Fashions come and go, and changes in the IRC are not immune to the latest popular styles. Tax reform means different things to different people, but one thing is sure: Everybody is in favor of it. Defining the "it" is more problematical, however.

One of the more popular vehicles of radical tax reform in the U.S. to gain popularity and recognition is the "flat tax." There are myths to dispel, but also there are some intriguing effects of which even its proponents are not aware.

What Is a Flat Tax?

A flat tax is one in which the marginal tax rate remains constant as taxable income increases. This constant marginal tax rate persists no matter how high the amount of taxable income.

The flat tax is not a novel idea that has suddenly been discovered in the academic literature by politicians. Indeed most states that have a personal income tax use a flat tax by assessing taxable income above a certain exemption amount at a flat, constant marginal rate. The suggestion that the Federal income tax be assessed by means of a flat- rate structure was proposed as early as 1962 by Nobel Laureate Milton Friedman in his classic work Capitalism and Freedom. Friedman's original flat-rate tax would have been 23.5% of taxable income. In a later 1980 work, Free to Choose: A Personal Statement, Friedman lowered the preferential flat rate to "less than 20 percent," which is in the acceptable range to many of today's political figures proposing a flat tax.

The most noteworthy of the current legislative proposals for a flat tax is from the current majority leader in the U.S. House of Representatives, Richard Armey (R-Texas). Armey, who has a PhD in economics, has proposed a flat rate of 17% on all taxable income above a certain exempted amount, $13,100 for a single person, $17,200 for a head of household, $26,200 for a married couple, and $5,300 for each dependent of the taxpayer. A married couple with two children would not pay any tax until their taxable income reached $36,800. Armey's proposal would exempt investment income, e.g., interest, dividends, and capital gains, from taxation. Only wages, salaries, and pensions would be taxable.

Armey's flat tax would tax businesses at a flat 17%, but not on gross income. Businesses would pay a flat 17% on net revenues, after deducting all expenses. Included in expenses are all purchases of capital assets such as land, building, and equipment, effectively eliminating the depreciation deduction.

To give an example of a typical flat tax on individuals (not specifically Armey's proposal), assume an exemption amount of $5,000 is given for each individual. Thus a family of four would have the first $20,000 of income exempted from taxation. In addition, all taxable income above $20,000 would be taxed at a flat rate of 18%. If taxable income before the exemption was $50,000, the amount of taxable income is $30,000 and the tax liability would be $5,400 (.18 x $30,000). If taxable income before exemptions was $70,000, the tax base is $50,000 and the tax liability is $9,000 (.18 x .$50,000). No matter how large taxable income becomes, the marginal tax rate will never exceed 18%.

What Is Taxable Income?

Most proponents of the flat tax axe basing their rate on a revenue- neutral stance. That is, even though tax rates for most people would be substantially lowered, their taxable income would be correspondingly increased. This increase comes with no increase in actual economic income, but rather by subjecting more of this actual economic income to taxation, or by eliminating many deductions from the tax code. For example, the Armey flat-tax proposal would completely eliminate all itemized deductions, e.g., home mortgage interest, state and local taxes, and charitable contributions, substituting for them some very generous standard deductions and exemptions. Business expenses of taxpayers, acting in their capacity as sole proprietor, would still be allowed.

To describe the concept of revenue neutrality, assume Taxpayer X currently has income of $80,000 from taxable sources and $15,000 from nontaxable sources, such as interest income on tax-exempt municipal bonds. Assume further, Taxpayer X has $20,000 in tax-deductible expenditures or exemptions so that her taxable income is $60,000. Assuming a hypothetical progressive tax rate that places her in a 30% marginal tax bracket, her tax liability is computed as $12,000.

To have a revenue-neutral flat tax would require Taxpayer X to still pay $12,000 in taxes. If a 20% flat tax rate on all taxable income is proposed, no alteration would have to be made in the tax laws determining taxable income. At a taxable income of $60,000, Taxpayer X would still pay $12,000 in taxes ($60,000 x .20). Another alternative would be to have a flat tax of 16% on all taxable income but to eliminate the exclusion of state and local bond interest. This $15,000 interest added to the other components of income would generate taxable income of $75,000. A tax liability of $12,000 would therefore result (75,000 x .16).

There are almost an infinite number of ways in which a revenue-neutral flat tax could be implemented. The actual implementation of the concept is wrought with political difficulties. The Budget Act of 1990 requires that any tax reductions be "paid for," i.e., be revenue-neutral. The lost revenues from reductions in tax rates must be paid for by increases in revenues caused by eliminating deductions or income exclusions. The political difficulties come in the determinations of just whose ox is to be gored. Do we eliminate the exclusion for state and local bond interest? Do we further limit, or repeal outright, the interest deduction for home mortgages? Are charitable contributions to be scaled back or eliminated altogether? These are questions that will ultimately be debated; but they are choices that have to be made nonetheless.

