The Obama Administration is looking at the flat tax


Senate Budget Committee Majority Staff Overview of the FY 2010 Budget Conference Agreement

April 29, 2009

111th Congress

OVERVIEW



FY 2010 BUDGET



CONFERENCE AGREEMENT



PREPARED BY: MAJORITY STAFF, SENATE BUDGET COMMITTEE



April 27, 2009


Laying a New Foundation for Nation's Economy


The Budget conference agreement for Fiscal Year 2010 is a fiscally responsible budget plan that addresses the fiscal and economic crises inherited by the Obama Administration and lays a new foundation for our nation's economy. It preserves the major priorities in President Obama's budget with strategic investments in energy, education, and health care - investments needed to restore our crumbling economy and put the country in a position to remain globally competitive. It provides significant middle-class tax relief, directed at families with incomes under $250,000. And it begins to put the country back on a more fiscally responsible path by cutting the federal budget deficit in half by 2012 and by two-thirds by 2014 - bringing the deficit down to three percent of GDP.



Inheriting Fiscal and Economic Crises

President Obama and the Democratic Congress have been handed a colossal mess. We are now in the midst of the worst recession since the Great Depression. We face housing and financial market crises that have wiped out home values and weakened our credit markets. We have lost 3.7 million jobs in the last six months. And we have ongoing wars in Iraq and Afghanistan.

Spending nearly doubled under the prior administration and revenues have now fallen to the lowest level as a share of the economy since 1950. Not surprisingly, we have seen record deficits and a doubling of the national debt over the last eight years. Gross debt rose from $5.8 trillion in 2001 to an estimated $12 trillion in 2009. While that $6.2 trillion includes some debt resulting from the economic recovery package, the additional debt load is directly a function of the collapsed economy - a collapse that occurred under the watch of President Bush.

The economic mess left for the Obama administration has made the budgetary outlook even worse than originally believed. The Congressional Budget Office's re-estimate of the President's budget showed the 10-year deficits would be $2.3 trillion more than originally projected. To keep the deficit on a downward trajectory and meet the President's goal of cutting the deficit in half, the conference agreement makes adjustments to the President's budget proposal, while supporting the President's core priorities.



Restoring Economic Growth

President Obama and the Democratic Congress acted swiftly in February to adopt an economic recovery package to jumpstart the economy, create jobs, and begin laying the foundation for long-term economic growth. The package included investments in infrastructure, energy, education, and health. It provided tax cuts for 95 percent of working Americans. The package strengthened the economy by increasing food stamp and unemployment insurance benefits, which have a strong stimulative effect on the economy. The Obama Administration has also taken steps to address both the housing and financial market crises, which are being coordinated with additional actions by the Federal Reserve and other agencies.



Preserving Major Priorities in Obama Budget

The conference agreement includes President Obama's budget proposals that focus on areas that will lay the foundation for our nation's long-term economic security, including: reducing our dependence on foreign energy; striving for excellence in education; and reforming our health care system.

Energy Independence. It has never been more clear that our nation's economic and national security are directly linked to our energy policy. We must address our dangerous addiction to foreign oil and confront the challenges of global climate change. In the process, we can create new "green collar" jobs that will help our nation's economic recovery. To meet these challenges, the conference agreement builds on the energy initiatives in the economic recovery package with continued investments in alternative and clean energy technology, energy efficiency, and modernization of our energy infrastructure. It includes a deficit-neutral reserve fund that could accommodate initiatives to invest in clean energy or address global climate change, such as that proposed by the President.

Education . The conference agreement also recognizes that education is crucial to our nation's future economic strength. For too long, we have been falling behind our competitors in educating our citizens. The conference agreement responds with investments in education and training programs that will help our economic growth and build a highly skilled workforce to compete in the global marketplace. Increasing access to higher education is central to this effort. This is why the conference agreement assumes a Pell grant level of $5,550 in 2010 and includes a deficit-neutral reserve fund to allow for increases in Pell grants in line with those proposed in President Obama's budget. This will make college more affordable and more accessible for millions of Americans.

