Flat Tax


Flat Tax Essay, Research Paper

An Analysis of the Flat Tax Rate System

Vince Viloria

Political Science 1, 7:40 P.M.

Ms. Entity

July 16, 1997

Should the flat tax rate system be implemented? No, the flat tax rate system should not be implemented. In this paper, the pro arguments will be presented, which will affirm the thesis. Then the con arguments will be presented. A rebuttal will then follow, and finally, the author’s conclusion will be offered.

The loudest clamor against the flat tax would come from homeowners, Realtors, and builders, who would be hammered as the flat tax does away with deductions for mortgage interest payments and local property taxes. If not negotiated with skill, this issue could be the flat tax movement’s Achilles’ heel. An analysis by the economic consulting firm DRI/McGraw-Hill estimates that the market value of all homes could drop by 15 percent if the tax were introduced without a phase-in period. The brunt of the blow would be borne by those in middle and upper income groups. The flat tax could cause mortgage interest rates to drop by a full percentage point, which would chore up prices. But even so, the DRI economists calculate that were the flat tax enacted with no phase-in period, the price of a $150,000 home could fall to $113,571, a decline of 24 percent. (Dishman 39)

Middle class votes who have most of their money tied up in home and hearth will scream blue murder. Nor will they be soothed by economists’ armchair arguments that the government’s roughly $80-billion-a-year tax subsidy to owner-occupied housing has led to a vast overbuilding of the nation’s housing stock. Roger E. Brinner, DRI’s chief economist, figures the plunge in housing value would wipe out more than $1.5 trillion of householder’s net worth. The collapse of the housing market and new home construction, Brinner predicts, would slice 1.2 percent off GDP the year after the flat tax passed, and 1.6 percent in the second year. (Dishman 39)

A potentially troublesome law lurks in the flat tax plan of House Majority Leader Richard Armey. The Armey flat tax plans to eliminate business exemption for most fringe benefits, especially employer paid health care. Flat tax enthusiasts like Harvard University economist Dale Jorgenson argue that employers, who look at the total cost of compensation, would simply increase their employees’ cash compensation, leaving them free to purchase their own health insurance. In theory, the workers then become more price-conscious consumers of medical services than they are under today’s employer paid system. (Dishman 40)

What if workers, particularly those modestly paid folks who would face no tax under the Armey plan, choose to pocket the cash instead of paying health insurance premiums? Dallas Salisbury, president of the Employee benefits Research institute in Washington, worries that they might expect the government to pay for their care when they need it. Presumably, a system to avoid the problem could be created, but it is clearly going to b a thorny issue. (Dishman 40) The flat tax eliminates deductions for home mortgages. In addition to getting hit on their stock holdings, homeowners will likely suffer a 10 to 15 percent drop in the value of their homes. (Darell)

Another negative effect of the flat tax is that of the decreased market value of tax-free bonds. Under the most popular flat tax proposals, market value of tax-free bonds could easily drop by 20 percent. High on the list is the blow that investors take when they trade the securities. Because there are so many thousands of small issuers, the market for municipals would have wide spreads between the bid and asking prices. That increases transaction costs. Also, getting good and timely financial information on many issuers is difficult. When Orange County filed for bankruptcy in December of 1995, for example, the most recent financial statements available to the public were for the fiscal year ending June 30, 1993. In other words, they were nearly 18 moths out of date (Tarik 50)

So in a flat tax world, why bother with municipal bonds, with all their attendant difficulties, even if they are AAA-rated? It would be much easier to buy a Treasury bond with a similar yield. Like in-state municipals, most tax reform treasuries would still pay interest exempt from state and local taxation. Inevitably, municipals would have to offer richer yields than Uncle Sam. That means that issuers of new municipal bonds would have to pay higher interest rates too. Up would go the cost of public works. Local officials would have to abandon municipal projects. (Tarik 51)

The proponents of the flat tax have a perspective unlike its opponents. The Flat Tax was crafted by two Stanford University taxation experts, Robert E. Hall and Alvin Rabushka. First published in 1985 and updated in 1995, their model would tax the wages, salaries, and pensions of individuals that exceed such basic exemptions of $9,500 for a single taxpayer. Basic exemptions would vary with the size and composition of the household. There would be no further deductions. Investment income from capital gains, interest, and dividends would be exempt. Businesses would deduct necessary goods and services, wages and benefits, and investment purchases from gross revenue. There would be no deductions for dividend or interest payments. The flat rate would be 19 percent, which the authors calculate would be sufficient to avoid an increase in the federal deficit. The tax burden on lower and higher income Americans would decline. (Flanegan 34) The flat tax should be simple.

