Tax Briefing Book | |
Tax Reform |
Rep. Dick Armey (R-TX) has introduced the Freedom and Fairness Restoration Act (H.R. 1040 in the 105th Congress). This act would reform the U.S. tax system, slash government spending and rein in federal regulation. It is the most radical reform proposal in recent memory to receive serious consideration on Capitol Hill. Tax Reform: Trading Deductions for a Lower Tax Rate. The key element of the Armey plan is tax reform. Based on a proposal developed by Stanford University professors Robert Hall and Alvin Rabushka, the plan would scrap virtually all current deductions, credits, exclusions and exemptions, as well as the five current tax brackets. In their place, it would establish a single tax rate -- 20 percent the first two years and 17 percent thereafter -- on a much broader tax base.
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| "More than half of all personal income goes untaxed." | The Armey plan does not promise a free lunch. Lower tax rates are possible only if the tax base is expanded by ridding the tax code of deductions and exclusions -- even such popular items as the mortgage interest deduction. This means that in return for lower rates, people will have to subject more of their income to taxes.
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A 17 Percent Tax Rate for Individuals. Armey isn't proposing to go all the way to a 10 percent tax. Generous personal exemptions under the plan prevent the rate from going below 17 percent. Taxes under the plan, however, would be low, flat and simple. For individuals, the tax base would consist of all wages, salaries and pensions.
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| "A family of four would have to earn $32,000 before paying federal income tax." |
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In addition to exempting about half the households in America from any personal income tax, the Armey plan's tax system would be so simple that all taxpayers could fill out their returns on a postcard. [See the diagram.] A 17 Percent Tax Rate for Business. Business taxes would be almost as simple. For them, the tax base would consist of total receipts less cash wages and purchases of goods, services and materials used in business, as well as all capital equipment. Companies would pay the same tax rate as individuals on the remaining balance. As a consequence, even the largest corporations could file their tax returns on a postcard-size form. A Tax Cut. If the Armey plan for tax simplification were completely revenue neutral, it would require a tax rate in the range of 19 to 20 percent. Establishing a rate of 17 percent, therefore, constitutes a tax cut. The loss of revenue is paid for by capping government spending, including so-called entitlements. Also, the 17 percent rate is phased in, starting at 20 percent and falling to 17 percent after two years. Thus the deficit would not rise under the Armey plan. Abolishing the Double Taxation of Savings. All income is taxed only once in the Armey plan, in sharp contrast to our current tax system. Today we tax profits first at the corporate level and again when they are paid out to the company's owners, the shareholders, in the form of dividends. We also double-tax saving relative to consumption by taxing income when it is earned and again when it earns a return. We also effectively double-tax all capital income by imposing a capital gains tax on the increase in value of capital assets, even though we already tax the return on such assets (e.g., interest, dividends, rent, etc.). The Armey plan eliminates double taxation by abolishing all taxes on interest, dividends and capital gains. There is no convincing argument for taxing capital gains, since the value of a capital asset is only a function of the return on that asset, which we already tax. This is most clearly shown in the case of bonds, which automatically rise in value when interest rates fall and fall in value when interest rates rise. Since we are already taxing interest income, it makes no sense to levy an additional tax on the bond itself, since the bond has no value without the interest. The same is true of corporate stock and commercial real estate, whose value is entirely a function of the profit or rent they generate. The failure to index the capital gains tax for inflation creates even more distortion.
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| "The Armey plan abolishes all taxes on interest, dividends and capital gains." | Stimulating Economic Growth. Our current tax system taxes capital excessively. This discourages investment, saving and capital formation, which are the foundations of economic growth. Slower growth, in turn, reduces employment, productivity and wages. Thus all Americans ultimately pay the price for our ill-designed tax system.
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For these reasons, most economists now agree that the best tax system is one that taxes consumption only. Congress has before it many other proposals that would move us in the direction of an economy-wide consumption tax. However, only the Armey plan would do so while also simplifying and reducing taxes for most Americans. Except for those who now receive tax money from the government rather than pay it (because of the Earned Income Tax Credit), all taxpayers would pay less under the Armey plan. Moreover, even though everyone would pay the same 17 percent tax rate, because the personal allowances do not increase with income the effect is to make the tax burden progressive, although less so than at present. Starting Point for Tax Reform. The Armey plan is the most consistent and comprehensive tax reform proposal currently under consideration. It would eliminate the inequities of the current system, promote growth and improve fairness and simplicity. It is internally consistent and intellectually sound. It should be the starting point for all future discussions of tax reform. Today's graduated income tax system is a morass of deductions, exemptions, allowances, credits and other loopholes. According to Stanford University tax specialists Robert Hall and Alvin Rabushka:
There is a better way. Under a flat tax, all income is taxed, and it is taxed at the same rate. Furthermore, income is taxed only once, at its source, when it is realized. Let's take a closer look.
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| "It Costs the private sector between 24 cents and 65 cents per $1 it pays to the IRS." | All Income Is Taxed. Surprisingly, the amount of revenue the federal government collects from the personal income tax is only 9.5 percent of total personal income. If corporate income is included, federal income taxes take only 11 percent of income. Thus, in principle, government would have just as much money if it levied an 11 percent, across-the-board tax on all personal and corporate income. Today's deductions, exemptions and loopholes result in more than half of all personal income not being taxed at all.
