourages both individuals and businesses to consume rather than to build for America's future.
As discussed earlier, the only ways to boost per capita income are to work more hours or produce more per hour worked. Since leisure has a positive value to Americans, particularly those with families, most would prefer to raise their living standards by increasing their hourly productivity. This is why taxes on capital are especially damaging. They penalize the very economic actions saving and investment necessary for increased productivity and the growth in wages that accompanies it. Thus, while it is important that the tax code not discourage people from working more if that is what they desire, eliminating the multiple layers of taxes on saving and investment is even more critical if we want higher incomes without sacrificing leisure time.
Why High Tax Rates Depress Economic
Since taxes affect incentives to work, save, and invest so powerfully, it should come as no surprise that major tax changes almost always have a significant impact on the economy. Herbert Hoover's decision in 1930 to increase the top tax rate from 25 percent to 63 percent certainly contributed to the Depression. Lyndon Johnson's surtax on income tax liabilities, enacted in 1968, together with an increase in the capital gains tax helped end the 1960s expansion. Large tax increases, including inflation-induced bracket creep, contributed to the economy's dismal performance under Jimmy Carter. George Bush's record tax increase in 1990 was a principal cause of the recent recession and subsequent anemic recovery. And the sub-par performance of today's economy, particularly the decline in median household income73, almost certainly is attributable in part to the record tax increase pushed through Congress in 1993 by Bill Clinton.
Once again, the evidence is confirmed by academic research. As the examples in Appendix 3 indicate, tax codes that penalize productive economic behavior are associated with weaker growth, fewer jobs, and lower incomes. Other studies find that the damage occurs when government spends the money. In either case, the message is clear: The larger and more intrusive a government is, the worse its economy performs.
Q : Will a flat tax encourage job
A: A flat tax will encourage more jobs and higher wages by
boosting incentives to work, save, and invest
In the long run, the elimination of most of the tax code's bias against savings and investment will have the biggest effect. As studies show, a flat tax will encourage capital formation, leading over time to higher levels of productivity, increased wages, and more jobs. A flat tax also will have a more immediate impact on job creation, however, by making work more attractive. High tax rates drive a wedge between what it costs a business to employ a worker and how much the worker receives in take-home pay.74 By increasing the cost of labor, taxes lower the number of workers a company is willing to hire. Businesses do not exist to pay workers more than they are worth. They exist to make money and will hire only as long as the value of each new worker's additional output exceeds the total cost of employing that worker.
When politicians enact policies that raise the cost of
employment, the total cost of some workers will rise above the
value they bring their employers. In the long run, a business has
only two options when faced with this predicament: close its doors
or lay off workers who are net money losers. Even workers who
retain their jobs pay a price. Taxes on labor income, whether paid
by employee or employer, dollar for dollar, unavoidably reduce the
amount that finds its way into their paychecks. Politicians may
pretend otherwise, but every time the tax burden climbs, workers'
after-tax income declines.75
Q: Would a flat tax reduce the budget deficit?
A: This depends on which flat tax is implemented
More specifically, it depends on the tax rate and whether the proposal includes limits on government spending. Even though lower rates generally stimulate economic growth and expand the tax base, at some point they translate into less revenue. A flat tax of 20 percent, for instance, almost certainly would raise more money than a flat tax of 10 percent. The size of the personal exemption/family allowance also plays a key role, since the decision to protect a certain amount of income ($36,800 for a family of four in last year's Armey bill) generally means the rate on taxable income must be higher.
According to a Treasury Department analysis leaked to the media before the 1994 elections, the Administration estimates that the Armey flat tax would result in a $244 billion revenue loss to the federal government in 1995.76 But this study contained a $500 billion error, as the Department later admitted77, and used the 17 percent rate to analyze 1995 revenues even though the Armey bill calls explicitly for an initial rate of 20 percent (which would be phased down to 17 percent). The Treasury Department now claims that, once fully phased in, the Armey flat tax would "cost" the government as much as $186 billion per year.78 Because it is based on static analysis, however, this figure assumes that reduced tax rates and simplification would have no positive effect on the economy. Hence, it ignores the additional revenues produced by income growth (as well as the binding caps on federal spending that the Armey bill would impose).79
A flat tax almost certainly would reduce long-term government borrowing since its reduced rates and lower taxes on savings and investment would boost economic growth. Each year, the result would be an expanding tax base and at least some reduction in outlays for certain means-tested programs and the unemployment compensation system. According to one relatively modest estimate of supply-side impact, a flat tax would increase the economy's long-run annual growth rate by just 0.5 percent. By the tenth year, national economic output would be $578 billion higher than it would have been without a flat tax.80 Government's "share" of this production of additional goods and services would be $86 billion in tax revenue.81 By the twentieth year, added growth of 0.5 percent would mean an increase of more than $2 trillion in GDP and additional tax revenues in excess of $300 billion.
