The Flat Tax: Simplicity Desimplified
Roger W. Garrison*
 In
modern American politics, advocating a flat tax is the surest way of labeling
yourself as a supply-sider, a Jack Kemp/Steve Forbes Republican. Michael
Evans(1) made the case for the flat tax
in his Truth About Supply-Side Economics (1983); Robert Hall and
Alvin Rabushka(2) have made it twice in
their book-length treatment of The Flat Tax (1985 and 1995).
Libertarians,
many of whom get their economics from the Austrian school and eschew the
Republican label, also tend to favor a single rate. In explaining Why
Government Doesn't Work (1995), Harry Browne(3)
offers a flat tax as part of the fix, but he devotes barely more than a
page to this issue. The space he allocated to the flat tax as compared
to the space allocated to it by the supply-siders as well as his attention
to the size of the tax take rather than the shape of the tax schedule suggests
a significant difference in priority and perspective. (4)
"How Much" and "Just How"
The primary concern of the libertarians is with
"how much" the government be allowed to extract from income earners and
only secondarily with "just how" it is best (i.e. least painfully) extracted.
Browne, for instance, suggests a 10% rate, which might raise as much as
$500 billion. Barely one third of the current total tax take, this amount
is to finance the correspondingly pared down expenditures of the federal
government. Supply-siders, by contrast, deal with the just-how question
as if it can be answered independently of the how-much question. The most
common proposal, for instance, is for a revenue-neutral reform: We should
scrap our current progressive tax, which we know to be hopelessly complex
and inefficient, and adopt a simple and efficient flat tax that would yield
the same�or nearly the same�revenue. Some supply-siders (e.g. Evans) would
hold out for even more revenue.
Opponents
of the flat tax can easily point to perceived social inequities, exaggerated
claims, and outright fallacies that conventional supply-side arguments
entail. A more defensible case for the flat tax is one that keeps the questions
of "How much?" and "Just how?" in proper perspective: A flat rate may do
little to make a big tax simpler or more efficient, but it may be a near-perfect
device for keeping a small tax small. The key issues are (1) the actual
incentives created by eliminating deductions in the pursuit of simplicity
and (2) the political alliances created by incorporating a large personal
exemption for the sake of voter appeal. A healthy consideration of these
and related issues suggests that reducing the total tax take should have
priority over imposing a single tax rate.
TANSTAA...
We owe to Robert Heinlein the memorable if nearly
unpronounceable TANSTAAFL (there ain't no such thing as a free lunch),
which expresses one of the most fundamental principles in all of economics.
Each major field of study within economics would do well to find its own
Heinleinian acronym so as to keep policy prescription anchored to the fundamentals.
Let me propose a suitable one for the field of public finance: TANSTAABST.
There ain't no such thing as a big simple tax. Head taxes, the only truly
simple taxes, are never big; income taxes, the primary source of revenue
for the welfare state, are never simple. The claim, made repeatedly by
supply-siders, that with a flat tax our tax form would be the size of a
postcard can easily be exposed as bad science fiction.
The gains in simplicity are supposedly achieved by the elimination of deductions.
Instead of multiplying our income (minus a myriad of deductions) by the
effective tax rate, we multiply our income (minus a single personal exemption)
by the flat rate. The multiplicand that the tax reformers have in mind,
of course, is the income routinely reported on W-2 forms (or on 1099s and
the like). For taxpayers in the post-reform period who continued to earn
W-2 income, filing would indeed be simple. We should realize, however,
that the W-2 form remains a tolerable means of reporting precisely because
it is only the starting point for calculating taxable income. To eliminate
deductions, which give the taxpayers scope for bargaining with the tax
collector, is to eliminate the acceptability to the taxpayer of receiving
income on a W-2 basis.
Even
under the current system, there are strong incentives for avoiding the
W-2. In many areas of the business world the conventional employer-employee
relationship is being replaced by the firm's contracting with individuals
for services rendered. The elimination of deductions that would accompany
the institution of a flat tax would undoubtedly accelerate this trend toward
self employment�which has been driven from the start largely by tax considerations.
Under a contractual arrangement, the payment by the firm to the individual
is not W-2 income but gross receipts. Income is to be calculated by the
individual, with advice from his or her tax accountant, as receipts minus
expenses. Even a wholesale elimination of deductions, then, would not achieve
a dramatic simplification; it would simply shift the battleground on which
taxpayers and the tax collector confront one another. Tax-avoidance strategies
would aim at minimizing receipts minus expenses rather than minimizing
income minus deductions. TANSTAABST. And the very open-endedness of what
might reasonably be counted, in each line of business, as an expense would
quite likely make the tax system more complex rather than less.
