In 1980 and 1981, supply-side economics swept through the land. This year's phenomenon is the flat-rate income tax.
As was the case with supply-side economics, there is no precise definition of what a tax scheme must include to carry the flat-rate label. A wide range of proposals have emerged this year under that rubric. The proposals are as varied as their supporters, who cover most of the political spectrum and include both Republicans and Democrats.
In its purest form, a flat-rate income tax includes a comprehensive definition of income and no deductions whatsoever, except perhaps an allowance so that very low-income individuals do not pay tax. All income would be taxed at the same rate rather than at a rising rate as income went up, as is the case with the present progressive income tax.
The broadest proposal for change, from Robert Hall and Alvin Rabushka of the Hoover Institute, would apply the same approach to income of businesses. Hall and Rabushka would tax both personal and business incomes at a flat 19 percent rate, except that capital gains and payments of dividends and interest by business to individuals would not be taxed at all.
Why should such a radical proposal attract so much attention? After all, it scraps entirely the principle of ability-to-pay that has been a part of the nation's income tax structure for the nearly 70 years it has been in existence. Not only would tax rates not rise along with incomes, but also deductions, such as for unusually large medical expenses or uninsured casualty losses--which were justified originally on the grounds they affected a taxpayer's ability to pay--would also be dropped.
The answer is complex, but it seems to boil down to a growing feeling among the American public that the present income tax system is unfair and too complex, and that wealthy individuals routinely escape paying what they should because of loopholes that riddle the system. Moreover, most backers of a flat tax approach argue it would greatly enhance economic growth by eliminating the influence of tax consequences on investment decisions and by lowering marginal tax rates. In the latter regard, the flat tax is the ultimate extension of the key to supply-side economics: lower marginal rates.
Sen. Dennis DeConcini, an Arizona Democrat, introduced a sweeping flat-rate bill in March, and declared, "We must return to the basic principles upon which a sound tax system must stand: equity, efficiency and simplicity. We must get rid of all the complexities--the personal tax preferences, the special deductions and credits, the exclusions from income. These only lead to contempt for our tax system, endless pressures to create loopholes for some privileged group, and use of the tax code to further some ill-conceived project in social engineering."
Equity, efficiency and simplicity. Those were also the watch words of the tax reform movement of the 1960s and early 1970s, which ground ignominiously to a halt in 1978 when Congress gave short shrift to a set of Carter administration recommendations for reform.
Most of the tax reform efforts of those decades sought to simplify the tax system by eliminating many special provisions, particularly those used mostly by people in the upper income brackets.
But a major goal of most reformers was to eliminate the distinction between capital gains--the increase in the value of an asset, such as corporate stock or a home--half of which was not taxed (now 60 percent is not taxed), and other types of income that were taxed fully.
Like their counterparts today, those reformers also believed in lowering tax rates. That goal did not necessarily conflict with that of achieving more progressive tax rates, a point that is, in the view of some tax experts, getting lost as this year's debate proceeds.
It would be perfectly possible, for instance, to take Hall and Rabushka's proposal and use a set of progressive rates. Such a scheme would be only slightly less simple than one with flat rates, but would involve a different notion of what tax experts call "vertical equity."
"Vertical equity" is a matter of how tax burdens vary among different income groups. In a progressive tax structure, tax burdens rise as incomes go up. But the burden may rise rapidly or slowly, depending on how progressive the rate structure is. With flat rates, the burden would be the same for all income levels.
Naturally, "vertical equity" is contrasted with "horizontal equity," which is a matter of how tax burdens vary among individuals within the same income group. For instance, people who rent a house or an apartment have no opportunity to claim a deduction for payment of mortgage interest and property taxes. Someone who owns the home or apartment in which he lives can claim such a deduction. As a result, two taxpayers with identical incomes can end up with substantially different tax burdens.
By making a series of different choices about vertical and horizontal equity, one can design quite different tax systems. And that is what is being done this year as one after another sweeping proposals for changing the income tax system emerge.
Hall and Rabushka, and DeConcini, believe a single tax rate should apply to all income, but they would allow a single $5,000 personal exemption for a married couple filing jointly and $3,000 for a single individual. Sen. Dan Quayle (R-Ind.), on the other hand, has proposed using a $600 allowance for each dependent, levying no tax at all until income reached $17,500, and an 18 percent tax on incomes up to $50,000 and a 25 percent rate thereafter.
