The Economic Effects of A Flat Tax

Policy Reports | Taxes

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

Why the Flat Tax is Efficient

Table I - Effective Tax Rate on Capital in Production Sectors

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.

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 I shows. Thus, for example, although the average effective tax rate on capital for the overall U. S. economy is 36.4 percent:

  • The average rate on capital for the processed food and tobacco production sector is 46 percent, but the rate for tax-subsidized agricultural crops is only 26 percent.
  • Manufacturers pay an average rate of 40 percent, but the services sector (other than financial services) pays an average rate of 32 percent.

As a result, there is overinvestment in subsidized crops and in services other than financial services, and underinvestment in processed food and tobacco and manufacturing. The flat tax would move the taxes on inputs closer to a uniform rate, removing the distortions that inhibit the growth of national income.4

Removing Exemptions, Deductions and Loopholes. As Figure I shows, 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.

Figure I - Personal Income%2C 1991

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.

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