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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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