|
Commentaries
Tax Reform
Savings,
Retirement and Social Security Reform
Contributing
Members Commentaries
|
The Tax Restructuring Phenomenon: Analytical
Principles and Political Equation
National Tax Journal
September, 1995
By Ernest S. Christian
INTRODUCTION
There is a high likelihood that the federal income tax of
today will soon be replaced by a new American tax system.1
The long reign of federal income tax has had an enormous impact
on the daily lives and behavior of 250 million Americans.
It is thoroughly embedded in their consciousness. Abandoning
it in favor of a new tax system will be a historic event that
will have far-reaching consequences for generations to come.
As bad and unpopular as the present Internal Revenue Code
is, it will not be an easy task to enact a proper replacement.
It is not hard to construct a tax system that would be both
simpler and better than the present one. It is, however, not
so easy to construct a tax system that the American people
will accept and that will actually be enacted into law. It
is even harder to enact a new American tax system that is
based on core principles of enduring merit that will continue
to serve the nation as political and economic circumstances
change in the future.
The two leading competitors to replace the present income
tax are the Flat Tax and the USA Tax.2 Either would
be vastly superior to the present incumbent. Both are highly
sophisticated in the sense of minimalism. The art of using
the fewest and simplest elements to achieve the greatest effect.
While structurally different, both approaches derive from
the same analytical roots. Both share many of the same goals.
Both have many of the same consequences, most particularly
with respect to simplification and in eliminating the bias
against saving and investment. In fact, the USA Tax is a version
of the Flat Tax and vice versa. By evaluating the similarities
as well as the differences, the purpose here is to put both
in perspective and to speculate about how these two seemingly
separate paths toward tax restructuring may merge into one
(see Figures 1 and 2).
BUSINESS-LEVEL TAXES: PARTICULAR SIMILARITIES AND DIFFERENCES
Both the USA Tax and the Flat Tax would replace the present
corporate income tax with a new form of annual business tax
that includes U.S. sales revenues and deducts amounts paid
to other businesses. Both would eliminate the present distinction
between incorporated and unincorporated businesses, and both
would uniformly apply the business tax to partnerships and
proprietorships, as well as to corporations of all types.
Neither would allow a deduction for dividends paid and neither
would includin income dividends received. Both would disallow
the present law deduction for interest paid and both would
exclude interest received. Both would abandon the depreciation
concept and would, instaed, allow capital purchases to be
expensed (See Table 1).
Up to this point -- except for the tax rate -- the Flat Tax
and the USA Tax at the business level are identical, but there
is more to the story. Businesses also pay compensation to
employees, and it is here that big differences between the
USA Tax and the Flat Tax start to emerge. The Flat Tax allows
a deduction for direct compensation paid to employees. The
USA Tax does not. On the other hand, the USA Tax allows a
business a tax credit for the FICA payroll tax it pays on
employee wages. The Flat Tax does not. Because the USA Tax
allows no deduction for either direct or indirect compensation
to employees, it is border adjustable for exports ant imports.
Because the Flat Tax allows a deduction for direct compensation,
it is not border adjustable for exports and imports. The USA
Tax provides appropriate transitronal rules for business capital
assets and inventory acquired prior to the effective date
of the new tax system. Apparently, the Flat Tax does not,
although it could and may do so when fully drafted and introduced
in legislative form (see Table 2).
At an 11 percent business tax rate, the USA Tax is (designed
to raise about the same aggregate amount of revenue (inclusive
of the employer payroll tax) from the business sector as present
law. If the 11 percent rate rernains constant year-toyear
as the amortization deductions for pre-effective date capital
and tnventory costs decline, the USA Tax will, over time,
moderately increase the aggregate amount of taxes collected
at the business level-especially if the tax on net imports
is attributed entirely to domestic business firms instead
of being attributed in part to the foreign-sited capiital
and labor factors that produced and sold those imports. A
business tax ra!e that gradually declines from roughly 11
percent to roughly 9 percent in the out years would have an
entirely revenue-neutral result at the business level over
time. Because labor services comprise roughly 80 percent of
gross domestic product (GDP), about that same proportion of
business tax revenues under the USA Tax comes from the output
value of labor. The remainder comes from a combination of
net (in excess of cost) returns to capital invested after
the effective date, giross returns to old capital in excess
of transitional amortizatron deductions, and from net Imports.
