April 23, 1995
"Flat Tax Trade-offs and Truths"
San Jose Mercury News
By Timothy Taylor
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IN LATE April, when thoughts of income taxes are as vivid as a dentist's drill, America is especially ready for talk of a flat tax. Any flat tax proposal involves a trade-off. First, increase tax revenue by eliminating deductions, credits and exemptions that shield income from taxes; then, return the extra revenue to taxpayers in the form of lower tax rates.

The most widely discussed flat tax plan, from House Majority Leader Richard Armey, would eliminate all deductions and credits. However, it would keep large personal exemptions, and then charge a flat tax rate of 20 percent on income above that level. Others have proposed replacing the income tax with a national sales tax, which can be thought of as an extremely flat tax, without even any personal exemptions.

A gradual movement toward fewer tax breaks and lower tax rates makes sense. A flatter tax promises less time spent on record-keeping and tax gamesmanship, and more time focusing on working, saving, earning a living, and the basic stuff of economic life. But the more extreme flat tax plans involve some hard truths and trade-offs.

For starters, most flat tax proposals would replace only individual and corporate income taxes -- and those represent only about half of federal tax receipts.

In 1995, federal tax receipts are projected at $1.35 trillion. Individual income taxes will be $588 billion, while corporate taxes will collect $150 billion. The other $618 billion of federal taxes -- the payroll taxes for Social Security and Medicare, along with excise taxes on gasoline, alcohol, and tobacco -- wouldn't be affected.

So when a politician promises you a flat income tax rate of 20 percent, remember that you and your employer would each still be chipping in 7.65 percent of your income in payroll taxes (up to the earnings ceiling for these taxes). The overall combined federal tax rate would be more like 35 percent on a significant slice of your income.

Another problem is that eliminating tax deductions and credits often sounds better in general than in specifics. However peculiar the existing tax code, people and organizations have made plans based on it. Changing the tax ground rules, however worthy the reason, is always politically and economically difficult. It always has a whiff of unfairness.

For example, eliminating the deduction for mortgage interest would hurt home buyers who were counting on that provision. Cutting the deduction for charitable giving will be tough on organizations that depend on such contributions. Ending tax credits for investment won't be popular with business. Taxing fringe benefits like employer-provided health insurance is deeply unpopular. Collecting taxes on the interest paid by state and local bonds would hurt investors who bought such bonds thinking that they would be tax-exempt.

Although some of the flat tax proposals would result in lower taxes, there is no logical reason that a flat tax needs to include a tax cut. In formulating the Tax Reform Act of 1986, there was bipartisan agreement that tax reform should be "revenue neutral." Keeping arguments over the form of taxation separate from arguments over the level of taxation avoided political gridlock, and helped a flatter tax to pass in 1986.

But if a flat tax is a zero-sum game, then anyone who pays less under the tax will have to be counterbalanced by someone paying more. Most flat tax proposals seem likely to shift taxes to the middle class.

To understand why, consider Armey's flat tax proposal. In his plan, the poor would be shielded by large personal exemptions: a couple with two kids and income below $36,800 would pay no federal income taxes. The very rich who now face the top tax brackets of almost 40 percent would be paying at the flatter marginal rate of only 20 percent. But if the poor and rich both pay less, and the tax reform is revenue neutral, the middle class will be left to pay.

A national sales tax, the most extreme form of flat tax, would apply only as income is consumed. Since the wealthy spend a lower proportion of their income (and save the rest), such an approach would cut taxes on the rich even further, and a revenue-neutral national sales tax would necessarily have to collect more taxes on the middle class and the poor.

A final promise of the flat taxers is that lower tax rates will unlock a vast surge of entrepreneurial talent and savings. I think such gains are likely to be modest.

Most Americans already work pretty hard; anyone who is sitting around waiting for a flat tax before becoming an entrepreneur probably won't be much of a success anyway. America does need to save and invest more, but the evidence isn't especially strong that cutting tax rates will make a huge difference. U.S. savings rates have been low for decades, and they sunk further when the top income tax rates were cut in the 1980s.

It's always worth trying to limit special provisions in the tax code and to keep tax rates low. But an extreme flat tax would wipe out America's most cherished tax breaks and give a substantial tax cut to the super-rich. As those issues become clear, I expect the late-April fever for a flat tax will cool.

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