Flat tax on income systems and policy implications

Flat Tax on Income

The objective of this work is to examine the pros and cons of a flat tax on income as a viable option to deal with the current recession in the United States. The concept of a lower tax rate that would result in higher tax revenues. This work will include a graph used as an explanatory tool of the economic principle presented by the student.

The work of Gale (1999) reports that Robert Hall and Alvin Rabushka "...in the early 1980s...developed a consumption tax systems that achieves some of the administrative advantages of a value-added tax (VAT) relative to sales tax, while also partially addressing concerns that consumption taxes impose a relatively heavier tax burden on lower-income taxpayers. The Hall-Rabushka system is often called the 'flat tax'." (Gale, 1999, p.1) The flat tax assesses a 19% tax on all businesses "identical to the VAT, except that wages, pension contributions, material costs, and capital investments are deducted from the tax base." (Gale, 1999, p.1) Under this flat tax rate plan, individuals are assessed a 19% flat-tax rate on wages and pensions "above an exemption of $25,500 for a family of four. No other income is taxable and no other deductions are allowed." (Gale, 1999, p.1)

I. COMPARISON OF FLAT-TAX AND PERSONAL INCOME TAX METHODS

The personal income tax is reported by Gale (1999) to have provided exemption of $9,800 for a family of four, an earned income tax credit and the choice of $6,350 standard or itemized deductions for mortgage interest, state and local income and property taxes, charity and large health expenditures" in 1994. (Gale, 1999, p.1) Gale states that without the personal exemptions "the flax tax would be equivalent to a VAT, but with taxes on wages remitted by households other than business." (1999, p.1) In other words, the flat tax would be a consumptions tax, although it would appear to be a wage tax to households and a variation of a VAT to most businesses." (Gale, 1999, paraphrased)

The result is that the economic effects of the FairTax would be practically the same as those of a VAT or sales tax. The family exemptions would mean that the flat tax is progressive for low-income households however "at the high end of the income distribution, the tax is regressive, just like sales taxes and VATs." (Gale, 1999, p.1) Critics of the flat tax note that the tax advantages that many will be expecting will not culminate noting that homeowners will no longer receive a tax deduction on their mortgage.

II. FLAT TAX

Those who supporter a flat tax hold that the only fair method of taxing income would be to apply an equal percentage to all taxpayers. Stated to be the most notable element of the Flat Tax is that "it would completely abolish Federal income and corporate taxes as well as the Internal Revenue Service. Instead it would institute a national sales tax that would pull in enough to cover all government programs -- taking revenue from what is spent rather than what is earned." (McGrath, 2009, p.1) To ensure that the poor do not suffer under this tax scheme the government would send a check to families each month (referred to as a 'prebate') that would serve to cover taxes on expenses that were necessary.

The idea, according to McGrath is "that no American pays tax on necessities." (McGrath, 2009, p.1) The work of Paulus and Peichl (2008) entitled: "Effects of Flat Tax Reforms in Western Europe on Income Distribution and Work Incentives" states that the flat income tax has become increasingly popular recently, yet its implementation it limited to Eastern Europe." (p.3) Paulus and Peichl conduct an analysis of the "distributional and efficiency effects of flat tax scenarios for Western European countries." (2008, p.1) Results of this analysis are stated to show that "flat tax rates required to attain revenue neutrality with existing basic allowance improve labor supply incentives. However, they result in higher inequality and polarization." (2008, p.1)

III. THREE MAIN BENEFITS OF FLAT TAX SYSTEMS

Three main benefits are reported to be associated with flat tax systems and these include those of:

(1) Flat taxes enhance labor supply incentives;

(2) A flat tax rate can increase tax compliance and reduce tax evasion; and (3) A flat tax rate is often part of more fundamental tax reform, it can simplify income taxation significantly. (Paulus and Peichl, 2008, p.2)

Flat tax rates however "can have a serious drawback in terms of their impact on the distribution of tax burdens...previous flat tax reforms and typical proposals lower marginal tax rates at the high income levels but increase the tax burden for middle-income ranges, resulting in a widening of the distribution of after-tax incomes." (Paulus and Peichl, 2008, p.2)

Paulus and Peichl report that there have been only two reforms examined in the literature which are those of "the 2001 Russian reform by Ivanova et al. (2005) and the 2004 reform in the Slovak Republic by, among others Brook and Leibfritz (2005)." (2008, p.2) In the case of the Russian reform, real growth resulted in personal income tax revenue however "there was no strong evidence that this was caused by the reform itself or by improved law enforcement, nor could any positive labor supply responses be identified." (2008, p.1)

The Slovakian reform is stated to have been "expected to be revenue neutral, to increase the level and efficiency of capital formation and to enhance the incentive of unemployed workers to seek work. However, no evidence apart from revenue-neutrality has been reported yet." (Paulus and Peichl, 2008, p.2) Paulus and Peichl (2008) state that the implication is that there is "some sort of proportionality embedded in the [flat tax] income tax system..." (p.3) There are two dimensions that are distinguished and those are the:

(1) Tax schedule; and (2) The tax base. (Paulus and Peichl, 2008, p.3)

The tax schedule "can apply the same rate on all incomes or different rates on different types of incomes." (Paulus and Peichl, 2008, p.3)

The work of Steven Forbes entitled: "Flat Tax Revolution" questions whether the tax base should be on income or consumption and states that "one issue associated with the choice of a tax base is equity -- how the tax burden will be distributed across income classes and different types of taxpayers." (p.163) There are several proposals for how this would be accomplished. The first of these is the 'Shelby Proposal' (S.1040 in the 108th Congress) the Tax Simplification Act of 2003 which was modeled after the Hall and Rabushka proposal. The second proposal is the "Spector Proposal' (S. 907 in the 108th Congress) which was also modeled after the Hall-Rabushka proposal and which is similar to the Shelby Proposal. This proposal contains two primary components:

(1) wage tax; and (2) cash-flow tax on businesses.

This is a form of a modified VAT in which wages and pensions are subtracted from the VAT base and taxed at the individual level beginning at 19% and declining to 17% after being phased in. Government employees and nonprofit employees would add to wage tax base the value of fringe benefits.