Health Reform . The conference agreement recognizes that reforming our nation's health care system is essential to ensuring our long-term fiscal stability and economic strength, in addition to the well-being of our citizenry. Soaring health care costs are the biggest source of the projected explosion in federal debt in our long-term budget outlook. Rapidly rising health costs make it harder for our businesses to compete globally, while putting a tremendous strain on family budgets. The conference agreement follows up on the health investments made in the economic recovery package, and includes, as requested by the President, a reserve fund to allow for a major health reform initiative. This deficit-neutral reserve fund is in keeping with President Obama's commitment to paying for the cost of health reform.



Returning to a Sound Fiscal Course

The conference agreement begins to return the nation to a sound fiscal course by cutting the deficit by more than half by 2012, and by two-thirds by 2014. Under the conference agreement, the deficit will be cut to $620 billion in 2012 and to $523 billion in 2014 - bringing the deficit down to three percent of GDP.

Spending as a share of the economy falls under the conference agreement, with domestic discretionary spending declining from 4.4 percent of GDP in 2010 to 3.4 percent in 2014. In nominal terms, non-defense discretionary funding increases at an average annual rate of 2.9 percent.

The conference agreement retains crucial budget enforcement provisions, such as a strong paygo rule and allowing reconciliation for deficit reduction only.

The conference agreement generates valuable savings by expanding oversight activities in large benefit programs, more aggressively pursuing fraud, and increasing tax compliance and enforcement activities to ensure taxpayer dollars are spent wisely.

The conference agreement also includes a two-year placeholder for the cost of possible disaster relief.



Providing Tax Relief for Middle Class

The conference agreement provides significant middle-class tax relief. In total, the conference agreement cuts taxes by $764 billion over the next five years. This tax relief includes:
 $512 billion to extend middle-class tax cuts, such as the 10 percent bracket, the child tax credit, marriage penalty relief, and education incentives, as well as the other 2001 and 2003 tax cuts extended in the President's budget for taxpayers making under $250,000;

 $214 billion for three years of AMT reform;

 $72 billion to match the President's estate tax reform proposal - which would permanently extend the 2009 level of a $7 million exemption for couples and $3.5 million for individuals;

 $54 billion for two years of extenders; and

 $9 billion for other tax cuts.

The conference agreement includes $97 billion in loophole closers and raisers. The specifics of these proposals will be developed by the Finance and Ways and Means Committees.

The conference agreement allows for the extension of the President's Making Work Pay tax credit beyond 2010 through its deficit-neutral reserve funds. This is consistent with the President's commitment to ensuring the extension of this tax credit is paid for.



Supporting Our Troops and Accounting for War Costs

The conference agreement matches President Obama's core defense budget and the President's request for additional war costs. Unlike Bush administration budgets, which repeatedly left out or understated likely war costs, President Obama's budget includes a far more honest accounting of the likely costs of overseas contingency operations including the wars in Iraq and Afghanistan. The conference agreement follows this approach, which will enhance oversight of war funds and save vital defense resources.



Honoring Our Veterans

The conference agreement honors our veterans by providing a $5.6 billion, 11.7 percent, increase over the 2009 level in veterans' health care and other services. It follows the President's budget in ending the Bush administration's ban on enrolling modest-income veterans for Department of Veterans' Affairs (VA) health care. It provides more funding than 2009 for VA to research and treat mental health, post-traumatic stress disorder, and traumatic brain injury. It also assumes VA's current policy of paying for the treatment of veterans' service-connected conditions and billing private insurance companies only for treatment of non-service-connected conditions.



Addressing Long-Term Fiscal Challenge

While the conference agreement takes important steps in the near-term of cutting the deficit in half by 2012 and by two-thirds by 2014, it is clear that more will be needed to address the long-term fiscal imbalance confronting the nation beyond the five-year budget window. The combination of our retiring baby boom generation, soaring health care costs, and an outdated and inefficient revenue system are projected to explode federal debt over the long-term to an unsustainable level. The economic downturn has only worsened that long-term debt outlook.

As noted above, to begin addressing our soaring health care costs - the biggest source of the projected long-term debt explosion - the conference agreement provides for a major health care reform initiative to be done on a deficit-neutral basis. It will be critical for that effort to follow up on the health care investments made in the recently passed economic recovery package, such as funding for health information technology, prevention and wellness interventions, and comparative effectiveness research. Over time, these investments and other steps can help to bend the cost curve on health care and put our health care accounts back on a sustainable course.

