The Flat Taxers' Flat Distortions

Having attacked the liberal accomplishments of the Great Society and New Deal, congressional Republicans are preparing to eliminate a reform that stretches even further back into history: the progressive income tax. Republicans in both houses of Congress have introduced plans for a flat tax, claiming that its simplicity and fairness will be a boon to all. Majority Leader Dick Armey, presenting his plan, states that "millions of taxpayers are taken off the rolls entirely, and middle Americans receive a tax cut."

The first part of that claim is largely true. Since Armey's plan does not tax income from interest, dividends, or capital gains, those taxpayers who live completely off of investment income would be taken off the rolls entirely. The second part of the claim is, by any serious accounting, wrong. Armey's plan has two parts: It replaces the progressive income tax with a flat tax, and it replaces business taxes with a consumption tax. Both elements would dramatically shift the tax burden from the wealthy toward the middle class and the poor.

If not for stunning misrepresentations, this would be obvious to everyone. Our personal income tax now starts with a zero effective rate on lower-income families (families of four currently earning up to about $23,200 pay no income taxes) rising to a 39.6 percent top marginal rate on the incomes of the richest 1 percent. Replace that with a flat rate of, say, 20 percent and clearly the rich will pay far, far less in taxes. That has to be made up somewhere.

Flat-tax advocates imply that the lower tax rate will be made up by closing loopholes for the wealthy and well-connected. In fact, the opposite is true. The complete tax exemption for personal investments replaces many small loopholes with one enormous loophole. Rather than alleviating the plan's regressivity, this aggravates it: A large share of the income of the wealthiest Americans wouldn't be taxed at all. That would leave middle- and low-income families holding the bag.

The flat-tax proposals currently in Congress are based upon a plan put forth by Robert Hall and Alvin Rabushka, two Stanford economists. In their 1983 book, Low Tax, Simple Tax, Flat Tax, they said that their flat tax "will be a tremendous boon to the economic elite." They honestly delivered what they admitted was "some bad news": "it is an obvious mathematical law that lower taxes on the successful will have to be made up by higher taxes on average people." Hall and Rabushka calculated that their flat tax would raise taxes by $1,400 to $2,400 a year (in today's dollars) on families earning between $25,000 and $75,000. But "the truly successful get a better and better deal," they pointed out. "Families with incomes around [$285,000] receive tax breaks of about 7 percent of income, those with incomes of [$1.5 million] get 10 percent, and the handful with incomes approaching [$4 million] get 13 percent."


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The politicians who have embraced this plan are less candid about its effects. Armey, for example, tries to sell his flat tax by (a) talking only about the wage portion of his tax, while pretending that nobody pays the business sales tax part, (b) denying that his proposed 17 percent rate and high exemptions entail a huge revenue shortfall, and (c) nevertheless insisting that almost everyone will get a tax cut.

Let's start with the first part. The business tax part of the plan would tax all corporate receipts, exempting investments in capital, with wages taxed separately. Economists call this a consumption tax. Armey delicately avoids the term. Calling it a "business tax" allows him to pretend that consumers don't pay it, but Hall and Rabushka have failed to cooperate in this political charade. During a 1982 Senate Finance Committee hearing, Senator Bill Bradley asked Hall, "So you are advocating a consumption tax?" Hall responded, "That's right, but we are careful not to label it as such." In the revised edition of their book, they are not so careful. "The flat tax," they write, "by expensing investment, is precisely a consumption tax."

Although flat-tax backers seem to think that their business sales tax would be immune from political pressures, this is not the experience with value-added taxes in Europe, nor with sales taxes in the states (the closest existing approximations). On the contrary, lobbying for special exemptions and loopholes is rampant with those taxes, cheating is widespread, and administrative costs are generally as high or higher than for income taxes.

Even the introduction of this huge new consumption tax, however, would not make up for the huge losses of revenue brought about by the plan. Armey proposes a tax exemption of $13,000 for an individual, $26,200 for a married couple, and $5,300 for each child. "A family of four would have to earn $36,800 before it owed a penny of federal income tax," explains Armey, declining once again to mention the effect of his consumption tax. Too good to be true? Of course.

Although it's difficult to gauge what effect such a radical change would have on economic behavior, a study by the Treasury Department of the impact of Armey's plan pegged the revenue shortfall at $186 billion a year. To make up the difference, Armey would have to drastically reduce his proposed exemptions for children, jack the rate up from 17 percent to about 23 percent, or some of each.

Once these changes are taken into account, Treasury's analysis shows that the typical family would pay close to $2,000 a year in additional taxes under the Armey flat tax. Very rich people, however, would get tax cuts averaging more than $50,000 each.

