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Flat 155

Flat tax come from wages, would pay no federal income on the first $23,700 of income, 15 percent on William G. Gale the next $31,000 or so, 28 percent on the next The Brookings Institution $53,000, and higher rates on additional income, reaching 39.6 percent on above A proposal for fundamental that $250,000. would replace the system with a Without the personal exemptions, the flat tax , to be collected by levying a would be equivalent to a VAT, but with taxes on flat-rate tax on businesses and individuals. wages remitted by households rather than business. That is, the flat tax would be a consumption tax, even though it would look like a wage tax to house- Background holds and a variant of a VAT to most businesses. Consumption is income less savings. Thus, the only Therefore, other than the exemptions, the economic difference in principle between a consumption tax effects of the flat tax should be essentially the same and an income tax is the treatment of the savings. as those of a VAT or a . An income tax taxes savings both when the money The family exemptions make the flat tax pro- is earned and again when the savings earn interest. gressive for low-income households. But at the high A consumption tax taxes saving only once: either end of the income distribution, the tax is regressive, when the funds are withdrawn and used for con- just like sales taxes and VATs. sumption or when the funds are first earned. Al- The Hall-Rabushka proposal could be amended though this difference appears simple, consumption in several ways. Princeton economist David Brad- taxes come in many forms. ford has proposed an X-tax similar to Hall- Rabushka but with graduated tax rates on household The Hall-Rabushka flat tax wage income to raise progressivity. (The business In the early 1980s, Robert Hall and Alvin Rabushka tax would be set equal to the highest on of the developed a consumption wage income.) The flat tax could also be modified tax system that achieves some of the administrative to retain the EITC, allow a deduction for charitable advantages of a value-added tax (VAT) relative to a contributions, and provide a (a one-to-one sales tax, while also partially addressing concerns reduction in taxes paid under the flat tax) for payroll that consumption taxes impose a relatively heavier taxes paid. The credit would be a huge boon to tax burden on lower-income taxpayers. lower- and middle-income households, because The Hall-Rabushka system is often called the most now pay more in payroll taxes than in income “flat tax”: It assesses a 19 percent tax on all busi- taxes. These changes would, of course, require nesses (corporate or otherwise)—identical to the higher rates. But a tax system with these features VAT, except that wages, pension contributions, might be able to retain the progressivity of the cur- materials costs, and capital investments are deducted rent tax system while also reaping most of the gains from the tax base. Individuals (or households) are of the Hall-Rabushka proposal’s broader base, gen- assessed a 19 percent flat-rate tax on wages and erally lower rates, and simplified compliance. The pension benefits above an exemption of $25,500 for question remains, though, of how large these gains a family of four. No other income is taxable, and no would be. other deductions are allowed. The Hall-Rabushka proposal has served as the Evaluating the effects of adopting a flat tax blueprint for several proposals to reform the federal Analysts find it hard to predict with precision the ef- tax system, including a proposal introduced by Rep- fects of minor tax changes, and heated debate con- resentative Richard Armey (R-Texas) and Senator tinues about the effects of the major 1980s tax re- Richard Shelby (R-) and one offered by forms. Hence, efforts to evaluate the effects of presidential candidate (R) in the 1996 uprooting the entire tax system must be appropri- presidential primaries. ately qualified. (The economic effects of the flat tax In comparison to the Hall-Rabushka proposal, are addressed by a number of contributions in Aaron the personal income tax in 1994 provided exemp- and Gale 1996.) tions of $9,800 for a family of four, an earned in- A central issue in tax reform is always who come tax credit (EITC), and the choice of a $6,350 wins and who loses. Under the flat tax, low-income or itemized deductions for mort- households would lose because they now pay no in- gage interest, state and local income and property come tax and are eligible for a refundable EITC of taxes, charity, and large health expenditures. Esti- up to $3,370. Although the flat tax is more progres- mates indicate that in 1996, a family of four taking sive than a VAT, it is more regressive than the cur- the standard deduction and the EITC, with all in- rent system. A flat tax would provide huge gains for 156 Flat tax high-income households, both because their mar- Hall and Rabushka estimate that General Motors’ ginal tax rate would fall and because they consume annual tax liability could rise to $2.7 billion from relatively less of their income than do low-income $110 million, while Intel’s would fall by 75 percent. households. As a result, if a flat tax were to raise as The effects of a consumption tax on international much revenue as the current one, the tax burden for economic transactions and on the financial sector the middle class would have to rise. Consumption are potentially far-reaching and need to be examined taxes are generally less regressive when viewed over carefully. longer periods of time because income