Flattening the Tax Code: A Plan for Fiscal Fairness and Freedom

April 15 is anathema to most Americans. This date is the Internal Revenue Service filing deadline for income taxes. The tax code, inaugurated in 1913, has been at the forefront of American politics since its inception. Something about the income tax is un-American. Maybe it’s the purported unfairness of it, professed by economic conservatives; maybe it’s the deep hole it leaves in our pockets—the common sense of injustice uniting our individual antipathy; or maybe it’s the feeling of qualified freedom it arises, redistributing hard-earned private property and reminding us that liberty has its price, the price of democracy, the price of government patronage. There is no doubt that taxation is a highly contentious issue.

It is often the litmus test that wins and loses the Presidency. Because the Republican Party is dedicated to limiting the role of big government, it often curries favor with those in opposition to our current progressive income tax structure. For example, President Bush won popularity off a tax-cut stance in 2000. And during his first term we’ve seen those tax cuts he promised. He’s championing to do the same if he wins this November.

But maybe this time he should try reform of a different sort, proposing a flat tax as the center of his 2004 reelection bid. Polls continue to fluctuate and political forecasters inform us that it will be an exceptionally dose election. A war in Iraq coupled with what many feel is questionable domestic policy-highlighted by amnesty to illegal immigrants, among other things-have left this year’s presidential election much closer than thought months ago. Conservatives must find a solution to expand this small margin.

The flat tax could be it. Despite current sentiment, the flat tax shouldn’t be an ideological issue, it can benefit us all. It could fortify Bush’s reelection bid and renew many of the tenets upon which traditional conservatism rests – principles that have been surrendered to our age of accommodation. Indeed, the flat tax could remedy the shortcomings of Bush’s first term. This bold move could galvanize the electorate – gaining votes from conservative Democrats and reassuring conservatives within the Republican Party.

Ironically, Iraq is living the economic consetVative’s dream. On September 15 of last year, the u.s. administrator in Baghdad, L. Paul Bremer, signed into legislation a flat-tax system effective January 1, 2004. The flat tax appeals to conservatives for its simplicity, efficiency and fairness. But the virtues of the flat tax are not recognized only among those on the Right, Russia and the former Soviet Bloc countries of Ukraine, Latvia and Estonia, not to mention a robust Hong Kong, all boast a flat tax. libertarian presidential candidate Harry Browne even attributed his campaign success in 1996 to the momentum gained from promoting the flat tax in his platform. The flat tax transcends partisan bounds. And careful analysis will be instructive to all parties.

Since the adoption of the modern income tax, the U.S. tax code has been predicated on one basic concept: the rich pay a greater share of their income than the poor. The rationale: because the wealthy own more property, they should pay more since they benefit more from a stable government and the healthy social order it fosters. It is no surprise that because of this foundation, the income tax structure has been so divisive. The amorphous concept of equity comes into question. To conservatives, everyone should pay the same—a flat rate. To most liberals, the current progressive tax code is sufficient, at best.

In his seminal work, The Wealth of Nations, Adam Smith, the father of modem economics, delineates three attributes essential to any “good” tax: certainty regarding the amount, time and place of payment; efficiency through cheap and convenient collection; and equity in the burden of providing the funds for support of government distributed in rough proportion to the benefits taxpayers receive from government And indeed, while the first two components are rarely contested, the third, fairness, sits at the aux of the tax debate. The flat tax resonates with Smith’s sense of fairness: all income is taxed only once and at the same rate.

We can see redoubtable efforts to achieve this fairness from our own legislators.Texas Representative Richard Anney introduced one of the most recent flat-tax proposals. Ironically named H.R. 1040,the bill emphasizes the fundamental goals of a flat tax. Anney chose a flat rate of 17 percent to be taxed on personal income, save exemptions–$13,1oo for a single individual, $17,200 for a head of a household, $26,200 for a married couple, and $5,300 for each dependent. Investment income, in the form of interest, dividends, and capital gains, would be exempt from taxation while wages, salaries and pensions would be taxable.