President Obama's Fiscal Responsibility Summit - which occurred within roughly the first month of his administration - initiated an open bipartisan dialogue on ways to address the long-term fiscal challenge. That dialogue will hopefully lead to bipartisan action on this challenge in the near future. The administration has also indicated its seriousness about reforming our nation's tax system by appointing former Federal Reserve Chairman Paul Volcker to lead a task force on tax reform this year.

No matter how successful we are in pulling out of the current economic downturn, our long-term economic security will remain in jeopardy until we address this projected long-term fiscal imbalance.

Congressional Research Service Report for Congress --Flat Tax: An Overview of the Hall-Rabushka Proposal, April 22, 2009

April 29, 2009

111th Congress

Flat Tax: An Overview of the Hall-Rabushka Proposal

James M. Bickley
Specialist in Public Finance

April 22, 2009

Congressional Research Service

7-5700

www.crs.gov

98-529



Summary

The concept of replacing the current U.S. income tax system with a flat rate consumption tax is receiving congressional attention. The term "flat tax" is often associated with a proposal formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover Institution. This report analyzes the idea of replacing the U.S. income tax system with this type of consumption tax. Although the current tax structure is referred to as an income tax, it actually contains elements of both an income and a consumption-based tax. A consumption base is neither inherently superior nor inherently inferior to an income base. On March 30, 2009, Senator Arlen Specter introduced S. 741, Flat Tax Act of 2009, which is modeled after the Hall-Rabushka proposal.

The combined individual and business taxes proposed by H-R can be viewed as a modified valueadded tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension receipts. Part or all of an individual's wage and pension income would be tax-free depending on marital status and number of dependents. The business tax would be a modified subtractionmethod VAT with wages (and salaries) and pension contributions subtracted from the VAT base, in contrast to the usual VAT practice.

The analysis of the flat tax proposal is covered by the following four topics that sometimes overlap: broad economic issues, narrow sectoral economic issues, simplicity, and international comparisons. First , broad economic issues relate to economic effects of the flat tax on the entire economy: equity, efficiency, international trade, price level, interest rates, and revenue. Second , sectoral economic issues deal with specific industries or sectors of the total economy: differential effects on businesses, charitable organizations, housing, financial services, pensions and insurance, health care services, and state and local governments. Third , tax economists, government leaders, and taxpayers are interested in the simplicity of a tax system, and the current income tax system is complex. A positive aspect of the proposed flat tax is the ease with which the individual and corporate tax systems could be integrated. But, the complexity of the current tax code is partially due to attempts to achieve greater equity or to improve economic efficiency, and there are often tradeoffs between simplicity, equity, and efficiency. It can be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax; by the time a consumption tax becomes enacted, it may become complicated. Fourth , there are major distinctions between recent consumption tax proposals for the United States and the current tax systems of other developed nations. Numerous aspects of the H-R flat tax proposal have not been fleshed out and many important policy issues have yet to be analyzed.

This report will be updated as issues develop or legislation is introduced.



Contents

Introduction
Income Versus Consumption Taxation

Types of Consumption Taxes

Retail Sales Tax

Value-Added Tax

Consumed-Income Tax

Hall-Rabushka Flat Tax
Justification

Operation

Individual Wage Tax

Business Tax

Selected Policy Issues
Broad Economic Issues

Equity

Efficiency

International Trade

Price Level

Interest Rates

Revenue

Sectoral Issues

Differential Effects on Businesses

Charitable Organizations

Housing

Financial Services

Pensions and Insurance

Health Care

State and Local Governments

Simplicity

Integration and Measuring Capital Income

Simple Returns and Other Simplicity Issues

International Comparisons

Conclusion



Figures

Figure A-1. Individual Wage Tax

Figure A-2. Business Tax



Appendixes

Appendix. Tax Forms under the Flat Tax



Contacts

Author Contact Information



Introduction

Some Members of Congress have indicated interest in the concept of replacing our current federal income tax system with some form of a consumption tax, including proposals with a flat rate. The term "flat tax" is often associated with a proposal formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover Institution at Stanford University. In 1981, they proposed the replacement of the federal individual income tax and the federal corporate income tax with a flat rate consumption tax. In early 1995, Hall and Rabushka published the second edition of their book titled simply The Flat Tax . 1 In 2005, Dr. Hall provided some additional insights into his flat tax proposal. 2 This report explains and evaluates the Hall-Rabushka proposal for three reasons. First, on March 30, 2009, Senator Arlen Specter introduced S. 741, Flat Tax Act of 2009, which is modeled after the Hall-Rabushka proposal. Second, the Hall-Rabushka proposal concerns many issues relevant to other tax reform proposals. Third, unlike a number of other reform plans, the H-R proposal has sufficient detail to permit examination, although numerous aspects of the proposal have yet to be fleshed out. 3

