Reed: Flat Tax? A Wonderful, Unworkable Concept

If I were to say to you, "It doesn't matter how much money or how little money you make, or how much or how little you spend, we're all going to pay the same tax rate," your first reaction would be, "Well, makes sense to me."

That was certainly my reaction when Steve Forbes proposed a flat tax system during his Presidential campaign in 1996. While I gave the publishing magnate a less than 17 percent chance of actually winning the Republican nomination, I paid close attention to his point, well-received on both sides of the aisle, that our tax system was inherently unfair, unwieldy and complicated, and reform was necessary.

But my research then, and my belief now, is that the "flat tax" proposal Steve Forbes proposed, and most if not all such proposals prior and subsequent to Forbes', are incapable of meeting the revenue needs of the government of the United States while still preserving our institutions and protecting our citizens.

Forbes was certainly not the first to point out the flaws of America's system of collecting the funds necessary to run our government. From the founding of America to today, leaders and citizens have debated the pros and cons of taxation as a means to "establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty for ourselves and our posterity".

But no one denies that these principles, espoused in the preamble to our Constitution, are necessary to uphold, with our labor, our honor and our dollars.

So as our society has evolved over 232 years, so has our system of taxation, and no longer is it possible to say, "Okay, you earned $5000.00 this year, give Uncle Sam $500.00 and he'll protect you." What we earn, what we save, what we spend is all relative to factors that make a flat-tax system unworkable.

A simple but telling example of the fallacy of flat taxation rests in pure geography. According to the U.S. Census Bureau, the state with the lowest household income is Mississippi, at $34,500.00. (see: www.census.gov/hhes). I'm confident this does not come as a surprise. What is surprising is that the state with the largest household income, based on the same census data, is New Jersey (can you say "Tony Soprano?"), at $60,000.00. But the most telling statistic rests in the corresponding Consumer Price Index for each state. In Mississippi, the CPI is 169.7, while in New Jersey, it is slightly higher at 181.8. One would assume that living in New Jersey would be much more expensive than living in Mississippi. But Mississippi families pay .5% more of their income just to survive than do residents of New Jersey.

This would seem to indicate that our current tax system is "regressive", that is, skewed toward the wealthier citizens. Many in the upper middle class and beyond would argue the opposite. But most data indicate that almost any system of taxation is "regressive", based on definition and practical application.

The value-added tax, or VAT, has been offered up by some economists as a "flat tax" which could replace the income tax as the government's main source of revenue. The VAT is a sales tax which is applied to a product at all levels of its "life-span", from production to consumption (www.investorglossary.com/value-added-tax.html). The website indicated gives an example of a tree, which is taxed at the point it is cut down, taxed again at the mill, again at the manufacturer who turns it into a table, again at the trucking company who transports the table to the retailer, and again at point of sale. Obviously, the bulk of the tax is then paid by the ultimate consumer, because all the entities, from lumberjack to truck driver, will pass their costs on to the buyer.

The VAT is a regressive tax because the wealthy, with their income now non-taxable, can continue discretionary spending for such things as a new table, and still afford to invest and spend at will. The middle class family is left to determine if a heavily-taxed item is a necessity, or a luxury.

Another potential problem with the VAT also applies to the flat sales tax proposal put forth by organizations such as FairTax.org. A 30% sales tax as proposed would cause many products to be manufactured and sold on the "black market", through cross-border or Internet transactions. Tax evasion would become the norm for major purchases, especially in households where income was below the median. But the wealthy would certainly not miss an opportunity to take advantage of these shady offerings, and the U.S. Treasury would be unable to maintain the revenue stream necessary to meet the government's Constitutional obligations as a result.

The Hall-Rabushka flat tax proposal of the early 1980's, proposed by two fellows of the Hoover Institution, was a variation of the VAT that would apply to businesses and individuals. It made adjustments for the inherent "regressive" nature of the tax by taking into consideration a company's or individual's income, material costs, pension contributions, etc. In other words, it weighed itself down in much the same way as has our current, convoluted tax system.

William G. Gale, a Brookings Institution fellow and proponent of the flat tax, pointed out that "many of the gains (attained through the flat tax) are also available through judicious reform of the income tax, in particular by making the taxation of capital more uniform." Reform, then, according to Gale, could solve many of the problems of the current tax code.

One of the most recent proponents of the flat tax has been Daniel J. Mitchell of the Cato Institute. In Cato's July/August 2007 Policy Report, Mitchell argued the merits of the flat tax by pointing to the various countries and protectorates that have adopted such a method of financing their government programs. Estonia, Latvia, Serbia, Slovakia, Mongolia, Kyrgyzstan, Macedonia and Montenegro are among the 19 economic "powerhouses" that have found merit in such a system. Would we trade our system for theirs?

Alas, it takes great political will to achieve even small, incremental change in such a vast wasteland as is represented by America's tax system. And until Congress can muster such will, or until we elect a President willing to take on the special interests that most benefit from the convoluted nature of our current code, then modest reform is all we can hope for.