At a 20 percent tax rate, the Flat Tax could substantially
increase business taxes and the percentage of total tax revenues
that IS collected from the business sector Absent transitional
adjustments, immediately after enactment of the business tax,
revenues will come from gross returns to old capital investment
that will decline year-by-year, net (in excess of cost) returns
to new capital investment, and output value of labor as measured
by indirect compensation.
As is standard in such exercises, the foregoing general
projections of revenue results assume the same levels of future
capital investment and GDP growth as would be the case if
the present income tax continued in effect. Proponents of
the Flat Tax and the USA Tax would expect GDP to grow more
rapidly after the present income tax is replaced. The USA
Tax would, in all cases, continue to collect from the business
sector about the same percentage of the total taxes as under
present law.
THE INDIVIDUAL-LEVEL TAXES: PARTICULAR SIMILARITIES AND
DIFFERENCES
Both the Flat Tax and the USA Tax would replace the present
federal income tax on individuals. Both are designed to eliminate
the bias against income that is saved and both are intended
to be less complex and less intrusive than the present personal
income tax. When viewed in traditional and somewhat superficial
terms of income definition, deductions allowed, rates of tax,
and credits against tax, the USA Tax and the Flat Tax do,
however, present markedly different pictures as shown in Table
3.
The Flat Tax has a single nominal rate for individuals (here
illustrated as 20 percent). Under the rigid constraint imposed
by the basic structure of the Flat Tax, the individual tax
rate must always be exactly equal to the business tax rate.
The USA Tax in 5.722 has three nominal rates that vary somewhat
by filing status as shown in Table 4.
Both the Flat Tax and the USA Tax have family (personal)
exemptions and dependent exemptions that effectively modify
the nominal rate (rates). In the case of the Flat Tax, these
exemptions appear to be as set forth below, although they
may be modified when the Flat Tax is fully articulated in
legislatrve bill form.
Joint return ........................... $26,200
Single filer ............................. $13,100
Head of household ................ $17,200
Per dependent ....................... $5,300
The USA Tax in 5.722 has the following exemptions:
Joint return .................................... $7,400
Single filer ..................................... $4.400
Married/separate ........................... $3,700
Head of household ........................ $5,400
Per filer and dependent ................. $2,550
As evidenced by the fact that they are substantially larger,
the exemptions play a much more significant role under the
Flat Tax. Because the flat exemptions decrease as a percentage
of income as income rises, they are the way by which the Flat
Tax achieves some degree of graduation on an effective rate
basis. However, because only wage income is included and taxed
on the individual tax return, it is only on wage Income that
the tax is graduated.
Assuming a joint return with no children, various effective
rates of tax on wage income are shown in Table 5. (If one
or more $5,300 dependent exemptions were also included, the
effective rates would also vary among taxpayers with the same
wage incomes.)
Thus, despite the nominal flat rate, the Flat Tax is not
a proportionate tax insofar as wage income is concerned and,
in fact, is significantly graduated in the range of income
that includes nearly all wage earners-going from 5 percent
at $35,000 to 18 percent at $262,200. The Flat Tax is flat
only at the bottom end of the income scale (0 percent up to
$26,200 in Table 5) and at the top of the income scale (19
percent, plus a fraction, above $524,000 in Table 5).
Under the theory and construct of the Flat Tax, it is also
flat and proportional on nonwage income such as interest,
dividends, and gains without regard to amount, The graduated
Flat Tax on wage income and the flat Flat Tax on nonwage income
can both been seen in a simple comparison.
Example I: A retired couple whose savings (stock)
has earned a pre-tax dividend of $35,000 would “prepay”
a 20 percent tax at the business level and receive an after-tax
dividend of $28,000. An unretired couple who earned $35,000
of wages would pay tax at an effective rate of 5 percent
and have after- tax income of $33,250 before taking into
account the 7.65 percent FICA payroll tax. After payroll
taxes, this couple would have take-home pay of $30,753.
Although primarily related to graduation versus proportionality
under the Flat Tax, example 1 also helps to illustrate the
“prepayment” concept on the basis of which the Flat
Tax excludes nonwage income from the individual tax return.