changes from year to year, but they would raise tax burdens on Economic efficiency and growth lower- and middle-income households over any time Ultimately, increased economic efficiency and frame. (For further discussion, see Gale et al. 1996 growth must be one of the key selling points of a and Gentry and Hubbard 1997). consumption tax. Without a significant gain in liv- Perceptions of fairness may also be difficult to ing standards, uprooting the entire tax system is retain when, under the flat tax, some wealthy indi- probably not worth the risks, redistributions, and viduals and large remit no taxes to the adjustment costs it would impose. government while middle-class workers pay a com- Efficiency gains might arise from five sources: bined marginal tax rate above 30 percent on the flat the change of the tax base from income to con- tax, , and payroll taxes. sumption; a more comprehensive tax base, which As for simplicity, the flat tax would likely slash eliminates the differential tax treatment of various compliance costs for many businesses and house- assets and forms of income; lower tax rates, which holds. But for many, the tax system is not that com- raise the rate of return to working, saving, and in- plicated. vesting and reduce incentives to avoid or evade And fundamental tax reform would not end the taxes; reduced compliance costs; and the taxation demands for special treatment that have so tangled of previously existing assets during the transition to the income tax. Ten years hence, we may find that a consumption tax (about which more later). All what started as simplicity has once again become a but the first and last are attainable under income tax confused jumble. Thus some simplification is likely reform. with tax reform, but it is by no means a certain or Although estimates vary, a recent study sug- lasting outcome. Moreover, many simplification gests that a pure flat tax proposal with limited per- gains could be made through changes in the in- sonal exemptions would raise economic output by come tax. between 2 and 4 percent over the first nine years and A third concern is how reform would affect dif- between 4 and 6 percent in the long run. But these ferent sectors of the economy. Removing the mort- results need to be interpreted carefully. First, many gage interest deduction and the deductibility of state of the gains are also available through judicious re- and local property taxes may have profound effects form of the income tax, in particular by making the on housing prices and home ownership, but the re- taxation of capital income more uniform. Second, sults would depend on how interest rates adjust, the the estimates provided do not allow for child ex- sorts of grandfathering rules that are introduced, and emptions, as the Hall-Rabushka proposal and all of other factors. How and when health insurance bene- the recent flat tax proposals do. Allowing exemp- fits and coverage rates would adjust to the elimina- tions for children reduces the effects by about 2 per- tion of tax-favored treatment of employer-provided centage points (e.g., to 0Ð2% over 10 years). Third, health benefits is an open question. the estimates apply to a pure, well-designed con- Removing the deduction for charitable contri- sumption tax. Compromises in the design, such as butions would reduce overall giving and could affect including mortgage interest deductions or allowing a its composition as well: Wealthy donors, for whom transition, reduce the gains or turn them into losses. the write-off is now worth the most, tend to favor Allowing for transition relief alone is enough to re- hospitals and universities; low-income donors, re- duce the impact on growth to zero in the long run. ligious institutions. The estimates also show that, even for well- Effects on businesses and investment would be designed consumption taxes, efficiency losses are complicated. The flat tax would eliminate corporate possible. (The estimates cited in this paragraph are income taxes, put all businesses on an equal tax taken from Auerbach 1997 and private communi- footing, reduce the statutory tax rate applied to busi- cations with Kent Smetters. For additional analysis ness income, and make investment write-offs more of the growth effects of tax reform, see Engen generous. But it would also remove the deductibility et al. 1997.) of interest payments and of state and local taxes, and A key element in raising growth and a major this could induce dramatic changes. For example, motivation for tax reform is increasing saving. Pro- Flat tax 157 ponents typically point to two reasons why con- from future wages or existing assets, a consumption sumption taxes should spur saving. First, a revenue- tax is a tax on future wages and existing assets. A neutral shift to a consumption tax would be ex- consumption tax that exempts old assets is just a tax pected to raise the after-tax rate of return on saving, on future wages. And the same studies that show while keeping total tax payments constant. Second, that a consumption tax (which taxes all old capital consumption taxes reallocate after-tax income to- assets) is more efficient than an income tax also ward high-saving households. Such reasoning is show that a wage tax is less efficient than an in- straightforward but incomplete. Saving is likely to come tax—because not taxing existing capital re- rise only a little, if at all, for several reasons. quires higher tax rates on wages to raise the same First, the current U.S. tax system is not a pure revenue and hence distorts people’s work decisions income tax; it is a hybrid between a consumption