The revenue feedback from higher growth, however, probably would not be enough in the short term to offset the revenue lost from lower tax rates and elimination of the multiple taxation of capital income. Achieving a deficit-neutral flat tax (at least the Armey version) would require some restraints on government spending. And if lawmakers were forced to balance the budget by 2002, the limit on spending increases would have to be even more stringent.
Q: What would happen to charitable
contributions and the housing market?
A: While many recognize that a flat tax is far better than
the current system, they fear that the transition would create
problems in particular, that the loss of charitable
and home mortgage interest deductions could cause turmoil in
affected markets. This is a legitimate concern. A wealthy
individual donating money to a museum no longer could claim the
gift as a deduction, reducing his tax burden by nearly 40 cents for
every dollar given and thereby also reducing the "price" of his
gift. The loss of the home mortgage interest deduction would
increase the after-tax cost of housing payments and could lead to a
drop in housing values, since experts believe the value of the home
mortgage interest deduction is factored into home values.
Fortunately, history suggests these fears are exaggerated. During the 1980s, the top tax rate was reduced dramatically, from 70 percent in 1980 to 28 percent in 1988. The effect was to slash the value of the deduction and raise the "price" of gifts. Similarly, the decline in tax rates increased the after-tax cost of mortgage payments. In fact, the after-tax costs of mortgage interest for homeowners and donations for charitable givers in the highest tax bracket jumped from 30 cents to 72 cents on the dollar, an increase of 140 percent. Most other taxpayers also experienced a significant increase in after-tax costs of contributions and mortgages.
If these sectors of the economy depended on the value of the tax deduction, there should have been a noticeable downturn in home values and charitable contributions during the 1980s. As the charts show, however, the value of housing did not drop. Also, charitable contributions rose throughout the 1980s even as the out-of-pocket cost to donors increased. These charts do not mean that lower tax rates necessarily encourage more charity and higher home values. They simply suggest that any adverse consequences from lower rates or from no deductions at all can be offset if the economy's performance is robust. In other words, charitable contributions and housing values may well depend more on rising incomes and wealth creation than on tax status.
There is strong reason to believe, moreover, that a flat tax would stimulate the housing industry because of its impact on interest rates. The current tax treatment of mortgage interest deductible to borrowers and taxable to lenders results in artificially high interest rates.82 One need only compare the interest rate on tax-free municipal bonds with the interest rate on taxable bonds to see how tax treatment of interest results in unnecessarily high interest rates. If adoption of a flat tax reduced interest rates to the level enjoyed by municipal bonds, the impact on the housing industry would be substantive and positive.
Q: What would happen to the price of
A: While the potentially negative impact on housing markets
and charity appears negligible, the positive impact on
income-producing assets would be large.
Assets such as stocks, bonds, and rental properties produce a stream of income over time. Their market price is determined by calculating how much income an asset will produce over time, after taxes, adjusted to reflect the fact that income today is worth more than the same amount of nominal income in the future.83 By lowering tax rates and removing the double and sometimes triple taxation of capital income, a flat tax can increase dramatically the after-tax income stream an asset will generate. Thus, a low-rate flat tax would be a boon to asset holders, offsetting any theoretical fall in housing prices, and would stimulate a surge of new investment in the economy. Harvard professor and tax economist Dale Jorgenson estimates that a flat tax would increase national wealth by $1 trillion.84 While this may seem high, it should be remembered that the mere announcement in Israel that a capital gains tax was being imposed caused the Israeli stock market to drop by 10 percent in just one day.85
Q: Would a flat tax benefit
A: If the question is considered narrowly (will anyone's tax
bill rise?) it depends on how a flat tax is structured
If it is designed to give the government as much money as it receives under the current system, and if there is no consideration of the increased revenue that would accrue from new job creation and higher economic growth, then it is impossible to avoid having winners and losers. In the long run, a flat tax presumably would generate higher incomes and living standards, raising after-tax income even for those who suffered a short-term tax increase. At the same time, it doubtless would have an adverse impact on the lawyers, accountants, and lobbyists who profit from the current law's complexity.