The report begins with discussions of congressional interest in the flat tax, the concept of an income tax base versus a consumption tax base, and three types of broad-based consumption taxes. Next, the justification and operation of the proposed H-R flat tax are explained. Lastly, selected policy issues are examined, including both broad and narrow economic issues, simplicity, and international comparisons. The broad economic issues relate to the economic effects of the flat tax on the entire economy, for example, equity, efficiency, and international trade. The more narrow economic issues deal with specific industries or sectors of the total economy, such as housing or charitable organizations.

In the 111 th Congress (as of April 22, 2009), four bills have been introduced that include proposals for fundamental tax reform; that is, basic changes in what is taxed, in tax rates, in how taxes are collected, or some combination of these reforms. Two of these bills are companion bills and would replace the current income tax system with a national retail sales tax. The third bill would broaden the income tax base ("simplified taxable income") and reduce marginal tax rates. The fourth bill, as previously indicated, would levy a flat tax based on the H-R proposal as a replacement tax for both the current income taxes and the estate and gift taxes.



Income Versus Consumption Taxation

Although our current tax structure is frequently referred to as an income tax in popular discussions, it actually contains elements of both an income and a consumption-based tax. For example, it excludes some income that goes to savings, such as pension and individual retirement account (IRA) contributions, which is consistent with a tax using a consumption base. Overall, however, the return to new investment is taxed, which is consistent with an income tax.

The easiest way to understand the differences between the income and consumption tax bases is to define and understand the economic concept of income. In its broadest sense, income is a measure of the command over resources that an individual acquires during a given time period. Conceptually, an individual can exercise two options with regard to his income: he can consume it or he can save it. This theoretical relationship between income, consumption, and saving allows a very useful accounting identity to be established; income, by definition, must equal consumption plus saving.

Should the tax base be income or consumption? Is one inherently superior to the other? How do they stack up in terms of simplicity, equity, and efficiency? There appears to be insufficient theoretical or empirical evidence to conclude that a consumption-based tax is inherently superior to an income-based tax or vice versa.



Types of Consumption Taxes

The three general types of consumption-based taxes are: a retail sales tax, a value-added tax (VAT), and a consumed-income tax. 4 A broad-based consumption tax, however formulated, is equal to a tax on wages plus a lump sum tax on old capital in existence at the time the tax is imposed.



Retail Sales Tax

A retail sales tax (RST) is a consumption tax collected only at the retail level by vendors. A RST equals a set percentage of the retail price of taxable goods and services. Retail vendors collect the RST and remit tax revenue to the government.



Value-Added Tax

The H-R flat tax can be considered a modified value-added tax. Hence, an examination of specific aspects of a VAT is particularly important in explaining the operation of the proposed flat tax. 5



Concept of a Value-Added Tax 6

A value-added tax is levied at each stage of production on firms' value added. The value added of a firm is the difference between a firm's sales and a firm's purchases of inputs from other firms. In other words, a firm's value added is simply the amount of value a firm contributes to a good or service by applying its factors of production (land, labor, capital, and entrepreneurial ability). 7

The prevailing procedure is to treat the purchase of capital inputs (plant and equipment) the same way as the purchase of any other input; that is, the purchase price is deducted at the time of purchase. This tax treatment of capital purchases is equivalent to expensing.



Methods of Calculating VAT

Three alternative methods of calculating VAT are the credit method, the subtraction method, and the addition method. Under the credit method , the firm calculates the VAT to be remitted to the government by a two-step process. First, the firm multiplies its sales by the tax rate to calculate VAT collected on sales. Second, the firm credits VAT paid on inputs against VAT collected on sales and remits this difference to the government. Under the credit-invoice method , a type of credit method, the firm is required to show VAT separately on all sales invoices and to calculate the VAT credit on inputs by adding all VAT shown on purchase invoices. Under the subtraction method , the firm calculates its value added by subtracting its cost of taxed inputs from its taxable sales. Next, the firm determines its VAT liability by multiplying its value added by the VAT rate. Under the addition method , the firm calculates its value added by adding all payments for untaxed inputs (e.g., wages and profits). Next, the firm multiplies its value added by the VAT rate to calculate VAT to be remitted to the government. 8