Businesses would be taxed this same flat rate, but only on net revenue-expenses would be tax deductible. Investment in capital assets such as land and equipment fall under this purview, consequently eliminating the depredation deduction.

Critics contend that bath of these measures are inherently inequitable Two families with the same income could be subject to widely disparate tax burdens. A family earning its income predominantly from investment-interest and capital gains-will pay less than one whose earnings are largely the product of labor. Hence, the flat tax purportedly creates a bias against labor, hurting the working class while adding to the coffers of the well-off.

This argument is holistically superficial. Exempting the return to investment from taxation promotes investment, giving workers more capital to increase their productivity, allowing them to earn higher real wages and achieve higher standards of living. This point is irrefutable. But opponents will argue the losses outweigh the gains.

Reaganomics and one-hundred months of consecutive economic growth provide one compelling example of the virtues of supply-side economics and the gains we will achieve from a flat tax. In 1981, the Reagan tax cuts reduced marginal tax rates for individuals by 25 percent, reducing the top marginal tax rate by 20 percentage points to 50 percent. Five years later a second round of tax cuts lowered the top marginal rate once again, from 50 percent to 28 percent Economic activity increased then in the 80s and it will now. Harvard Economist Dale Jorgenson expects that a flat tax will increase economic activity by about 10 percent, while many economists place the figure even higher.

Many opposed to the flat tax also argue it would hurt working poor families. And it is often assumed that a flat tax leads to a redistribution of income to the rich. This is patently false. Tax reform could effectively redistribute income to lower-income groups while abolishing progressive marginal tax rates because it would eliminate exclusions and deductions—”loopholes for the rich.”

Moreover, a flat tax can still be a progressive tax. Inevitably, flat-tax proposals are not static, and can be tailored to fit different demands. A flat tax can be defined as a tax rate that increases the average tax rate of the taxpayer as his income increases. This progressive tax structure is a function of the average tax rate, not the marginal rate. Assume a hypothetical flat-tax system in which an exemption of $5,000 per person is allowed under a 20 percent flat rate. A family of four filing a joint return will be exempt from paying taxes on the first $20,000 of income earned. Also assume all deductions are abrogated by law. Total tax liability as a proportion of total income will be greater at higher income levels as average tax rate increases commensurate to the increase in income.

By eliminating most deductions, a flat tax also takes away a disproportionate share of tax benefits heavily incurred by high income groups. Some of these benefits include home mortgage interest,income exclusions, such as interest on state and local bonds, and charitable deductions.

But the skeptic’s arguments keep on coming. They oppose the elimination of the very deductions that serve to meet their end of a more equal income distribution. They further argue that a flat tax, by eliminating deductions, namely charity and mortgage-interest, will cripple these various important parts of our current tax code.

First, they argue that eliminating the charity deduction will create a disincentive for giving, drastically reducing charity donations. Empirical evidence tells us otherwise. The large majority of taxpayers do not itemize their tax returns, over 70 percent, receiving no benefit from deductions. And giving is strong. Moreover, donations have remained fairly constant since World War II, hovering around 1.8 percent, despite widely fluctuating income tax rates, the top marginal rates fluctuating from 28 percent to 91 percent

Many factors impel charitable donations: marital status, religious participation, age, and the “asking” organization. Surveys show that the tax deduction is not overly important Indeed, a pro-growth flat tax could very well generate higher levels of giving. Growth in personal income is incontrovertibly good for charities.

The second argument is that the elimination of the mortgage interest deduction will precipitate a plummet in real estate values, bringing the supply and demand for houses back into equilibrium. But home mortgage interest rates are expected to fall 2-percent with the enactment of a flat tax. This will more than offset the lost deductible.

Further, only 27 million of 116 million taxpayers claimed a mortgage interest deduction in 1992.And approximately 40 percent of homeowners do not even have a mortgage on their homes. Even more amenable is the prospect that any flat tax enacted by Congress would allow homeowners to continue deducting interest for existing mortgages until the termination of their contracts.

