Ramifications of a flat tax--shifting the burden to the middle class.

Abstract An alternative to the current US tax system would be a flat tax. According to its supporters, the flat tax would decrease the complexity of the tax system. Opponents contend that the flat tax will shift the tax burden to the middle class. The current research tested the claim that the flat tax will shift the tax burden to the middle class by developing simulations of two flat tax proposals, the Steve Forbes Plan and the Hall and Rabushka Plan, and then examining the change in the tax burden for different income levels as compared to the current tax system. The results show that both plans shift more of the tax burden to middle income class taxpayers than under the current US tax system.

Keywords Flat tax Tax system Middle class Steve Forbes Hall and Rabushka

JEL M00

Introduction and Purpose

Much recent attention by Congress, economists, and the press has focused on the budget deficit. Ostensibly, the economy and Congress balanced the budget in 1998. However, since that time the budget deficit has risen to over a trillion dollars. Because the income tax is a major source of funding for the federal budget, the tax system is constantly under criticism and review.

Most observers agree that the current US tax system needs changing. The more important question is What is the best way to change the tax system? Among the stated reasons for a change in the current US tax system is a need for more efficiency, equity and simplicity. In addition to those deficiencies, the current tax system has also been criticized for "artificially and unnecessarily suppressing living standards." (1)

Two major weaknesses in the current tax system are the complexity of the law and the concern that much of the tax burden falls on the middle class. Over the years many proposals have been made to change the current policies. One change, which has received support, is a consumption-based tax or a flat tax. A flat tax had been proposed as early as 1981, but received little interest. However, during the 1995 legislative year both Representatives Armey and Shelby, and Senators Nunn and Domenici introduced flat tax proposals in Congress. (2) According to its supporters, the flat tax would decrease the complexity of the current tax system and should decrease the tax liability for many taxpayers. Hall and Rabushka (HR; 1995, pp. 92-93) concluded "The current personal and corporate taxes tax wages heavily and business income lightly. The flat tax would reverse this inequity and benefit a great majority of Americans, whose income comes almost entirely in the form of wages."

Projections of the flat tax proposals indicate that they will not produce any more tax revenue than the current system, and in fact Summers (1996) suggests that some versions of the flat tax would actually produce less money than the current system. Summers (1996) argues that the tax rate would need to be over 20% for a flat tax to be revenue neutral. Therefore, the change in the tax law will not by itself decrease the budget deficit and may in fact increase it. What the change should do, according to its supporters, is stimulate the economy. As the drill goes: a decrease in tax rates should increase investment, thus leading to a stimulation of the economy, thereby increasing overall revenue, which in turn will increase overall tax receipts, which will decrease the budget deficit. Using this theory, revenue would increase while decreasing the actual tax rate, a goal that is very important to Congress.

Opponents of the flat tax contend that it is a zero sum game and that the tax burden will only shift under the current flat tax proposals. According to these critics, the flat tax will shift the tax burden from the high income and low income taxpayers to the middle class taxpayer. According to studies performed by Enis and Craig (1984, 1990) and Dunbar and Pogue (1998), approximately 70% of all taxpayers would have their tax liability increase and a majority of the tax burden would shift from the upper 20% of taxpayers to the lower 60%. Also according to these studies, the largest tax increase would occur in the middle income class. The prior studies only examined the Armey-Shelby flat tax proposal. The current research examines the effect of two different flat tax proposals, the Steve Forbes (SF) Plan and the Hall and Rabushka Plan. If the results of the current study are similar to those found in prior research, it could be concluded that all the current flat tax proposals have a bias against the middle income class.

According to other critics of the flat tax, a decrease in tax rates will not create a substantial increase in economic growth. Stokey and Rebelo (1995) and Lucas (1990) both found that tax reform would have little or no effect on growth rate. Summers (1996) also noted that the economy will not grow as proponents of reform predict, based on prior experience with tax changes. Summers (1996) also notes that a flat tax system may not be as simple as its supporters claim due to transition issues that must be addressed and the possibility of allowing taxpayers to deduct certain expenses such as mortgage interest and charitable contributions.