The
extent to which the taxpayers would resist clipping their checks onto a
postcard-size tax form is measured by the tax rate itself. Current levels
of government spending would require a high rate. Special features of the
supply-siders' flat tax would reduce the tax base and make the rate higher
still. One of these features, not strictly implied by�and actually at odds
with�the concept of the flat tax, is the source of the widely perceived
inequity: Interest income is to be treated as if it were not income.(5)
This special reward to savers and hence to high-income earners (since they
are the ones who can most easily save) derives from the belief that it
is actually consumption and not income per se that should serve
as the basis for taxation. According to this view, people whose current
demands for consumer goods are being satisfied should pay the taxes. The
preferential status accorded savings�and hence investment and economic
growth�is what justifies naming supply-side policies for their one-sidedness.(6)
The pro-saving feature of the flat tax means that the portion of income
not
saved will have to be taxed at a higher rate than would otherwise be necessary.
At the same time, it constitutes one�possibly significant�way for taxpayers
to avoid the tax. Instead of awarding raises to its employees, a firm may
well offer them the opportunity to buy low-risk, high-yield bonds, whose
coupon payments (interest-in-lieu-of-wages) are not taxable. The tax collector
would, no doubt, attempt to police this and other such tax avoidance schemes,
but the process through which the market tries to arrange them and the
government tries to curb them is unlikely to contribute to either simplicity
or efficiency.
With
a tax base that includes salaries and pensions plus business income, the
tax rate that achieves revenue neutrality would have to be about 19%, according
to Hall and Rabushka. During his bid for the Republican nomination for
president, Steve Forbes proposed a 17% rate, calculated to give most taxpayers
a small tax cut�and to give them all a higher budget deficit. But any rate
in this range (i.e., 17% - 19%) is certainly high enough to sustain a reconstituted
tax-avoidance industry.
The Flatly Progressive Tax
All of the Republican proposals involve a second
departure from a strictly flat tax applied to all income, namely, a relatively
high threshold level below which no taxes are collected. A substantial
personal exemption (Forbes would have allowed for about $36,000 for a family
of four; Hall and Rabushka suggest $25,000) has the effect of blurring
the distinction between a flat tax and a progressive tax. As a matter of
terminology, flat means not progressive. How, then, could Hall and
Rabushka(7) argue that one advantage to
their flat tax is its progressivity? The so-called single rate is actually
two rates: 0% for income up to $36,000, using Forbes' proposal for illustration,
and 17% for all income above $36,000. Calculating the average tax
rate for incomes up to ten times the personal exemption, we get the progressive
pattern that rises from 0% at the threshold level to 8.5% at twice that
level to 15.3% at ten times that level and that thereafter approaches 17%
asymptotically.
Supply-siders
do not consider this progressivity objectionable at all. What they do find
objectionable is an unnecessarily high marginal rate, such as our current
top rate of about forty percent (on taxable income over $250,000). Why,
then, do they allow for substantial inframarginal incomes to go untaxed?
This, too, causes the top marginal rate of 17% to be higher than it needs
to be. That is, if a positive rate of, say, 8% were applied to some portion
of income below $36,000, then a rate of, possibly, 15% could be applied
to all income above that level. And the lower the top marginal rate, the
stronger the standard supply-side arguments about increasing employment,
exploiting the Laffer curve, and reducing the federal budget deficit through
economic growth.
It
seems clear that the generous personal exemption is included in the flat-tax
proposals largely if not wholly for its voter appeal. The prospects of
earning lots of tax-free income and enjoying a progressivity in the average
rate on incomes well over the threshold level is attractive to the so-called
"middle class"�which is to say, to the median voter. But, whatever the
benefits of a flat tax, political attractiveness achieved in this way is
a double-edged sword. Once such a tax system is in place, that same political
attractiveness would attach itself to government spending in the minds
of low- and medium-income voters. An overly generous personal exemption
creates an alliance between these voters and elected officials in their
efforts to gain economically and politically at the expense of the higher-income
taxpayers. Government spending could have (gross) benefits for us all or
could benefit mostly the poor while being paid for by the rich. This pattern
of benefits and costs and resulting conflict among the differently situated
taxpayers is precisely what any worthwhile tax reform would have to preclude.
Actually Achieving Simplicity
The advertised simplicity of a flat tax cannot
be achieved by the elimination of deductions. As already suggested, determining
what constitutes income would be, if not more complex, just as complex
as determining what counts as a deduction. Further, the flatness of a flat
tax does not translate into simplicity in any relevant sense. Progressivity
in the sense of multiple brackets with stepwise increases in the marginal
rates eliminates big jumps in the tax schedule while adding little or no
computational complexity. Taxpayers who look up their tax liability on
a suitably constructed tax table, like the cashier who looks up the sales
tax on a similar table taped to the cash register, may not even notice
whether the table was constructed on the basis of one rate, two rates,
or ten rates. And while reasonable people could disagree about the relative
merits of having a single rate or having ten, the merits of having just
two, as entailed by a flat rate with a generous personal exemption, are
dubious. People may prefer living in a one-story house rather than having
to cope with stairs. But it doesn't follow that a two-story house can be
"simplified" by removing the staircase. Similarly, replacing the several
small steps in the current progressive tax schedule with one giant step
at $36,000 is not an obvious improvement.