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Most flat-tax proposals would require a tax rate higher than 11 percent -- say 17 or 20 percent -- because they allow two deductions: (1) a generous personal exemption and (2) an immediate write-off of all investments in capital goods. (See the discussion below.) All Income Is Taxed at the Same Rate. Under the current tax system, a housewife can enter the labor market in a minimum-wage job and be taxed at a 40 percent marginal tax rate because of her husband's earnings. Because of the tax on Social Security benefits and the Social Security earnings penalty, some elderly workers face marginal tax rates in excess of 100 percent. Under a flat tax:
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| "A spouse entering the labor market at minimum wage can be taxed at 40 percent." | All Income Is Taxed Only Once. Under the current system, investment income can be taxed two, three or even four times. Income is taxed first at the corporate level. When the remainder comes to you in the form of dividends or interest, it is taxed a second time. If you sell the business, you can be taxed a third time through a capital gains tax on income your investment is expected to generate in the future. And after you die, your investment can be taxed a fourth time through the inheritance tax.
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A flat tax system would tax income only once -- when it is earned. All Income Is Taxed at Its Source. Under the current tax system, businesses send out more than a billion Form 1099s reporting payment of dividends and interest. Each taxpayer is supposed to be taxed on these payments at that individual's tax rate. However, less than half of interest income actually is reported on individual tax returns. The flat tax would eliminate this leakage by taxing business income at its source:
All Income Is Taxed When It Is Realized. There is no item in the national income accounts called "capital gains." Nonetheless, the capital gains tax forces people to pay taxes today on income that is expected to be earned many years in the future. For example, the expectation that a company will earn higher revenues will cause its stock price to rise. If you own shares in the company and sell them, you will be taxed on the "gain." But if expectations change tomorrow and the stock price falls, the government doesn't give a refund to the new buyer. Whatever the merits of the argument for capital gains, if capital gains are to be taxed, capital losses should be fully deductible. But if that were the case, government would collect very little net revenue and might even lose revenue on balance. The better approach is to stop taxing expectations and instead tax all income if and when it is realized. Deductions and Allowances. Individuals would be able to deduct a personal allowance from their gross income. Those with gross incomes below the personal allowance would pay no income tax. For example, as discussed above, legislation introduced by House Majority Leader Armey provides for an allowance of $32,000 for a family of four. This exemption means that as many as half the households in America would pay no income tax. The only other deduction would be an immediate write-off for investment in real capital. Businesses would no longer depreciate assets by a certain amount each year, but would expense the investment at the time it was made.
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| "The flat tax is actually a consumption tax." | There are only two things one can do with income: save it and spend it. Allowing full, immediate expensing of capital equipment and taxing all income only once removes savings and investment from the tax base. Thus the flat tax is truly a consumption tax.
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Some flat tax proposals would continue deductions for home mortgage interest and for charitable contributions, but most would end these deductions. No Deduction for Mortgage Interest. Home builders and lenders fear that ending the deduction for home mortgage interest would cause real estate values to plummet. However, home mortgage interest rates are expected to fall by about 2 percentage points if a flat tax is enacted, and a family earning $50,000 a year would benefit more from a 6 percent nondeductible mortgage than from an 8 percent deductible mortgage.
Further, it is likely that any flat tax passed by Congress would allow homeowners to continue deducting interest for existing mortgages until they sold or refinanced. No Deduction for Charitable Contributions. The deduction for charitable contributions is one of the biggest "sacred cows" in the tax code. Churches, universities and museums all fear that loss of the deduction under a flat tax would sharply reduce giving and threaten their viability. There is no question that allowing contributions to be deducted from taxable income reduces the cost of giving. If one is in the top tax bracket, giving $1 to charity costs only 60 cents. But this also means that any reduction in tax rates will increase the aftertax cost of giving, even with the deduction. Thus reducing the top tax rate from 70 percent in 1981 to 28 percent in 1987 doubled the aftertax cost of giving for someone in the top bracket from 30 cents to 62 cents. If one believes that tax policy is what drives charitable contributions, then this should have caused giving to decline sharply. In fact, individual giving increased after rates were cut -- from $49 billion in 1980 to $107 billion in 1989. The reason is that charitable contributions are not just a function of tax policy. When the economy is expanding and incomes are growing, people are more able to contribute to charity. Another factor is that government welfare spending displaces private charity. In a February 1984 article in the Journal of Political Economy, Russell Roberts found that private relief expenditures rose steadily in the United States until 1932 and declined steadily thereafter as government welfare spending rose. He concluded that government spending crowded out private spending almost dollar for dollar. A similar analysis by Burton Abrams and Mark Schmitz in the December 1984 National Tax Journal found that "cuts in government programs may elicit significant additional interest in private contributing." Thus President Reagan's spending cuts may have been partly responsible for the rise in charitable giving. In any event, only 23.3 percent of taxpayers deducted any charitable contributions in 1995, according to the Joint Committee on Taxation. And according to Independent Sector, many of those who contribute most generously have incomes too low to itemize. In 1993 families with incomes below $10,000 contributed an average of 2.7 percent of their income to charity, while those making $50,000 gave only 1.1 percent.
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| "In 1993 individuals itemized only 53 percent of all charitable contributions." | Lastly, it is clear that much giving is totally unrelated to deductibility. As Ralph Reed of the Christian Coalition has noted, "The motivations for giving are not fundamentally economic, but involve emotional impulses and other intangible influences." Thus in 1993 only 53 percent of all charitable contributions were itemized on individual tax returns. This suggests that many of the charitable institutions people care most about are likely to be unaffected by the flat tax.