The theory is that after paying and deducting wages to employees,
and paying and deducting the cost of its capital equipment,
the corporation had taxable income of $35,000 on which it,
on behalf of the retired couple, paid a 20 percent or $7,000
tax. Example 1 further illustrates that while the 20 percent
nominal rate may be the real rate on dividends and other nonwage
income, the real marginal rate under the Flat Tax on each
additional dollar of wage income is, in most cases, higher
than 20 percent. Because the Flat Tax allows no credit for
the 7.65 percent FICA tax paid by employees, the real marginal
rate on wage income up to $61,500 is 27.65 percent.
As a consequence, the real effective rates of tax on wage
income are also higher than previously illustrated in Table
5 in the case of a joint return. When restated assuming only
the basic exemption of $26,200, the results are in Table 6.
Because the USA Tax allows a credit for the 7.65 percent
FICA payroll tax, its nominal rates (19, 27, and 40 percent
on a joint return in 1996) are inclusive of the payroll tax
and are, therefore, the real marginal rates. A useful comparison
to the Flat Tax is set forth as follows:
A somewhat different comparison can also be made between
the rate (rates) of tax on wage income under the Flat Tax
and the USA Tax. If the FICA payroll tax is ignored (on the
ground that it will continue to be paid in all events), the
additional rate of the Flat Tax on all wage income is 20 percent.
On the other hand, the additional rate of the USA Tax on wage
income up to $61,500 is in each case 7.65 percentage points
less than the applicable nominal rate. The additional rates
(joint return in the case of the USA Tax) are illustrated
as follows:
Although the foregoing comparison of additional rates may
be used to illustrate another way of loioking at the payroll
tax credit allowed by the USA Tax on wage income, the fact
remains that the actual rates on a USA Tax joint return are
19, 27, and 40 percent, and these rates are inclusive of the
payroll tax.
These rates, and the comparable rates for individuals In
other filing status, apply uniformly to nonwage income (such
as dividends and interest) as well as to wage income. Unlike
the Flat Tax, which uses the yield-exemption approach to eliminate
the tax bias against savings, and where, as a conselquence,
the individual tax return only includes wage income, the USA
Tax individual tax return includes both wage income and nonwage
income. At the individual level, both types of income are
taxed exactly at the sarne progressive rates.
Because the USA Tax Includes and taxes at the individual
level earnings on income that has previously been saved and,
therefore, become “capital,” the USA Tax uses the
traditional approach of allowrng a deduction for saving, In
order not to tax both the income tlhat is saved and the earnings
on savings. The Flat Tax allows no deduction for saving because
it uses the yield-exemption approach, which excludes earnings
on savings.
While the familiar deduction approach under the USA Tax
and the less familiar yield-exemption approach both eliminate
the tax bias against saving and although the return on savings
is, all else equal, the same in both cases, the cash flow
results to the saver in the year the saving occurs are not
the same. Ignoring the payroll tax, the different curreht-year
cash flow results are easily seen iin a simple comparison.
Example 2: By working overtime, a two-earner couple
earns an additional $1,000 that is taxable at 20 percent
under the Flat Tax and that comes within either the 19,
27, or 40 percent tax bracket under the USA Tax. They desire
to save $1,000. Under the Flat Tax, which allows no deduction
for savings, they must pay an additional $200 of tax. In
order to save $1,000, they must cut back their current standard
of living by $200. Under the USA Tax, which allows a deduction
for saving, they pay no additional tax and can save the
full $1,000 without reducing their current standard of living.
The USA Tax and the Flat Tax have different aggregate revenue
results, counting the individual taxes and business taxes
together. In total, the USP Tax is revenueneutral relative
to present law and maintains about the same split between
individuals and businesses as under present law.
In contrast, the proponents of the Flat Tax apparently intend
that it reduce aggregate revenues by about $40 billion in
the first year. Some preliminary estimates by the Treasury
have suggested substantially higher revenue losses at a 20
percent rate, but those estimates are disputed. In the absence
of a fully articulated Flat Tax in legislative bill form and
official revenue estimates, the split between individuals
and businesses is unclear, but it would appear that over time
the business share would increase and the individual share
would decrease, relative to present law and relative to the
USA Tax.
The USA Tax is neutral with respect to the distribution
of the tax burden by expanded family income class. As shown
in Table 7, the USA Tax maintains and makes slightly more
“progressive” the present law distribution.
