After 15 years of fermentation in academia, that concept has become a Hot New Idea. Steve Forbes has ridden the flat tax to second place in the Republican polls. A committee of GOP bigwigs led by former representative Jack Kemp is endorsing the flat-tax idea this week, and Sen. Bob Dole, the party’s leading contender, is likely to sign on. About the only candidate who’s openly opposed is Bill Clinton. Come fall, predicts House GOP leader Richard Armey, “it’s going to be a big issue.”
“Flat tax,” in truth, is a misnomer. Nobody advocates a single tax rate on all income. Forbes and Armey would junk today’s array of five different rates on personal income for just two: zero on a family of four’s first $36,800 of earnings, and 17 percent on everything more. There’d be no other deductions, no credits and no tax at all on income from interest, dividends and capital gains. Businesses would pay 17 per-cent of the difference between each year’s revenues and expenses. Says University of Michigan economist Joel Slemrod, “That kind of radical simplification puts an end to a lot of games.”
Watch closely. The flat tax looks like an income tax, but it works like something Congress has never mustered the courage to pass: a hefty tax on consumption. Higher business taxes would drive up consumer prices, while investment income would be tax-free, creating an enormous incentive for saving over spending. Backers like Harvard’s Dale Jorgenson foresee “a huge investment boom,” leading to a much stronger economy and higher incomes all around.
What grabs the public, however, isn’t growth. It’s simplicity. The flat tax’s inventors, economists Robert Hall and Alvin Rabushka, designed a return that fits on a 10-line postcard. Armey embraced the idea. It sounds revolutionary. So what if 18 million taxpayers already file 10-line returns on Form 1040EZ? “This whole thing about the postcard is bulls–t,” says Phil Wiesner, a tax partner at Peat Marwick. “Most people will be filing electronically anyhow.” Ah, yes. But the public loves the postcard.
If the flat tax is so great, why didn’t Congress pass it years ago? Perhaps because it isn’t exactly as advertised.
Upper-bracket folks, who pay the most taxes, get the biggest tax cut. The Forbes-Armey plan would raise taxes for families earning less than $25,000, because it ends the earned income credit. The average couple with two kids and a $300,000 income, on the other hand, would save $49,000, according to Peter Merrill and Shvetank Shah of Price Waterhouse. And then there’s Richie Rich. By living only on inherited wealth, he “would not pay one dime of taxes,” Merrill says. “But the maid, butler and chauffeur who are working for him would be taxed on all their income.” Rabushka counters that economic models can’t project who’ll gain the most. But try explaining that in a 30-second commercial.
The big economic bump from the flat tax comes by eliminating what economists call “distortions.” Of course, one person’s distortion is another’s deduction. Consider the deduction for mortgage interest, which cuts taxable income by $200 billion a year. Killing it could hurt home prices. But if the break remains, “a lot of the benefits of shifting to the flat tax would be nullified,” Jorgenson says, because the tax code would still favor housing over other investments. The status of municipal bonds, which produce $43 billion a year in tax-free interest, is another hot-button issue. If loopholes survive, the tax rate will have to be higher. Under Forbes and Armey’s no-deduction plan, a 21 percent rate, not the touted 17 percent, would be needed to replace today’s income tax. With deductions for mortgages and charity, says Federal Reserve Gov. Lawrence Lindsey, figure on 24 percent.
Did somebody say simple? Don’t bet on it. When should company cars and fringe benefits be taxed? Flattening the rate won’t flatten the Internal Revenue Service’s rule-writers. And then there’s the matter of getting from here to there. Consider a bakery that bought an oven last year, planning to deduct 10 percent of the cost from its income each year until 2004. Under the flat tax, a brand-new oven could be written off all at once–but the unused deductions for the existing oven would be gone for good. Congress might write special rules to aid the bakery, but once that process begins, it’s Katy bar the door. Says Reagan-era tax official Charles McClure, “You start to get into a mare’s nest.”
Today’s tax system has few defenders. But it’s hard to know whether the flat tax would work better. The answers to even the most basic questions–would it make interest rates fall, or would they rise?–are uncertain. “It’s an expensive experiment,” warns University of California economist Alan Auerbach. Congress, he adds, could achieve the same ends by closing loopholes in the current law. He’s right. But if Congress had ever managed to do that, the flat tax wouldn’t be on the table.
