April 1995: How About A Flat Tax?

Explanation of the Flat Tax Proposal

As Americans struggled with completing their tax returns and with the exasperating effort to find the "correct" tax form, the call for a simple "flat tax" was once-again heard. The most recent version of the flat tax, sponsored by Republican Representative Richard Armey of Texas, has the following features:

Americans would be taxed at the flat rate of 20% on all wage and salary income for 3 years; thereafter, the percentage would drop 17%.

No tax would be paid on capital gains, dividends or interest.

There would be no deductions from gross income. Deductions for mortgage interest, retirement accounts, medical payments, state income taxes, charitable contributions, moving expenses, union dues, and the credits for earned income and child care would be eliminated entirely.

Taxpayers would deduct from gross income a personal exemption of $13,100 for each adult and $5,300 for each dependent. This means that a family with two adults and two children would pay no tax on an income less than $36,800.

The tax return could be completed on the back of a postcard in four steps: (1) gross income listed on the first line; (2) personal and dependency exemptions calculated and listed on the next line; (3) taxable income computed by subtracting line 2 from line 1; and (4) the tax computed by multiplying line 3 by 20% (17% after 3 years).

Example: Assume a husband and wife with two dependent children had combined wages of $120,000. In addition, they earned $5,000 in interest and had a $10,000 capital gain.

After tax amount: $118,160 (wages, interest, capital gains, less taxes paid)

Analysis of the Proposal

While everyone agrees the current tax system is a convoluted mess,no one really knows what to do about it. Theories abound as to why the tax code is so complicated. Nobel prize economist, Milton Friedman, believes the current tax system permits members of Congress to raise campaign funds from lobbyists and this causes the nearly-annual changes in the tax code. Under Friedman's theory, changes in the tax code affect the lobbyists' members, and lobbyists therefore contribute heavily to political campaigns to gain special privileges for their constituents. Friedman believes that the logic of a flat tax is compelling, but the political reality of campaign fund raising will prevent Congress from enacting such a sweeping change in our tax laws.

My view is somewhat less cynical. Congress uses the tax code to motivate and encourage people to spend money to benefit the economy or society. The tax code had been used in this manner long before the issues involving campaign financing arose. Consequently, there are breaks for low-income housing and charitable giving. The deduction for home mortgages involves the judgment that Americans should own their own homes. Child care exemptions provide a benefit to dual-income households. Under a flat tax, there would be no incentives for investing; therefore, Congress would lose a valuable tool for channeling investments into what it believes are socially desirable projects.

Some of the complaints Friedman expresses can be traced to a recent tax writing provision that for every tax break given, there must be an off-setting tax increase. Hence, lobbyists not only bargain for tax breaks for their members, they make tax increase proposals as well. For instance, the increased payment of estimated taxes is now extremely complex and largely unworkable, because a lobbyist proposed this change to off-set a tax break for his or her constituency, knowing there was no lobbyist on the other side to oppose the change.

When discussing the flat tax, one must keep in mind that there are two irreconcilable forces within any tax system: fairness and simplicity. The flat tax embodies simplicity. Our tax system is complex because of fairness concerns and past abuses. The tax code has eliminated many of the loopholes and tax shelters wealthy taxpayers previously enjoyed. Provisions such as the passive loss limitations, elimination of the capital gains deduction of 50% and the alternative minimum tax, are aimed at making the wealthy pay their fair share of taxes. Under Armey's proposal, the wealthy taxpayers would get the largest tax breaks and some middle income taxpayers would actually see their taxes rise.

Benefits of the Flat Tax

The flat tax would, however, eliminate the current spending on record keeping, IRS audits, and tax preparation fees paid to tax preparers and accountants. Under some estimates, tens of billion of dollars are spent in complying with the present tax system. Armey does not dispute that the wealthy would prosper under his proposal, but he claims that so much income would be freed-up for investment that the wealthy could end up paying more tax than they currently pay.

This theory is really just another spin on the "trickle-down" economics espoused by Ronald Reagan and the supple-side economists: If you give the wealthy tax breaks, they will invest their money in ways that will benefit everyone in society. Remember, President Clinton won election, in part, because of his articulate rejection of 12-years of trickle-down economics under the Reagan and Bush administrations.

The Future of the Flat Tax

Before moving to a flat tax, we must bear in mind that the present complexity affects only 20% of all taxpayers. Most taxpayers receive wages and salaries, and take the standard deduction. Also, most taxpayers who currently itemize their deductions enjoy their home mortgage interest deduction, and the ability to deduct state income taxes and charitable donations. The high-tax states, real estate industry and charitable lobby will scream long and hard over the elimination of these deductions.

Remember, the savings and loan debacle in the late 1980's can be traced, in large part, to the elimination of the tax shelters for real estate under the Tax Reform Act of 1986. Taxpayers were encouraged to invest in real estate and the savings and loan industry financed those real estate projects. Then the Tax Reform Act of 1986 came along and eliminated any incentive for purchasing those investments. With no buyers, the developers of those projects went broke and the savings and loan industry was stuck with billions of dollars of bad loans.

The same thing could happen if the mortgage deduction is eliminated. A homeowner who can barely afford to make tax-deductible mortgage payments might default on his or her loan, if the law took away this tax advantage. Currently, if a homeowner makes a monthly mortgage interest payment of $1,000, he or she deducts the entire amount from taxable income. Under the flat tax of 20%, the taxpayer would have to earn $1,250 to net $1,000.

Also, housing prices might drop (or crash!), and rentals might skyrocket, if the mortgage deduction is eliminated since there would be no tax advantage to owning real estate. Recall the lesson from the Tax Reform Act of 1986: Radical changes to the tax code often cause unexpected and catastrophic results.

The fairness issue can be addressed by creating another tax bracket of 25% for incomes over $100,000. By using a two-bracket approach, the fairness issue can be addressed without sacrificing simplicity to any great extent.

Conclusion

The flat tax is an intriguing proposal and we will hear more about it in the coming months. Whether it has the appeal to withstand the pressure from lobbyists and from the real estate industry, high-tax states and the charities remains to be seen.

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