Like Hall and Rabushka, DeConcini would not tax capital gains, interest and dividend income, while Quayle would. A failure to tax capital gains--with today's exclusion of 60 percent of a gain coupled with the 50 percent top marginal tax rate means a maximum 20 percent tax on a gain--would mean retention of the complex portions of the tax code defining a capital gain and ordinary income.
Still another approach to sweeping income tax revision has been thrown into the flat-rate debate as a "discussion vehicle" by Democrats Sen. Bill Bradley of New Jersey and Rep. Dick Gephardt of Missouri. Their plan was endorsed for study purposes by the Democrats' National Party Conference last month.
Bradley and Gephardt would allow single taxpayers a $2,300 "zero bracket amount"--a sort of standard deduction--as at present, while raising the personal exemption to $1,500 from the current $1,000. The ZBA for married taxpayers would be raised from $3,400 to $4,600 and they would have two personal exemptions worth $3,000.
Their proposal calls for a 14 percent tax on all income, with a 6 percent, 11 percent or 14 percent surcharge on higher incomes. The surcharges would begin at $25,000 for single individuals and $40,000 for married couples, with a top combined rate of 28 percent reached at $37,000 and $65,000, respectively.
Furthermore, this version would keep some deductions "claimed over many years by the majority of taxpayers or those needed to alleviate genuine hardship," Bradley said. He included deductions for charitable donations, mortgage interest, property taxes, some medical expenses, and state and local income taxes. The tax-free status of most state and local government bonds and of Social Security and veterans' benefits would also be continued.
Thus, the Bradley-Gephardt proposal is not, in fact, a flat-rate tax system. Nor would it eliminate one of the largest violations of horizontal equity, the deductions associated with homeownership. In short, it is much more in the tax reform tradition of past years.
If the public believes a tax system is unfair, there will always be support for change. But the emphasis on some of the excesses in the present system, such as the use of highly questionable tax shelters, masks some key attributes of the system:
First, even with capital gains exclusions, tax shelters, tax-exempt bonds and all the other devices, the system remains progressive across all income levels above about $4,000. Statistics complied by the Internal Revenue Service for 1979, the latest available in full detail, confirm this. For returns on which some tax was due, the average tax for each income group, expressed as a percentage of adjusted gross income, ranged upward from 3.5 percent for income between $4,000 and $5,000 to 50.2 percent for those above $1 million.
The average rate for all returns as a percentage of adjusted gross income was only 15.3 percent in 1979 and 15.5 percent in 1980.
Second, studies done for the Brookings Institution several years ago showed that most personal deductions actually added to the progressivity of the system. That is, the total of deductions claimed falls, not in total but as a percentage of adjusted gross income, as incomes rise. In particular, this is true for mortgage interest, property taxes, sales taxes, casualty losses and medical expenses.
Third, while the income tax is progressive, the Social Security payroll tax is regressive. The payroll tax applies only to income from labor, not property. It is a flat 6.7 percent of wage and salary income up to $32,400 and is zero beyond that point. None of the discussion of a flat tax thus far has included any consideration of the payroll tax and its regressive nature. If flat is beautiful, some tax experts believe the payroll tax should be cranked into the equation that produces flatness.
As the debate over a flat rate system continues, it is likely to focus more on who would win and lose. That 15.5 percent average rate figure for 1980 is important, because it indicates that average rates are not nearly as high as most people think they are--precisely because all the exclusions and deductions and credits offset the higher rates.
Clearly, the IRS figures indicate that high income taxpayers would end up paying less under any of the true flat-rate schemes now on the table. What happened at the bottom end of the scale would depend on how generous were the personal exemptions or dependents' allowances. Congress' Joint Taxation Committee examined one version of a scheme with an 18.7 percent flat-rate tax raising about the same revenue as today's system. It found the taxes paid by those in the $20,000 to $30,000 income range would go up 9.3 percent compared to current levels while taxes of individuals in the $100,000 to $200,000 group would go down 23.1 percent.
Within every income group, the relative winners would be those who claim few deductions today. The losers would be those who do.
The flat-tax balloon likely will keep rising for a while. The Senate Finance Committee will hold hearings on it later this year. But some experts think the air will go out of it once Congress begins taking a really close look. "It might appear to be a good idea, but when they actually stare it in the face, they'll see the problems, the practical political problems," declares one critic, economist Joseph Pechman of the Brookings Institution.
Finance Chairman Sen. Robert Dole (R-Kans.) also is a bit of a skeptic. He thinks the idea deserves "a hard look." Asked if putting such sweeping changes in place would require a long lead time, he quipped, "I would need lead time. I would want to get out of town. It seems to me it'll be a great idea until you start to discuss it."