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No Deduction for State and Local Taxes and No Tax Advantage for Municipal Bonds. The elimination of these provisions would put an end to the unwise practice of using the federal tax system to subsidize spending by state and local governments. No Deduction for Nonpension Employee Benefits. Under the current system, wage and salary income is taxed but compensation in the form of fringe benefits is not. This is the big reason employee benefits have grown from 20 percent of payroll in 1953 to more than 41 percent today. The tax subsidy for such items as employer-provided health insurance is inefficient and unfair because most of the benefits go to people who least need them -- families in the top fifth of the income distribution get six times as much subsidy as those in the bottom fifth. Further, current law encourages wasteful spending on health care and penalizes employers and employees who keep health costs under control. Advantage of the Flat Tax: Fairness. Those who complain that the rich would gain are too caught up in the politics of envy to acknowledge that others would gain even more. Every time the nation has significantly lowered the top marginal tax rate, total tax revenue and the share of taxes paid by the highest-income earners has gone up. It happened in the 1920s and during the Kennedy and Reagan administrations. Advantage of the Flat Tax: Simplicity. Under a flat tax, most individuals and businesses would fill out a tax return the size of a postcard.
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| "The flat tax would add as much as 2 percentage points to the nation's economic growth rate." | Advantage of the Flat Tax: Pro-growth. Because the flat tax is pro-savings and pro-investment, it would add as much as 2 percentage points to the nation's economic growth rate. And even if it only increased the annual growth rate from the current 2.5 percent to the 3.3 percent rate of the Reagan era:
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A flat or single-rate income tax would replace the current system of five rates and hundreds of deductions, credits, exclusions, etc. This change is grounded in widely accepted principles of taxation. Following is a brief review. Simplicity. At least since Adam Smith, simplicity in taxation has been considered a virtue. By simplicity we mean not only that the tax system is conceptually easy to understand, but also that the cost of complying with its requirements is low. Our current tax system fails both tests. It is conceptually incomprehensible, even to tax professionals, and imposes large compliance costs on taxpayers. The principal cost is the time we must spend keeping records, filing forms and paying the tax. A government study estimated that Americans spend some 5 billion hours per year just doing that. Some critics of the flat tax ridicule the idea that reducing the size of the tax return to a postcard contributes to meaningful simplification. They point out that only 9 percent of filers of the current 1040EZ form, which is just one page, require professional assistance. This only shows that true simplicity comprises more than simple forms; it requires a simple tax system as well. Creating a simple tax system requires stripping away unnecessary exemptions, deductions, credits and exclusions. It means stripping away unnecessary rates and unnecessary levels of taxation. It means moving the point of collection as close to the source as possible. And it means moving any necessary complexity away from individuals and toward businesses, which are better equipped to deal with it. The flat tax achieves all of these goals. Thus it would significantly simplify the tax system. Efficiency. All taxes impose a cost on the economy over and above the amount of actual revenue collected. Economists call this the excess burden or deadweight cost of the tax system. It is in addition to the compliance cost. Although all taxes impose some deadweight cost, the magnitude of the cost varies enormously, depending on how the tax system is structured. Two different tax systems raising the same amount of revenue can impose significantly different burdens on the economy. At the low end is the head tax or poll tax. Since every taxpayer is liable for a specific dollar amount of tax, there are no penalties for those who work, save and invest. At the other end is the steeply progressive income tax, under which the same income is double and triple taxed. This is the tax we have now. Various economic studies have found that in addition to the direct tax burden, the cost of the U.S. tax system to the private sector is very high.
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| "At present, it costs the system 24.4 percent to collect each additional dollar of taxes." |
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Jorgenson and Yun's 18 percent figure implies that our system of collecting taxes costs approximately $250 billion per year. By collecting the same amount of revenue in a way that does not discourage work, saving and investment, we can potentially gain $1,000 per person each year. The flat tax achieves this goal by eliminating distortions in the tax base and the rate structure and eliminating the tax bias against saving and investment. And without progressivity, taxpayers are no longer pushed into a higher tax bracket by inflation.
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| "By changing our tax collection method, we could gain $1,000 per person per year." | Fairness. In Washington, fairness has traditionally been defined only one way: the rich should pay more. Of course, this can be achieved simply by a flat rate. Someone with an income 10 times higher than another would pay 10 times more. To many Americans this is the essence of fairness. But under progressive tax rates, someone with an income 10 times higher would pay more than 10 times the amount of taxes. During World War II the top tax rate reached 94 percent. As recently as 1981 it went as high as 70 percent. Today it is 39.6 percent. (See Figure X-2.)
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There are other concepts of fairness. Under "horizontal equity," people with the same incomes would pay the same taxes. Our current system violates this principle because one's tax liability depends not just on the amount of income, but on the form of that income (wages vs. business income) and the tax deductions, exclusions, credits and exemptions to which one is entitled. Another principle is the "benefit principle," which says that one's tax liability ought to be related to the benefits one receives from government. In fact, Professor Richard Epstein of the University of Chicago Law School argues that the Fifth Amendment to the Constitution requires the benefit principle. Of course, our current system does not in any way relate taxes to benefits. While a flat tax will not fix this problem, Epstein believes that the flat tax is more constitutionally sound than a progressive income tax. Finally, there is a question of fairness in having a tax system that imposes differentially high income tax rates on a minority. In a recent article in the National Tax Journal, Professor James Buchanan, a Nobel laureate, argued that the most "politically efficient" system of taxation "would involve a flat-rate, proportional tax on all sources of income, without deduction, exclusion or exemption."
