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No. 85 February 7, 1996

WHY LIBERALS SHOULD SUPPORT THE FLAT TAX

Daniel J. Mitchell McKenna Senior Fellow in Political Economy The flat tax continues to gain support across the country as more and more Americans realize that the existing tax code cannot be fixed and should be replaced by a fair and simple tax code. Polls show that workers, investors, savers, entrepreneurs, farmers, small business owners, and the elderly are among the groups of Americans drawn to the proposal because they feel they will pay less in taxes, benefit from a faster growing economy, or simply avoid the hassle of today's mind-numbing; tax code. There is one group, however, which should support the flat tax but has yet to do so: liberals. Con- sider the following eight features and consequences of a flat tax which one would expect to appeal specifically to this group: 0 The key philosophical principle of the flat tax is equality. All taxpayers play by the same rules, no matter how wealthy they are. 0 Lower rates result in the rich shouldering more of the tax burden. This happened in the 1920s, the 1960s, and the 1980s. 0 Deductions disproportionately benefit the wealthy and others able to exploit loopholes. Eliminating them with a flat tax allows for a lower rate for those with lower incomes. 0 Radically simplifying the code with a flat tax will help end the corrupting effect 'of tax lob- byists and prevent politicians from exploiting the tax system to generate campaign contributions. 0 Because of a generous family-based allowance, the poor are shielded from the income tax burden. A family of four pays no income tax on their first $33,000. 0 The flat tax will boost wages and income for lower-income and middle-income workers by eliminating the double, triple, and sometimes quadruple taxation of capital. 0 A pro-growth tax system. will reduce the budget deficit by increasing the tax base and reduc- ing demands for government spending. 0 Lower-income and middle-income taxpayers will enjoy a more financially secure retire- ment if they are not forced to pay a double tax on their savings.

A Brief Description of the Flat Tax The most notable feature of a flat tax is that all income is taxed, but only once. Amother major feature is "neutrality," the term economists use when referring to a tax system which applies the same tax regardless of the source of income or how that income is spent. The third major feature is simplicity-for example, the two postcards which would replace the current system's more than 600 forms if the Armey-Shelby flat tax is enacted.

Tax Forms on a Postcard: The Armey-Shelby Flat Tax

Form I Individual Wage Tax 1998

History illustrates that a flat tax will generate immense benefits for Americans of all backgrounds and incomes. 1 Honest liberals-those who are genuinely concerned about helping the less fortunate and who favor eliminating special advantages for the rich and powerful-should be among the strongest supporters of sweeping tax reform. There are some on the left, however, who oppose the flat tax in the belief that some short-term political advantage can be gained from fomenting class warfare-even if the ultimate victims are those who have the most to gain from a more rapidly growing economy.

LIGHT REASONS FOR UBERALS TO SUPPORT A FLAT TAX

1. A flat tax promotes equality. Liberals often say they are fighting for equality. No other word better describes the flat tax, whose key principle is that the law should apply equally to all taxpayers and all income. More spe- cifically, supporters of the flat tax believe all taxpayers should play by the same rules and that gov- ernment should not grant special prefer- ences or impose spe- cial penalties based Tax Bill Rises As Income Rises: All Taxpayers Treated Equally on how income is earned or spent. $180.000 011 Taxes Paid Under a 17% Flat Tax Equality under the $160,000 law means a tax system with just one rate I for all levels of in- $120,01V come. Anything else explicitly allows the $80,000 government to discriminate among tax- $40.000 payers and ultimately $20,000 is self-defeating. .411111111 'A1111111 'A1111111 'A11111111 I" Chart 1 shows how $10.000 $25.000 $SO,000 $100,000 $200,000 $500,000 $1,W0,000 the principle of equal- Taxable Income ity applies to taxpay- Scum: HerftW cAdatiom ers with different I @ - - 1. @, 07. taxable incomes. Under a system that treats citizens equally, a taxpayer with twice as much taxable income as his neighbor pays twice as much in taxes.

