Understanding the Flat Tax

Rarely has a public policy proposal been more tortured and abused than the so-called "flat tax". Like any sweeping change, the flat tax contains numerous features that are distasteful to one group or another and thus wonderfully inviting for demogoguery. It is thus worth the effort to understand exactly what is proposed by flat tax advocates, and what a national flat tax might mean for Vermonters.

Here are ten important things to understand about the flat tax, using the model first proposed by Stanford economists Robert Hall and Alvin Rabushka, and currently advocated by House Majority Leader Dick Armey and Republican Presidential candidate Steve Forbes.

1. Unlike our present Federal and Vermont taxes on what comes in ("income") to the taxpayer, the flat tax taxes what is consumed; it does not tax what is saved and invested. Individuals are taxed on what they take out of the economy (when they spend money to consume) and not on what they produce (reflected in working and saving.) The flat tax is a consumption tax that favors saving and investment, and thus economic growth.

2. The flat tax includes both a tax on businesses and a tax on individuals. The two are inextricably linked. What may appear to escape taxation at the individual level will already have been taxed at the business level.

3. The flat tax system taxes all economic flows once, and only once, wherever possible at the source. For example, it does away with the present double taxation of dividends and interest.

4. The flat tax is extremely simple. Both businesses and families can fill out a return on a postcard. Ordinary people can comprehend the system, where the IRS itself has great difficulty in explaining the 7000 pages of law and regulations that define the present income tax system. It would save over $100 billion now spent every year by taxpayers trying, often vainly, to comply with the law.

5. "Flat" is a misleading description. A true flat tax, like the Biblical tithe (10%), would be levied at one single rate, with no exemptions. All current "flat" tax proposals allow a generous individual and dependent exemptions. Thus they actually have two rates: zero up to the total of the exemptions (in the Armey-Forbes version, $36,000 for a family of four), and 17% above that. This feature makes the flat tax progressive. A family of four with an income of $36,000 will pay no tax at all. The higher its income above that, the higher an effective tax rate it will pay.

6. The flat tax gets rid of all the special interest loopholes which, under the present graduated income tax system, help high income taxpayers to shelter their income from taxation. In doing so it gets rid of all the Washington lobbying and influence peddling centered around corrupting the tax code, and the Congress, for the benefit of well-heeled clients.

7. Because of the very broad base the flat tax rate can be low - in the 17-19% range - to equal present income tax receipts. This low marginal rate will unquestionably spur economic growth, job creation, wealth production, and government revenue collections.

8. Because there is only one tax rate, there is no incentive to try to convert ordinary income into capital gains which are now taxed at a lower rate. This alone gets rid of thousands of pages of tax regulations.

9. All capital gains, dividends and interest are subject to tax once, at the business level. Because they are not taxed at 17% when received by individuals does not mean they have escaped being taxed. They are included in the tax base once, at the source, at the 17% rate. The only thing not taxed is the capital gain on the sale of an owner-occupied home.

10. The elimination of the most popular individual deductions (charitable contributions, home mortgage interest, and state and local taxes) will be offset for virtually every taxpayer by the lower tax rate, lower interest rates, and stimulation of the economy as a whole. Under current tax law these deductions must exceed $6,550 per couple to make it worthwhile to itemize, and the deductions are worth 2.4 times as much to a $118,000 taxable income family (in the 36% bracket) as to the $11,800 family (in the 15% bracket.)

What effect would a national flat tax have on Vermont? Since Vermont has very high state income taxes and local property taxes, itemizing Vermont taxpayers would lose more from the elimination of those deductions than residents of low-tax Tennessee. But taking into account all of the benefits of replacing the present system with the flat tax system, it seems to me to be a fair guess that almost all Vermonters would come out well ahead economically.

Those who oppose economic growth in Vermont would have reason to be apprehensive, however, because the flat tax is a major investment generator. Their obvious strategy would be to make land use control and business regulation more severe, so that newly-favored investment flows out of the state to improve the economy somewhere else.

What about a flat tax system for Vermont, whether or not the national government adopts it? Given the present tax and regulatory barriers to economic growth in the state, shrewd Vermonters seeking tax-favored investment opportunities would probably export much of their newly-available capital instead of investing it in Vermont. If that occurred, most of the economic benefits of a Vermont flat tax system would be captured by other states.

February 1996