Dano: The Flat Tax is Fair, Necessary

This week, Reed and I are discussing the flat tax concept for tax reform. I am arguing in favor of a flat tax. In the interest of full disclosure, I have to tell you that I cannot locate an "objective" web site that argues either for or against a flat tax. This is because, in modern politics, flat tax proposals are almost always championed by Republicans, and criticized as either unfair, unworkable, or irresponsible by Democrats. Even sources that are typically fairly neutral on most policy issues seem to show their conservative/liberal biases on this topic. To locate the reasons that a flat tax is good, therefore, it was necessary to consult fairly conservative sources - I chose The Heritage Foundation (http://www.heritage.org/research/taxes/) and the National Center for Policy Analysis (http://www.ncpa.org/pi/taxes/tax71.html#1). There were many more, but they almost all agree on the features of a flat tax system, so I chose these two for their fairly well-laid-out approach. Most of what follows, therefore, comes from these sources. I suspect that Reed will have had to do the opposite to argue against the flat tax.

Many people don't know what a flat tax is, so I'll give just a brief description. The truest form of flat tax is one that taxes everyone and every business at the same, fixed rate; usually, there are no deductions or exemptions in such systems. A single mother of four making $18,000 a year would pay the same percentage of her income as would someone making $500,000 a year with no children to support. This is patently a bad idea, because it burdens the poor disproportionately. Why? Because each dollar of a poor person's income is worth more to them than each dollar of a wealthy person's income. This is why our current tax system is graduated such that as a person's income increases, the rate at which each additional dollar (within given brackets) is taxed increases.

Assume a flat tax rate of 17%. The $3060 tax burden on the single mother is a more critical insult to the single mother's (and her children's) welfare than the $85,000 tax bill is for the half-million dollar earner with no kids. Because of this inequity, no serious flat tax proposals are true flat taxes - instead, they incorporate an income threshold below which there is one flat tax rate, 0%, and above which there is another flat rate, usually something under 20%. They also provide personal exemptions and exemptions for number of dependents. In such a system, with a taxable income threshold of $30,000 and the dependent exemptions, the aforementioned single mother would pay no income tax, while the wealthier worker with no children would pay the 20% flat rate. In this way, such a flat tax is progressive, or graduated, though it could be argued that there is still only one tax rate, and that those below the income threshold (or who have enough exemptions) simply aren't subject to the tax system. In any case, no serious proposals eschew the minimum taxable income "loophole."

The benefits of a flat tax are many. The most obvious benefit is simplicity. Our current tax code is some nine million words in length, and there are between eight and nine hundred forms necessary to deal with all of the exemptions, deductions, credits, exclusions and other complexities. More than 80% of the tax code deals with these issues. Under a flat tax, there would be two forms - one for individuals, and one for businesses. Both these forms would be so simple they could be placed on a post card (see, e.g., http://www.cse.org/flattax/index.php).

A related benefit, one that represents an almost immediate increase in personal and business wealth, is the money that would be saved by this simplification of the code. It has been calculated that Americans spend around $600 billion per year on income tax compliance; they feel compelled to hire tax accountants and lawyers and financial analysts to help navigate through the IRS rules. This expenditure would be unnecessary under a flat tax.

But there are more goodies. Without going into exhaustive detail, the following are several of the other beneficial features of a flat tax system:

• No double taxation or asset taxation. The flat tax system taxes only income, and only when it is first earned. Unlike the current system, it does not tax savings, capital gains, interest income, or dividends. There is no death tax, either. Because of this feature, a flat tax would instantly increase the value of assets held by Americans.

• Less IRS intrusion. Under a flat tax, the IRS has no need to know what your assets and liabilities are - just income. Because of the lack of deductions, exclusions, loopholes, and related audits, the IRS can be simplified and downsized, further saving Americans' tax dollars.

• Increased global competitiveness. The current tax structure makes the U.S. one of the world's most expensive nations in which to do business. It is therefore attractive to migrate jobs and capital to countries with lower tax rates. A flat tax system, with a much lower tax rate, would eliminate this incentive to leave our shores, and would actually make the U.S. a more attractive operating arena for foreign owned companies as well. This is because the flat tax is based on "territorial taxation," meaning that only income earned within our borders is taxed. Eliminating "worldwide taxation" should make the U.S. much more competitive on the world economic playing field.
  

• No marriage penalty. The flat tax would apply to all earners, so both a husband and wife would get taxed at the same flat rate. It would no longer be possible for one spouse's income to push the couple into a higher tax bracket. Moreover, because a married couple's family-based allowance is twice as high as a single person's, there would be no penalty for being married and filing jointly.

• Reduction in political corruption. Much of what lobbyists and special interest groups do in the halls of Congress has to do with currying favor with regard to tax breaks and other loopholes. Under a flat tax, because of the lack of exemptions and exclusions, politicians would no longer be able to engage in the corrupt practice of trading favors with big business. This would greatly reduce corruption, but would also save corporations the immense cost of lobbyists and, thus, aid in business growth.

Fundamentally, the current Revenue Code is so complex and so flawed that some kind of tax reform is both desirable and necessary - particularly in light of the fact that world governments are jumping on the flat tax bandwagon in droves. The former communist nations in Eastern Europe have almost all adopted a flat tax system, and have achieved remarkable economic gains.

Representative Dick Armey (R-TX) has the most promising flat tax proposal here at home, and it has garnered the most support in Washington (http://www.ncpa.org/ba/ba136.html). While it is unlikely to pass under a Democratically-controlled Congress, Democrats would be wise to give more attention to the concept of the flat tax. Because it taxes all earners at one flat rate, but gives valuable and necessary income threshold exemptions to the poorest taxpayers, it is ultimately fair. Moreover, in the increasingly competitive global marketplace, America cannot continue to maintain a tax system that provides disincentives for businesses, jobs, and capital to remain within our borders.