If
tax simplicity is achieved, it will be achieved not by the tax rate's flatness
but by its lowness. TANSTAABST. There ain't no such thing as a big simple
tax. But a small tax can be simple�and for a simple reason: If taxpayers
find it easier and less costly to pay the tax than to redesign their economic
lives so as to avoid paying it, the incentives for creating and exploiting
complexities are effectively blunted. The resulting simplicity, of course,
is not a goal unto itself but rather a healthy indicator that we have achieved
the prerequisite goal of low taxes.
As
Hall and Rabushka have emphasized, the tax rate can be its lowest if the
tax is applied broadly, although they would apply it broadly to all consumption
rather than (even more) broadly to all income. Salary income encourages
working; interest income encourages saving. With a broad base that encompasses
both, the disincentive effects of taxing are minimized. Our current tax
system has a strong anti-saving bias; Japan's tax system has a strong pro-saving
bias. Neither bias has a justification in economic theory, and both biases
cut into the tax base. There is a strong and obvious case for avoiding
a bias in either direction while at the same time broadening the base.
A low rate applied to a broad base lets income earners make their decisions
about working and saving on the basis of the actual�non-tax-related�tradeoffs
that these decisions entail.
A
lower rate still is facilitated by the elimination�or minimization�of the
personal exemption. (Browne allows for none.) The paring down of government
expenditures provide a double-barreled justification for eliminating this
exemption. First, the rate would be low, so as not to significantly burden
even the low-income taxpayer. Second, since the services actually provided
by government would be only those considered as essential to our wellbeing
as other necessities that low-income taxpayers buy in the private sector,
no taxpayer would be unduly burdened. Subjecting the low- and medium-income
taxpayers to a tax burden proportional to the burden of the high-income
taxpayers is in full compliance with both the letter and the spirit of
a flat tax. Stringent voting rules need to be in place to guard against
uncalled-for increases in the flat rate, and even more stringent rules�possibly
at the constitutional level�are needed to assure that the flat rate remains
flat.
Importantly,
a universal application avoids the perverse political alliance with respect
to government spending mentioned earlier. In fact, a constitutionally guaranteed
flat rate creates a healthy alliance among income earners at all levels
and against elected officials who, under other tax arrangements, could
more easily gain political advantage through targeted government spending
to be financed by selectively adjusting the tax rates. Taxpayer solidarity
as a check against increased taxing and spending should be seen as the
sine
qua non of the case for a flat tax.
The Flat Tax in Perspective
Currently we have a big, complex and inefficient,
progressive tax. It is folly to think that the "complex and inefficient"
derive significantly from the "progressive." The "complex and inefficient"
derive from the "big." Given the efficiency and adaptability of the market,
there is probably no knee-of-the-curve below which the tax take can be
declared "small." But 10% can be declared smaller than 17%, and, at any
rate, opportunities for further reform still exist.
TANSTAABST.
Revenue-neutral tax reform is no solution. The smaller the tax, the greater
the prospects for simplicity and efficiency. And a flat rate may be the
best means of keeping a small tax from becoming a big one.
Notes:
*Roger W. Garrison is Professor
of Economics at Auburn University, Auburn, AL 36849. He wishes to thank
David Laband, Jim Long and Leland Yeager for helpful comments.
1. Michael K.
Evans, The Truth about Supply-Side Economics (New York: Basic Books,
1983).
2. Robert E.
Hall and Alvin Rabushka,
The Flat Tax, Second Edition (Stanford,
CA: Hoover Institution Press, 1995 [First Edition, 1985]).
3. Harry Browne,
Why Governement Doesn't Work (New York: St. Martin's Press, 1995),
pp. 182-83.
4. Not long after
his campaign book was distributed, Browne began advocating a complete abolition
of the income tax and arguing that essential government services could
be funded by (1) existing tariffs and excise taxes and (2) proceeds from
the sale of government assets, such as land in the western states.
5. Individuals
would pay taxes only on wages, salaries, and pensions; business firms would
be allowed to fully expense investment, which is the present-value equivalent
of allowing them to exempt the competitive yield on those investments.
Taken together, these provisions, which have the effect of excluding interest
income (or, equivalently, saved income) from the tax base, convert the
income tax to a consumption tax.
6. Critics of
interventionist policies may be tempted to embrace supply-side theory as
the antithesis of Keynesian theory, which focuses almost exclusively on
demand. However, a critical assessment of both theories suggests a more
balanced view: On analytical issues (How do markets work?), we should be
both-siders: supply and
demand. On policy issues (What kind of bias
should be built into our tax system?), we should be neither-siders.
7. Robert E.
Hall and Alvin Rabushka, "Simplify, Simplify," in Edwin Mansfield, ed.,
Leading Economic Controversies of 1996 (New York: W. W. Norton and
Company, 1996). Reprinted from the New York Times, February 8, 1995.
See also, Hall and Rabushka, The Flat Tax, p. 55 and passim.
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