More specifically, Citizens for Tax Justice (CTJ) has calculated the effect of the flat tax on a range of income groups. For simplicity, CTJ focuses on non-elderly couples with two children, based on actual tax return and Census data (adjusted to 1996 levels). The results are similar to those shown in the tables presented by the Treasury and by Hall and Rabushka in 1983. For example:

Family income: $25,000. Under current law, a family of four earning $25,000 pays essentially nothing in combined personal and corporate income taxes. Taxes that would otherwise be due are offset by the earned income tax credit, which Armey would repeal. Under the Armey plan, with its proposed exemptions but with a 22.6 percent break-even tax rate, such a family would typically pay $810 in taxes on its $3,600 in fringe benefits and $1,540 as its share of the business tax. Thus, its tax bill under the Armey flat tax would increase by about $2,400. Under the alternative scenario, with a 17 percent tax rate but lower exemptions, this family's tax bill would increase by almost $3,700.

Family income: $45,000. This family would currently owe about $3,800. Under the Armey plan, its taxes would increase by $1,740 to $4,200 a year, depending on the version.

Family income: $85,000. Current personal and corporate income taxes on this family would typically amount to $11,140. Under the Armey plan, wage taxes alone would be $10,400 to $11,650. When taxes on fringe benefits and the business tax are added in, this family would owe $4,600 or more a year in additional taxes.

Family income: $500,000. Under current law, this family would pay $154,000 in combined personal and corporate income taxes. Under the Armey plan, the family's tax would be slashed by half or more for a tax cut of between $78,000 and $93,000 annually.


SUPPLY-SIDE REDUX

How, then, does Armey conclude that his plan will cut everyone's taxes without losing revenue? He relies upon Hall and Rabushka's estimate in their book that the new incentives brought about by the flat tax will lead to a $1,900 increase in per capita income by 2002. This is just a leap of faith. There is no basis for this claim other than supply-side economics, the notion that lowering taxes on the wealthy will cause an explosion in economic activity whose riches trickle down to everyone. History has not been kind to this view.

Supply-side proponents of the tax-shift policies adopted during the Carter and early Reagan years confidently predicted that their approach would produce an investment-led economic boom. But despite the rosy scenarios, the supply-side experiment failed. After the 1978 capital gains tax cut was enacted, for example, the gross domestic product (GDP) dropped by 1 percent over the next year and a half, after having grown by 5.8 percent the previous year. The 1981 supply-side tax-loophole bill was followed by the deepest recession since the 1930s.

After several years of weak business investment, rampant tax-sheltering, and huge budget deficits, President Reagan himself switched gears. The supply-siders were banished and Reagan helped lead the charge for the loophole-closing 1986 Tax Reform Act. The result was a fairer, more efficient tax code that treats income more equally, regardless of how it is earned or used. And to the consternation of supply-siders, productive investment surged dramatically after the loopholes were closed and business tax avoidance was curtailed. As former Reagan Treasury official, J. Gregory Ballentine, told Business Week: "It's very difficult to find much relationship between [corporate tax breaks] and investment. In 1981 manufacturing had its largest tax cut ever and immediately went down the tubes. In 1986 they had their largest tax increase and went gangbusters [on investment]."

More recently, our economy has enjoyed an investment-led economic rejuvenation following the increases in the top tax rates on corporations and the best-off people in President Clinton's 1993 deficit reduction act -- defying the tocsins of doom sounded at the time by Armey, Gingrich et al. Indeed, from the third quarter of 1993 (when the deficit reduction act was approved) through the end of 1994, real GDP rose by 5.7 percent, led by real business investment growth of 18.4 percent. The stock market is at a record high. Indeed, the economy has done so well since 1993 that the Federal Reserve has taken repeated steps to try to slow it down.

The current flat tax plans dwarf all previous tax change battles. President Clinton had to wage political holy war to win a slight increase in the highest tax bracket. The flat tax would cut it by more than half. While Congress has fiercely debated lowering the capital gains tax by a few points, this plan would drop it to zero. Liberals are shocked that the Republican Congress now seeks to cut the earned income tax credit by a tenth. Armey's plan would eliminate it entirely.

The irony is that the flat tax is coming into political favor at a time when the economics undergirding it have never been less credible. Worse, at a time when Americans face a long-term rise in inequality and a decline in middle-class wages, Congress is considering solutions that would throw gasoline on the fire. Fortune magazine recently ran a cover story, "Get Ready for the Flat Tax," as if it were a fait accompli. The message for anyone who cares about the future of economic justice in America couldn't be any clearer: Get ready to fight the flat tax flat out.

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