Consumed-Income Tax

A consumed-income tax would have a tax base that includes all sources of income but allows deductions for saving. This base would result in the taxation of only consumption. Taxpayers would deduct contributions to qualified savings accounts (equivalent to individual retirement accounts, with unlimited contributions permitted). All withdrawals from qualified savings accounts would be taxable at the time of withdrawal. Policymakers would have the option of applying a progressive rate structure to the level of consumed income. In contrast to a RST or VAT, each individual would be responsible for calculating his level of consumed income and paying his tax obligation. 9



Hall-Rabushka Flat Tax



Justification

Hall and Rabushka argue that replacing the existing individual income tax with their flat tax would be a major improvement for three reasons: the flat tax would be much simpler than the current income tax, consumption is a better tax base than income, and the flat tax would be much more efficient than the current income tax system.

First , Hall and Rabushka maintain that there is a need for tax simplification. They argue that the complexity of the current federal individual and corporate income tax systems results in excessive administrative and compliance costs. 10

Second , Hall and Rabushka argue that a consumption tax is superior to an income tax because "... individuals would be taxed on what they take out of the economy (when they spend money to consume), not on what they produce (reflected in working and saving)." 11 They claim that
By exempting investment from taxation, consumption taxes encourage investment and discourage spending. (Over time, each act of investment traces back to an act of saving; thus exempting investment from the tax base amounts to exempting saving.) 12

Third , Hall and Rabushka assert that the current tax system results in an inefficient use of resources. They argue that their flat tax proposal would improve the allocation of resources, which would result in higher economic growth and a rise in living standards.

As will be discussed in more detail, some economists dispute H-R's justifications for a flat tax.



Operation

With a standard VAT, firms collect the tax and remit it to the Government. The H-R flat tax is essentially a modified VAT . The H-R flat tax proposal breaks the VAT into two parts: "an individual wage tax" (to collect tax on wages and pension receipts) and "a business tax" (to collect tax on old capital). 13 The principal effects of the H-R flat tax are like those of a standard VAT. In 1995, Hall and Rabushka published the second (and most current) edition of their book about their flat tax proposal. Hence, their analysis utilizes data from 1991, and their presentation of their proposal is for 1995. From 1991 through 2008 and from 1995 through 2008, according to the Bureau of Labor Statistics, the consumer price index rose 58.08% and 41.27%, respectively. 14 Thus, these rises in the price level should be considered in examining the data in their proposal.

The proposed bill in the 111 th Congress based on the H-R concept includes much higher "personal allowances" for taxpayers and dependences than proposed by H-R for 1995, as described in the subsequent sections of this report. As previously indicated, on March 30, 2009, Senator Arlen Specter introduced S. 741, the Flat Tax Act of 2009. This bill's individual wage tax includes a "basic standard deductions" (equivalent to H-R's "personal allowances") of $25,000 for a joint return, $25,000 for a surviving spouse, $18,750 for a head of household, $12,500 for a married taxpayer filing separately, and $12,500 for a single taxpayer. The Flat Tax Act of 2009 also includes a deduction for each dependent of the taxpayer of $6,250. The dollar value of these deductions are indexed for inflation.



Individual Wage Tax

The individual wage tax would be imposed on wages (and salaries) and pension receipts at a 19% rate. Part or all of an individual's wage and pension income would be tax free depending on marital status and number of dependents. For tax year 1995, the personal allowance for a married couple filing jointly would be $16,500 and the personal allowance for each dependent would be $4,500. Thus, for a family of four (husband, wife, and two dependents) the first $25,500 in wage and pension income would not be taxed. All current income tax deductions would be eliminated including those for charitable contributions, mortgage interest, and state and local income and property taxes. An individual's Social Security contributions would not be deductible and his Social Security benefits would not be taxable. The current partial taxation of benefits for higherincome taxpayers would be eliminated. 15 H-R estimate that 80% of taxpayers do not run businesses, and consequently, they would only have to file this simple individual wage-tax form. 16



Business Tax

The business tax would be a modified subtraction method VAT at a 19% rate with wages (and salaries) and pension contributions subtracted from the VAT base. (Under a standard subtractionmethod VAT, a firm would not subtract its wages and pension contributions when calculating its tax base.)