The perspective of the current research is that the current tax system does need improvement and a new plan should be considered, not only for what revenues it can bring into the budget but also for the effect that it has on taxpayers. Unfortunately, data is not available to determine if a flat tax will have the desired effect on the budget deficit or the policy implications. Therefore, we cannot test to see if a flat tax is a better tax than the current tax system. What can be tested is the opponent's claim that the flat tax will shift the tax burden to the middle class, a crucial political issue. To examine this question, the current study develops simulations of two specific flat tax proposals, the SF flat tax proposal and the HR flat tax proposal; then examines the change in the tax burden for different income levels as compared to the current tax system to determine if there is a shift in the tax burden under the two proposals.

With the existing cumulative budget deficit, any viable alternative that will increase revenues must be seriously considered. However, the flat tax would not be an improvement if it shifts the tax burden to the middle class. To date, few empirical tests have been conducted to determine any effect the proposed flat tax plans might have on the distribution of tax burden. The current study will hopefully provide some answers which will help Congress make an informed decision when the time comes to vote on the adoption of a new tax system. The research also provides information to taxpayers as they decide how a flat tax will affect them personally. The results of this study found that both the SF Plan and the HR Plan shifts more of the tax burden to middle income class taxpayers and away from upper income taxpayers than under the current US tax system. In addition, the results show that both plans would produce substantially less revenue than the current tax system. Instead of the proposed tax rate that is between 17% and 19%, the plans would have to use a tax rate over 25% to produce the same level of revenue as the current system.

In the next section the flat tax alternative is examined. In the third section the SF and HR Plans are explained. The fourth section, the methodology section, discusses the data and procedures used to estimate the change in tax burden. The last section presents the findings of this study and highlights some of the policy implications.

The Flat Tax Alternative

Complaints of the Current Tax System

One major complaint of the current income tax system is that the tax burden falls unfairly on the middle class. Similarly, many people believe that the system is unfair and that the government takes too much of taxpayers money. Dr. Richard K. Caputo (2005) conducted a study to show the distribution of tax burden during the past several presidential administrations. According to Caputo, the G.H. Bush administration in 1990 and the Clinton administration in 1993 were both forced to increase taxes in order to reduce the federal budget deficit. The 1993 tax increase was more progressive as it was aimed at increasing the tax rate for high income payers. However, in 1997 when the Clinton administration passed tax cuts, half of the tax cuts went to the highest 5% of the income scale while the lowest 40% received no tax cut. The current Bush administration has constantly pursued tax cuts since 2001. The Bush tax cuts have reduced tax rates that favor high income levels more than middle and lower income levels (Caputo 2005).

When Steve Forbes ran for President of the United States in 1996 and 2000, tax reform was a major platform of his campaign. He suggested that the current system be thrown out and replaced by a single tax rate for individuals and corporations. In his book, The Flat Tax Revolution (2005), he states that the current tax code makes no sense for taxpayers or for society. He points out that the tax code not only confounds taxpayers, but it is not even fully understood by the government's own professionals. A 2003 Treasury Department study cited by Forbes shows that more than 25% of the time Internal Revenue Service (IRS) experts answering calls for the agency's toll free hotline gave the wrong answer on tax related questions. And even though the IRS experts made the errors, the taxpayers are liable for the mistakes (Forbes 2005).

The History of the Flat Tax Plans

Although tax reform is always a hot topic, the flat tax reform proposals were first introduced in 1981 when Hall and Rabushka wrote an article for the Wall Street Journal. The public, media and politicians latched onto the idea, making it a widely discussed option for over a decade. It was then revived in 1992 when former California Governor, Democrat Jerry Brown, ran for President. He gave three reasons for supporting the flat tax: (1) to eliminate the power of special interest to buy favors from the tax writing committees of Congress by closing almost every loophole; (2) to simplify the system so that everyone could understand their tax obligations and easily file their returns; and (3) to improve economic performance by dramatically slashing tax rates.