The objective would be a flat-tax that is revenue-neutral for the economy as a whole. This does not mean there will be neutrality at the individual level. Some people will pay more, some will pay less under a flat-tax system. Whether it is more or less depends on the individual's type of income and how it is treated tax-wise before and after the institution of a flat tax. Under the Armey proposal, for instance, it is likely that those individuals with large amounts of itemized deductions would be worse off under the flat tax. Those individuals with little or no present deductions would be better off under the flat tax because they would now be granted rather large exemptions.

So Why the Flat Tax?

If current budgetary rules require a revenue-neutral flat-tax rate, it is tempting to ask just what is the point of it all? To answer this question, the dynamic nature of what the flat-rate tax is supposed to accomplish must be examined.

The principal purpose of the flat-tax system, according to its proponents, is to encourage more productive effort from taxpayers, fostering additional time at work as well as increased capital investment. This result, which would spur forth economic activity and growth, is a fundamental notion of "supply-side" economic policy. This release of productive energy would be due to the reduction in the taxpayer's marginal tax rate. Economic theory would predict that if, at the margin, additional work effort or investment is subject to a smaller marginal tax rate, more work and investment will occur, since after-tax earnings are higher. If, as with the Armey proposal, there is no taxation of investment income whatsoever, this effect would be even more marked. The end result is a purported increase in economic growth, most notable because additional savings and investment will occur, leading to a larger stock of capital equipment in the economy.

Common sense would seem to agree with this point. Taxpayers will be motivated to work harder, and invest more, if they can keep more of the fruits of one's labor. A worker thinking about overtime work, an entrepreneur deciding whether to expand operations, or an investor considering spending the additional effort to find another investment opportunity is more apt to do so if the government leaves her with more "take-home pay" from that decision.

Does the evidence support this theory? Although certainly not conclusive, consensus has developed among economists who have studied this issue that both investment decisions and additional work effort are actually not very responsive to reductions in tax rates. Although there are certainly dissidents from this consensus, it must be asked just why the empirical evidence seems to disagree with common sense logic. To answer the question requires us to understand what economists mean by the "income effect" and the "substitution effect" of any change in marginal tax rates.

TABLE1

PROGRESSIVITYINAFLATTAX

IncomeTaxableIncomeTax(20%)AverageTaxRate

$20,000-0--0-0%

30,000$10,000$2,0005

40,00020,0004,00010

50,00030,0006,00012

70,00050,00010,00014

100,00080,00016,00016

150,000130,00026,00017

200,000180,00036,00018

500,000480,00096,00019

TABLE2

PROGRESSIVETAX

Exclusions&AverageTax

Income(Y)DeductionsTaxableIncomeTax(T)Rate

L$20,000$5,000$15,000$2,25011.25%

M60,00010,00050,00012,00020.00

U125,00045,00080,00022,00017.60

Taxwascomputedfromthefollowingschedule:

TaxableIncome(TI)Income-TaxLiability

$0-$20,00015%xTaxableIncome(TI)

20,001-70,000$3,000+30%(TI-$20,000)

Over70,00018,000+40%(TI-70,000)

L=LowM=MiddleU=Upper

Proponents of the flat-tax, by nature, think the substitution effect is more representative of taxpayer behavior. Basically, under the substitution effect the taxpayer substitutes more work or investment effort for leisure time, because leisure time is now more expensive. In otter words, the opportunity cost, what the worker/investor is giving up by taking nonproductive leisure time, rises because at the margin, the worker/investor has greater gains from additional effort, i.e., "more take-home pay" if marginal tax rates decrease.

However, economic research tends to support the notion that the substitution effect is almost equally matched by the income effect of any changes in marginal tax rates. If tax rates decrease, a target level of income can sometimes be reached by actually working less, since take- home pay has increased. To take a simple example, Taxpayer Y might be happy with after-tax income of $45,000. Assume he currently faces a flat-tax rate of 25%, with $60,000 in income and no exclusions or deductions. With a flat 25% tax rate, he pays $15,000 in taxes, and has $45,000 in after-tax "take-home pay." Now assume all facts remain the same except the tax rate is reduced to a flat 20% rate. If he is happy with his target after-tax income of $45,000, he will actually reduce his work effort and generate income of $56,250. At a flat rate of 20%, this results in a tax liability of $11,250, and after-tax take-home pay of $45,000. Notice that tax revenues to the government have actually decreased by $3,750. Perhaps more importantly, the gross domestic product (GDP) decreases by the same amount, which is equivalent to Y's decline in his gross income. In conclusion, the income effect actually renders a perverse result from what the supply-side school predicts.