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| "The current tax system is inefficient - and it lowers the national income." | The current tax system taxes income inefficiently and causes the national income to be smaller than it otherwise would be in three ways: (1) by failing to tax capital and other production inputs at a uniform rate, the tax system prevents resources from being allocated to their highest valued use; (2) because of exemptions, deductions and loopholes, marginal tax rates on all inputs are much higher than they need to be; and (3) the taxation of investment income leads to a lower capital stock than would otherwise be the case.
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Opponents of the flat tax claim that it would impose considerable burdens on the poor because it would eliminate the Earned Income Tax Credit and on workers because it would tax their benefits, including health insurance and the half of payroll taxes currently paid by employers. They further claim that it benefits wealthy individuals because it would abolish the personal income tax on interest, dividends and capital gains (which proponents view as double taxation because these gains are taxed at the business level) and would abolish inheritance taxes. Moreover, they claim, the flat tax would increase federal deficits and the national debt. Modeling the Economy. In recent years, economists have developed a way of calculating the consequences of the complex economic interactions caused by changes in the tax code. The method makes use of a computable general equilibrium (CGE) model. Although different scholars use different variations of this model, the core concept is well understood and has appeared many times in the economic literature.
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| "A model is used to show the total effects of the flat tax." | A CGE model can be used to calculate the effects of the flat tax on the various sectors of the economy, changes in the income of different income groups and the effect on government revenues. The findings of the model, based on levying a 17 percent flat tax, differ considerably from the pronouncements of those who ignore the totality of economic changes a flat tax will produce as the effects work their way through the entire economic system.
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The model divides the economy into 14 production sectors and 14 consumption sectors. The goods and services consumers buy come from combinations of output from various primary production sectors. For example, the sale of food products to consumers requires outputs from the subsidized crop, other crop, livestock and food processing sectors integrated with outputs from the services sector such as advertising and distribution. The model compares relative prices and quantities of the output of the various production and consumption sectors before and after the imposition of the flat tax rate to see how they change and how the changes interact to cause other changes. In turn, these changes affect the economic welfare of the various income groups, which affects government revenue. Because there is only one tax rate, because the only exemption is a personal allowance and because all income is taxed only once, the flat tax removes distortions of the current tax system that prevent resources from being allocated to their highest valued use.
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| "The current tax system causes capital and other inputs to be taxed differently from industry to industry." | Uniform Taxation of Capital Inputs. Under the current tax system, the different marginal tax rates and varying tax treatments cause capital and other inputs to be taxed differently from industry to industry, as Table X-1 shows. Thus, for example, although the average effective tax rate on capital for the overall U. S. economy is 36.4 percent:
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Removing Exemptions, Deductions and Loopholes. More than half of all personal income is not taxed under the current system. Under the proposed flat tax reform, except for a personal allowance all income is taxed, but taxed only once, at its source and at one rate. There are no other exemptions, no deductions, no loopholes. Removing the Anti-Savings Bias. Under our current tax system, people are taxed on what they earn and save, taxed again when the savings earn a return and taxed yet again when they die. Thus the system as it exists is biased against saving and toward consumption, although Congress has passed some special provisions to encourage saving (tax-free retirement accounts, for example). This multiple taxing of investment income has hampered economic growth by causing the United States to have a lower capital stock than it otherwise would have. Under the flat tax, earnings from saved income are not taxed at the individual level. Investment in real capital assets is expensed at the time it is made, rather than being depreciated. Thus the flat tax is pro-saving and pro-investment. Removing the distortions of the current tax system by replacing it with a flat tax would have a highly stimulating effect on the nation's economy and its output. In addition to removing the distortions caused by inequitable tax rates, the flat tax would result in an increase in disposable income at all income levels, discussed below. In turn, the increase in disposable income would bring about an increase in consumption across almost all sectors, which would increase the demand for producer goods and services.
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| "Giving equal tax treatment to all inputs would result in higher growth in every production industry except currently subsidized agricultural crops." | Effects on Production. Giving equal tax treatment to all inputs would result in higher growth in every production industry except currently subsidized agricultural crops; the reason in that case is the loss of tax subsidies. As shown in Table X-2:
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The increased output in manufacturing, chemicals and plastics, food and tobacco and noncoal mining is especially high because these industries are so important in supplying other industries -- most of which also expand to produce consumer goods and services. To illustrate the interaction of these industrial sectors:
In the same way, the increased output in the food and tobacco sector leads to an expansion in livestock husbandry and nonprogram crops -- that is, crops that do not receive government tax subsidies, such as fruit, vegetables and nuts. However, output of subsidized crops such as corn, wheat and cotton falls, reflecting the loss of subsidies enjoyed under the current tax code. The loss of subsidies is also the reason for almost no increase in output for the logging sector. The wood products sector, with 3.1 percent growth, will get its raw material from imports.
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| "Removing the distortions caused by the wide variation in tax rates on producers will lead to growth in consumption." | Effects on Consumption. Two consequences of the flat tax -- a growth in aftertax income, to be discussed below, and removing the distortions caused by the wide variation in tax rates on producers shown in Table X-1 -- lead to a growth in consumption. Obviously the growth in production is fueled by this growth in consumption. The model has 14 consumption sectors, and all but one show growth, mostly between 2 percent and 4 percent. (See Table X-3.) The exception is the consumer financial services industry, where growth will be slightly negative because so much of the available capital is going to production sectors.
