The Economic Effects of A Flat Tax

Policy Reports | Taxes

No. 205
Saturday, June 01, 1996
by Barry J. Seldon and Roy G. Boyd

Executive Summary

Using an economic model published in several peer-reviewed journals - a computable general equilibrium (CGE) model - this study examines the effects of a 17 percent flat tax on the various sectors of the economy, on the income of different income groups and on government revenues. The findings are based on a flat tax as proposed in the Freedom and Fairness Restoration Act introduced by Representative Dick Armey (R-TX) and Senator Richard Shelby (R-AL).

Opponents of the flat tax claim that it would impose burdens on the poor, benefit the wealthy disproportionately and increase the federal deficit. However, the findings of the model do not support those objections. Instead, it finds that:

  • Every income group would gain, with the greatest gain in percentage terms (7.6 percent) going to the lowest-income Americans; this result holds even though the Earned Income Tax Credit, which now benefits many low-income people, would be eliminated.
  • In percentage terms, the gains of the highest income group would be third highest among the six income groups.
  • The increased economic activity that would result from elimination of tax variations and from changes in incentives would be so great that government revenues would increase by 1.8 percentage points.

The model divides the economy into 14 production sectors and 14 consumption sectors, then compares relative prices and quantities of the output of the sectors before and after the imposition of the flat tax to see the effects on the various sectors, income groups and government revenue.

It finds that, under a flat tax, every production sector would grow faster than otherwise except for subsidized agricultural crops, which would lose their tax subsidies. The only consumption sector to contract would be consumer financial services, which would be affected because so much of available capital would go to the rapidly growing production sectors.

Further, the model finds:

  • The fastest-growing sector of the economy would be savings, which would increase by 7.4 percent more than they otherwise would.
  • Although there would no longer be a deduction for mortgage interest, the housing sector would grow by 1.5 percent.

A flat tax would remove existing biases against saving and toward consumption, by removing investment returns from the tax base and by taxing capital and other production inputs at a uniform rate.

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