February 10, 1997 | Backgrounder on Taxes
A Guide to the Flat Tax: What Everyone in Business ShouldKnow
How a Business Fills Out a Flat Tax Form
With a Flat Tax, Amount of Taxes Paid by Businesses Would Decline
American companies are burdened with one of the world's most
anti-business tax systems. The U.S. tax code is littered with
provisions that seem designed to undermine competition,
entrepreneurship, risk-taking, and investment. And because the tax
system's abundant flaws are so deeply ingrained, no amount of
tinkering or modification is likely to solve its problems. Instead,
the entire Internal Revenue Code should be repealed and replaced by
a simple, fair system that taxes all income just one time at one
low rate -- a system known as the flat tax.
Because most of the changes in the tax system that have taken
place in the past have made the tax code even worse, many people in
the business community have become apprehensive about tax reform.
Some believe that a flat tax would increase the tax burden on their
business income. Such fears are unfounded. Calculations of business
tax liability using Internal Revenue Service data indicate that,
with a flat tax, corporate tax burdens would drop by an average of
9 percent.2 There are some areas of legitimate concern
about the flat tax, but these largely involve the transition from
the current system and almost surely will be addressed by
policymakers when reform occurs.
WHY THE CURRENT TAX SYSTEM IS
It is hard to imagine how anything could be worse than the
existing Internal Revenue Code. Part of the problem, of course, is
that the tax burden is too high, but high tax rates are just the
tip of the iceberg. One of the most egregious features of current
tax law is its systematic bias against savings and investment.
Capital, the lifeblood of business expansion and the key to higher
wages, is subject to as many as four layers of taxation.
Adding insult to injury is the complexity of the code.
Individual taxpayers might have a hard time believing that the
business side of the tax code makes the 1040 form, with its various
attachments, seem simple by comparison. And all this complexity
carries a hefty price tag. According to the Tax Foundation,
businesses incur more than $100 billion in compliance costs from
the income tax code. Small businesses are hit hardest of all,
facing more than $7 in compliance costs for every $1 the government
collects in taxes.3
The anti-business provisions of the current tax code are
well-known. Some of the most damaging are:
- Depreciation. In the logical world, annual profits are
defined as total revenue for the year minus total costs for the
year. The current tax code, however, deviates from this commonsense
understanding by prohibiting businesses from deducting the full
costs of their investments when these costs are incurred. Instead,
investment expenses can be deducted only in small increments (known
as depreciation) over a period of as many as 40 years. This not
only forces a business to overstate its income at tax time, but
also is one of the most complex parts of the tax code.
- Alternative minimum tax. Many businesses are forced to
calculate their taxes in two different ways, and pay whichever
amount is greater. This feature, called the alternative minimum tax
(AMT), has no rationale, except perhaps a feeling on the part of
some politicians that the regular corporate income tax might not
impose quite as heavy a burden on companies as they would like. In
addition, this extremely complex provision often takes effect
during economic downturns.
- Estate tax. Perhaps the greatest threat to family-held
businesses is the estate tax. An entrepreneur will spend decades
building a company, often becoming the major employer for a
community, only to realize that the company will be destroyed or
broken up upon his death in order to pay a tax on assets -- a tax
that can be as high as 55 percent. Moreover, since the income used
to build an estate was taxed at least once when first earned, the
estate tax is a major form of double taxation.4
- Double tax on dividend income. Owners of corporations
are forced to pay taxes twice on the income they have generated.
The first tax occurs at the business level as the corporate income
tax, which takes as much as 35 percent of annual income (the actual
percent is often higher because of features like the alternative
minimum tax and depreciation). When the remaining after-tax profit
is then distributed to the owners, it is taxed yet again by the
individual income tax, with the rate rising to nearly 40 percent
depending on the total income of the individual. Needless to say,
the real tax on this income is the combination of the two levies, a
penalty that results in sharply reduced incentives to invest in
- Foreign tax rules. Choosing the most ridiculous tax
provisions would be difficult, but the foreign tax rules certainly
would be on such a list. The Internal Revenue Code not only taxes
companies on their American income, but also taxes them on income
they earn in other countries. Since other countries tax that same
income, however, the tax code provides a credit for taxes paid to a
host country. The tax burden in America is often lower than the tax
burden in other countries, so the net result of all these
complicated calculations is that the U.S. government collects very
little money. In effect, the staggering amount of paperwork caused
by foreign tax rules means that American businesses trying to
compete overseas are hit with a meaningless compliance tax.