The flat tax proposal that has attracted the most notice so far is the one that Richard Armey introduced in Congress. This version of the flat tax would apply a uniform tax rate beginning at 20 percent and falling to 17 percent two years following its passage as a law. It will apply to all business income and to individuals’ wages and salaries beyond a large standard deduction. According to its proponents, the flat tax would achieve a myriad of desirable economic and public policy goals. Its backers say that because it would eliminate all deductions beyond a family exclusion—$33,300 for a family of four—the flat tax would be simple enough to file on a postcard sized return. They say it would be fair; it would tax everyone at the same rate and close loopholes that many middle income taxpayers suspect benefit only the well off. The flat tax is supposed to unleash a torrent of productive new investments, reduce long term interest rates, and boost living standards. The flat taxers claim that everyone will get a tax cut. (Consumer Reports 9)

American business would flourish under a simpler tax code. Fast-growing, capital-intensive companies and new entrepreneurial startups, the kinds of businesses that create lots of good, well paying jobs, will be among the biggest winners. Because their capital spending needs are large relative to their revenue, they will benefit mightily from the freedom to expense their investments. They should be able to tap a deeper pool of equity from investors who will no longer be subject to capital gains tax. Says economist Gary Robbins, president of Fiscal Associates, an economic consulting firm in Washington: “Given a lower cost of capital, U.S. companies may discover that it’s profitable to manufacture flat-panel computer screens without a huge government subsidy or to ass market consumer electronics products they cannot compete in today.” (Dishman 44)

The current tax treatment of corporate earnings discourages equity investment in general. Every dollar of earnings companies pay out as dividends today is taxed twice—once at the corporate level at a rate as high as 39.6 percent. The combined blow lifts the marginal tax on equity to a crushing 69 percent. (Dishman 44)

Under the flat tax, those leg irons hobbling America’s most dynamic companies would come off. A flat tax rate of just 20 percent paid by business could lower the cost of equity by one third. For Hewlett-Packard, a technological company, cheaper equity capital would be a wind fall. Hewlett-Packard depends almost entirely on equity financing to make its risky high-tech investments because the company does not want to be saddled with the interest payments on borrowed funds should technology shift or the economy fall into recession. Says Dan Kostenbauder, Hewlett-Packard’s general tax counsel: “Anything tat would reduce our cost equity would tilt the competition in our favor.” (Dishman 45)

Smaller firms that now find it difficult to attract high cost equity would also be big winners under the flat tax. Entrepreneur Stephen King, CEO of Tomah Products, a specialty chemical manufacturing company with 51 employees, thrills at the prospect. The sales of his $21 million company are growing by better than 15 percent per year. But because Tomah has a small asset base, it cannot offer lenders sufficient collateral to borrow what it needs to expand. King has been able to attract some scarce venture capital but had to pay a stiff price—a substantial portion of his own stake in the company—to get it. Says King: “Show me a tax system that would lower my cost of equity, and I’ll back it in a minute.” (Dishman 45)

Economists judge fairness by horizontal equity, the equal treatment of people with equal income. The U.S. tax system notoriously flouts this principle by taking income two to three times when it is saved and invested, but only once when it is consumed. (Henderson 57)

Why should one be taxed twice or three times when one adds to the capital stock while others who consume avoid this double taxation? The so-called flat tax, on the other hand, treats people the same whether income is spent or invested. Under a flat tax, a proportional one, income is taxed once and never again. (Henderson 57)

According to the Armey flat tax plan, taxes would be simple enough to file on a postcard sized return. However, for most Americans, paying taxes, though unpleasant, is not actually very complicated. More than 70 percent use the standard deduction. Twenty million filers use 1040 EZ forms that are almost postcard-like; this year, taxes can be files via a ten minute phone call. (Miller 6)

Some provisions of the flat tax would make the lives of most ordinary wage earners far more difficult. Employers would no longer be allowed to deduct from their gross revenues the cost of group health insurance and most other fringe benefits they provide for their employees. Eliminating deductions for such non-cash compensation would raise the cost of doing business and provide many employers, who are already inclined to trim benefits, with an incentive to pare them back further or end them entirely. Most employers may be willing to pay employees additional wages to compensate them for lost fringe benefits they could no longer deduct. But employees would have to pay taxes on that income and spend their own money to buy the health insurance or other protection the employer once provided. (Consumer Reports 9)

The Armey plan invites abuse. The flat tax doubles the exemption for each dependent, but the postcard does not leave space to list dependents. Seven million bogus dependents—dogs, cats, etc.—vanished when the IRS began requiring names and Social Security numbers in 1988. To prevent their return, the postcard must expand. (McNamara 135)

The self-employed would face more paperwork. Now, a small business owner reports on his own personal tax return. To claim the flat tax’s personal exemptions, he would have to pay himself a salary, file quarterly and annual wage reports, and fill out two tax returns. The business tax retains some complex rules, too. Under the flat tax proposal, foreign income is tax-free. But firms would continue to battle the IRS over transfer prices, which determine how much of their income is earned abroad. (McNamara 135)

An error would arise in areas where the flat tax creates new loopholes. Under Armey’s plan, interest income is not taxed. Thus, an appliance store might offer an $800 refrigerator for $100, provided the customer take a 24-month 400 percent financing. The customer still pays $800, but the dealer will pay tax on only $100. (McNamara 135)

