FREE ESSAY ON THE FLAT TAX

THE FLAT TAX

The United States tax system is in complete disarray. Republicans and Democrats agree that
the current tax code is complex, unfair, and costly. The income tax system is so complex;
the IRS publishes 480 tax forms and 280 forms to explain the 480 forms (Armey 1). The
main reason the tax system is so complex is because of the special preferences such as
deductions and tax credits. Complexity in the current tax system forces Americans to
spend 5.4 billion hours complying with the tax code, which is more time than it takes to
manufacture every car, truck and van produced in the United States (Armey 1). Time is not
the only thing that is lost with the current tax system; Americans also lose great deal
of money complying with the tax code. Resources that are currently wasted on record
keeping, filing forms, learning the tax code, litigation, and tax avoidance. The cost of
complying with the current tax code totals about $200 billion annually, or $700 for every
man, woman, and child in America (Armey 1). The overwhelming consensus that the current
tax system is inadequate has ignited the search for tax reform. There are numerous
proposals for tax reform; one particular proposal brought forth by various conservatives
is the idea of national flat rate income tax. The idea is to replace the current income
tax with a single rate that everyone pays. 
This paper will take a close look at the concepts of the "flat tax," and look at the
possible benefits and potential failings. Although there is a basic format to the flat
tax, there are multiple flat tax proposals that have been offered by conservatives. Along
with critiquing the basic format of the flat tax, this paper will compare and contrast
the different flat tax proposals. There is no doubt among Americans and politicians that
there is need for tax reform, the flat tax and one of its proposals could possibly be the
answer to tax reform. 
The American people are in the presence of the highest tax burden in American history;
taxes represent a larger share of the U.S. economy than ever before (Armey 2). After
World War II, the average family sent only about three percent of its income to
Washington. The same family today gives 24 percent of its income to the federal tax
collector (Mitchell 1, 9). Once state and local taxes are added to the federal take,
taxes make up the biggest slice of the average family's budget. As Daniel Mitchell of the
Heritage Foundation shows in Figure 1, the typical American family now pays more of its
budget in taxes than it spends on food, clothing, transportation and shelter combined
(Mitchell 1, 10). 
Policy makers have introduced a solution to the staggering proportion of taxes that
Americans spend. The flat tax, based on an idea developed by Professors Robert Hall and
Alvin Rabushka of Stanford University to create a fair, simple, and pro-growth tax system
(Mitchell 1, 11). There are four basic criteria that make up a flat tax. First is a
single low rate on taxable income, the baseline for taxable income would be raised to a
certain amount dictated by a personal exemption. Second is simplicity, all Americans
would fill out the same postcard-sized form to pay their taxes. Third is the reduction or
elimination of deductions, credits, and exemptions, depending on the different proposals.
Last is the elimination of double taxation, the government will no longer be able to tax
income saved or invested (Mitchell 1, 11). These four pillars of the flat tax make the
proposed plan very appealing to many Americans, each proposal uses these pillars to try
and create the most efficient flat tax.
The Armey/Shelby flat tax, based on the Hall/Rabushka flat tax would replace the current
personal and corporate income tax with a simple 17 percent tax on all income. With the
exception of a generous family allowance ($33,300 for a family of four), all labor income
is taxed at the individual level. Taxes on business income (such as interest, dividends,
capital gains, and rent) are withheld and paid at the business level. Both businesses and
individuals would fill out simple post card sized returns (Mitchell 3, 3). Using the same
model as the Armey/Shelby flat tax, Senator Arlen Specter, purposes a slightly higher
rate of 20 percent and lower personal allowance in order to maintain limited deductions
for charitable contributions and the full deduction for home mortgage interest (Mitchell
2, 3). Steve Forbes proposal is much the same as the Armey/Shelby proposal. Forbes uses
the same 17 percent as the Armey/Shelby plan, but increases the family of four allowance
to $36,000 (Mitchell 3, 3). 
Senator Phil Gramm and Pat Buchanan both setup their respective proposals quite different
from the others. Gramm uses a 16 percent rate, however keeps deductions for home mortgage
interest and charitable deductions, but the biggest difference is the continued double
taxation of many forms of income. Capital gains taxes would not be abolished, while
income used for savings would continue to be taxed twice and the bias against business
investment would be reduced, but would not be eliminated (Mitchell 3, 3). Buchanan
follows Gramm's format but uses a low 15 percent rate. Corporate profits would continue
to be taxed at both the individual level and the business level. Savings would be taxed
twice. There would be a flat 17 percent rate on corporations, but provisions biasing the
current system against investment, such as the alternative minimum tax and depreciation,
would remain (Mitchell 3, 3). All of these competing flat tax proposals are possible
plans for tax reform. However, because only the Armey/Shelby has spent a generous amount
of time in the public eye there is limited discussion on the other proposals. For the
purpose of a fair analysis of the flat tax this paper will focus on the basic structure
of the flat tax as created by Robert Hall and Alvin Rabushka. 