This examination shows that the effects of the flat tax are directly related to the design of the flat tax structure, a structure that is open for discussion. It can be tailored to fit individual needs while working in the common interest of providing fairness and eliminating the tax bureaucracy, saving taxpayers billions.

While the flat tax is able to be shaped according to different needs, we must not take this concept too far. There are certain principles of a flat tax that are not subject to discretion. These are the heart of the flat tax, its virtues, and principles which give it life. For under the flat tax, all income will be subject to taxation. Under our current progressive tax structure, the last dollar of income is not necessarily taxed at the same rate as the first dollar. An individual who earns 100,000 is taxed at different rates on different layers of income under graduated taxation. It is true that an individual earning $100,000 will not be taxed a higher marginal rate on his entire income, but at different marginal rates on different amounts, in accordance with preset levels. Suppose that the first $20,000 of taxable income is subject to a 10 percent tax rate, while the next $30,000 is taxed at 20 percent and anything above $50,000 is taxed at a 40 percent marginal rate. An individual earning $15,000 has a net take-home income of $13,500, after paying $1,500 in taxes while the same individual would pay $22,000 in taxes, $2,000 on the first $20,000, $4,000 on the next $20,000, and $16,000 on income earned over $50,000, taking home $68,000 after earning a nominal $90,000. Flat taxes would tax all income at one flat rate.

Proponents of progressive taxation argue that people are treated fairly under this system because dollars are treated equally. They also attempt to couch fairness in subjective terms. Because the marginal utility of one dollar is greater to those earning less, the poor should pay a smaller share of their income than the rich, while the wealthy can afford a higher share.

In the conservative’s view, markets distribute income based on how hard people work, not on marginal utility.As Robert Shapiro, President of the Progressive Policy Institute states that “Flat taxers may be right that it would be morally offensive to tax higher income people more heavily if differences in income reflected how hard different people work.” Many attribute cultural and environmental factors as the preponderate reasons for poverty and abjection. Indeed it is naive to assume that these real factors have no bearing whatsoever, but is it even more imprudent to assume that a dearth of hard work is not the more compelling reason for adversity. The bottom line is clear: workers should be penalized for the minimal amount for the work they do while facing the maximum incentive to engage in work.

The flat tax partially addresses this issue. It aims to provide such an incentive. In economic theory, the substitution effect holds that individuals will substitute more work for leisure when real incomes increase. The premise of this argument is that the opportunity cost of leisure has now increased—due to higher real wages made possible by the flat tax—and consequently workers will decide to work more, devoting more time to “investment activities.”

For the most part, that increase in real income is a corollaty of the flat tax. Part of this investment incentive derives from the fact that a flat tax would tax all income only once. The progressive system taxes investment income several times. Initially, income is taxed at the corporate level. Next, it is taxed when it is distributed to the shareholder in the form of dividends, interest, or capital gains. When corporate profits are distributed to shareholders, they are taxed at rates as high as 39 percent. Double taxation increases the cost of capital and encourages inordinate borrowing.

Ostensibly, the current system provides a disincentive for saving and investment, effectively a disincentive to work. And any System that provides a disincentive to work is not a good system. Taxing all income once at one flat rate will provide the incentive to invest in capital, increasing output and employment. These gains will strengthen our economy, effects that will touch most Americans.

But a flat tax won’t only increase incentives; it will also increase government revenue. Lower taxes mean more economic growth and greater government revenue. Histoty illustrates this truth. The tax cuts of the 1920s, 1960s and 1980s all led to increased government revenue. In the 1920s, the top marginal rate was cut nearly 50 percentage points, falling from 73 percent to 25 percent. The result: tax revenues rose precipitously, over 50 percent, to $1.16 billion. In the 1960s,the top rate was again reduced from 91 percent to 70 percent, resulting in tax revenues increasing 16 percent. Once again, between 1980 and 1988, the top rate was reduced from 70 percent to 28 percent, increasing revenues by more than 50 percent.