Many flat tax proposals are structured so that few taxpayers, if any, would have higher tax bills. This is because they are designed to go beyond simplification and rate reduction to include significant tax cuts for the American economy. The Armey plan is a good example. Using static estimating techniques, it probably would save taxpayers hundreds of billions of dollars over a five-year period. While the combination of a 17 percent tax rate and generous family exemption would not necessarily guarantee lower tax bills for everyone, few would face higher taxes.
Q: Is there a way to stop politicians
from raising tax rates in the future?
A: There is no guarantee that a future Congress would not
turn a simple flat tax back into a complicated "progressive"
This is the Achilles' Heel of tax reform. The sweeping reform enacted in 1986 expanded the tax base by eliminating many deductions while simultaneously reducing tax rates to keep the total tax burden from climbing. Skeptics warned that politicians could not be trusted to honor this arrangement and that eventually they would raise rates while failing to restore deductions. This is exactly what happened under Presidents Bush and Clinton.
Could this happen with a flat tax? Using the promise of low tax rates, could politicians take away the home mortgage interest deduction, the charitable contributions deduction, and other tax preferences but then raise tax rates in the future? It is to reduce this danger that most proponents of a flat tax include an ironclad provision to make raising tax rates difficult or impossible. One way to accomplish this would be by amending the Constitution to require that no increase in tax rates can be approved without the votes of at least three-fifths or two-thirds (in other words, a "super-majority") of both the House and Senate.86
Q: Should the income tax be abolished
A: Proponents of a flat tax note that the current
"progressive" income tax penalizes growth, discourages savings and
investment, imposes heavy compliance costs, destroys jobs, and
reduces America's international competitiveness.
It has been pointed out, moreover, that a flat rate income tax reduces but does not eliminate these negative effects. Thus, the question for some becomes whether it would be better to replace the income tax with a sales or "consumption" tax. Proponents of this view, including House Ways and Means Committee Chairman Bill Archer (R-TX) and Senator Richard Lugar (R-IN), usually suggest that the foregone revenue could be offset by spending cuts, consumption taxes, or some combination of the two.
Most advocates of a flat tax recognize that this argument is sound, at least in theory. Abolishing the income tax, closing down the Internal Revenue Service, and repealing the 16th Amendment clearly would be in the national interest. Eliminating the income tax would lead to even more economic growth and job creation than would occur under a flat tax. The real question is how that goal can be achieved.
Supporters of the flat tax have decided that eliminating the income tax is unlikely, especially in the short run. Because so many interest groups benefit from the current tax system, enacting a flat tax will be difficult by itself. Moreover, there is some concern that proposals to abolish the income tax could play into the hands of those who want a national sales tax, or value added tax (VAT), as an add-on tax. If implemented as a replacement for the income tax, either of these would be less destructive to the economy. The experiences of other countries, however, suggest that, while a VAT would be implemented with the promise to eliminate other taxes, politicians would never take that second step. The country then would have the worst of both worlds: income and direct consumption taxes.87 In any event, enacting a flat tax is probably necessary as an interim measure for those who favor eliminating the income tax.
Q: Would a flat tax eliminate the
A: Probably, but again it depends on
how the flat tax is structured.
The marriage penalty refers to the increased tax faced by a married couple compared to two single people with similar incomes. This penalty is most severe for couples with similar earnings. A flat tax automatically solves part of this problem by making it no longer possible for one spouse's income to push a couple into a higher tax bracket. But the marriage penalty also arises if the personal exemption for a married couple is not twice the size of the exemption for those filing singly. The Armey proposal solves this part of the problem by giving a married couple twice the exemption of a single filer. Nevertheless, a flat tax could be constructed that retains this penalty.
Q: How would a flat tax affect
business and payroll taxes?
A: It would be possible to reform the personal income tax
dramatically while leaving the corporate income tax
As mentioned earlier, many businesses file using the personal tax code, so many of their problems would be solved by a flat tax that left the corporate tax code untouched. All flat taxes based on the Hall/Rabushka model, however, reform both the personal and corporate income tax codes. Under the Armey proposal, for instance, the business rate would fall to 17 percent, the same as the personal rate, and the code would be reformed to eliminate the excess taxation of capital.