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Effects on Housing. Although home mortgage interest will no longer be deductible under the flat tax, the housing sector will grow 1.5 percent more than it otherwise would. This expansion can be attributed primarily to the increase in disposable income of all income groups, which is discussed below. Effects on Savings. One of the most significant effects of the flat tax is that it will cause savings to grow by more than 7 percent -- more than twice as much as any other sector of the economy. This is particularly important because savings are needed to fuel future economic growth. There are two major reasons for the high growth in savings. First, dividends and interest are not taxed at the individual or household level under the flat tax (having already been taxed at the corporate or business level), which encourages real investment in the economy. Second, income increases across all income groups under the flat tax, and as incomes increase households save more. This increased saving is measured by the model. Effects on Income. Critics of the flat tax allege that fundamental tax reform would benefit the rich at the expense of the middle class. Some maintain that low income families would also be worse off if the Earned Income Tax Credit (EITC) were removed, as it would be under the Armey-Shelby proposal or the Hall-Rabushka proposal. These criticisms, however, are based on a simple-minded application of the tax law to existing incomes. The critics ignore the fact that the flat tax will affect different people in different ways and will effect changes throughout the economic system. We cannot know whether a particular income group would be better off or worse off until we know how that group's aftertax income changes. The model accounts for these changes and finds:
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| "The lowest-income Americans would gain the most from a flat tax." | As Table X-4 shows, the lowest income group realizes the highest percentage gains from adoption of a flat tax despite the abolition of the EITC. The relatively high 7.6 percent gain to the lowest income group can be explained in part by the fact that this group pays no income tax with the advent of the flat tax. Therefore, this group's aftertax wage rate increases despite a decrease in before-tax wages of one-third of 1 percent, making it willing to supply a larger quantity of labor relative to the upper-income groups; and the expansion of virtually all the sectors in the economy means that the lower-income group is able to supply more labor and therefore earn more income.
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| "The lowest-income group receives a relatively higher percentage of its income from land and capital." | Land, Capital and the Lowest-Income Group. An additional and extremely important factor is that the lowest-income group receives a relatively high percentage of its income from land and from capital, as shown in Table X-5. This does not mean that this group owns a large percentage of all land and capital, but rather that the group benefits more than others on a percentage basis from the increase in land rents and in the return to capital after the flat tax is imposed.
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The percent of income from capital for the lowest-income group may be surprising. It may be due to several reasons. Some in this group are self-employed and take little in salary while owning the company brings income from capital, some are retired or semiretired individuals and some are individuals who depend on interest and dividends that usually would place them in a higher-income group. The second highest percentage gain in disposable income (2.5 percent) is realized by the third-lowest income group ($20,000 - 29,999). This is largely an aftertax wage effect. This income group gains considerably from allowances under the flat tax, resulting in a sizable increase in the aftertax wage rate. Hence, individuals in this group are willing and able to supply a larger quantity of labor and enjoy a relatively high gain in disposable income by doing so. Effects on Government Revenues. The model differs from Treasury Department findings that a 17 percent flat tax would reduce government revenues; instead we find that it increases government revenues 1.8 percent annually. The difference probably can be accounted for by the fact that our model allows for behavioral changes resulting from changes in incentives and accounts for effects throughout the economy. It finds that the increase in government revenues is driven by the increases in the majority of sectors in the economy and accompanying increases in employment of labor, capital and land which, in our experience in CGE modeling, are relatively large. Sensitivity Analysis. As with any simulation exercise, these results must be regarded with some caution. However, sensitivity tests indicate that our results are robust. This in turn suggests that many of the fears expressed about a flat tax are unwarranted. An increasingly common criticism of the flat tax is that it is untried, untested and therefore too risky to adopt. While it is true that neither the United States nor any other major country has ever replaced its individual income tax with a flat tax, it is not true that we have no experience with such taxes.
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| "President Franklin Roosevelt proposed the Social Security system, a flat-rate tax." | The best example of a flat-rate tax is the payroll tax for Social Security. When President Franklin Roosevelt proposed the Social Security system, he strongly endorsed the principle of a flat-rate tax. His purpose was to emphasize that it was a "contribution" to which workers had a legal right.
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It has stayed that way ever since. The payroll tax is a flat 5.6 percent tax rate on both employer and employee on all wages up to $62,700. There are no exemptions whatsoever and no taxes at all on income from capital or wages above the maximum. Thus it essentially is a flat-rate consumption tax. Because it has no exemptions, the payroll tax is the most administratively simple tax the federal government has. And because it does not apply to capital or high-wage incomes, its efficiency cost is very low. That is, it discourages very little economic activity per dollar of revenue -- far less than the income tax, which raises about the same revenue. Yet despite the fact that the Social Security program is by far the most successful program the Democratic Party has ever come up with, Democrats would universally condemn it if it were proposed for the first time today. The tax would be considered far too regressive, injurious to labor and much too easy on the wealthy. Applying current Democratic thinking to Social Security would have killed the program in the cradle. The economic cost of a "progressive" Social Security tax would have prevented the rate from rising as much as necessary to raise current revenues. All flat-rate tax advocates really want is to make the income tax more like the Social Security tax -- a flat tax that works. In addition to the Armey proposal for a flat rate income tax, a more fundamental tax reform idea that has garnered congressional support is scrapping the income tax altogether and replacing it with a national sales tax. Reps. Dan Schaefer (R-CO) and Billy Tauzin (R-LA) have introduced the National Retail Sales Tax Act (H.R. 1325); Sen. Richard Lugar (R-IN) supported income tax abolition and the sales tax in his campaign for the 1996 Republican presidential nomination; and House Ways and Means Committee Chairman Bill Archer (R-TX) says he personally prefers this alternative.