2. The rich pay more. Liberals often equate a fair tax system with one that results in the rich paying more. If so, the flat tax is the answer to their prayers. Why? While the flat tax is designed to treat all taxpayers equally, history strongly suggests that one effect of moving to a flat tax is that the share of the income tax burden borne by the rich actually will increase. America has had three major episodes of tax rate re- duction-in the 1920s, 1960s, and 1980s. In each case, lower tax rates removed incentives to hide income, shelter income, reduce earnings, and transfer money overseas. The result: Upper-income taxpayers were willing to earn and report more taxable income, and the amount of tax they paid in- creased. The evidence speaks for itself. V In the 1920s, tax rates were reduced from a high of 73 percent to 25 percent between 1921 and 1926. Did the rich get a free ride? Hardly: The share of the tax burden paid by those mak- ing more than $50,000-a great deal of monv back then-rose dramatically, climbing from 44.2 percent in 1921 to 78.4 percent in 1928. V In the 1960s, the Kennedy tax cuts lowered the top rate from 91 percent to 70 percent. The re- sult: Tax collections from those making over $50,000 per year climbed by 57 percent between 1963 and 1966, while tax collec- tions from those Rich Pay Greater Share of Income Tax earning below Burden After Reagan Tax Cuts $50,000 rose 11 60% Sham of ToW Income Taxes Paid percent. As a re- sult, the rich saw their portion of the income tax burden climb from 11.6 per cent to 27.5 cent to 15.1 per- cent.3 20 - _17.6%_In the 1980s, 10 Ronald Reagan reduced the top rate from 70 per- Top 1% Top 10% Top 1% Top 10% cent in 1980 to Source. Interndl Revenue SeMce. 1981 1988 28 percent in 1988. The share of income taxes paid by the top 10 percent of earners pmped significantly, climbing from 48 percent in 1981 to 57 percent in 1988 (see Chart 2).

3. Deductions help the rich. Liberals presumably do not favor laws that confer special advantages on those with more income. Thus, the elimination of all loopholes, preferences, credits, exclusions, subsidies, and deductions un- der the flat tax should be particularly attractive to them. As Chart 3 illustrates, the three best-known deductions offer almost no benefit to the poor and middle class. Upper-income and wealthy taxpay- ers, by contrast, benefit immensely.

4. A flat tax ends special-interest tax lobbying. There are 12,609 special interests officially registered to lobby in Washington, and the tax code is one of their chief targets. 5 Former Members of Congress, former legislative staff members, consult- ing firm employees, and law firm partners are among those who can earn up to $500 an hour wield- ing influence in the tax-writing committees of Congress. It is precisely this process that has caused America's tax system, Chart 3 z which began in 1913 with one simple form, Tax Deductions Offer Little Relief to Poor and Middle Class to turn into a mon- strosity encompassing more than 600 forms in which even the sim- $IBD.OW plest-the 1040EZ- $160.0w is accompanied by 33 $14%OW $12MOW pages of fine-print in- $IW.000 structions. $W,000 - A-= Benefit ff wn State and $60.01" - Tax Deduction While lobbyists are $40.OW - Averap Bmefit from Charitable very well compen- $211WO Contributions Deduction sated for their efforts Averap Benefit from Home Income, M, Mortpp Interest Deduction (and not all of them Income Upper Rich $I%ODD- $40.000- Irmwne $4rage Get the Most Contributions ... ... Including PAC Dollars contribution levels for members of the $MOW - - - - - - - - - $00.01V House tax-writing --------- -- ------- committee compared - - - $4W.OW $6KOW with the average for other House members. $5ROW - - - $350AID This is one reason --- $31KOW why the House Ways $4KOW and Means and Sen- $2M.OW ate Finance Commit- tees are considered ways a Odwr Ways a Oftr Means House Means House the plum assignments Members Members Members Members for new Members of Congress. Source: Federal Election Commission.

S. The poor pay no tax. The only loophole in the flat tax is the one that protects the poor. Under the Armey-Shelby pro- posal (H.R. 2060, S. 1050), a family of four does not pay the 17 percent rate until its annual income reaches $33,300. This personal allowance, which is indexed to inflation to prevent bracket creep, is considerably above the poverty level and will ensure that even the low rate of a flat tax is not an im- pediment to those trying to climb the economic ladder. As Chart 5 illustrates, the personal allowance also has the effect of making the tax system progres- sive. The tax rate on a family of four with $30,000 of income would be zero compared to an effec- tive rate of 2.8 percent for a family with $40,000 of income and 5.7 percent for a family with earnings of $50,000. The effective rate continues to rise with income, reaching 9.5 percent on $75,000 of income, 11.3 per- z cent on $ 100,000 of income, No Tax on Poor, Rising Effective Rate on Rich and 14.2 percent for a family with income of $200,OW. For Maw Tax Rate 20% X the well-to-do, the effective rate approaches 17 percent, 16 as families with $500,000 of income pay 15.9 percent and 14 a millionaire's household -12 would pay'16.4 percent. 10 6. A flat tax promotes : higher wages. 4 Considerable discussion 1111 111 P pop IP has been devoted to the I I IdP plight of the middle class. 4P While some assertions am Amum-n-me from Wages false (for example, middle- Soume: HeftV cWculations. (For a Fandly of Four) class incomes have not fallen wK-'_fflw"a"@ .. ... ...... over the last 20 years), there is no question that earnings could and should be rising at a faster rate. Fortunately, there is widespread agreement among all economists that the way to increase incomes is to make workers more productive by giving them more and better tools with which to produce. As liberal economist Paul Samuelson has written:

What happens to the wage rate now that each person works with more capital goods? Because each worker has more capital to work with, his or her marginal product rises. Tberefore, the competitive real wage rises as workers become worth more to capitalists and meet with spirited bidding up of their market wage rates. 6

Or consider the views of the White House. In the 1994 Economic Report of the President, the Ad- ministration noted that:

The reasons for wanting to raise the investment share of the GDP [gross domestic product] are straightforward: Workers are more productive when they are equipped with more and better capital, more productive workers earn higher real wages, and higher real wages are the mainspring of higher living standards. Few economic propositions are better supported than these-or more important.

