The Economic Effects of A Flat Tax

Policy Reports | Taxes

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

Effects on Economy

Table II - Effects of a Flat Tax on Production Sectors

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 later in this paper. 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.

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 II:

  • Growth would be especially high in the chemicals and plastic industry and in manufacturing - each more than 3.5 percent.
  • The food and tobacco sector and the non-coal mining sector would have increases of almost 3.5 percent.

The increased output in manufacturing, chemicals and plastics, food and tobacco and non-coal 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:

  • The manufacturing and chemicals and plastics industries supply capital goods that other industries use to produce consumer goods and services.
  • The increased output by manufacturing and chemicals and plastics requires more new or refined material from the non-coal mining sector.

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.5

Table III - Effects of a Flat Tax on Consumption Sectors

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 I - 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 III.] 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.

Effects on Housing. Although there will no longer be a deduction for home mortgage interest 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.

"Savings will grow by more than 7 percent -- more than twice as much as any other sector of the economy."

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, as we will see, 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.6

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