Nor are these the only bizarre, complicated, anti-growth
provisions to be found in the current tax code. Businesses also are
burdened by pension rules, capital gains taxes, expense allocation
rules, uniform inventory capitalization, and economic performance
rules that impose huge economic and compliance costs. Perhaps the
best way to explain how bad the tax code has become for business,
however, is to see how it has mutated over the years. Between 1954
and 1994, the number of "code sections" (each of which deals with a
major section of tax law) expanded from 103 to 698, an increase of
578 percent. The number of words contained in the tax laws and IRS
regulations grew even faster, rising by 647
In addition to hindering national competitiveness, destroying
jobs, and slowing growth, the problems inherent in the current tax
code share another characteristic: They all would be solved if
America changed to a flat tax system.
WHAT A FLAT TAX WILL MEAN
The key principle behind the flat tax is equality. Regardless of
how a taxpayer earns income, how a taxpayer spends income, or how
much income a taxpayer makes, the law is applied evenly.
Three Key Features of a Flat Tax
A flat tax contains three core features, each designed to fix a
major problem with the current tax code. These key features can be
summed up in a single sentence:
income should be taxed at one low rate and only one time, and the
tax should be collected in the least intrusive way
- A single flat rate. Under the flat tax, income is taxed
at one low rate. This ensures that taxpayers are treated equally
while also addressing the problem of high marginal tax rates. The
one low rate in the flat tax will promote faster growth by
minimizing the tax penalty against work, risk-taking, and
- No bias against savings and investment. A flat tax
eliminates the current tax code's bias against capital formation by
ensuring that no income is taxed more than one time. Since double
taxation of capital income is a pervasive problem under current
law, this reform will stimulate higher incomes and faster growth by
minimizing the tax penalty on savings and investment.
- Simplification. The flat tax eliminates provisions of
the code that result either in tax preferences or in tax penalties
on certain behaviors and activities. In addition, a large amount of
income is taxed at the source rather than at the recipient level,
dramatically lowering paperwork and compliance costs. These changes
would solve the problem of complexity, allow taxpayers to file
their tax returns on a postcard-size form, and ensure that the tax
code affects everyone equally.
Four Key Benefits for America
The obvious national benefits of a flat tax include:
- Faster economic growth. A recent conference on tax
reform hosted by Congress's Joint Committee on Taxation highlighted
the work of the country's top economic forecasters. They agreed
that the flat tax would boost economic activity and estimated that
the nation's gross domestic product (GDP) would grow between 5
percent and 14 percent.6
- Increased national wealth. All income-producing assets
would increase in value because the after-tax stream of income they
generated would increase, causing national wealth to climb
instantly as well.
- An end to micromanaging and political favoritism. By
getting rid of all deductions, loopholes, credits, preferences,
shelters, and exemptions, the flat tax would deprive politicians of
the ability to pick winners and losers, reward friends and punish
enemies, and use the tax code to impose their values on society
through the economy.
- Enhanced civil liberties. Under current law, people
charged with murder have more rights than taxpayers who must deal
with the Internal Revenue Service. With a simpler, fairer tax code,
infringements on freedom and privacy would decrease
HOW A FLAT TAX WILL BENEFIT
From the business perspective, the structure of the flat tax is
remarkably simple. Wage, salary, and pension income is taxed at the
individual level. Taxes on all other types of income are collected
and paid at the business level. Chart
1 illustrates just how easy it will be for a business to comply
with the flat tax.
Simply stating how the new tax system would work, however, does
not necessarily indicate whether businesses will embrace it. There
are some things that businesses will find very attractive and
others that will not be welcome. The beneficial aspects of the flat
tax for businesses include:
- Full expensing each year. Instead of complicated
depreciation, under a flat tax all investments are given an
immediate first year write-off. This will lead to dramatic
simplification and lower the tax penalty on investments.
- No alternative minimum tax. The AMT disappears under the
flat tax. No longer would businesses be forced to calculate their
tax liabilities two separate ways and then pay the larger of the
- No estate tax. Family-held businesses will be much more
stable with the elimination of the estate tax, which destroys
capital and imposes an unjustifiable additional tax on income that
already has been taxed at least once.
- No double tax on dividends. By taxing corporate income
just one time and at the source, the flat tax eliminates the
current code's bias against corporate investment.
- No double tax on interest income. The flat tax
eliminates the present practice of taxing income when it is first
earned and then a second time if it is invested and earns a return.
Eliminating this anti-savings bias will increase the pool of
capital for business.
