The Economic Effects of A Flat Tax

Studies | Taxes

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

Effects on Income

Table IV - Income Group

Critics of the flat tax allege that fundamental tax reform would benefit the rich at the expense of the middle class.7 Some maintain that low income families would also be worse off if the Earned Income Tax Credit (EITC) were removed,8 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 makes it possible to account for these changes, and finds:

  • The elimination of inefficiencies produced by the current tax system will cause the economy to be larger than it would be otherwise, and the gains are widely distributed; every income group will gain as a result of the flat tax.
  • Among all income groups, the lowest-income Americans will gain the most (in percentage terms) even with the elimination of the EITC.
  • In percentage terms, the gains of the highest income group will be third highest among the six income groups.

As Table IV shows, the lowest income group realizes the highest percentage gains from adoption of a flat tax despite the abolition of the earned income tax credit (EITC) under the Armey-Shelby bill. The relatively high 7.6 percent gain to the lowest income group may 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.

Table V - Percent of Income Groups' Income by Sources

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 V. 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.

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 ownership of the company yields income from capital; some are retired or semi-retired individuals; and some are temporarily in this group (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.

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