Except for pension contributions, all fringe benefits would be included in the firm's tax base. "The employer's [Social Security] contributions would be treated like other fringe benefits --it would not be deductible from the business tax." 17

All purchases of plant and equipment would be immediately expensed (deducted from gross income). There would be no depreciation expenses for previously purchased plant and equipment. There would be no recovery of cost of goods sold (existing inventory) --a firm selling off inventory would not be able to deduct the cost.

A standard subtraction-method VAT would rebate negative amounts of VAT that might occur when a firm's subtractions exceed its revenue --for example, when a firm invests a large amount but has low sales. Under the H-R business tax, any negative tax would be carried forward to the next year with interest paid on the carry-forward.

Self-employed individuals would usually find it advantageous to file both a business tax return and an individual tax return. From their business operations, they would be able to pay themselves a salary, and thus use the personal allowance to exclude some income from taxation. For example, a married couple operating a business could exclude up to $16,500 in salary from taxation.

All owners of rental real estate would be required to file the business tax return. 18 "The purchase price [of rental property] would be deducted at the time of purchase, and the sale price would be taxed at the time of sale." 19



Selected Policy Issues

The H-R tax presented policy issues that fall into four broad categories: broad economic issues, more narrow sectoral economic issues, simplicity and international comparisons.



Broad Economic Issues

Broad economic issues concern the economic effects of the flat tax on the entire national economy. There are six: equity, efficiency, international trade, price level, interest rates, and revenue.



Equity

Policymakers are concerned about the distributional (or equity) effects of taxation; the proposed flat tax is no exception. A tax change has both a horizontal effect and a vertical effect on equity. Horizontal equity concerns the equal treatment of households with the same ability-to-pay. Vertical equity concerns the tax treatment of households with different abilities-to-pay. The most common measure of ability-to-pay is some measure of income, but some prefer a measure of consumption. Tax incidence usually is measured by using a one-year time period although a lifetime period sometimes is considered. 20



Hall-Rabushka Analysis

Hall and Rabushka acknowledged that their proposed flat tax would cause some taxpayers to pay more taxes and some to pay less in the short run, but in the long run, they claimed that a higher rate of economic growth would cause many taxpayers who initially lost to eventually benefit. 21

For 1991, H-R compared taxes on adjusted gross income consisting only of wage income with a hypothetical tax payments from the wage tax for a typical family (a married couple with 1.1 dependents). H-R concluded that currently the typical family with wage income below about $10,000 does not pay significant individual income tax on that income and would pay no flat tax on wages. The typical family with wage income between $10,000 and $30,000 would pay less under the flat wage tax than they currently pay in income tax. But, the flat wage tax would be slightly higher on average for the typical family in the $30,000 to $90,000 range. The typical family with wage income over $100,000 would pay less under the flat wage tax. 22

But, H-R pointed out that there are limits to the preceding comparison.
The individual wage tax component of the flat tax, however, will raise less revenue than the personal income tax, and, correspondingly, the business tax component of the flat tax will raise more revenue than the existing corporate income tax. 23

The comparison above only covered wage income. For 1991, the average tax rate on wage income under the flat tax would have been only 8.5% because personal allowances would have excluded one-half of wage income from taxation. 24 In contrast, for 1991, the average tax rate on wage income under the individual income tax was 10.4%. 25

Because of the substantial data problems in attempting to measure the incidence of the flat tax compared to the current individual tax, H-R conclude that
We can't tell if there are any income groups who would pay significantly higher taxes, including the wage taxes they would pay directly and the business taxes they would pay indirectly. This group could not include the poor, who receive almost no business income. 26



U.S. Treasury's Analysis

The U.S. Treasury analyzed the incidence of the proposed Armey-Shelby flat tax, which is based on the Hall-Rabushka concept. 27 The Treasury used a broad-based income concept called Family Economic Income (FEI): a concept that includes, for example, employer-provided fringe benefits and the imputed rent on owner-occupied housing. 28 In order for the Armey-Shelby flat tax to be revenue neutral, the U.S. Treasury maintained that a 20.8 percentage rate would have to be levied. The Treasury calculated the incidence of the change to the flat tax on eight different FEI classes. The Treasury concluded that only the highest income class (FEI of $200,000 or more) would pay less in taxes; other classes would pay more. 29 These distributional effects are partially the result of assumptions concerning the incidence of different components of the flat tax. 30