Of course not all individuals are the same. Some will respond to lower marginal tax rates by increasing effort. Others will actually "purchase" more leisure time, since their target incomes can be reached now with lower effort. In a macroeconomic sense, however, what economists have found, generally, is that the two effects, or the two types of behavior, tend pretty much to cancel each other out. All this is in direct contradiction to supply-side economic theory that maintains tax revenues will increase with tax rate reductions as people increase their productive efforts.

The conclusion from this research is that, with no increases in the tax base itself, tax revenues would probably decline. This result would occur because those working and investing more might be equally matched by those working and investing less. Thus the same amount of income is generated overall, and with lower tax rates, the obvious result is lower tax revenues. This is why an adoption of a revenue-neutral flat-tax will ultimately require the unpopular measure of a parallel increase in the tax base, by eliminating certain exclusions and deductions.

Will the Flat Tax Decrease Tax Avoidance and Evasion?

Flat-tax advocates will often point out their critics are ignoring another behavioral aspect to the argument. If tax rates are lowered, the argument goes, people have less incentive to practice tax avoidance or evasion.

Economic theory predicts that if marginal tax rates increase, there is more incentive to practice either tax avoidance or evasion, a theory that has been born out by the evidence. Again, this makes conceptual sense. Imagine a marginal tax rate of 90% on income, which actually existed in the United States in the 1950s. The incentive to underreport income, or to arrange transactions in a legal manner, to avoid taxes, is incredibly strong at this point. For example, if an extra $10,000 in earnings is taxed at 90%, an individual would be willing to spend almost $9,000 in legal and accounting fees to avoid payment of the $9,000 in taxes. If she pays a tax accountant or attorney $8,000 to arrange a legal device that makes the $10,000 tax-free, she is still $1,000 wealthier than if she simply paid the $9,000 to the IRS.

By implementing a flat tax with a relatively low marginal rate, e.g., 15-20%, the tax system encourages individuals to avoid antisocial behavior such as tax evasion, as well as reducing their incentive to spend resources seeking legal means to avoid taxes.

Supply-side advocates thus feel that with lower marginal rates, not only will economic activity increase, but a higher percentage of income will now be reported since the incentive to avoid or evade taxes has diminished. In effect, this behavior will increase both taxable income and tax revenues at any given rate of economic income. Whether it will be sufficient to generate enough tax revenues to offset lower tax rates is an empirical question that will have to be answered at a later date. Certainly the possibility is there, if it is combined with other tax base enhancements, e.g., eliminating certain income exclusions and current deductions.

Is the Flat Tax a Fair Tax?

A Look at Progressivity. Perhaps no issue concerning the flat tax is debated more heavily than the proposition that the flat tax is "unfair" to poor and middle-income Americans, that it is a redistribution of wealth and income to the rich. This belief centers around the notion that any tax reform that eliminates progressive marginal tax rates is, by definition, one that increases the maldistribution of income and wealth.

While this supposition seems, on the surface, to be self-evident, it is not necessarily true. The imposition of a flat tax does not have to lead to a redistribution to upper-income groups. A reform of the entire tax system, i.e., eliminating deductions, exclusions, and other "loopholes for the rich" can actually redistribute income to lower-income groups, even with an elimination of the progressive marginal tax rates. Before exploring this hypothesis, it is worthwhile to point out that a flat tax can be a progressive tax itself.

A progressive tax can be defined as one that causes the taxpayer's average tax rate to increase as the taxpayer's income increases. Notice that progressivity is considered a function of the average tax rate, and not the marginal tax rate, which in a flat-tax system would naturally be constant. Under a flat tax, if the taxpayer is presented with a certain amount of income that is automatically exempt from tax, i.e., a standard deduction or exemption, a flat tax can yield a progressive tax structure. Consider Table 1, which presents data for a family of four at various income levels. Under a hypothetical flat-tax system the family will file a joint tax return and face a flat tax of 20%. The family is allowed an exemption of $5,000 per person, however, so that the first $20,000 of income is not subject to taxation. Furthermore, assume all deductions have been repealed from tax law, so that only the exemption is allowed. The last column reflects a ratio of the total tax liability to total income, the average tax rate. As can be seen, this ratio actually increases at higher amounts of income. Mathematically, this increase is due to the fact that the first $20,000 is not subject to taxation. Table 1 shows that as income increases, the average tax rate increases as well, meaning that higher-income groups pay a greater fraction of their income in taxes than do lower-income groups. A flat tax, as long as it exempts a de minimis amount of income, will yield a tax structure that is mathematically progressive. It is only fair to point out, of course, that although a flat tax can be progressive, it is usually less progressive than the traditional tax structure with its progressive marginal tax rates. Mathematically, of course, this is because the average tax rate can never exceed the flat rate. The flat rate itself places an upper limit on the mathematical value of the average rate. In Table 1 for example, the average rate approaches 20%, the flat rate, but by definition it cannot exceed it. Contrast this with the present tax structure in the U.S. where the marginal rate currently approximates 40%, and, in the past, has been between 70 and 90%. Obviously, the higher the maximum marginal rate, the higher the avenge tax rate can be, and the higher the amount of progressivity in the system. To make the adoption of the flat tax politically acceptable, the rate will probably have to be closer to 25%, combined with a large exemption amount for each taxpayer.