A flat tax can be designed to include substantial reform of Social Security and Medicare payroll taxes. Under current law, payroll taxes totaling 15.3 percent are levied on the first $61,600 of income (7.65 percent each from employer and employee, though economists agree that the entire tax is borne by the worker).88 Although none has reached legislative form, some flat tax plans incorporate the payroll tax, making the total marginal tax rate a fixed percentage regardless of income.
Q: Would a flat tax help America
A: The historic tax rate reductions launched by Ronald Reagan
in the 1980s caused a chain reaction around the world.
Many nations followed America's example and have made similarly dramatic reductions in marginal tax rates in recent years. In large part, this worldwide shift in tax policy was driven by competition as investors avoided nations with high tax rates. Unfortunately, America seems to be one of the few nations that have not learned from the experience of the 1980s. While the rest of the world has been cutting taxes, the United States stands alone as the only major nation to impose sharply higher tax rates in recent years. Investors have reacted accordingly, and the amount of new investment in American jobs and business from overseas has dropped from an average of $175 billion per year during the low tax years of the 1980s to an average of only $108 billion in 1990.89
Q: What happens to capital gains taxes
and estate taxes under a flat tax?
A: They are all eliminated.
One of the key principles of a flat tax is that income is taxed only once. A capital gain for a financial asset is simply a reflection that the market's expectation of the after-tax streams of income from that asset has risen. Under a flat tax, that income is taxed at the business level when it is realized. To tax the capital gain is double taxation. Similarly, the estate tax is a second layer of tax on earning which, under the current system, already has been taxed at least once.
America's income tax system punishes the economy, imposes heavy compliance costs on taxpayers, rewards special interests, and makes America less competitive. A flat tax would reduce these costs drastically and create a tax system that rewards productive behavior. Perhaps more important, it would reduce the federal government's power over taxpayers' lives and get government out of the business of trying to micromanage the economy. No tax is good for the economy, but the flat tax moves the system much closer to where it should be to being a tax that raises needed revenue in the least destructive and least intrusive way possible.
J. Mitchell, Ph.D., McKenna Senior
Fellow in Political Economy
Taxes Affect Decisions to Work
The four Asian tigers adopted supply-side tax policies decades before the Reagan and Thatcher revolutions. Finance ministers oversaw systems of taxation that featured low rates and/or low levels of direct taxation of individuals and businesses, the absence of or very light charges on capital income (interest, dividends, capital gains), and a smorgasbord of inducements for domestic and foreign enterprises to invest and reinvest in each economy. 126
Other studies have found that the economy is harmed when government spends tax revenue:
See, for example, George F. Will, "We Need the Flat Tax," The Washington Post, September 11, 1994; William F. Buckley, Jr., "New Flat Tax Idea Stirs Up Interest," Omaha World Herald, July 28, 1994; Tony Snow, "One Way to Flatten Big Government," USA Today, June 13, 1994; Patrick Buchanan, "Texas' Armey lays plans for his war on Washington," Arizona Republic, June 27, 1994; W. Russell G. Byers, "Finally, a tax plan that makes sense," Philadelphia Daily News, July 26, 1994; "Declaring War on Big Government," The Washington Times, June 16, 1994, p. A18; Walter E. Williams, "Armey's marching toward tax fairness," Cincinnati Enquirer, July 31, 1994; Mona Charen, "Flat Tax Appeal," The Washington Times, December 1, 1994; William Murchison, "Armey brings common sense," The Dallas Morning News, June 22, 1994; "The Armey Revolt," The Detroit News, June 13, 1994; Malcolm S. Forbes, Jr., "Happy Days Will Be Here Again, Forbes, July 18, 1994, p. 23; Robert Dietz, "Flat Tax on Income a Horror for Some," Charleston [SC] Post and Courier, November 19, 1994; Bruce Fein, "Morally Right, Fiscally Astute," The Washington Times, December 13, 1994; James K. Glassman, "Praise the Capital Gains Cut and Pass the Flat Tax," The Washington Post, November 30, 1994; Phyllis Schlafly, "Tax Return Plan with Postcard Potential," The Washington Times, December 18, 1994; "Simplifying Taxes Would Save a Bundle," Business Week, January 30, 1995; Claudia Winkler, "Converts enlisting in the flat tax ranks," The Washington Times, January 15, 1995; Christopher Farrell, "A Jumble Only a Flat Tax Can Untangle," Business Week, January 9, 1995.