Dueling Tax Plans: One Adds Up, The Other Doesn't

House Majority Leader Richard K. Armey's proposal for a flat-rate income tax has gotten more publicity phan it deserves. The Texas congressman advertises his plan as simplifying the system, reducing taxes, and stimulating savings, investment, and growth. Quite apart from whether this is a wise approach, Armey's numbers don't work. But there's a different plan, offering less hype and more careful analysis, that merits serious attention: the USA Tax unveiled last week by Senators Pete V. Domenici (R-N.M.) and Sam Nunn (D-Ga.). Superficially, the plans have similar goals, but their treatment of personal income could hardly be more different.

Armey proposes a flat 17% rate, with no deductions. It would leave moderate incomes untaxed, thanks to an immense personal exemption--$36,800 for a family of four. Thus, a family of median income (about $38,000) would pay almost no tax, and even a family with $50,000 income would pay less than 6%. So who would pay taxes? Armey projects that virtually every income group would pay less--which is, of course, too good to be true. The Treasury Dept. projects that, with a 17% flat rate, the plan would increase the deficit by at least $186 billion a year. To be revenue-neutral, Armey's plan would need a rate of 23% or 24%--meaning tax increases for all but the bottom and the top.

KEEP IT PROGRESSIVE. Beyond the dubious arithmetic, Armey's concept is flawed. It confuses tax simplicity and tax equity. The simple part of calculating taxes is multiplying the taxable income by the applicable rate. The hard part is calculating taxable income. Deciding which deductions are legitimate is complex, because life is complex. If we want to go ahead and discard all deductions--even mortgage interest, health care, charitable contributions, casualty losses--for the sake of simplicity, we can still keep graduated rates. A better approach would be to close the truly uneconomic tax preferences that still litter the tax code, and to lower rates while retaining progressivity.

In contrast to the Armey plan, Senators Domenici and Nunn's USA Tax--that stands for unlimited savings allowance--is extremely complex and retains graduated rates, with a top rate of 40%. USA Tax is a variation on an old idea--"progressive expenditure taxation." Domenici-Nunn would tax only spending. All income set aside as savings would be tax-exempt. Money withdrawn from savings and spent, however, would be taxed as current consumption. The rationale is twofold: It is fairer to tax people on what they consume than on what they earn, and the tax break on savings would sharply increase savings rates.

The Armey and Domenici-Nunn bills are similar in one respect: Both would replace the current corporate income tax with a flat tax on companies' gross profits, allowing deductions for purchases of inputs and permitting immediate write-offs of all capital investments, thus doing away with depreciation schedules. Armey would allow deductions of wages; Domenici-Nunn would not, but would allow a credit against payroll taxes. Although no sponsor emphasizes it, both approaches to business are a form of value-added tax (VAT).

MORE RECORDS. Is the Domenici-Nunn bill good tax policy? It has two major defects. First, it is complex. Taxpayers would need a new set of records and tax schedules to report flows into and out of savings. VAT-style business taxes are costly to administer and especially complex in their treatment of international business. Before embracing a VAT, we should debate its costs and benefits directly and not back into it as a means of seeking to promote savings.

Second, like the Armey bill, the Domenici-Nunn plan is highly regressive in the high-income range, where most savings occur. If a household with $4 million income consumes $1 million, taxes are owed only on that consumption. The nominal top rate in the USA Tax plan is 40%, but the tax in this case would be $400,000--an effective rate of 10%. If taxes on the very rich go down, taxes on others must go up. The original advocates of this approach, such as the British economist Nicholas Kaldor, writing in the 1950s, proposed offsetting this regressivity with modest net-wealth taxes or steeper estate taxes. But this remedy is nowhere in the Domenici-Nunn bill.

Still, Domenici-Nunn is a serious look at tax policy and not a political gimmick. It is the work of bipartisan moderates and deserves a respectful debate on details. Domenici, now chairman of the Senate Budget Committee, places deficit reduction ahead of supply-side fantasy and does not appear to be cooking his numbers. That cannot be said of Majority Leader Armey.

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