Many,however, argue that excessive tax cuts cater to the wealthy. Empirical analysis tells us differently. The share of the tax burden paid by the upper class—those in the top marginal tax bracket—increased in the 20s, 60s and 80s. Tax cuts can indeed help the economy, avoiding the “class warfare” so widely espoused by progressive tax advocates.

The rich are the primary beneficiaries of tax deductions, and in this domain, are hurt by a uniform tax rate. The flat tax proposes to do away with most exemptions and loopholes, widening the tax base while increasingthe tax rate. This outcome balances a revenue neutral flat tax with the need to maintain government tax revenues in keeping with budgetary requirements. The Budget Act of 1990, for example, requires that tax cuts must be “paid for” by either eliminating income exclusions or deductions. The elimination of deductions, a trade off for a lower tax rate, is the cost of increased government revenue and economic growth.

Government revenue will also increase as a result of increased compliance. Tax evasion costs the United States’ government billions. Russia shows us what compliance can do. In July of 2000,the country enacted a 13 percent flat tax on personal income, replacing the previously progressive system. Adjusted for inflation, tax revenues increased an astounding 28 percent, even exceeding expectations.

Over 60 million employees receive salaries or wages in Russia but only roughly 3 percent filed income tax returns in 2001. This illuminates yet another virtue of the flat tax; it taxes income at the source. This drastically increases tax revenues. For example, according to the IRS, only half of interest income is reported on individual tax returns. Under a flat tax, business income will be taxed at the corporate level, further allowing individuals to receive investment income tax free.

The fact that taxes will be levied at the source also demonstrates the inequity of the capital gains tax. If you buy a share of stock low and sell it high, you are taxed 20 percent on your gain. But,if you buy a share of stock low and sellitlower, you are not reimbursed for your loss. In effect, the government is taxing expectations. There is no way of knowing the future value of a company. There is no concrete intrinsic value upon which the government can judge. If a capital gains tax is fair, then a deduction for capital losses is fair. A flat tax will eliminate this paradox by taxing income at its source.

While Russia’s revenue gains are incontrovertibly a product of increased compliance and the efficient taxation of taxing at the source, it must be conceded that it does not have the infrastructure of America. Logically, then, tax evasion is much more pronounced there than it is here. But we must not let the main point escape us. Decreased tax rates facilitate compliance. People now have less to gain from tax evasion because of the reduction in the amount of taxes they pay.

A reduced tax burden does not, however, holistically account for increased compliance. Perhaps the more compelling reason is simplicity. To many, this is the most appealing feature of a flat tax. In Rep. Armey’s proposal, tax filing would be done on a postcard. In contrast, the IRS sends out over eight billion pages of firms and instructions every year, paper requiring the cutting of nearly 300,000 trees. One study conducted by the IRSeven estimated that for every tax dollar collected, it costs the private sector 24 cents. A study published by the American Economic Review placed the figure between 15 percent and 50 percent for each additional dollar collected.

Supply-side economics is not voodoo economics, and neither is the flat tax fiction. In fact, many of its concrete advantages have proven true. To conservatives, the flat tax protects individual liberty because it places the same burden on us all, creating a wide base and taking us closer to getting the government out of our lives. To liberals, it is a siege on equity, an underhanded attempt to perpetuate the well-off while miring the poor. Ultimately, for all of us, taxation is a civic relationship of bilateral responsibility. Our duty to our country and it to us is unquestionable. The question becomes what exactly we do owe and what do we owe in relation to each other.

President Bush cut taxes last year and the positive effects abound. In the third fiscal quarter of 2003,economic growth reached 8.2 percent. Business investment is the highest it has been in nearly a decade. The flat tax could perpetuate this progress if both parties can agree on a common denominator that is crucial to the future economic growth of America. Because the virtues of a flat tax transcend the partisanship that has become so trite in politics today, the GOP could use this issue to galvanize voters in November, rejuvenating a political system that has been all too entangled in the sticky web of kick-backs and tax evasion made possible by the complications of the current tax code.