TABLE3

FLATTAX

Exclusions&Average

Income(Y)DeductionsTaxableIncomeTax(T)TaxRate

L$20,000$20,000$-0-$-0-0.00%

M60,00020,00040,00010,00016.67%

U125,00020,000105,00026,25021.00%

L=LowM=MiddleU=Upper

TABLE4

AFTERTAXDISPOSABLEINCOME(Y-T)

BeforeFlatTaxAfterFlatTaxIncrease

(Decrease)

L$17,750$20,000$2,250

M48,00050,0002,000

U103,00098,750(4,250)

L=LowM=MiddleU=Upper

The foregoing analysis, however, does not lead to the conclusion that a flat tax will redistribute income to lower economic groups, or vice versa. Indeed, the flat tax says nothing at all on this matter. The effects of a flat tax on the distribution of income will depend on the nature of the tax system before the flat tax is enacted, as well as the actual design of the flat tax structure. This lather structure would include not only the flat tax rate itself, but the decision of just what will comprise taxable income.

A View on the Distribution of Income. What will the flat tax do to the distribution of income in any society? That can only be determined once a flat-tax system is put in place and the evidence accumulates. No prima facie case can be made that the institution of a flat-tax system will create more income inequality, or less for that matter. This conclusion can be shown by example. Table 2 presents a tax structure (before implementation of a flat tax) with three representative taxpayers, one (L) from the "low-income" group, another, (M) from a "middle-income" group, and yet another, (U) from a "high income" group.

The last column depicts the avenge tax rate as a function of economic income (Y). It is the true measure of progressivity under any tax system, as it measures taxes paid against an economic income before any deductions, exclusions, and other tax preferences. Under this scenario, the average tax paid by the upper income taxpayer (U) is less than the middle taxpayer (M). This is not a mere mathematical exercise. The reason for the almost regressive nature of the tax in Table two is due to the fact that the benefits of deductions, such as, home mortgage interest, charitable deductions, and income exclusions, e.g., interest on state and local bonds, is heavily weighted toward high-income groups. In other words, high income groups presently claim a disproportionate share of these tax benefits. This leads to a much lower taxable income vis-a-vis economic income, with a resulting trend in avenge tax rates, as shown in Table 2. The results of Table 2 come closer to describing the actual situation in the U.S. than does the statutory tax-rate schedule, which is a progressive system applied to taxable income, an amount that can be significantly below actual economic income.

Now assume that a flat-tax system is inaugurated, with a flat tax of 25% of all income, after an exemption of $20,000. All other exclusions and deductions are eliminated. Table 3 shows the resulting tax liabilities, and corresponding average tax rates in the last column.

Table 3 depicts a flat tax that, by eliminating so many of the tax preferences of upper-income groups, yields more actual progressivity than the more ostensibly progressive tax used in Table Two. Moreover, this increased progressivity is accomplished in a revenue-neutral manner, i.e., tax revenues remain constant at $36,250.

The effects on the distribution of income are shown in Table 4, which shows after-tax income (Y-T) from Tables 2 and 3. Table 4 shows the implementation of the flat tax has led to a redistribution of income from the upper economic group to the lower and middle groups. This transfer was accomplished by a combination of the high exemption amount ($20,000) with the elimination of the exclusions and deductions, which previously benefitted the upper economic group disproportionately.

Of course, Tables 2 through 4 do nothing more than prove a flat tax is not automatically going to cause a more unequal distribution of income. It neither proves nor disproves that distribution of income will necessarily become more equal. Obviously, by changing the assumptions in Tables 2 through 4 we could just as easily see that income was redistributed toward the upper economic group.

The Verdict of Posterity

The 104th Congress faces a revolutionary task if the flat tax is to be seriously considered as the latest version of tax reform. The projected effects on economic behavior can only be presented with an educated guess. The actual effects of the tax, and its popularity, will have to wait for the verdict of posterity.

James A. Fellows, PhD, CPA, is the Florida Progress Professor of Accounting at the University of South Florida, St. Petersburg. He received the Max Block distinguished article award for his article "Consumption Taxes: A View of Future Tax Reform in America" appearing in the April 1994 issue of The CPA Journal.