A Flat Tax That Falls Flat

By Eric Toder, Deputy Assistant Secretary of the Treasury for Tax Analysis,
Department of the Treasury

A proposal to reform or replace the current income tax system must necessarily address three basic design questions: What is the tax base? What is the level and structure of rates? Should preferences be provided to support economic and social goals? Unfortunately, a report from The National Commission on Economic Growth and Tax Reform is long on rhetoric about the failures of the current income tax, but unlike the Armey flat tax proposal explained elsewhere in this magazine the Commission comes up short on specifics.

The Commission would replace the current income tax with a flat tax that would impose its tax at a single rate, in excess of standard deductions, on a new base that excludes income from new saving. But the Commission doesn’t specify the tax rate, the levels of the standard deductions, or the treatment of consumption from existing assets. Although the Commission comments on the importance of the home mortgage interest deduction and the desirability of private charitable giving, it avoids specific recommendations on these and other tax preferences in the current system.

The Tax Base

The Commission’s proposal would exempt new saving from tax, either by permitting taxpayers to deduct their saving and including in the tax base amounts withdrawn from savings (as in a deductible IRA), or by including contributions to saving in the tax base while excluding interest, dividends, and capital gains (as in a “backloaded” IRA). Either approach would exempt new saving from tax. The Commission’s proposal also exempts the return to new saving at the firm level by allowing businesses to “expense” purchases of new capital. The combination of these mechanisms ensures that income from capital — the return on new saving and new investment — is exempt at both the individual taxpayer and business level.

Traditionally, many tax theorists have considered income to be the best measure of an individual’s ability to pay tax. In response, supporters of a consumption tax argue that a consumption base better measures lifetime income than an annual income tax because it treats two individuals with the same present value of lifetime resources (earnings plus inheritances) equally, regardless of their time patterns of earnings or consumption. While the lifetime concept has some abstract theoretical merit, it may clash with more popular notions of fairness. It would be hard to explain to college students and retirees who are consuming more than their annual incomes, for example, that they should pay higher tax rates on their current income than their contemporaries because their future (or past) income will be (or was) higher.

The Commission is less clear about rules for taxing consumption from existing saving. Making consumption from all existing assets taxable (for example, setting the basis of these assets at zero) hurts taxpayers who are “dissaving” (including retirees) and businesses with undepreciated assets relative to current tax treatment. But the alternative rule of maintaining the existing basis while exempting interest income provides an enormous windfall to taxpayers who plan to consume the income from existing wealth. It would effectively convert a consumption tax to a tax on wages alone. Tax rules for existing capital are no small matter; Treasury has estimated that household wealth in the form of tax-paid financial and business assets is approximately $10 trillion. The Commission discusses the need for fair transition rules for existing assets, but gives no hint on what these might be.

The Rate Structure

The Commission proposes a single rate to replace the graduated rate structure under current law. Switching to a single rate produces a substantial rate cut for a very small fraction of the highest-income taxpayers. For example, in 1992, 72 percent of taxable returns were in the 15 percent bracket and 24 percent were in the 28 percent bracket; only four percent of taxable returns faced marginal rates above 28 percent. (The 1993 tax rate increases affected less than two percent of tax returns). The combination of a single rate and exemption of capital income shuffles the tax burden from high-income families to those with low and middle incomes. Because capital income is concentrated disproportionately among upper-income families, these families would pay less tax as a percentage of their incomes than middle-income families.

Using the Tax System for Economic and Social Goals

The Commission proclaims the principle of tax neutrality. But the largest departures from neutrality in the current income tax reflect longstanding policies to use the tax system to promote widely held social goals, such as home ownership, private charitable giving, provision of state and local public services, and employer-provided insurance coverage. The Commission does not explicitly endorse eliminating any specific preferences, but does suggest considering retention of deductions for home mortgage interest and charitable contributions. The Commission explicitly favors adding a new deduction for the employee portion of payroll taxes on the grounds that one should not impose a “tax on a tax.” The same double tax issue also applies to state and local income taxes, but the Commission is silent on whether or not to keep these taxes deductible.

Conclusion

The flat tax proposed by the Commission promises a new tax base without specifying whether it would be consumption or wages, and a single low rate and generous exemption without saying what the rate or exemption level would be. The proposal avoids specific recommendations on every major design issue that would have to be addressed by serious tax reform and describes the resulting lack of specificity as simplicity. In the final analysis, only the direction of the Commission’s proposal is clear: wealthy Americans would likely pay less than at present, with other taxpayers making up the difference.

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