Companies and businesses will not benefit overall from the flat tax plan. Though moving to a flat tax would be a vast improvement for corporate taxation, one area where it falls a little flat is in the treatment of the income U.S. companies earn abroad. Currently, the government taxes all U.S. corporate earnings on a worldwide basis. While American companies may claim a credit for the taxes paid overseas, the IRS has devised such a complicated nexus of rules for computing it that the cost of rearranging the company’s finances to qualify for the credit sometimes exceeds its value. In order to qualify for a tax rebate for the cars it sells in Europe, for example, Chrysler is considering establishing 15 subsidiaries, mainly to take better advantage of its European tax credits. Since a flat tax would fall only on a company’s U.S. operations, American based multinationals and exporters would be relieved of much of the administrative burden. (Dishman 46)

But that will still leave them at a disadvantage. Some 90 countries with which the U.S. competes rely on value-added taxes (VATs), levies exacted on goods as they are sold at each stage of the production process, as a major source of business taxes. When companies based in those countries sell products abroad, their governments refund the VAT. But international trade agreements do not permit the U.S. to refund any of the flat tax that American exporters would pay, just as, under current law, no corporate income taxes are refunded to them. Chuck Hahn, the tax director for Dow Chemical, estimates that the tax advantage Dow’s powerful global competitors enjoy cuts Dow’s profits on sales outside the U.S. by 3 to 4 percentage points, a huge differential in this ruthlessly price competitive industry. (Dishman 46)

Even households with earnings as low as $20,000 a year would see their total tax bill rise. It is true that the large individual and family deductions will drop many modest income Americans from the federal income-tax rolls. But under current tax law, wage earners trying to support two children on yearly incomes up to $26,673 are eligible to offset both their income tax and a portion of the Social Security taxes they now pay by claiming an earned income tax credit (EITC) of up to $3110. The flat tax would withdraw that economic lifeline by repealing the EITC. (Consumer Reports 9)

House Majority leader Richard Armey presents a plan which replaces the progressive income tax with a flat tax, and it replaces business taxes with a consumption tax. Both elements would dramatically shift the tax burden from the wealthy toward the middle class and the poor. (McAfee 93)

If not for stunning misrepresentations, this would be obvious to everyone. The personal income tax now starts with a zero effective rate on lower income families (families of four currently earning up to about $23,200 pay no income taxes) rising to a 39.6 percent top marginal rate on the incomes of the richest 1 percent. Replace that with a flat rate of, say, 20 percent and clearly the rich will pay far less in taxes. That has to be made up somewhere. (McAfee 93)

Flat tax advocates imply that the lower tax rate will be made up by closing loopholes fore the wealthy and well connected. In fact, the opposite is true. The complete tax exempting for personal investments replaces many small loopholes with one enormous loophole. Rather than alleviating the plan’s regressive nature, this aggravates it: A large share of the income of the wealthiest Americans would not be taxed at all. That would leave middle and low income families holding the bag. (McAfee 94)

Under the flat tax, many of the wealthiest individuals would pay absolutely no tax. For example, a family whose income consists solely of millions of dollars of dividends, interest, and gains from the sale of stock held investment would pay zero tax. (Robertson 24)

Non-business gains from investments, not only in stock, but in such assets as bonds, land, options, futures, antiques, and collectibles would be tax-free. While it may be unintentional, it appears that rental income would be tax-free under the bill. Also, outside the context of a business, income from lottery and other gambling activities, theft, embezzlement, bribery, and many other sources apparently would not be taxed. Yet for the employee who loses a job, unemployment compensation would be taxable. (Robertson)

It is hard to imagine why so much income should escape taxation while, for people who work for a living, wages, and salaries should be taxed. And for those who take some comfort in the fact that public officials who take illegal bribes are currently subject to tax on them, with possible penalty for tax evasion, the idea that these bribes would apparently be tax-free is certainly troublesome. It is also worth noting that, for the politician who withdraws money from a campaign fund for personal use, even if it is unlawful to do so, this is taxable under the present law. But it appears to be tax-free under the flat tax. The typical wage earner certainly has the right to be skeptical about this “fair and honest” tax. (Robertson 26)

In conclusion, it is clear that the flat tax rate is not a good concept which would be beneficial to the people. The current tax system, for now, is by far the better choice.

Astrikson, John, “Flattening Taxes”, Consumer Reports December 1995, 34-37

Darell, Bobby, Modern Economy, New York: Harper, 1994

Dishman, Kris, The Science of Taxation, New Haven: Yale, 1996

Flanegan, Jim, The Treasury, Cambridge: Harvard UP, 1995

Henderson, Margaret. A Look at the Economy, New York: Dell, 1994

McAfee, Charles, The National Debt, New York: Appleton, 1993

McNamara, Ellen, Your Tax Dollars at Work, New York: Bowker, 1995

Miller, Shawn, Commerce and You, New York: Norton, 1996

Robertson, Oliver, Learning the System: New York: Grove, 1994

Tarik, Alfred, The Economy and the System: Boston: Houghton, 1993

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