(1) It Imperils Vertical and Horizontal Equity. Our current tax code, while far from perfect,
does a reasonably good job of ensuring that people with similar total incomes pay similar amounts in taxes (horizontal equity),
and that people with higher incomes pay more in taxes (vertical equity). Eliminating any taxation
of capital income at the individual level, as would the flat tax,
will make the tax code far less equitable. Families with the
same total income will bear vastly different individual tax
burdens, depending on how they earn that 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 -- even though it is no better off. Similarly, two families
with vastly different total incomes may pay the same
individual tax if both families have the same amount of labor income. The
flat tax, in short, produces a bias against labor, in much the same way that
the current tax code produces a bias against saving.
(2) A Double-Tax on Labor and Less Than a Single Tax on
Capital. Proponents claim the flat tax would tax all
labor and capital income once--capital at the
business level and labor at the individual level. In fact, the proposal allows
much capital to escape tax entirely, and taxes labor disproportionately. On the
individual side, the flat tax taxes only labor, because the tax base
is only wages, salaries, and pension benefits. And since nothing is done
to reduce the tax burden on labor from the existing payroll tax, the
total tax on labor is economically excessive. On the business side, taxable
profits include a return to labor as well as capital, so labor does
not escape all taxation at the business level, as proponents claim.
Moreover, under certain conditions, short-term profits from stock-market trading would also
be untaxed: An investor purchases a stock which rises in value, sells it,
and then the stock price declines to its original level. The investor's gains would be
untaxed at the individual level, and the short term price increase would likely not be reflected in
business performance. (While it is true that some investors who bought high
and sold low would lose money under this scenario -- a zero net gain
for the economy -- the tax code should not necessarily treat
these two investors as equals under the individual tax: One person's income
and wealth, and thus his ability to pay has increased,
while the other's has declined. Should they pay the same tax?)
(3) The Windfall for the Rich. Flat tax proponents argue that by eliminating
the individual tax on capital source income, we will stimulate future savings
and investment. But the proposal would exempt from tax not only income from
future saving and investment, but also income from existing saving and
investment. This would represent a huge tax windfall to current investors,
most of whom are in the top 5 percent of the income distribution. The
windfall is exacerbated by the fact that the flat tax does not tax at all
capital income derived from the sale of non financial assets, such as real
estate or collectibles. A basic test of the sincerity of flat tax proponents
would be to make their tax break apply only to new savings and investment.
(4) It Probably Won't Stimulate Saving and
Investment.
The basic argument for the flat tax, that reducing the tax burden on capital will cause savings and
investment rates to skyrocket and thus spur higher economic growth, is not supported by
evidence.
Reaganomics sharply cut the tax burden on capital in the early-1980s, and real rates of return
increased; yet personal savings and net investment rates continued to fall. Similarly, four cuts in
the capital-gains tax rate from 1977 to 1985 did not raise net investment rates -- which is why
in 1984 the Reagan Treasury Department recommended the elimination of all tax preferences for
capital income.
(5) It Would Raise the Deficit and Reduce National
Savings. Rep. Armey has conceded that his proposal would increase the deficit by $40 billion a year--which he defends as a spur to further spending cuts. However, the
Treasury Department has estimated that his 17 percent flat tax plan would
increase the deficit by $160 billion a year, decimating national savings,
pushing up interest rates, and leading to higher taxes in the future. In
order to make the Armey proposal revenue neutral, its basic flat tax rate
would have to rise from 17 percent to between 21 and 23 percent. If some
popular deductions (e.g., mortgage interest, charitable contributions) were to
be reinstated, the tax rate would have to be even higher.
(6) It Would Harm Working Poor Families. Today, millions of
working families living in poverty receive 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. For many families, it makes their federal income tax burden negative because
families receive a net refund. The Armey proposal would eliminate the EITC, thereby reducing
work
incentives for low-paid people while pushing several million families below the poverty line.
The large personal tax exemption provided by Armey does not help working poor people,
because their incomes are already too low to require federal income tax. The flat tax
would
thus amount to a tax increase for families that currently rely on the EITC to survive.
(7) It Wouldn't Help Everybody Else. Flat-tax
supporters
claim that its a single, low rate and large personal exemption would cut everyone's taxes. This is
false. Once again, a tax rate of more than 22 percent would be required to avoid expanding the
deficit. With the plan's elimination of all deductions, including mortgage interest, charitable
contributions, state and local taxes, and medical expenses, a 22 percent flat tax with Armey's
personal
exemptions would mean higher taxes for millions of middle-income families, as well as for the
working poor -- and much lower taxes for wealthy investors.
(8) Simplification: Yes, But... The flat tax would simplify the
system,
but not because it ends progressive rates, but because it ends deductions, credits, depreciation
allowances, and so on. This simplification is equally consistent with a single rate or
progressive tax rates. Remember, the complicated part of figuring one's taxes is calculating
taxable income; once you've done that, calculating the taxes owed is easy, whether
there is one marginal tax rate or several.
(9) The Business Tax May Be Bad for Business. An interesting aspect of the
flat tax debate is that the nation's largest businesses have been either
opposed to the proposal or silent on the issue. This is because the flat tax,
as written, would drastically shift the tax burden within the business
community. The tax eliminates the deduction of interest, but allows for
immediate expensing of new investment. While this policy may have some
attractive aspects, moving to it without a transition period (which introduces
complexity) would be a boon to 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.
(10) Its Purpose is to Boost Saving, But It Raises Taxes on Savers.
By only
taxing wages, salaries, and pensions at the personal level, the flat tax will
reduce the tax burden on those with the highest propensity to consume: the
elderly, many of whom have substantial capital income to supplement Social
Security and private pension income. At the same time, the relative tax
burden will rise for one of the groups with the highest propensity to save:
middle class families, who are saving for homes or their childrens' college
education. Cutting taxes on spenders and increasing taxes on savers is not a
"pro saving" policy. Not until everyone in the economy has lived under the
flat tax for their lifetimes (called the "steady state" by economists) does it
become equivalent to a consumption tax.
(11) It Makes Meaningless Income Thresholds for Means-Tested
Programs. Eligibility for many means tested entitlement programs is based on total
income. Under the flat tax, however, there will be no mechanism to calculate
total income, because individual income tax returns will contain only labor
income, and business income will not be carried forward to individuals. This
means that a person who receives a large inheritance and chooses to have no
labor income would be eligible for food stamps; or that a retiree with
substantial capital income but no pension income could be eligible for
government funded long term care under Medicaid! The means tested programs
will be thrown into disarray unless we have some accounting for capital income
at the personal level.
(12) In effect, the
Armey plan for the individual tax is a higher payroll tax. Like the current
payroll tax, Armey's flat tax would impose a single rate on all labor income
up to around $61,000. The only form of capital income subject to individual
tax under the plan is pension income -- the capital income that comes directly
from labor and therefore is most common among working people. In effect, the
Armey plan would raise the payroll tax on the first $61,000 of wages from its
current level of 15.3 percent to 32.3 percent -- with a higher deficit to boot.