History shows a very close relationship between worker income and productivity, indicating the importance of capital formation. Since the flat tax eliminates the multiple taxation of capital in- come, levels of savings and investment will climb, worker productivity will increase, and wages Will rise.

7. Budget deficits are reduced. Another desirable feature of the flat tax, at least for liberals, is that government revenues will rise. As discussed earlier, the United States has had three major periods of tax rate reduction-the 1920s, 1960s, and 1980s. In addition to the fact that the rich paid a greater share of the tax burden and the economy boomed, these reductions resulted in dramatic increases in tax revenues. 3C In the 1920s,, the top tax rate was slashed from 73 percent in 1921 to 25 percent by 1926. Because of improved incentives to work, save, and invest, income tax revenues increased substantially, rising from $719 million in 1921 to nearly $1.2 billion in 1928, an increase of more than 61 percent during a period of virtually no inflation. The Wbite House today would do well to heed the words of then Treasury Secretary Andrew Mellon, who wrote that "The history of taxation shows that taxes which are inherently excessive are not paid. The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business and invest it in tax-exempt securities or to find other lawful methods of avoiding the realization of taxable income. The result is that the sources of taxation are drying up; wealth is failing to carry its share of the tax burden; and capital is being diverted into chan- nels which yield neither revenue to the Government nor proflt to the people."8 3C In the 1960s, President John F. Kennedy proposed a series of tax rate reductions that re- sulted in legislation which reduced the maximum rate from 91 percent in 1963 to 70 percent by 1965. Just as happened in the 1920s, tax revenues again grew significantly, rising by more than 16 per- Oart 6 cent between 1963 and 1966.9 Lower Tax Rates Work: Revenues As President Ken- Grew Faster Under Kennedy and Reagan nedy remarked in Averdge Annual Change in ReW Income Tax Revenues 1962, "an economy - - - - - - - -4.79% - - - - - - - - - - - - - - - - - - - - - hampered by restric- 5% five tax rates will never produce 4 enough revenues to ------- --------------------- balance our budget 3 - - - - - - - - - - - - - - - - 12% just as it will never 2 1.53% 1.34% produce enough jobs ------- or enough profits.... 1 0.01% In short, it is a para- doxical truth that tax 1953- 1962- 1969- 1981- 1990- rates are too high to- 1%1 1969 1976 1989 1995 day and tax revenues Now: 1977-1980 excluded the to bracicet creep, Source: Budget Orthe U.1 GDmnffmt Hiswricaf Tables are too low and the soundest way to 10 raise the revenues in the long run is to cut the rates now."

31C In the 1980s, President Ronald Reagan presided over two major pieces of tax legislation which together reduced the top tax rate from 70 percent in 1980 to 28 percent by 1988. As supporters predicted, the tax cuts triggered the longest peacetime expansion of the economy in the nation's history. Critics charge, however, that Reagan's program caused big deficits. These accusations may resonate politically in some quarters, but they are false. Reagan's crit- ics conveniently forget that the first tax rate reductions, in 1981 and 1982, were offset by bracket creep and previously legislated payroll tax increases. Once the economy received an un- ambiguous tax cut, beginning in January 1983, income tax revenues climbed dramatically, in- creasing by more than 54 percent (28 percent after adjusting for inflation) by 1989.

8. Americans will have a more secure retirement America's Social Security system is in deep trouble. The bipartisan entitlement commission esti- mates the system's unfunded liability (the differences between how much is promised and how much will 'Charti-7 .. ... ..... .... be available) -------------- - ------ --- . . . ........ at a stagger- ing $7.3 tril- Nest Eggs Generated by $1,,000 Annual Private Savings: lion. With Flat Tax 'vs. Current law the baby boom gen- eration ap- $450,000 urrent Dollars proaching retirement, $4W.000 Total 50-Year Savings ----------------- the Social $350,000 Current Tax Code: $212,061 Private Savings Security Ad- With Flat Tax $406,529 With Flat Tax ministration $300,000 Gain from Hat Tax $194,468 -------------- -- projects that the system $250,000 will begin to $200,000 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - run a deficit in less than $150,000 15 years. While there $100,000 --------------------- --- --------- Private Savings am ways to $50,000 With Current avert this up- Tax System coming ca- ....... tastrophe 5 10 15 20 25 30 35 40 45 50 (the best op- Years of Savings tion would - be to follow Note: Amount based on $ 1,000 saved per year, with annual rate of return of 7X the Chilean Sourom Heritage calculations. example of W@@M privatization), 12 it is widely expected that lawmakers will be reluctant to address such a politically- charged issue.