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| "Sales tax supporters propose to eliminate the income tax altogether." | This support for a national sales tax (NST) must be distinguished from the idea of instituting a national sales tax (or a value-added tax) as a way to raise more money for the federal government. The intent of most sales tax supporters is to completely replace the income tax with a sales tax. While the Schaefer-Tauzin proposal includes features supported by all NST supporters, there are additional features that others might include, or specific provisions with which they might differ.
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Features of a Proposed Sales Tax. The Schaefer-Tauzin bill would repeal the federal personal and corporate income taxes, inheritance and gift taxes, and excise taxes not dedicated to trust funds. In their place, it would institute a federal sales tax added to the sales price of goods or services sold to domestic end users -- that is, at the retail level. The legislation sets the sales tax at 15 percent -- which the authors of the bill claim is about the "revenue-neutral rate," one which will yield the same amount of net revenue to the federal government as the taxes it replaces. It in effect amends House and Senate rules by making it "out of order" for them to even consider legislation increasing the sales tax rate without a two-thirds vote of approval. The sales tax would apply to purchases by individuals, businesses, nonprofit organizations and local, state and federal governments; however, purchases of goods and services at intermediate stages of production -- that is, used in the production of other taxable items -- would be exempt, as would exports. The tax would be collected by businesses and self-employed individuals and remitted to state tax authorities -- minus a credit that would compensate businesses for about half the cost of collection and record-keeping. State governments would pass the revenue on to the U.S. Treasury, minus compensation for the cost of administering the tax. Since the states would administer the sales tax, and income tax reporting requirements would be eliminated, the Internal Revenue Service would no longer be necessary: it would be abolished and replaced by a smaller Federal Excise Tax Bureau.
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| "The Internal Revenue Service would be eliminated." | Another important provision of the Schaefer-Tauzin bill is a per person rebate to every family equal to the amount of the tax that would be paid on consumption expenditures up to the poverty level. This would be a refundable tax credit against payroll or self-employment taxes owed, meaning that those persons with no wage income subject to the payroll tax could receive a rebate check. (Responsibility for collecting taxes for Social Security and Medicare would be transferred to the Social Security Administration.) Thus for example:
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Taxing Consumption. Both the sales tax and the flat tax are true consumption taxes, although they attack the problem from opposite sides of the same coin. All income is either spent on current consumption, held as cash or put in some form of savings or investment for future consumption. Thus consumption is the flip-side of income, and like a flat tax, a retail sales tax would remove the penalties on savings and investment in the current tax system that perversely encourage consumption and debt-financed spending. The flat tax does so by taxing income only once; the sales tax does so by taxing retail purchases. Simplicity. A sales tax such as that proposed in the Schaefer-Tauzin bill would be much simpler to administer than the income tax. Instead of more than 100 million income tax filers, only the businesses and self-employed individuals who collected the sales tax would file reports. Economist Arthur P. Hall of the Tax Foundation found that either a flat tax or an NST would drastically reduce the costs of complying with the tax system.
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| "The current tax system imposes a huge drag on the economy." | Efficiency. Even larger than the compliance costs imposed by income tax system is the drag on the economy caused by the tax system, called the excess burden or deadweight loss. All taxes create some economic distortions, but economists say the cost of the current, progressive tax system ranges from a third-of to more-than the amount of taxes collected.
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Most of this deadweight loss would be eliminated by a flat rate income tax or sales tax. For example, studies show the large marginal tax rate reductions in the national sales tax combined with neutral tax treatment of savings vs. consumption would increase economic growth.
Fairness. Progressive income taxation penalizes each additional dollar of earnings or production by imposing a higher marginal rate, whereas a sales tax taxes each dollar of consumption at the same rate. Thus a sales tax is "fairer" in the sense that it does not discriminate for or against any good or service and does not distinguish among taxpayers according to their income. But because they are proportional taxes, both the sales and flat income tax have been labeled as regressive -- implying that a heavier burden falls on lower-income groups.
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| "The Schaefer-Tauzin bill would offer a rebate that would make the sales tax fair for lower-income people." | It is true that lower-income people tend to use more of their income for current consumption; moreover, a greater percentage of their consumption tends to be for "necessities," rather than "luxuries." The Schaefer-Tauzin plan addresses these issues by a per person rebate of the tax that would be paid on consumption expenditures equal to a poverty-level income, similar to the generous personal allowance in the Armey flat tax bill. Since the rebate is universal -- there is no income qualification -- it is fair to every taxpayer and does not require maintaining income records for purposes of means testing.
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However, the rebate necessitates a higher tax rate.
