A Flat Tax That America Might Buy

Bet you can't guess how much it costs Americans to file their taxes. The tax code has become so complex (3,458 pages) and so intrusive (the Internal Revenue Service gets more than 1 billion Form 1099s annually to track interest, dividends, and other forms of business income) that the cost of compliance can be measured in billions of hours and billions of dollars. Individual Americans, including the self-employed and the owners of small businesses, spend about 2.1 billion hours each year to do their taxes, while big corporations take a bit longer--3.6 billion hours--to pay their corporate income taxes, according to economists James L. Payne and Arthur Hall. Dollar cost? About $57 billion for individuals and $175 billion for companies. Then, of course, there is the cost of maintaining the small army of government tax collectors--$13.7 billion for 136,000 IRS and other federal agents.

No wonder the drumbeat for a flat tax or some version of a consumption tax is getting louder and louder in Washington. The current tax system has serious problems. It does have a high level of compliance, but it is convoluted, opaque and open to manipulation by special interests. Even the ongoing effort to cut taxes is rife with examples of special-interest lobbying. Social conservatives want a $500 children's tax credit to bolster the family, investors and high-tech startups are pumping for a capital-gains rate cut, Wall Street is championing an IRA-type savings account, and there is even a tax credit for people who adopt. All worthy causes, yet each one further complicates an already arcane tax code and reduces the overall efficiency of the economy.


Better to simplify. Simplifying the tax code accomplishes two goals. First, it permits the markets to operate more sensibly--boosting growth and jobs--by removing government from the economic decisions of businesses and citizens. Income would be taxed at the same rate no matter what its source, and debt and consumption would no longer be encouraged. Second, tax simplification removes social engineering enacted through the tax system. Political choices become more transparent and accountable. The true cost of government programs becomes much clearer.

The logic of simplification has bred a raft of proposals, some better than others. The current favorite appears to be the radical single-rate flat tax of Representative Richard K. Armey (R-Tex.) that would levy one 17% tax on businesses and individuals, with no deductions or credits. Meanwhile, House Ways & Means Chairman Bill Archer (R-Tex.) favors a national sales tax, perhaps in the form of a value-added tax, which levies taxes on each stage of production. Then there is the more complex USA consumption tax designed by Senate Budget Committee Chairman Pete V. Domenici (R-N.M.) and Senator Sam Nunn (D-Ga.). A less radical Democratic proposal, a son-of-1986 Tax Reform, would close loopholes and lower all tax rates at the same time.

We favor a modified flat tax that would flatten the rate structure into two or three rates and preserve deductions for home mortgage interest contributions. Here's our thinking: Europe has had a VAT in place for decades, and it has become a bureaucratic nightmare, with exemptions that reflect all kinds of social-engineering policies--exactly what the U.S. wants to reverse. Since America already has an income tax infrastructure in place that people are accustomed to, it's more efficient to streamline it, use it, and not build another one. That way is just simpler.

We also favor making one big political compromise with economic efficiency by allowing deductions for mortgage interest to stand. It is politically unrealistic to believe that Congress would end this deduction for middle-class homeowners. And estimates of the possible loss from fully eliminating the deduction range as high as 15% to 20% of the value of the nation's homes. That adds up to a loss of up to $1 trillion in householders' net worth, the main source of personal savings. These amount to strong arguments for keeping the mortgage deduction but capping the deductible amount of the mortgage at $200,000. Totally eliminating the mortgage deduction would be highly deflationary, not only in terms of actual asset values but psychologically as well.


The flat tax is also economically neutral, while consumption taxes along the lines of the Nunn-Domenici bill favor investment. The tax system should favor nothing. Better to let individuals and families decide how they want to spend their earnings and let the markets determine investment flows.

Finally, by using two or three rates and exempting incomes of, say, up to $36,000 for a family of four, a flat tax can be designed so that it doesn't fall too heavily on the poor. All flatteners agree that the poor should be totally exempt. In the 1980s, former Representative Jack Kemp (R-N.Y.) and former Senator Robert W. Kasten (D-Wis.) suggested a plan with two brackets--20% on wages and salaries and 25% on other income--that also preserved deductions for home mortgages and charitable contributions. Senator Bill Bradley (D-N.J.) and House Minority Leader Richard A. Gephardt (D-Mo.) came up with a plan with three brackets: 14%, 26%, and 30%. Both plans tried to lower the rates and broaden the tax base while making the tax system more neutral than it is now.

The U.S. was headed in the right direction under Ronald Reagan with the Tax Reform Act of 1986. Unfortunately, policy reverted under both Republican and Democratic Administrations. Tax simplification is an economic and social benefit. It's a wonderful chance to do three things: promote growth while cutting the government, permit individuals and businesses to make economically clean decisions, and give back to Americans billions of hours and tens of billions of dollars that they would otherwise spend on preparing their taxes. Now, that's a sweet springtime thought, isn't it?

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