This approach, unfortunately, means that the so-called baby boomers will face significant benefit reductions compared with what they are being promised and will be forced to augment their retire- ment income with private savings. The current tax system, however, punishes those who attempt to save and invest by imposing double, tiiple, and even quadruple taxation of savings and investment income. Even if income is "only" double-taxed, the effect on savings is dramatic. Chart 7 shows the difference in the nest eggs of someone who saves $ 1,000 a year under the current system and some- one who saves the same amount in a fiat tax world in which income is taxed just once. As shown, the double tax on interest income imposed by today's code dramatically reduces the amount which can be saved for retirement. By taxing income only once, the flat tax would allow interest earnings to compound, resulting in a nest egg almost 92 percent larger than the same amount of savings would generate under current law.

CONCLUSION

The U.S. tax system ostensibly is designed to make the rich pay more and improve living stand- ards for those with lower incomes. Even a cursory examination of the facts, however, underscores that the biggest victims of a progressive income tax which punishes success are precisely those who are on the bottom rungs of the economic ladder. By achieving the effects outlined above, a flat tax therefore should attract the support of well-meaning people of all ideological persuasions. This is a particularly important test for liberals. They must decide which is more important: main- taining lobbying power in Washington and keeping a tax system that may satisfy an ideological im- pulse to punish success, or adopting a system that ends special-interest corruption and helps boost the living standards of the less fortunate.

What Liberals Say About -the Flat Tax

thorciughly; -le& up -with d': tax: that'.' -is-!not only of'.'.:'. rodue @Corrtp exlty;:. 'Ut - also do w-fir'lght arbitrary. 164mpact. Replacing the system w!th.,-@`,`@L-4ow-rate nincome - Wlih-few, If any, ..exclusions allowed - is an idea that,%@,by promisingefficlency, equity,:,and simplicity, appeals to all parts of the po- .11ticii lspectrum." Washington Post Editorial J 3,1982 une

fall Income above an arbitra e1deal Income 1O.Lk would be a flat percentage o" ry threshold of, say, .$10,000 a year. It -would be simple, quick, and easy. As for fair- ness,. It would be no. less fair than the present tangle of exemptions, deductions, and",&edits that are currently producing not equity but a widespread public cyni- a' d hostility.. The flat tax dsm-... n Is thi':.-obvious remedy@'.., -Wa@hingtdn-Post-Editoriil- April 15, 1992 "I believe what the@country needs .. and what the American people want-is a re- turn to a fair and simple system of taxation. The legislation I am introducing to- day,. the Income ' Ta'x-Simpllflcatlon,,Act of 1982,would eliminate virtually all deductions, credits' :.:.and exclusions'...'Instead offfie current tax rate that ranges .from 12 to would:e@ Ush--a flat rate-tax of 19 percent-on gross In- come, minus basic', business expenses' . Then-Congressman Leon Panetta Current Chief of Staff, Clinton White House April 5, 1982 "R0markab1y,there:Js:a -reform thaf@' le.vesall these objectives [integration, sim- plification, [email protected]."p6or]. -Robieft-:r.-H - Alvin:.': Rabushka' economists at the.: 411 " and P Hoover Institution; have proposed .-An Integrated code that applies a single rate to both.,personal and corporate Income. Their plan wipes away most deductions and exemptions, permitting a low tax rate of 19 percent ... a superb Idea...." New York Times Editorial March 27, 1992 @.@,A &t.;tax...wouId:"::" ara exempt the rich eliminate the::p''' 91tic class ottik4fixers, who, and',the corporations,, from their Wi"share, and also eliminate the pulverizing bu- reaucracy which keeps people In permanent, servile confusion about whether or not they have complied with the law." Christopher Hitchens 7he Nation, December 12, 1994 [The ..-:.flat tax] -@offers'-:something we.-.on the left should always welcome: an oppor- tunity -to think ..about'-fundamental change. The plan has Its flaws, some of them serious. But the intent-to dean the Augean stables of the present tax code, with Its labyrinth of exemptions, exclusions and credits,. producing a revenue loss, at $393. billion, equal ib.-the federal defidt-is entirelyJaudable." "Why.-the Left Should Support the Flat TW' Alexander Cockburn -and Robert Pollin The Wall Street Journal, April 2, 1992