- No foreign tax provisions. The flat tax is a strictly
territorial system. Income earned in other countries will be taxed
by other countries, but there will be no need to go through the
ridiculously complex process of reporting that income to the
- A single, low rate. The one low tax rate under a flat
tax will give businesses the proper incentive to invest in
- No capital gains tax. Instituting a flat tax will end
one of the most pernicious forms of double taxation: the capital
gains tax. More specifically, elimination of the levy will end the
bias against new investment or business earnings that are
- Simplification. Businesses will realize significant
savings because complying with the tax code under the flat tax will
be so simple. Talented lawyers, accountants, and financial planners
will be able to shift their abilities to projects that help
increase the company's earnings and the nation's wealth.
- Faster economic growth. Even the economic forecasts put
together by critics of the flat tax show that it will increase
economic growth. The consensus is that the economy will grow
somewhere between 5 percent and 14 percent within five years. For
businesses other than bankruptcy law, this will mean more income
and higher profits.7
- Lower interest rates. Interest income will be taxed at
the source under a flat tax, with interest payments made
non-deductible for the payer but non-taxable for the recipient.
This approach, which is the same as giving all interest the tax
treatment now reserved for municipal bonds, will mean lower
interest rates (i.e., the tax premium disappears). Estimates of the
reduction in rates vary, but they generally fall somewhere between
1 percent and 2 percent.
- Capital Inflow. By eliminating the multiple taxation of
capital, the flat tax will make America a magnet for capital from
around the world. Combined with lower interest rates, this influx
of capital will make it very easy for businesses to expand and
create new jobs.
Other features of the flat tax, however, have generated concern
in the business community. Indeed, it is precisely these features
which have caused some businesses to estimate that the flat tax
would increase their tax liability. However, many of these
estimates are mistaken, largely because of they fail to recognize
the actual incidence of certain taxes paid by business.
The issues which cause the most unease in the business community
- Interest deductibility. Many businesses, particularly
those with large debts, fear that the loss of interest
deductibility will result in higher tax burdens. It is important to
note, however, that all interest under the flat tax will receive
the tax treatment currently reserved for municipal bonds. This
means, unambiguously, that interest rates will fall.8 As
a result, the potential tax increase caused by non-deductibility
will be offset by the lower level of interest payments on business
debt. The actual effects on business tax liability should balance
out. There is, to be sure, some concern about the transition period
and what businesses would do about outstanding loans and bonds that
carry today's higher interest rates. Some loans could be
renegotiated at lower interest rates, but policymakers would have
to include transition provisions in a flat tax to grandfather the
- Payroll taxes. Businesses also are worried because the
flat tax does not allow a deduction for payroll taxes. This fear is
misplaced, however, since the burden of this tax falls on the
worker, not on the business. A good analogy is the system of income
tax withholding. Businesses today "pay" 100 percent of an
employee's income taxes (actually more than 100 percent after
income tax refunds are taken into consideration), yet it is
universally understood that individual workers are the ones who
really pay the personal income tax. Likewise, while the actual
collection of the payroll tax may take place at the business level,
the cost of the tax is passed on and reflected in workers' pay.
This does not mean, incidentally, that workers' after-tax pay will
fall under a flat tax. The higher level of investment possible
under a flat tax will boost productivity, making workers more
valuable to employers and leading ultimately to higher wages.
- Fringe benefits. An issue similar to payroll taxes is
the tax treatment of fringe benefits. Businesses worry that the
inability to deduct things such as health care premiums would boost
their tax liability (pensions, incidentally, would be deductible).
As with payroll taxes, however, this should not be a concern
because the burden of the tax is borne by the worker. Indeed, one
of the most desirable features of a flat tax is that workers no
longer will have an incentive to use insurance to cover routine
health care expenses. By helping to reduce "third-party payments"
in health care, the flat tax therefore will help to rein in health
- Transition. One concern that businesses have about the
flat tax is warranted: What transition rules will guide tax policy
when the current system is replaced by the flat tax? What will
happen, for instance, to tax assets such as unrecovered
depreciation and unused tax credits? A "cold turkey" shift to the
flat tax, by wiping out these assets, would impose a burden on many
companies. Needless to say, there should be no doubt that lawmakers
will include transition rules to ensure that those who made
investment choices under the old law are not left with stranded
debts. Unfortunately, there is no way to estimate properly the
degree to which the transition rules will protect companies against
decisions they made under the old tax regime.
The current tax laws are bad for America, bad for business, and
bad for America's workers. The Internal Revenue Code is hostile to
work, savings, investment, risk-taking, and entrepreneurship.