No comparable income class distribution table has been put
out by the proponents of the Flat Tax, and one needs to be
circumspect in making comparisons on this sensitive subject,
but it seems to be the case that the Flat Tax would significantly
redistribute a percentage of the tax burden from upper income
groups to middle and lower middle income groups and, therefore,
by traditional standards, be “regressive” even though
the Flat Tax is somewhat graduated. For example, and stated
somewhat differently, the Treasury has indicated that proposals
along the lines of the Flat Tax would amount to a 7 to 17
percent increase in federal taxes for families with incomes
under $200,000 and a 26 percent decrease in federal taxes
for families with incomes above $200,000. Quibbles about the
precise percentages are not important. These estimates may
be somewhat off the mark but they probably do indicate the
general direction of the shift in tax burden that occurs under
the Flat Tax.
OVERVIEW: STEPPING BACK FOR ANOTHER LOOK
Against the background of long experience with the present
federal income tax, the Flat Tax presents a startling contrastno
deductions instead of many, not even for charity and home
ownership. There are no credits, not even child care. The
Flat Tax uses a single rate that applies to the rich and the
poor alike and everyone in between. Only wage earners file
personal tax returns. There is not even a line on the tax
return for interest and dividends. On the positive side, of
course, there is the idea that the tax return filed by most
Americans might be only the size of a postcard. Furthermore,
relieving the tax bias against saving may be the key to a
much more prosperous future for this generation of Americans
and the next. That is hard to argue with.
Repealing all deductions and having a flat tax rate might
seem fundamental to the Flat Tax and the positive goals it
is intended to achieve. From some perspectives, that may be
true. Many proponents of the Flat Tax would say so. From other
perspectives, there is nothing fundamental about having or
not having a few deductions, or about one instead of two or
more rates of tax. For example, from the perspective of the
highly flexible structure of the USA Tax, the deduction and
rate aspects of the Flat Tax are merely policy choices. They
are important ones in terms of the consequences to affected
persons such as charities and homeowners, but they are choices
nevertheless. The flexible structure of the USA Tax can readily
accommodate either multiple rates or a single flat rate. In
fact, relative to steeply progressive tax rates in the past,
the multiple rates in 5.722 are actually fairly flat. The
USA Tax in 5.722 has only three rates and as a practical matter
has only two rates of major significance. The top rate kicks
in fairly quickly and, as a consequence, the income brackets
to which the two lower rates apply are not very wide. In addition,
judged by historical standards, the higher of these two principal
rates is not all that much greater than the lower (e.g., in
1996, 40 percent compared to 27 percent on a joint return).
Similarly, the flexible structure of the USA Tax could easily
accommodate a policy choice to have no personal deductions
in the traditional sense. In fact, along with the deduction
for personal saving, which is critical, the USA Tax only allows
a few basic deductions. The charitable contribution deduction
is not the source of any appreciable complexity, and certainly
the home mortgage interest deduction is not complex at all.
All anyone has to do is transfer one number from the statement
furnished by the rnortgage lender onto the tax return. In
fact, the Flat Tax, itself, will almost certainly retain the
home mortgage interest deduction for existing mortgages. Otherwise,
many families, especially young couples, would no longer be
able to afford the mortgage payments on houses already purchased
and contractually committed to prior to the enactment of the
Flat Tax. Repealing the home mortgage interest deduction for
new families in the future may have some substantial consequences,
but a simpler tax return with fewer lines will not be one
of them.
Given the fact that the few deductions retained by the USA
Tax are not complicated, and given that having one tax rate
instead of two or three rates has almost nothing to do with
simplification, why then is the Flat Tax so rigid in that
regard and why do its propo ents focus so heavily on these
aspects? There must be some other reason. The same question
can be asked about using the yield-exemption approach to eliminate
the tax bias against saving, instead of the more familiar
and likely more politically palatable deduction approach under
the USA Tax. The Flat Tax appears to totally exclude interest,
dividends, and gains froth tax, and to tax only wage income.
That appearance may be hard to dispel and his rife with possibilities
for both genuine misunderstanding and political demagouery.
In addition, it can be said, with some degree of truth, that
the different current-year cash flow results under the USA
Tax make it more attractive to new savers, whereas the yield-exemption
approach is most attractive to those people dho already have
savings.
