The Economic Effects of A Flat Tax

Policy Reports | Taxes

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

Introduction: Alternatives to an Ineffective System

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.

These shortcomings have prompted scholars and politicians to propose alternatives to the current tax system. The best known of these alternatives probably is the flat tax. Under a flat tax, all income is taxed at the same rate after a personal allowance is applied. Steve Forbes advocated a flat tax in his campaign for the Republican presidential nomination. Representative Dick Armey and Senator Richard Shelby have introduced the Freedom and Fairness Restoration Act which proposes a flat tax rate of 17 percent with personal allowances of $11,350 for an individual, $14,850 for a single head of household, $22,700 for a married couple filing a joint return and $5,300 for each dependent.1

"Under a flat tax all income is taxed at the same rate after a personal allowance is applied."

Opponents of the flat tax claim that it would impose considerable burdens upon the poor, because it would eliminate the Earned Income Tax Credit, and upon workers, because they would be taxed for benefits including health insurance and the half of payroll taxes currently paid by employers, which are currently tax deductible. 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 it would abolish inheritance taxes. Moreover, they claim, the flat tax would increase federal deficits and the national debt.

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.2 Although different scholars use different variations of this model, the core concept is well understood and has appeared many times in the economic literature.3

In this paper, we describe the results of our use of a CGE model 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. Our findings, based on levying a 17 percent flat tax as proposed in the Armey-Shelby bill, differ considerably from the pronouncements of those who ignore the totality of economic changes that a flat tax will produce as the effects work their way through the entire economic system.

Our model, which is described in more detail in the appendix, 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.

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