A suggested alternative way to reduce the burden on lower-income groups is to exempt some "necessities" from the sales tax. But this would add back into the system some tax-caused distortions -- such as between investment and consumption of exempt goods and services versus others. It would also allow the opportunity for political mischief, as various producer and consumer groups lobbied for an ever-expanding list of necessities. Visibility. One of the advantages of the NST over other taxes is that it is immediately visible -- since the tax is paid by the end-purchaser and added to the cost of the sale -- unlike the cost of income and payroll taxes that are hidden in the final price of a good or service. Supporters suggest that due to this feature, congressional attempts to raise the rate would meet with greater taxpayer resistance. (For similar reasons, Rep. Armey originally proposed eliminating income tax withholding and requiring monthly remittance of income taxes owed as part of his flat tax proposal.) Less Intrusive Government. One paramount benefit of the NST to some supporters is that it would allow the abolition of the Internal Revenue Service and the tax code it administers. Income tax compliance and enforcement entails a loss of privacy and constitutional safeguards for due process; many perceive it as a threat to democratic government. Moreover, the sales tax introduces an element of voluntariness into the tax system. Individuals could choose when they pay the tax by timing their purchases, and they could avoid the tax to some extent by saving and pass on their estate to their children tax-free. And by removing biases in favor of current consumption or specified investments, the NST would eliminate attempts at social engineering using the tax code. Finally, unlike the income tax, the sales tax is an indirect tax -- one levied on transactions rather than individuals. This is the tax system originally envisioned in the U.S. Constitution; thus rather than being revolutionary, a NST would be a return to traditional constitutional principles. Effect on State Taxes. A national sales tax might also reduce the additional compliance costs and deadweight costs represented by the state tax systems. Just as many states now piggyback a state income tax on top of the federal one -- as a percentage of whatever federal taxable income a person owes -- presumably some states would replace their state income and sales taxes with a broad-based state sales tax levy added to the federal one. Forty-five states and the District of Columbia currently impose some type of sales and use tax.
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| "Critics maintain that the rate required for a national sales tax would be too high." | Objections to a Sales Tax. Critics of a national sales tax object that it would become or have to be supplemented by a value-added tax (VAT) -- which is hidden from the consumer in the final price of a product and thus easy to raise -- or that it would become a supplement to, or be supplemented by, an income tax. An NST as a supplemental source of federal revenue, as the VAT is used in Europe and Japan, is of no benefit, since it would only fuel additional growth of government, without making the economy any more efficient.
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Some critics suggest that one or more of these alternatives would inevitably be chosen because the sales tax rate required is so much higher than state sales tax rates now in effect that avoidance and noncompliance with the tax would become widespread -- leading to a spiral of increasing tax rates and lower collections. However there are other factors supporters say should be kept in mind:
Still Needed: Constitutional Guarantees. The Schaefer-Tauzin bill recommends that the 16th amendment to the Constitution, which authorizes an income tax, be repealed. But until a new amendment is passed to repeal it, there is nothing to prevent Congress from again imposing an income tax. Although the Schaefer-Tauzin bill makes it "out of order" for either house of Congress to consider raising the sales tax rate above 15 percent without the consent of two-thirds of the members, there is no way to enforce the provision because Congress would continue to have the right, with the agreement of the president, to change laws by a simple majority vote. Given the fundamental reform of the tax system implied by the NST, appropriate constitutional guarantees should be implemented. This could be done with a single constitutional amendment repealing the authority of Congress to impose an income tax; forbidding the imposition of a VAT; authorizing Congress to institute a sales tax; limiting other excises or import duties to the same rate as the sales tax; and requiring a supermajority of Congress (i.e., two-thirds or three-fourths) to increase any rate and/or limiting the percentage amount of any increase. Unless constitutional tax limitation is an integral part of the NST, it will probably be impossible to gain the political support necessary for passage.
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| "Since the value-added tax is hidden in the price of goods, governments can easily raise it." | One of the beauties of the valued-added tax is that it is hidden in the prices of goods. Although people know they are paying a VAT when they buy most goods and services, they tend not to object as strenuously as when they must send a check off to the government for their income tax. And since prices change with great frequency anyway, incremental increases in the VAT tend not to arouse much opposition. For this reason the French government recently found it easy to raise the standard VAT rate in France by 2 percentage points, from 18.6 percent to 20.6 percent.
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In 1965, before the VAT was adopted, total taxes as a share of gross domestic product in Europe averaged 27.3 percent, according to the Organization for Economic Cooperation and Development. This was only slightly higher than the figure for Australia and the United States, where taxes as a share of GDP averaged 23.2 percent and 25.8 percent, respectively. In the late 1960s and early 1970s, most of the nations of Western Europe adopted VATs, and the rest joined in the late 1980s and early 1990s. In fact, it is a requirement for entry into the European Union. Today Australia and the United States are the only OECD countries that do not have a VAT.
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| "Australia and the United States are the only major industrialized countries without a value-added tax." | Funding Leviathan. The VAT fueled vast expansion of government in Europe. Today, taxes in Europe are significantly higher than in Australia and the United States (see Figure X-3). Total taxes as a share of GDP averaged 41.4 percent in Europe in 1992, according to the most recent OECD data. By contrast, taxes in Australia and the United States are not much higher than they were in 1965, at 28.5 percent and 29.4 percent of GDP, respectively.
