Supply Siders See Equity In A Flat Tax Sounds Fair, But Single Rate Shifts Burden To Those With Less
As if scaling back the growth of Medicare and balancing the federal budget weren’t challenging enough, a Republican commission will soon call for the biggest tax overhaul in history.
A panel headed by former Rep. Jack Kemp - commissioned by Bob Dole and Newt Gingrich - will recommend scrapping the U.S. income tax and replacing it with a single-rate system that shelters savings and investment from taxation.
Meanwhile, the notion of a flat tax has swept the field of Republican presidential hopefuls like a trendy spring fashion or a tenacious fall flu.
It is the biggest plank in publishing heir Steve Forbes’ platform. U.S. Sen. Phil Gramm of Texas supports a single income-tax rate, as does commentator Patrick Buchanan.
Although neither endorses a completely flat tax, Dole and Lamar Alexander, former governor of Tennessee and U.S. education secretary, both promise to make the income tax “flatter, simpler and fairer.”
Flat-tax proponents tend to imbue the idea with talismanic qualities. To hear them tell it, the postcard-simple filing the flat tax would allow is the least of its myriad benefits.
Among supply siders, it is an article of faith that the plan will create vast pools of investment capital, unleash a frenzy of creative energy currently expended on tax-code compliance and touch off an economic renaissance.
“If five years from now this system is in effect, the dynamics will cause the economy to be working so efficiently that we won’t have people going to jail, we won’t have people committing crimes, we won’t have people underemployed or unemployed, because people will be actively engaged in entrepreneurial activity,” says conservative economic theoretician Jude Wanniski, a flat-tax proponent.
Perhaps, although believing all that requires a leap of faith into the misty chasm of supply-side assumption. Meanwhile, what’s striking about the flat-tax rhetoric is how it overlooks more immediate pitfalls in search of future benefits.
Whatever the possible future advantages, there are several immediate truths about the flat-tax that deserve examination.
No. 1: The tax burden shifts downward
Any realistic flat-tax system that is revenue neutral - that is, which brings into federal coffers as much as the current income tax - inevitably spells a tax break for the rich and an increase for middle-income earners.
“If you are going to raise the same amount of revenue as we are now and you are going to cut taxes substantially on higher income taxpayers, you have to make up the shortfall from people in the middle,” says Leslie B. Samuels, assistant secretary of the treasury for tax policy.
“That isn’t a matter of philosophy or ideology, it is a simple matter of arithmetic,” agrees Robert D. Reischauer, former director of the Congressional Budget Office and now a senior fellow in economic studies at the Brookings Institution.
“By eliminating the current progressivity when raising the same amount of money, you have to increase the tax burden on those who aren’t wealthy.”
A new study by the Treasury Department’s Office of Tax Analysis documents the way the tax burden would shift under a flat tax with revenue neutral rates.
That study shows that the bottom quintile, or fifth, of the population - those with incomes up to $15,604 - would see their tax burden rise 80.9 percent; for the second fifth, or quintile ($15,604 to $29,717), taxes would go up 37.7 percent. Those big swings come in large part because the flat tax eliminates the current earned income tax credit, designed to give a boost to borderline families.
The third quintile ($29,717 to $48,660) would see a tax increase of 13.7 percent; and the fourth quintile ($48,660 to $79,056) would take on a 9.8 percent increase in its federal taxes. But the upper fifth of income earners would enjoy a 7.4 percent break on their taxes.
The more you earn, the bigger the tax cut gets. The top 10 percent ($108,704 and up) would get a 14 percent tax break; the top 5 percent ($145,412 and up) a 21 percent break, and the top 1 percent ($349,438 and up) a whopping 36 percent break.
No. 2: There’s no 17 percent solution
For taxpayers currently taxed at the 39.6, 36, 31 or 28 percent marginal rates, one of the most alluring aspects of the flat tax is Forbes’ promise of a 17 percent rate.
But a 17 percent flat tax won’t replace the revenue raised by the current income tax. Not, that is, if the flat tax exempts enough income to keep from crunching the poor.
The Treasury Department study has done several analyses of the flat-tax proposal offered by House Majority Leader Richard Armey, which is the basic model the candidates build upon.
The Treasury analysis estimates that the most recent version of the Armey plan - which when fully implemented would have a 17 percent rate and exempts the first $31,400 of income for a family of four - would generate $138 billion less than the current system.
A March 1995 Treasury Department analysis showed that a proposal like Forbes’, which excludes from taxation a full $36,000 in income for a family of four - would fall $186 billion short of current revenue levels.
“Of course they advertise it as saving everyone in taxes,” says Sheldon Pollack, a professor at the University of Delaware’s College of Business and Economics. “That’s easy to do if you are raising $200 billion less.”
There are two basic ways to make a flat tax raise more revenue. One is to reduce the exemptions (or deductions) and thus exclude less income from taxation, but that hurts the poor: To have a revenue-neutral 17 percent rate, you could only exclude the first $11,000 of income, not the first $36,000, for a family of four, the March 1995 Treasury study found.
Or you can raise the overall tax rate.
To make the Armey flat tax revenue neutral, the rate would have to be at least 20.8 percent, Treasury says. Because he excludes the first $36,000, rather than $31,400, of family income from taxation, Forbes would need a rate of 22.9 percent to raise the same amount of revenue as the current system.
Forbes clearly wants a tax cut, though he is far less clear on where he would cut spending.
Progressives say that, either way, his plan hurts people of modest means. “Regardless of whether you make it up by raising the rate to raise more money or by cutting spending several hundred billion to avoid adding to the deficit, people who are middle or low income lose big-time,” said Robert McIntyre, director of Citizens for Tax Justice, a fair-tax advocacy group.
No. 3: Flatter isn’t fairer
As rhetoric, the promise of a “flatter, fairer, simpler” income tax packs a powerful punch, but as logic it simply doesn’t scan. If progressive taxation - the idea that the percentage of income people pay in taxes should increase as their income rises - defines fair, flatter isn’t fairer than the current graduated income tax.
To be sure, despite the uniform rate, a flat rate can achieve some modest progressivity in effective tax rates by exempting a healthy dollop of income, which all flat tax plans do. Still, as incomes rise, progressivity declines.
If by fair you mean that everyone pays the same proportion of his income in taxes, the flat tax comes closer. But even then, it doesn’t treat equal income equally, because …
Investment income goes untaxed. Besides the loss of progressivity, a second reason the flat tax imparts a break to the rich is that it doesn’t tax an individual’s unearned income.
As tax theory goes, that makes some sense. Flat-tax proponents argue, for example, that dividends have already been taxed, before distribution, at the corporate level. Removing the second layer of taxation - and eliminating the tax on capital gains - will increase rewards to investors and thus boost investment, they say. But it would also mean a dramatic change from the current system.
“That is a good idea, but it is going to lower the tax burden on individual wealth-holders,” said Alan Auerbach, director of Burch Center for Tax Policy and Public Finance at the University of California at Berkeley.
Thus a family that makes $125,000 in salaries would have a significantly higher tax burden than a family that earns $100,000 in salaries and $25,000 in (untaxed) investment income.
And, finally …
Simplicity is a complex issue. The real simplicity of the flat tax comes not just through one rate but also through the elimination of deductions, which makes it easier for a taxpayer to calculate his taxable income.
But deductions are in the tax code for a purpose. The mortgage interest deduction, for example, subsidizes home ownership, as does the deduction for property taxes. Eliminate those breaks and suddenly homes become far less affordable.