Monday, November 22, 2004

Flat Tax Revisited

I was sent the following in an email in response to my earlier post about a flat tax.
How does the flat tax measure up when it comes to simplicity, fairness, and economic incentives?

Making the transition from the current system to a flat tax would involve countless complications. Would the deductibility of home mortgage interest be eliminated for all homeowners regardless of when they purchased their property, which might be perceived as unfairly changing the rules in the middle of the game? Or would deductibility be phased out somehow? Any phasing out process would almost certainly be enormously complex. Similar transition problems would arise for changes in rules affecting capital gains, depreciation, corporate interest expenses, and so on.
  • The ivory tower version of the flat tax would be unlikely to resemble the less pure, more complicated version that Congress would actually enact. Almost certainly, Congress would strive to minimize the wrath of the large and well- financed constituencies who would defend the individual and corporate tax breaks they fought so hard to create and sustain in the past. As a result, some write-offs would be likely to endure. So would the complexity that each retained tax break entails, perhaps magnified by transition rules.
  • By reducing the top tax rate and eliminating taxation of investment income, which is predominantly collected by families with the highest incomes, a flat tax would provide an enormous windfall to the wealthiest. For such a tax to maintain the same level of government revenue, everyone else would have to pay higher taxes. As a result, a flat tax would be less progressive than the current system but less regressive than a pure consumption tax.
  • A Treasury Department analysis of one prominent flat tax proposal estimated that the plan would reduce taxes for those in the top 5 percent of the income distribution and increase the burden for everyone else. The average tax rate would decline the most for those in the top 1 percent of the income distribution and increase the most for those in the bottom 20 percent.43 These changes are due mainly to the elimination of graduated rates, the exemption of investment income, and the demise of Earned Income Tax Credit.
  • The flat tax would remain as vulnerable to tax avoidance attributable to undeclared income as the current system.
  • If a flat tax that ultimately emerged from the political process retained some tax breaks, those write-offs would continue to enable some taxpayers to pay less than others with similar incomes.
  • New opportunities for corporate tax avoidance and evasion would be created as businesses sought to redefine taxable sales as nontaxable interest received.
    • The ripple effects from eliminating various deductions could be enormous. For example, charities probably would be hurt by the absence of the charitable deduction, employer-provided health insurance and other benefits might decline because companies could no longer deduct such expenses, and housing values could fall after the elimination of the home mortgage interest deduction. The magnitude of such effects are unpredictable, but they could be considerable.44
    • The tax increase a flat tax would likely impose on low-, middle-, and some upper-middle income households could slow down the economy significantly if implemented suddenly.
My thoughts on this later. Or if someone smarter than me would like, feel free to respond in the comments.

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