April 15, 1992
"How Could He Possibly have Thought His Flat-tax Plan was a Good Idea?"
San Jose Mercury News
By Timothy Taylor
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TAXES CAUSE pain -- a fact never more evident than on April 15 -- and pain
concentrates the mind on reform, even if it's as misguided as Jerry Brown's flat
tax proposal.
Brown's flat tax would have two parts. First, it would replace the personal
income tax with a tax of 13 percent. Brown would permit deductions for mortgage
interest and charitable contributions, and add a deduction for rent (so that homeowners
wouldn't be treated so much better than renters). All other deductions, credits
and exclusions would disappear.
The second part of Brown's proposal would replace payroll taxes for Social
Security and Medicare and the corporate income tax with a 13 percent value-added
tax.
A VAT works much like a sales tax, but it is collected in stages as goods are
produced. For example, the 13 percent tax might be imposed on the output of a
company that mines iron ore; and then on the "value added" by the steel
company that purchases that iron; and then on the value added by the auto company
that purchases the steel. Through these steps, the full tax is eventually passed
along to consumers.
On paper, a flat tax appears enviably simple. In the real world, it can grow
complicated in a hurry. What happens when Congress enacts "transition rules"
for phasing in the tax, or revises the rules every few months? What about those
state legislatures that decide not to set up their own flat tax, thus retaining
complexity at a state level?
Even with these factors, Brown's flat tax would be at least somewhat simpler
than the existing system. Estimates of the value of time and money put into preparing
individual income tax returns run to $30 billion, according to work done by Joel
Slemrod at the University of Michigan, and the cost of corporate tax preparation
is probably even higher.
By contrast, an individual tax return under Brown's proposal would fit on a
postcard. And the 50 nations around the world that already have value-added taxes
generally find them quite easy to administer.
But under Brown's tax proposals, the poor would pay for this simplicity. One
achievement of the Tax Reform Act of 1986, the last sweeping reform of the tax
code, was to assure that most poor people wouldn't pay income tax. Brown's proposal
reduces the top income tax rate to 13 percent, but makes up the revenue by taxing
everyone, rich and poor alike, on the first dollar of income they earn.
The switch from Social Security payroll taxes and corporate taxes to a value-added
tax would also burden the poor. While payroll taxes hit the working poor by taxing
the first dollar people earn, a value-added tax hits even the non-working poor,
by taxing the first dollar they spend.
Moreover, most of the $100 billion collected in corporate income tax ends up
reducing the income of investors in companies, who tend to be relatively wealthy.
By contrast, a VAT weighs more heavily on the poor, who spend a higher proportion
of their income on consumption than do the middle- class or rich.
Flatter income taxes or value-added taxes need not weigh so heavily on the
poor. For example, many countries with VATs don't tax basic goods like food, medicine
or shelter, thus protecting poor people from the tax to an extent. The well- known
flat-tax proposal from Stanford researchers Robert Hall and Alvin Rabushka, from
a few years ago, exempted the poor from income tax completely. But Brown was apparently
so dazzled by the 13 percent rate that he was willing to impose it twice: both
with an income tax on the first dollar earned and with a value-added tax on the
first dollar spent.
Finally, a flat tax promises to help the economy move faster. To understand
this argument, consider a traveler carrying luggage through an airport. If the
burden is evenly distributed -- in a large wheeled suitcase, a small suitcase,
and a shoulder-bag -- the traveler can carry quite a lot. But if an iron ball,
weighing the same as that luggage, was chained to the traveler's ankle, he might
barely be able to stagger forward.
The moral: A well-distributed luggage burden is easier for travelers to carry,
just as a well-distributed tax burden is easier for economies to carry. This philosophy
guided the Tax Reform Act of 1986, which expanded the tax base by reducing the
number of loopholes, and then reduced tax rates.
But Brown's sweeping proposal for lower rates is destructively utopian. Based
on current tax law, businesses have made investments, homeowners have taken out
mortgages, and state and local governments have enacted income and sales taxes.
A Brown-style revolution in the tax code would erase the conditions under which
all those plans were made, forcing a disruptive adjustment period that would last
for years.
Economists sometimes say "an old tax is a good tax," to capture the
idea that change in the tax code always imposes costs, no matter how well-intentioned.
But setting aside the distraction of Brown's proposals, plenty of room remains
for a gradual movement toward a broader tax base and lower tax rates, gradually
improving incentives for working and saving.
For example, a broader tax base could include taxing the value of common fringe
benefits, including health and life insurance. It could limit tax breaks for particular
industries, and deductions for things like charitable contributions, mortgage
interest and state taxes. The incentives of corporations to take on debt can be
reduced, along the lines laid out in a recent report from the Department of the
Treasury.
I'm an easy sell for this sort of tax reform plan. But Brown's flat tax proposal
offers only the politics of flash and smash, where the emphasis is on the adrenalin
rush from angrily rejecting the current system, in favor of a simplistic and poorly
conceived alternative.
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