Flat Tax Proposals: An Introduction to Recent Legislation

November 1, 1998 02:19 PM | | Bookmark and Share

CTJ, November 1, 1998

The “flat tax” was first proposed by two Stanford economists, Robert Hall and Alvin Rabushka, in their 1983 book “Low Tax, Simple Tax, Flat Tax.” The Hall-Rabushka plan, on which the Armey-Shelby bill is based, would replace the current personal income and corporate income tax structure with a two-level tax designed to tax all income exactly once, and at the same rate (in H-R’s version, 19 percent). A number of so-called “flat tax” plans have been proposed by various prominent Republicans to replace the current federal personal income tax and the corporate income tax. The prototype proposal was put forward by House Majority Leader Richard Armey (R-Tex.), and has been sketchily drafted into actual legislation sponsored by Armey and Sen. Richard Shelby (R-Ala.) Introduced as legislation in 1994 and reintroduced in 1995, the Armey-Shelby bill was last revised in March of 1997.


The Armey plan

    Among the key elements of the Armey plan are:

  • Individuals would report only wages and pensions on their individual tax forms. Small business owners would pay themselves a salary so they could file an individual tax form (along with a business tax form) to take advantage of the proposed exemptions from the wage tax.
  • Income from interest, dividends and capital gains would not be reported on any form.
  • All individual itemized deductions and credits would be eliminated. Thus, there would be no deductions for mortgage interest, state and local taxes, charitable contributions or extraordinary medical expenses; no credit for child-care expenses; and no earned-income tax credit for low- and moderate-income working families.
  • Most adult taxpayers would be allowed a personal exemption of $11,000 each (two exemptions for couples), except that unmarried parents would get a $14,400 exemption each. There would be an additional deduction of $5,000 per child.
  • The flat tax would also apply (without exemptions) to employer-paid fringe benefits, defined to include employer-paid health insurance, certain other fringe benefits and the social security taxes (7.65% of wages up to $63,700) that employers pay on their employees’ behalf. The new fringe benefits tax would be collected from all employers, including state and local governments and non-profit organizations. There is general agreement that its burden would fall on workers in the form of reduced benefits and/or cash wages.
  • Businesses would file tax forms similar to the current forms, except that (a) all capital investments and inventory purchases would be deductible immediately, rather than depreciated or deducted when goods are sold; (b) business income from dividends and capital gains would not be reported; (c) interest income would not be included in income and interest expenses would not be deductible; and (d) outlays for tickets to sporting events, country club memberships, skyboxes, business meals, etc. would be 100% deductible, rather than only 50% deductible (or completely non-deductible) as under current law.
  • The federal estate tax would be repealed.
  • There would be no transition rules from the old system to the new one. Thus, for example, businesses would lose unused depreciation deductions on previous purchases of machinery and buildings.
  • Rep. Armey proposes a 20% tax rate in 1997 and 1998, dropping to 17% starting in 1999.
  • According to both Armey and the Treasury Department, at the proposed 20% rate and assuming no transition rules and no changes in taxpayer behavior to avoid the new tax, Armey’s plan would lose at least $30 billion a year in tax revenues. At Armey’s promised 17% rate, Treasury says the plan would add $138 billion to the annual budget deficit (in 1996 dollars).

According to the Treasury Department, at what Treasury says is a break even rate of 20.82% (or for that matter, at Armey’s proposed 20% rate), the Armey plan would increase taxes sharply on all income groups except those earning more than $200,000 a year. (Others believe that the break-even rate would have to be considerably higher than Treasury finds.)


Malcolm S. Forbes, Jr.

    Malcolm S. Forbes, Jr. has proposed a flat tax plan similar to Armey’s except that:

  • Forbes’s exemptions from the wage tax portion of the plan would be considerably larger than under the Armey plan: $13,000 per taxpayer plus $5,000 per child.
  • The tax rate under the Forbes plan would be 17% immediately.
  • Recently, Forbes has indicated that he may retain the earned-income tax credit (he gave different stories to Time and Fortune).

Based on Treasury’s analyses of the Armey plan, Forbes’s proposal would appear to entail a revenue shortfall of between $180 and $210 billion a year (in 1996 dollars). Others believe the revenue losses to be much larger..


The Kemp Commission

    The Kemp Commission endorsed an Armey-style flat tax, but with a number of amendments:

  • Itemized deductions, for mortgage interest, charitable donations and, apparently, state and local taxes would be retained.
  • Employer-paid social security taxes would not be subject to the flat tax as a “fringe benefit.” In addition, workers would deduct their share of social security taxes from their taxable wage income on their individual tax return.
  • The Commission called for “transition rules” to “protect” profits generated from existing investments. That would apparently entail allowing unused depreciation write-offs, perhaps some interest deductions, and many other deductions.
  • TThe Commission called for exempting multinational corporations from tax on their tax-haven activities—and probably on most of their domestic activities, as well.
  • The Commission did not specify a tax rate or wage-tax exemptions, but called for a rate “as low as possible” and for “generous” exemptions.

Based on Treasury’s analysis of the Armey plan, the Kemp proposal would appear to entail an increase in the budget deficit in excess of $300 billion a year, or a tax rate in excess of 30%.


Sen. Phil Gramm (R-Tex.)

    Sen. Phil Gramm (R-Tex.) has proposed a very sketchy flat tax plan, with several notable differences from the Armey proposal:

  • Individuals would still report capital gains on their tax forms, but the portion of capital gains subject to tax would be reduced, by indexing the basis of capital assets for inflation.
  • Businesses would continue to depreciate capital investments, rather than write them off immediately, but depreciation deductions would be increased from the already generous write-offs allowed under current law.
  • While not spelled out in detail, individuals would apparently continue to report dividends on their tax forms, but companies would apparently get a deduction for dividends paid.
  • Itemized deductions for mortgage interest and charitable donations would be retained.
  • The standard deduction would be $11,000 per taxpayer, plus $5,000 per child–about the same as under the Armey plan.
  • The treatment of interest is undefined. It may be similar to the Armey plan, which takes interest income and deductions entirely out of the tax system. Or it may retain current law’s treatment of interest income and expenses.
  • The treatment of employee fringe benefits (including employer-paid social security taxes) is not specified. But it is implied that most fringe benefits would be taxed.
  • There is no explanation of what would happen to existing tax credits, including the earned-income tax credit.
  • The flat tax rate would be 16%.

Not enough details have been provided by Sen. Gramm to understand his plan fully, but its revenue cost almost certainly exceeds $200 billion annually, and may exceed $300 billion a year.

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