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VAT Is Efficient. Ironically, the reason why the VAT has led to such an increase in taxation is that it is probably the most efficient tax ever devised -- efficient in the limited sense that it discourages productive economic activity less than other taxes raising the same amount of revenue. All taxes discourage production, some more than others. Economists call this the deadweight cost of the tax. Thus the true burden of a tax system is the total tax revenue raised plus the excess burden. Estimates of the excess burden of the United States tax system run into the hundreds of billions of dollars per year. High marginal tax rates on entrepreneurial activity are especially burdensome. Taxes on consumption, however, penalize productive activity much less. Thus a revenue-neutral shift from a tax system that penalizes work, saving and investment to one that taxes consumption would significantly reduce the excess burden. It is equivalent to an actual tax cut. Professor Dale Jorgenson of Harvard University estimates that such a shift in the United States tax system would lead to an immediate increase in national wealth of well over $1 trillion. Since the excess burden is part of the tax burden, it stands to reason that to the extent there are economic and political limits to taxation they apply to the total cost of the tax system, including the excess burden. And there clearly are limits to taxation. The dismantling of border controls on capital, labor and goods in recent years has made it far easier for businesses and individuals to escape heavy taxation. And for those who choose not to leave, there is the underground economy, which estimates put at roughly 10 percent of GDP in most industrialized countries. Therefore, the more efficient a tax system is, in the sense of having a low excess burden, the more revenue a government can raise before reaching the limit. This is the key to understanding why the VAT led to the expansion of government in Europe. By eliminating inefficient taxes -- mostly turnover taxes that tended to cascade, impending trade and investment -- and replacing them with value-added taxes, the nations of Europe were able to dramatically reduce the excess burden of their tax systems. They could thus raise the overall level of taxation much higher than would have been possible otherwise. Had they attempted to raise the same amount of revenue without the VAT, they would have encountered severe economic and political difficulties.
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| "The VAT fueled a vast expansion of the welfare state in Europe." | It is not surprising, then, that nations that have had VATs the longest have imposed the greatest rate increases. The 12 OECD countries that adopted VATs before 1973, for example, have seen their VAT rates rise by an average 71 percent, while those with VATs adopted since 1985 have raised rates by an average of just 14 percent.
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Giving European politicians a powerful tax that could be raised incrementally without generating either significant politicial opposition or negative economic effects set the stage for a vast expansion of the welfare state. In 1965 government spending as a share of GDP in Europe averaged 34.6 percent according to the OECD. By 1993, spending had risen to 52.1 percent. Fueling the Poverty Trap. Much of this increased spending went to welfare benefits that sharply cut the cost of not working. This has created a poverty trap in which the combination of direct taxes and lost benefits reduces the real amount of return on work to almost nothing for many people. For example:
Welfare for businesses expanded as well. According to another OECD study, industrial subsidies are at least four times higher in Europe than in the United States. While industrial subsidies amounted to just 0.5 percent of GDP in the United States in 1986, they consumed 2.6 percent of GDP in Denmark, 2.9 percent in the Netherlands, 3.3 percent in France, 4.1 percent in Norway and 7.4 percent in Sweden. These subsidies ultimately made European businesses very uncompetitive in international markets. Although subsidies are now being reduced, it will be many years before most European businesses get their costs down to U.S. or Japanese levels. The real burden of the VAT has not been a direct tax effect. Rather, it has impoverished Europe by allowing politicians to easily raise revenue, which in turn has fueled a vast expansion of government spending. This spending inevitably went into programs such as welfare and industrial subsidies that reduced the incentive to work and made European businesses uncompetitive. But ultimately there is a limit to taxation, even with a VAT, and Europe seems to have reached it. Taxes and spending as shares of GDP seem to have finally leveled off in Europe, after decades of steady increases. International competition and the decline of trade barriers have forced cutbacks in industrial subsidies, while budget deficits and rising unemployment are forcing welfare reforms. And there is increased talk of using VAT revenue to reduce marginal income tax rates, instead of just spending it. VAT Burden on Japan. On April 1, 1997 the Japanese value-added tax (VAT) rose from 3 percent to 5 percent. The increase was enacted in 1994 but postponed until now. A key reason for Japan's economic success in the 1950s and 1960s was that it had the lowest taxes among the major industrial democracies. According to the Organization for Economic Cooperation and Development (OECD),
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| "Japan's VAT rate increased 40 percent in 1997." | In recent years the VAT has been fueling the heavier tax burden in Japan. This tax was first proposed by Prime Minister Nakasone in the mid-1980s and it was so unpopular that it eventually forced him to leave office. In spite of this, his successor, Prime Minister Takeshita rammed through the new tax in 1988. It took effect in 1989 at a 3 percent rate amid 60 percent public disapproval.
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The growth of taxation in Japan bears much of the responsibility for the nation's dismal growth rate. Real GDP grew less than 1 percent in 1994 and 1995. Ironically, in 1996 the VAT stimulated the growth rate, which rose to 3.6 percent. This was because consumers rushed to buy goods, especially houses, before the higher VAT rate took effect. But the effect was purely temporary. The OECD expects growth to fall back to just 1.6 percent this year.
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| "Press reports indicate that President Clinton favors a VAT." | In the long run, higher taxes always depress growth. Japan is only the latest country to learn this lesson. For good or ill, the VAT is here to stay, and the United States may soon join the club. Pressure for U.S. tax reform is strong, and press reports indicate that President Clinton favors a VAT. Many members of Congress appear enamored of the VAT's border adjustability, believing that it subsidizes exports and penalizes imports. (Actually, it just puts them on the same footing.) In 1996, Senate Democrats introduced a tax package that would have replaced the current corporate income tax with a VAT.
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While it is too soon to say whether the United States will follow Europe to a VAT, the European experience with the tax is certain to play a major role in the debate. | |
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