The answer to these questions is clear. It is the same answer
that explains why the Flat Tax does not contain explicit bordertax
adjustments for imlports and exports, even though many who
otherwise favor the Flat Tax idea consider these border adjustments
to be an important goal of tax restructuring. All these results
and rigidlties arise directly frpm the bifurcated structure
of the Flat Tax. As shown by the schematics at the begipning
of this paper, both the Flat Tax and the USA Tax are vertically
bifurcated, viz, a tax is imposed at the business level tihen
income is produced and a tax is imqosed at the individual
level when income is received. That Flat Tax, but not the
UISA Tax, is then also horizontally bifurcated, viz., at the
business level only capital IIncome is included and taxed,
and, at the individual level, only labor Income (wages and
salaries) is Included and taxed. In contrast under the construct
of the USA Tax, both labor income and capital income are included
in the tax base at both the business level and the individual
level.
The doubly bifurcated structure of the Flat Tax is highly
rigid and constrains choices. For example, within that structure
a deduction for charitable contributions could only be allowed
against wage income, but if such a deduction is going to be
allowed, it is anomalous for people with only interest and
dividend income not to also get that deduction. Many of them
are most likely to be the largest donors. Further, for example,
the doubly bifurcated structure virtually mandates a flat
rate. If progressive rates were applied, they could only be
applied to wage income. However, in order for the average
rate in a multiple rate system for wage income to produce
the same revenue as a 20 percent flat rate, the top rate on
wage income would be higher than 20 percent and higher than
the 20 percent rate on nonwage income that is implicit in
the prepayment concept of the Flat Tax where capital income
is taxed only at the business level. Similarly, and for the
same reasons, the present construct of the Flat Tax generally
precludes use of the deduction approach to personal saving.
In addition, border tax adjustments at the business level
are precluded because the present construct of the Flat Tax
requires that wage income be deducted at the business level
because it is taxed at the full Flat Tax rate at the individual
level.
ACHIEVING THE MAIN GOALS
The main goal of both the Flat Tax and the USA Tax should
be to serve the national interest by actually enacting into
law a simplified tax system that eliminates the tax bias against
savings and enhances our ability to compete in international
markets.
The main debate will be political, focused on whether the
main goal will be achieved with or without changing the existing
distribution of the tax burden between high-, middle-, and
low-income groups as determined by the very inexact process
and methodology of distributional analysis. That political
debate will alone be enough of a problem without adding additional
political barriers that arise out of the basic structure of
the Flat Tax itself and without using a basic structure that
can achieve the main goal only if the political debate is
resolved in a certain way.
In order to isolate the main goals from the political debate
about progressivity, and to ensure the enactment of a new
American tax system in all events, the proponents of the Flat
Tax should express it within the highly flexible framework
of the USA Tax where labor income and capital income are taxed
at both the business level and the individual level, and where
the border tax adjustments can be made. The busrness-level
taxes would be identical. At the individual level, there would
be the following two, highly workable versions of the Flat
Tax:
1. One with a single rate, no personal deductions (other
than the savings deduction), and no payroll tax credit.
2. Another with two additional rates, a few personal deductions
for charity, home mortgage interest, education, and so on
(plus the savings deduction), and a payroll tax credit.
ORIGINS AND EVOLUTIONARY DEVELOPMENT OF THE FLAT TAX
AND THE USA TAX
There are many intellectual parents. The concepts reflected
in both the Flat Tax and the USA Tax have been written about
by eminent scholars too many to cite. The real origins are,
however, more fundamental and derive from the way the economy
actually works-from the way real goods and services are actually
produced, from the fact that this productive process is the
source of all income, and from the way that individuals actually
receive that income either as employment flows (wages and
salaries as compensation for work) or as financial flows (interest
and dividends, and so on as compensation for the use (of their
capital and, ultimately, a return of that capital). When a
tax is injected Into the economic process by which income
is created, it must be collected either at the point of production
(businesses) or at the point of receipt (individuals). If
the tax is collected at the point of production, it must be
based either on the labor component of production or the capital
component of production, or both. If the tax is collected
at the point of receipt, it must be based either on the employment
flows to Individuals, or the financial flows to individuals,
or both. Therefore, this basic structure and operation of
the economy dictates the structure of any tax-whether it is
called the Flat Tax, the USA Tax, or, generically, “X.”
