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Commentaries
Tax Reform
Savings,
Retirement and Social Security Reform
Contributing
Members Commentaries
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Kemp Commission Report: The Good, The Less
Good, and the ...
Tax Notes
January 29, 1996
By Ernest S. Christian
Ernest S. Christian was the deputy assistant secretary (tax
policy) of the Treasury Department in the early 1970s. He
is the author of a soon-to-be published book, The American
Tax Revolution: Seeking a Higher Order of Integrity and Competence
in Government.
The Kemp Commission report represents a significant step forward
in the long march toward replacing the current federal income
tax with a new tax structure that is simple, economically
rational and, therefore, consonant with the national interest.
The report is also to be commended for highlighting the moral
and ethical issues that are involved when, as at present,
government uses the tax system to penalize saving, ration
resources and regulate behavior, and in the process constrains
our liberty and reduces our living standards to a degree that
goes far beyond the amount of tax we pay. The incipient American
tax revolution is about more than rational economics and the
arcanities of tax accounting.
Many readers may have expected the report either to lay out
the detailed operational structure of a new tax system of
the commission's own making or to embrace one of the alternative
tax structures already out in the public arena. That it did
not do so, but, instead, stuck mostly to core principles that
are important to nearly all the major alternative tax structures,
is a large part of the reason the report is likely to have
good consequences. It is hard to argue with the basic proposition
of a neutral and, therefore, fair tax system that leaves to
us the choice of how to conduct our personal and financial
affairs.
Moreover, although the commission did stray somewhat into
the area of tax architecture and recommend a single-rate tax
system, it did so only in a generic sense, in recognition
of the fact that any of the several already available alternative
tax structures can have a flat tax rate. Therefore, it moved
beyond rigid adherence to the confining structure of the Hall-Rabushka
("H-R") construct which has for so long been associated
with a single-rate system that it had almost become definitional.(1)
For proponents of a single-rate system (which I am not), this
apparent new flexibility opens up greater opportunities for
success. For one thing, they are free of the H-R limitation
that mandates that wage income be included in the tax base
at the individual level, but that interest, dividends, gains,
and other returns to capital be excluded from the tax base
at the individual level. Thus, if they wish, single-rate proponents
can uniformly include both capital income and labor income
in the individual tax base and, in both cases, allow a deduction
for the amount of personal saving. When withdrawn from savings,
all previously deducted amounts and earnings thereon would
be taxed. Like a front-end IRA, this tax-deferral approach
to eliminating the tax bias against saving is more likely
to be understood by the American people and to be enacted
into law. Only economists readily understand and accede to
the tax-exemption approach mandated by the H-R construct.
No longer being foreclosed by the H-R construct from having
border tax adjustments for imports and exports, single-rate
proponents can, if they wish, now implement the commission's
recommendation that the new tax system be "territorial"
in its application and have a more realistic expectation that
the territorial rule would be enacted into law. Some advocates
may advance a rationale for territoriality on a stand-alone
basis, but it is not realistic to think that a territorial
rule would actually be enacted unless accompanied by border
tax adjustments such as are found in the USA tax and related
alternative tax proposals.(2) The reasons are fairly
obvious. Under a territorial system, U.S. companies that manufacture
abroad for sale in foreign markets would pay no U.S. tax,
and that is a correct result, but, absent a parallel export
adjustment, companies that manufacture in the U.S. for export
sale into those same foreign markets would be taxed. Absent
an import tax, U.S. companies that manufacture abroad for
sale back into the U.S. market would pay no U.S. tax, whereas
companies that manufacture in the U.S. for sale in the U.S.
would be taxed. Border tax adjustments and territoriality
each have additional and separate merits of their own, but
the combination of both is almost certain to be necessary
for either to be enacted.
If the commission's report is as flexible as it appears to
be insofar as concerns the structure of the new tax system,
many good features are now available under a single-rate system,
just the same as they have always been available under various
multiple-rate systems that were never constrained by the H-R
construct in the first place. All of the alternative tax structures,
whether single-rate or multiple-rate, relieve the American
people of the burdens of tax complexity and tax bias against
saving.
The question then becomes, why the single rate? The case for
lower marginal rates is impeccable, and proponents of a single
rate often argue their case as if single and lower were synonymous,
but, in fact, they are not. Further, as a practical matter,
there is no such thing as a single-rate tax and the commission
has not proposed one. Instead, like H.R. 2060, the commission
recommends a "generous" level of tax-free income,
which is the equivalent of a zero-rate bracket. Under H.R.