tax more. So exempting old capital removes any pre- and an income tax. About half of private savings sumption that tax reform would result in a more already receive consumption tax treatment. Funds efficient system. placed in pensions, 401(k) plans, Keogh plans, and Surely, the strongest argument for exempting most individual retirement accounts (IRAs) are not old capital from taxes is fairness. The assets have al- taxed until they are withdrawn. The return on these ready been taxed once; is it fair to tax them again? investments, then, is the pretax rate of return. But The answer may not be as obvious as it seems. First, the introduction of a consumption tax would reduce a onetime implicit tax on existing capital is very the pretax interest rate, so that the rate of return progressive. The distribution of such capital is more on these forms of saving would fall, which could skewed toward wealthy households than is the dis- reduce saving in these forms. tribution of overall wealth, which in turn is more Second, pension coverage could fall. Under an skewed than the distribution of income. Second, income tax, pensions are a tax-preferred form of within any age group, wealthy households do most saving. But a consumption tax treats all saving of the saving. Because these households would equally, making it less likely that workers and em- benefit most from eliminating the on ployers would continue to accept the high regulatory future saving under a consumption tax, it is reason- and administrative costs of pensions. To the extent able that they pay for some of the costs. Third, older that workers did not resave all of their reduced pen- households tend to have more assets than younger sion contributions, saving would fall. ones, and taxing existing capital places heavier bur- Third, under a pure consumption tax, all capital dens on older generations. But those older house- existing at the time of the transition is (implicitly) holds have received transfers through Social Secu- taxed again when the capital is consumed. But tran- rity and Medicare that far outreach what they have sition rules likely to be added to a consumption tax put in. And the vast majority of income and wealth to avoid this double taxation would reduce or elimi- for most elderly households is in the form of future nate the long-term effect on saving and growth, as earnings (which have not yet been taxed), housing noted above. (which receives extraordinarily preferential treat- ment under the current tax), pension income (which The transition: Can we get there from here? already receives consumption tax treatment), Social Even if a consumption tax is the right system for an Security benefits (which are not taxed under the flat economy starting from scratch, it may not be the tax), and Medicare benefits (which are not and right way to reform an existing system. would not be taxed). Relatively few elderly house- The main transition issue is the taxation of “old holds finance much of their living expenses by other capital”—capital assets accumulated earlier out of assets, and those that do tend to be very well off. after-tax income whose principal would not have been taxed again under the income tax. Although Pros and cons of the flat tax some transitional treatment of old capital is typically In principle, replacing the income tax with a con- thought to be likely, not having a transition—that sumption tax, such as the flat tax, offers the possi- is, implicitly taxing old capital again under a con- bility of improving the efficiency, equity, and sim- sumption tax—is arguably consistent with the three plicity of the tax system. But these gains are main goals of tax reform: efficiency, equity, and uncertain and depend critically on the details of the simplicity. reform. At least some of the gains could be made Certainly, not having a transition is simpler. The simply by modifying the existing system. transition rules could be very complex, and the tran- Idealized consumption taxes may always look sition period could stretch out for years. better than actual income tax systems. Once in Not having a transition is also more efficient. place, though, they would be subject to the same Because future consumption can be financed only compromises and pressures as the income tax is. 158 Flat tax

They could even lead to a system that is less effi- Gale, William G., Scott Houser, and John Karl Scholz. “Dis- cient and less fair than the one we have. tributional Effects of Fundamental Tax Reform.” In Eco- nomic Effects of Fundamental Tax Reform, edited by Henry Additional readings J. Aaron and William G. Gale. Washington, D.C.: The Brookings Institution, 1996: 281Ð320. Aaron, Henry J., and William G. Gale, editors. Economic Effects of Fundamental Tax Reform. Washington, D.C.: Gentry, William, and R. Glenn Hubbard. “Distributional Ef- Brookings Institution Press, 1996. fects of Adopting a National Retail Sales Tax.” In and the Economy, vol. 11, edited by James M. Poterba. Altig, David, et al. “Simulating U.S. Tax Reform.” National Cambridge, Mass.: MIT Press, 1997, pp. 1Ð47. Bureau of Economic Research Working Paper 6248, October 1997. Hall, Robert, and Alvin E. Rabushka. The Flat Tax. Stanford: Hoover Institution Press, 1995. Auerbach, Alan J. “Quantifying the Current U.S. Fiscal Im- balance.” National Tax Journal 50 (September 1997): 387Ð98. Engen, Eric, Jane Gravelle, and Kent Smetters. “Dynamic Cross references: consumption taxation; tax Tax Models: Why They Do the Things They Do.” National reform, federal; value-added tax, national; value- Tax Journal 50 (September 1997): 657Ð82. added tax, state.