Commentary: A Flat Tax Is Flat Out RiskyChristopher Farrell
America's latest tax revolt is gathering momentum. Multimillionaire Steve Forbes has launched his GOP Presidential bid with an all-out assault on the federal income tax. Representative Bill Archer (R-Tex.), the powerful chairman of the House Ways & Means Committee, wants to "pull the income tax out by its roots so it can never grow again." The recent report of the GOP-chartered Tax Reform Commission, chaired by supply-side cheerleader Jack F. Kemp, argues that "the current tax code cannot be revised, should not be reinvented, and must not be retained." It's time, they tell us, to begin anew.
Right now, in the vanguard of the movement to replace the 83-year-old income tax is the 17% flat-rate tax championed by Forbes and House Majority Leader Richard K. Armey (R-Tex.). Thus far, the debate over the flat tax has revolved around the politically explosive question of income distribution. By design, a flat tax reduces the load on the wealthy by exempting from personal taxes interest, dividends, and capital gains. Flat-tax advocates justify the move by claiming a dramatic economic payoff. Although it shied away from endorsing a flat tax, the Kemp Commission predicts a doubling of the nation's growth rate with a switch to a single-rate system.
Sounds good, doesn't it? Problem is, the revolutionaries are wrong. Their florid rhetoric vastly overstates the economic gains and deeply underestimates the risks. There could be a long-term payoff from a flat tax as measured by savings, investment, and growth, but it would be hardly overwhelming. The gains could be easily dwarfed by wrenching business and household upheavals as America shifts to a new tax code.
DOUBLE HIT. Indeed, the transition to a flat tax is fraught with danger--so much so that the long-term payoff may never come. Businesses that borrowed money and invested under the existing income tax rules will suddenly be penalized. So will individuals who saved and bought homes. Businesses will lose interest deductions on borrowed money. Corporate depreciation allowances on existing investments will be wiped out. The stock market will tumble because Corporate America's assets will be worth less.
The flat tax also eliminates deductions for home mortgages. In addition to getting hit on their stock holdings, homeowners will likely suffer a 10% to 15% drop in the value of their homes. The effect on consumer spending could be disastrous. Flat-tax supporters claim that lower interest rates will cushion the drop in the stock market and housing, but it's unlikely rates can fall far enough to offset these downward economic pressures. The initial impact of an Armey-type flat tax could be a recession, says Mark Zandi, economist at Regional Financial Associates Inc. It would take four years for any positive impact from the flat tax to become apparent, he says.
Of course, phasing in the flat tax over a long period of time--say, 10 to 30 years--would lessen the economic turmoil. But it creates new quandaries as well. Any safe harbor chips away at the promised efficiency gains. The more policymakers shelter decisions made under the old system, the higher the single rate must be, reducing the promised incentives to work, save, and invest more, says William G. Gale, economist at the Brookings Institution. Indeed, Laurence J. Kotlikoff, an economist at Boston University, argues that with transition rules "you could end up with less savings, investment, and growth than with the current income tax."
True, many economists support the principles behind the flat tax. Right now, corporate earnings are effectively taxed at least twice, at the corporate level and at the individual level, which tends to discourage capital spending. The flat tax gets rid of double taxation by exempting capital income from personal taxes, which should, in theory, boost savings and investment. The other proposed alternatives to the income tax, such as the Nunn-Domenici USA Tax, similarly encourage savings and investment (table).
Yet it will take time for tax incentives to affect consumer savings. For instance, more than half of all private savings already are in tax-sheltered pension plans, making it unlikely that savings will rise much. Anyway, the big drain on national savings has been the federal budget deficit. The fastest, surest way to hike America's savings pool is to eliminate the deficit, not to undertake a wholesale transformation of the tax code--which at a 17% rate would send the deficit into the stratosphere.
The case for the proposed flat tax boosting new investment is more compelling--mainly because of changes in depreciation rules. New investment would get a boost from expensing, an immediate 100% first-year tax write-off. Much of the gain would show up in structures and buildings; depreciation on equipment such as computers already is quite rapid. Yet in the Information Age, it's investment in high-tech equipment--not more bricks and mortar--that matters. At best, flat-tax-induced hikes in savings and investment would raise economic growth 0.1% to 0.2% a year over the next decade, estimates Roger Brinner, economist at DRI/McGraw-Hill.
To be sure, the time is ripe for some reform. Almost everyone agrees that the tax code is riddled with too many exemptions, deductions, exclusions, and credits. The system is expensive, too, with an annual tax-compliance cost of at least $75 billion, says Joel B. Slemrod, economist at the University of Michigan. In the global economy, a simpler tax system would make the U.S. an even more attractive place for business and investors. "Cleaning up the tax code makes us better off," says David Bradford, economist at Princeton University.
MORAL SOCIETY. Why not embrace a progressive, lower-rate income tax system with fewer deductions--but keep the most justifiable deductions, such as charitable contributions and home mortgages? It would be far superior to and much simpler than what currently exists. The 1986 Tax Act, with three rates topping out at 28% and with no difference between income from work and capital, was a step in the right direction. Similarly, lower the corporate tax rate by eliminating as many industry-specific tax preferences as possible, such as oil and gas allowances. And get rid of the burdensome corporate alternative minimum tax. "There is a lot of room for streamlining, simplification, and rationalization," says Slemrod.
The flat-tax idea of sweeping away all the complexities of the current code is appealing. But a tax system that adjusts to changing economic circumstances and business needs is not a bad thing. In A History of Taxation and Expenditure in the Western World, authors Carolyn Webber and Aaron Wildavsky contend that the income tax is "a paradigm of responsive democracy at work." For example, owner-occupied housing offers substantial social benefits in encouraging home and neighborhood maintenance. The charitable contribution deduction is an extremely effective matching-grant system for charities. These tax "loopholes" very much reflect traditional ideas of a good and moral society.
There is a need to cut tax rates for the highest-income taxpayers. The top decile of the population is no longer dominated by what Thorstein B. Veblen called the "leisure class." Today's top 10% is to a large extent made up of entrepreneurs, professionals, and two-earner households. America is still the land of economic mobility. Taxing people by their ability to pay (taking progressively more from the rich and less from the middle class and poor) has proved a remarkably durable idea in American democracy. The rich can afford to pay more, but their rates should come down.
The danger is that radical reform will doom any realistic chance to streamline and simplify the existing tax code. Remember that health-care reform in 1994 was also a laudable goal. But the means for overhauling the health-care system would have been so disruptive that the movement collapsed. This time, policymakers shouldn't blow a chance for real tax reform in the pursuit of single-rate purity. By all means, clean up the code. But don't tear it up.