2060, for example, the exemptions are $31,000 for a family
with two children and $41,000 for a family with four children,
but these are probably only opening gambits and are likely
to increase substantially as the 20 percent single rate in
H.R. 2060 is increased to 25 percent or more to avoid major
revenue losses. To point out that there are two rates, zero
and 25 percent, may sound like hair-splitting, but the existence
of the large zero bracket goes to the heart of the single-rate
system and explains why it has consequences that, in my opinion,
the commission did not fully come to grips with.
First, go back to the issue of lower marginal rates. It is
obvious that a single-rate of 25 percent is lower than the
rates of primary application under current law (28, 31, 36,
and 39.6 percent). It is, however, also obvious that under
a multiple-rate system, where large exemptions are not necessary,
marginal rates could be reduced more than under a single-rate
system where large exemptions are necessary. For example,
a new three-rate system of 10, 15, and 20 percent with only
a small amount of income exempt from tax, compared to a new
one-rate system of 25 percent with a large amount of income
exempt from tax. It is a truism that the higher the level
of exempt income, the higher will be the single rate and the
higher the single rate, the greater the exemption level. Thus,
at any given revenue yield, a single-rate tax does not necessarily
achieve a lower marginal rate than a multiple-rate system.
The opposite may be true.
Next, consider the pure, stand-alone argument for a single-rate
tax. It is the classic case for a proportional tax where Mr.
A's tax ($25,000) is the same percentage of his income ($100,000)
as Mr. B's tax ($12,500) is of his income ($50,000). The idea
that Mr. A should not be penalized for being more productive
than Mr. B is an appealing principle, but the generous exemptions
inherent in the commission's recommendation for a single-rate
have already compromised this principle greatly and created
a graduated tax. With a $41,000 exemption in both cases, Mr.
A would pay a $14,750 tax (0.25 ($100,000 $41,000)), which
is 14.75 percent of his income, whereas Mr. B would pay a
$2,250 tax (0.25 ($50,000 $41,000)), which is 4.5 percent
of his income. On the other hand, it is unlikely that even
these generous exemptions would make the single-rate system
sufficiently "progressive" to satisfy critics to
whom steep progressivity, equal to or greater than under present
law, is an article of faith. Thus, the single-rate system
departs from proportionality without neutralizing powerful
political forces that, if they do not defeat tax restructuring
altogether, are likely to either force a compromise on bedrock
matters such as the savings deduction or to push the tax-exempt
level under the single-rate system even higher.
Now, think about the single-rate system from a civics standpoint,
and consider the problem that no one seems to talk very much
about but that ought to be of the most fundamental concern
to everyone without regard to ideology or political persuasion.
Even at the levels currently contemplated, the exemptions
will create a large class of taxless citizens who can vote
for government and receive benefits from government, but who
bear no part of the cost of government. If not immediately,
certainly in the longer run as the tax exemption inevitably
creeps farther up the income scale and the number of taxless
voters increases accordingly, we face the clear danger of
having created an overwhelming majority of voters who impose
ever greater taxes on a minority of voters who pay all the
tax at ever higher rates. It is one thing to have a modest
zero bracket for the poor that is an innocuous ancillary to
a multiple-rate system where everyone else pays some tax at
some rate, no matter how low. It is quite another thing to
make tax-exempt status, in and of itself, one of the defining
elements of a new tax system and to extend that status on
up into the middle class that includes nearly everyone.
Therefore, I would hope that those who follow the lead of
the Kemp Commission would be as flexible on the single vs.
multiple rate issue. They should consider a lower and flatter
rate schedule with fewer rates and narrower brackets than
under current law. A single rate tends to cause more problems
than it solves.
FOOTNOTES:
1. Hall, Robert E. and Alvin Rabushka. The Flat Tax. 2d ed.
Stanford: Hoover Institution Press, 1995, reprinted in Tax
Notes, Special Supplement, Aug. 4, 1995.
2. USA Tax Act of 1995, as introduced in S. 722 on April 25,
1995, by Sen. Sam Nunn, D-Ga., and Sen. Pete Domenici, R-N.M.;
Christian, Ernest S., and George J. Schutzer. "USA Tax
System -- Description and Explanation of the Unlimited Savings
Allowance Income Tax System," Tax Notes, Mar. 10, 1995,
pp. 1481-1575.
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