In fact, David F. Bradford has proposed a variation that he
calls the X-Tax.3
The basic construct of the economy and the range of choices
available to the architect of any tax can also usefully be
depicted in the form of an X.
A potential component of a tax base appears at each of the
four endpoints marking the extremities of the two intersecting
lines in the form of an X, but there is, in a sense, some
duplic:ation. The Employments Flows (4) are a reappearance
at the Individual level of the Labor Component (1) at the
business level, and (4) is equal in amount to (1) less any
tax already collected out of (1) at the business level. Similarly,
the Financial Flows (3) are a reappearance at the individual
level of the Capital Component (2) at the business level,
and (3) is equal iq amount to (2) less any tax already colllected
out of (2) at the business level.
The foregoing construct is rigid and any tax system must
be built around it. The only flexibility in the depign of
a tax is in choosing to impose tax at all or only on some
of the four possible points, in choosing to impose tax at
uniform or varled rates on one, more, or all of the potential
components of the tax base, and in choosing to specially define
one, more or all of the potential cpmponents of the tax base.
Even these choices are, however, not open ended. Great care
must be exercised in order to avoid inconsistent treatments
of “likes” and similar anomalies that cause undesirable
economic or political consequences. The administrative consequences
of choices and combinations of choices must also be taken
into account.
Setting aside secondary matters such as the tax rates, and
concentrating on fundamentals, there are four basic constructs
that are highly pertinent to the origins and development of
both the Flat Tax and the USA Tax.
- Basic Construct X-1. Collect all tax at the business level
based on the Labor Component (1) of production and the Capital
Component (2) of production.
- Basic Construct X-2. Collect all tax, in the sarne total
amount, at the individual level based on the Financial Flows
(3) and the Employment Flows (4).
- Basic Construct X-3. Collect the same total amount of
tax, but collect it in part at the business level and in
part at the individual level as follows. Tax the Capital
Component (2) at the business level and tax the Employment
Flows (4) at the individual level.
- Basic Construct X-4. The same as Basic Construct X-3 except
that a partial tax at the business level is collected from
both the Labor Component (1) and the Capital Component (2),
and, at the individual level, a partial tax is collected
from both the Employment Flows (4) and the Financial Flows
(3).
The fundamentals of the Flat Tax are immediately recognizable
in Basic Construct X-3 where there is a double bifurcation,
both as between business and individuals, and as between Employment
Flows and Financial Flows. Similarly, Basic Construct X-4
represents the USA Tax in primal form. The essential ingredients
of a modified business cash flow tax or true tax on business
value added (as distinguished from the VAT form of retail
sales tax) can be found in Basic Construct X-l. Basic Construct
X-2 contains the basic building blocks of a household-only
cash flow tax.
ENDNOTES
1. As of May 1995, nearly all announced presidential candidates
plus the Majority Leader of the Senate (also a presidential
candidate), the Speaker of the House, the Majority Leader
of the House, the Chairman of the Committee on Ways and Means,
the Chairman of the Committee on Finance, and an array of
other leading members of Congress have either introduced legislation
to replace the income tax or have indicated substantial support
for the general idea.
2. The Flat Tax is as generally described by Robert E. Hall
and Alvin Rabushka and leading congressional proponents as
of May 1995 [See Hall and Rabushka (1995)]. When fully drafted
and introduced in legislative form, the basic structure of
the Flat Tax may be modified; either as suggested in this
paper or otherwise. The USA Tax is as contained in 5.722,
which was introduced on April 25, 1995. A prototype for the
USA Tax is explained in Christian and Schutzer (1995).
3 See Bradford (1986).
REFERENCES
Bradford, David F. Untangling the Income Tax. Cambridge,
MA: Harvard University Press, 1986.
Christian, Ernest S. and George 1. Schutzer. “USA Tax
System-Description and Explanation of the Unlimited Savings
Allowance Income Tax System.” Tax Notes 66 No.
11 (March 10, 1995): 1482-1575.
Hall, Robert E. and Alvin Rabushka. The Flat Tax.
2d ed. Stanford: Hoover Institution Press, 1995.
|