Proponents and critics of the flat tax agree on at least one aspect of the flat tax,
simplicity. The flat tax replaces the endless exemptions and loopholes with a
postcard-size form that all Americans would fill out whether they are a CEO or young kid
flipping burgers. The Tax Foundation estimates that a flat tax would reduce compliance
costs by 94 percent, freeing up resources that are currently wasted on record keeping,
filing forms, learning the tax code, litigation, and tax avoidance, saving taxpayers more
than $100 billion in compliance costs each year (Armey 3). 
One of the major areas that proponents of the flat tax claim fame to is the issue of
fairness. They argue that no matter how much money a person makes or what they do, they
will be taxed the same as every other citizen. With the elimination of deductions there
are no loopholes to help the wealthy get out of paying taxes. Critics argue that by
eliminating taxes on capital income the gap between rich and poor will become even
bigger. By eliminating the current tax on savings and investment not only will future
taxes on savings be avoid, but so will existing savings and investments. This would
represent a huge tax windfall to current investors, most of who are in the top five
percent of the income distribution (Hamond 1). Families with the same total income will
face vastly different tax burdens depending on how they earn their income. The family
that earns a larger share of its income from labor will pay a higher personal tax than
the family that collects more of its income from interest, dividends, and capital gains
(Hamond 1). Those in favor of the flat tax would rebut with the fact that all capital
income is already taxed at the business level.
One of the most debated topics on the flat tax is whether or not it increases economic
growth. Proponents of the flat tax claim that the flat tax would allow Americans to keep
more of the money they earn, creating the desire to work more, and to save and invest
more (Mitchell 1, 13). Even if a flat tax lifted long-term growth by as little as 0.5
percent (and most estimates show growth increasing by twice that amount, 1.6 percent),
the income of the average family of four after ten years would be as much as five
thousand dollars higher otherwise (Mitchell 1, 13; Gale 2, 2). According to one study by
a former chief economist for the Congress' Joint Committee on Taxation, under the flat
tax the economy would 5.7 percent larger after five years than under the current system.
That translates into $522 billion in higher output, or $3,000 in higher income for the
typical family of four (Armey 4). But this effect may be overstated, because it rests
upon a rapid increase in the saving rate, that is unlikely to occur (Gale 2, 2).
Opponents of the flat tax have a simple argument; if every person in the U.S. had their
taxes cut the federal revenues would fall thus increasing the deficit. The Treasury
Department has estimated that a 17 percent flat rate as proposed by Rep. Dick Armey would
increase the deficit by $160 billion a year. However, Armey and other conservatives have
taken this fact into account and agree that at the current growth rate a 17 percent rate
would not work, but with the increased saving and investment the economy will rise, thus
with strict government controls on spending as proposed by Rep. Armey, the budget would
work itself out (Mitchell 1, 39-40).
A real important issue raised by the opponents of the flat tax is what the flat tax would
do to the poor. Millions of low-income families living in poverty receiving a wage
supplement through the earned-income tax credit (EITC), which is designed to bring
families with a full-time, year-round worker up to the poverty level (Hamond 2). For many
families, it makes their federal tax burden negative because families receive a net fund.
Rep. Armey's proposal along with many other flat tax proposals would abolish the EITC,
which could possibly reduce work incentives for low-paid people while pushing several
million families below the poverty line. The large personal tax exemption does not help
working poor people, because their incomes are already too low to require federal income
tax (Hamond 2). However, there may not be a need for the EITC due to the fact that poor
would be able to save and invest more of what they earn because there would no longer be
a tax on savings and investments.
All business income, whatever the source, is taxed at one rate. The flat tax at the
business level would apply to the difference between sales of goods and services on the
one hand and the sum of wages, pension contributions, material costs and capital
investments on the other (Gale 1, 1). No deductions are permitted for fringe benefits,
interest, or payments to owners (Armey 7). The taxation of business at every level makes
sure that every part of the economy is taxed. The corporate income tax now raises about
20 percent of total income tax revenues; the Treasury Department estimates that the flat
tax would raise revenues from 20 to 42 percent (Gale 1, 1). Proponents of the flat tax
use this information to support their claim arguing that business will be likely to
invest more because the money that they invest would not be taxed. Opponents claim that
moving to this type of tax without a transition period, which would introduce complexity,
would hurt industries with little debt but much new investment, such as high technology,
while vastly increasing the tax burden on industries with high debt to investment ratios,
such as the automotive sector (Hamond 2). Although opponents make a valid argument, one
of the most important things that the flat tax does for business is let firms make
choices for economic reasons instead of for tax considerations.
In conclusion, as pointed out early in this paper there is a strong base for tax reform.
The flat tax could quite possibly be the missing link in tax reform. Although opponents
offer good arguments against the flat tax, with some modifications the flat tax could be
implemented in the American tax system. The current flat tax proposals could be modified
to insure security for businesses and the poor. With insurance for businesses and the
poor more people would be likely to get behind a flat tax or some type of proposal that
resembles a flat tax. All proposals will have their opponents, but it is up to the people
to weigh the pros and cons and decide what would work the best, because obviously are
current system is not working for the benefit of its people. 
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