Adding to this burden is the natural inclination among policymakers
to keep changing the code -- and rarely for the better. This
instability in the tax law makes complying with an already
complicated tax system even more difficult.
The only long-term solution is to replace the present system
with a flat tax. Not only will the flat tax promote growth by
minimizing penalties on productive behavior, but it also will yield
huge savings in compliance costs for individuals and for
businesses. Moreover, because a flat tax treats all taxpayers
equally, politicians would have a hard time manipulating the tax
code once the new system went into effect. The key question, of
course, will be whether the flat tax can overcome opposition from
the special-interest groups and income redistributionists who
support the current, abundantly flawed tax code.
Why All Taxes On "Business" Are Really
Taxes On People
Contrary to political rhetoric, a "business" does not really pay
taxes; individuals bear the burden of all taxes sent to the
government by business. The corporate income tax, for instance, is
a tax on the income of the owners of the corporation (and then this
same income is taxed a second time at the "individual" level).
Federal income tax withholding is a tax on workers even though the
business sends the money to Washington.
This practice of having businesses pay taxes on behalf of
individuals is known as taxing income at the source. When combined
with the principle of taxing income only one time, taxation at the
source can be used to simplify the tax system dramatically. Under
current law, for instance, more than one billion 1099 tax forms
circulate each year to help the IRS track interest and dividend
income. This massive paperwork burden is necessary only because the
current code taxes this income at the individual level. If the
income is taxed only one time and the point of collection is at the
source (i.e., the bank, corporation, or other business sending the
income to the individual), all this red tape and complexity
disappears. This is a major benefit of the flat tax, and one of the
reasons why compliance costs would fall by more than 90 percent
when the flat tax is instituted.
It should be noted that taxing income at the source does have a
few negative aspects. It probably contributes to the popular
misconception in Washington that taxes, regulation, mandates, and
other burdens imposed on business do not hurt individuals. Taxing
income at the source also has the effect of hiding the true extent
of the tax burden from some individuals. A good example is income
tax withholding; while it makes the tax system simpler, many
Americans fail to grasp just how much of their income is being
confiscated because they never see it in their paychecks in the
Taxing income at the source also creates an unfortunate
opportunity for political mischief by opponents of tax reform.
Ill-informed or dishonest opponents of the flat tax, for instance,
frequently charge that the proposal would allow "fat cats" living
off interest and dividends to escape taxation. Needless to say,
this charge is baseless because interest and dividends received
under a flat tax are after-tax payments, and hence completely
analogous to a worker's pay under the current with-holding
At the cost of adding complexity, supporters of sensible tax
policy could try to negate this attack by shifting collection of
the tax from the source to the individual. This tactic, however,
would still leave an opening for demagogues to complain that the
flat tax was a windfall for corporations. What these opponents
really favor, of course, is taxing the income twice as is done
under current law. Thus, there is little to be gained and much to
be lost by catering to those who are ideologically opposed to a
fair and simple flat tax.
- The author would like to thank William W. Beach, John M. Olin
Senior Fellow in Economics at The Heritage Foundation, for his
contributions to this analysis.
- This percentage decrease in business tax liability assumes a
flat tax of 17 percent. The figures have been derived from The
Heritage Foundation Corporate Tax Model, which is built around data
contained in the 1991 Internal Revenue Service Corporate Tax
Returns data file. See Table 1, below, for an analysis of how
business tax liability can vary depending on the period of
accumulated depreciation and the percentage of additional business
- "Tax Foundation's Ways & Means Committee Testimony Puts
1996 Federal Tax Compliance Costs at $225 Billion," Tax Foundation
Tax Bite, March 20, 1996.
- For more information on the estate tax, see William W. Beach,
"The Case for Repealing the Estate Tax," Heritage Foundation Backgrounder
No. 1091, August 21, 1996.
- Arthur P. Hall, "The Compliance Costs and Regulatory Burden
Imposed by the Federal Tax Laws," Tax Foundation Special
Brief, January 1995.
- Joint Committee on Taxation Conference on Dynamic Revenue
Estimating, January 17, 1997; papers available upon request.
- While it attacked the flat tax in 1995, DRI/McGraw-Hill, one of
this country's top economic consulting companies, announced at a
recent Joint Committee on Taxation Conference that the flat tax
would boost economic output by at least 5 percent.
- John E. Golub, "How Would Tax Reform Affect Financial
Markets?," Federal Reserve Bank of Kansas City Economic
Review, Fourth Quarter 1995.