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The Tax Tussle: Flat Tax Fever

By Ernest S. Christian
Sunday, September 10, 1995; Page C03

Having held near total sway for longer than most of us can remember, the progressive federal income tax is in danger of being deposed. Republican leaders in both houses of Congress are calling for its head. Presidential aspirants are vying for the job of chief executioner. The chairman of the House Ways and Means Committee has vowed to "tear it out by its roots." The ranking Democrat on Ways and Means agrees. The speaker of the House and the majority leader of the Senate have appointed former HUD secretary Jack Kemp to chair a commission charged with recommending one or more alternatives to the income tax before year-end.

We can, should and most likely will get rid of the federal income tax as it exists today. But what do we replace it with? Even assuming Congress passes all the spending cuts promised in its budget resolution, we must continue to raise way more than a trillion dollars of tax revenue every year.

Right now, there are several candidates for a replacement. Each has its own merits and each has a set of backers who have their own priorities: Minority Leader Richard Gephardt (D-Mo.) has proposed a version of the old Bradley-Gephardt bill that led to the Tax Reform Act of 1986. Personal tax rates would be compressed and reduced to a range between 10 and 34 percent. Except for home mortgage interest, all personal deductions would be repealed. His proposal succeeds in demonstrating one obvious truth: Whatever degree of simplification that arises from repealing personal deductions is not the exclusive province of a flat-rate tax.

Otherwise, Gephardt's proposal is to keep the income tax pretty much the same as now or to make it worse – judged by prevailing revolutionary standards. The bias against saving and investment would be exacerbated. The tax on capital gains would be increased. Wage earners would be denied the opportunity for tax-deferred saving through qualified employer-sponsored retirement plans. Existing IRA deductions for low-income savers would be repealed. So would Keogh deductions for the self-employed. Wage earners would get no credit for the nearly 8 percent in social security and medicare payroll taxes withheld from their paychecks. Thus, real marginal rates on most wages would be higher than on other income of the same amount – for most of us, 18, 28 and 34 percent on wages compared to 10, 20 and 26 percent on dividends.

Most of the complex provisions of the income tax would remain. Compliance costs would remain high. Other than a promise to close $50 billion of corporate "loopholes," Gephardt has not specified his plans for businesses. Would the present tilt in favor of imports and against exports remain? Would he cure the tax bias against new investment in plant and equipment?

Sen. Richard Lugar (R-Ind.) has suggested a national sales tax that in broad concept has much to offer. Libertarians at the Cato Institute and elsewhere are in strong support. No more abusive IRS! No more tax returns! All to the good so far. Income that is saved would not be taxed until spent, and that is also to the good, but existing savings, already heavily taxed under present law, would be taxed again at a rate likely to be near 20 percent – a tough hit for retirees planning to live on the fruits of their past frugality.

For current earners, such a high-rate federal sales tax on top of a nearly 8 percent federal payroll tax on top of a 6 to 8 percent state sales tax is a pretty heavy load of regressive taxation. To soften the impact, one suggestion is to have the IRS automatically send everyone with a social security number a "tax refund" check for $5,000 or $10,000 a year. Do we really want to come that close to converting the tax system into a federally guaranteed minimum income arrangement? Another suggestion is to make refunds only to people whose taxable purchases exceed a certain percentage of income. But how could that be administered if not by a tax return, and a fairly complicated one at that? And without intrusive IRS audits, the refund claims would be an open invitation to fraud. House Majority Leader Richard Armey (R-Tex.) and Sen. Richard Shelby (R-Ala.) have proposed a "flat tax" (the Freedom and Fairness Restoration Act of 1995) that would make dramatic changes long desired by supply siders. Marginal rates of tax would be reduced. Capital gains would not be taxed. Tax returns would be simplified.

The flat tax as designed by economists Hall and Rabushka in 1985 would, however, have many other consequences that may be harder to explain. People who get their income from interest, dividends and gains will file no tax return and pay no tax. Instead, only people with income from work file a tax return and pay tax. If they earn less than $62,000, they will pay a 20 percent flat rate plus a 7.65 percent federal payroll tax – a real marginal rate of nearly 28 percent. If they earn more, the marginal rate on the excess drops to 20 percent.

All homeowners will lose their mortgage interest deduction – including those with existing mortgage commitments that they may no longer be able to afford once the interest payments become taxable. No one will get a deduction for charitable contributions. As a general rule, middle-income families will pay a higher portion of the tax burden than now, while higher income families will pay less. Corporations and other businesses (small and large) will, on average, experience a major tax increase. Exports of American-made goods will still be taxed. Importers of foreign-made goods will still not pay a fair share of our tax burden. The international playing field will still be tilted against us.

None of these difficulties, however, is inherent in a simplified or even in a flat-rate tax. Many arise from a decision to tax income from capital only at the business level and income from work at the personal level. Others arise from ignoring the effect of payroll taxes on workers, and from an attempt to eliminate all deductions even when they do not add to complexity.

The best compromise may lie in the USA Tax Act of 1995 designed by Sens. Pete V. Domenici (R-N.M.) and Sam Nunn (D-Ga.). It lays out in full statutory detail a replacement for the federal income tax that is less than one-third its size and much simpler to apply. Their bipartisan effort has been applauded by others as politically diverse at Sens. Robert Bennett (R-Utah), Bob Kerrey (D-Neb.) and Joseph Lieberman (D-Conn.).

What the "USA tax" lacks in dramatics, it tries to make up in balanced results. Everybody files a tax return and all income is taxed, but everybody gets a deduction for the amount of income they save and pays tax when they spend it. Nobody gets taxed twice. (For example, a retiree who withdraws and spends previously taxed saving, will not be taxed.) Current earners get a tax credit for the federal payroll tax on their wages so that USA tax rates on most earned income are 11 percent, 19 percent and 32 percent, compared to current rates ranging from 15 to 40 percent.

The USA tax allows deductions for home mortgage interest, charitable contributions and a portion of post-secondary education costs. Businesses pay about the same total tax as now, but get to fully deduct investment in new plant and equipment in the first year. Imports are taxed, but exports are not.

The USA tax preserves the principle of progressive taxation. In fact, instead of shifting a larger portion of the tax burden to the middle class, USA maintains the existing tax distribution at all income levels – thereby dispelling the idea that allowing a deduction for saving always equates to regressivity. Like the other alternatives, the USA tax falls short of meeting every ideal. Some revolutionaries will object to having to file a tax return. Others, however, will point out that tax returns serve the positive purpose of forcefully reminding us each year how much tax we pay for what government spends. Some will object to multiple rates and to a marginal tax rate that can still mount to 40 percent on spent income, but others will favor the fact that rates are zero until income is spent.

Because the USA tax draws from all the other alternatives, something close to it may emerge as the end product of compromise among advocates of other schemes. But it is far too early to make that prediction. The simplicity of the sales tax may finally outweigh concerns about regressivity; the idea of a single flat rate of tax has broad appeal.

The chairman of the Ways and Means Committee has committed to give full consideration to all alternatives. He is right. A more perfect solution may be yet to come.

Ernest Christian, a Washington lawyer and former Treasury Department tax official, is co-author of "Explanation and Description of the Unlimited Savings Allowance Income Tax."

© Copyright 1995 The Washington Post Company

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