Gravelle's Analysis

Jane G. Gravelle, a Senior Specialist at CRS, emphasized that if a flat tax is passed, and the Federal Reserve did not change the money supply, then the flat tax would be shifted backwards onto owners of equities (old capital) and wage earners. Gravelle also assesses the lifetime and intergenerational incidence of a consumption tax:
The consumption tax tends to shift the burden to holders of old assets, who are likely to be old. The young tend to benefit if they are likely to do a significant amount of lifetime saving, but the young who do little lifetime saving can be made worse off if tax rates are much higher. Those who do little lifetime saving are likely to be the lifetime poor. At the same time, very wealthy individuals with accumulated assets who consistently pass on wealth across the generations may also avoid the tax and may find their tax burdens lowered indefinitely compared to an income tax. Thus, these generational shifts probably contribute to a less progressive tax. 31

Gravelle's analysis raises the issue of horizontal equity since the flat tax would shift the tax burden from the young to the old. It should also be noted that old capital and thus the old will bear a consumption tax regardless of whether the money supply is altered. Accommodating the tax with a price change will cause the burden to be shared by debt claimants --the cost of physical assets would rise resulting in the net of tax sales proceeds being fixed, but the purchasing power would fall and cause proceeds of both debt and equity holders to effectively bear the tax. If price is not changed, and there is no reason to believe it will be under the flat tax except for a minor revision to reflect the cost of fringe benefits, prices of goods will not rise, and the net of tax sales proceeds would fall by the amount of this tax. This tax will fall solely on equity since the value of outstanding debt is fixed. This tax could be very high for heavily leveraged assets that are recently purchased.

In summary, the current income tax system is progressive but the incidence of the H-R flat tax is uncertain. There is no general agreement concerning the vertical incidence of the proposed shift to the H-R flat tax --whether it would reduce or increase tax progressivity.



Efficiency

In public finance, the more neutral is a tax, the less the tax affects private economic decisions; and, consequently, the more efficient is the operation of the economy.

For households, two out of three major decisions would not be altered by this hypothetical consumption tax. First, this consumption tax would not alter choices among goods because all would be taxed at the same rate. Thus, relative prices would not change. In contrast, other taxes, such as excise taxes, which change relative prices, would distort household consumer choices by encouraging the substitution of untaxed goods for taxed goods. A hypothetical income tax on all income would be neutral in this respect.

Second, a flat tax does not affect the relative prices of present and future consumption. In contrast, the individual income tax affects the relative prices of present and future consumption because the income tax is levied on income which is saved, and then the returns on saving are taxed.

A household's work-leisure decision, however, would be affected by a flat tax or any other tax on either consumption or income. Since leisure would not be taxed, any tax increase would fall on the returns to work. Hence, under either an consumption or an income tax the price of leisure is reduced relative to the consumption an individual could finance with an extra hour of labor.

For a firm, the flat tax would not affect decisions concerning method of financing (debt or equity), choice among inputs, type of business organization (corporation, partnership, or sole proprietorship), and goods to produce. Other types of taxes may affect one or more of these types of decisions.

Because consumption is a smaller base than income, to raise the same amount of tax revenue, a consumption-based tax would require a larger increase in marginal tax rates than would an income tax. Distortions caused by these higher marginal rates could offset (or even exceed) other neutral advantages of the flat tax. Hence, whether an income tax system or a flat tax system is more efficient is unknown. 32



Savings

H-R argue that taxing only consumption rather than all income (saving and consumption) would increase the savings rate. H-R predict that in consequence, a flat tax would cause an increase in the capital stock that would increase gross domestic product (GDP) by 2% to 4% within seven years. 33

National saving consists of government saving, business saving, and personal saving. 34 Any tax increase or reduction in federal expenditures would be expected to reduce government dissaving, and consequently, raise national saving. 35 Thus, whether a flat tax increases or reduces revenue is relevant to its effect on national saving.

Another issue concerns the personal savings rate. But there is no conclusive theoretical or empirical evidence that a consumption tax will increase the savings rate and consequently the level of national savings. 36 According to economic theory, a rise in the after tax rate of return would have two conflicting effects. First , each dollar saved today results in the possibility of a higher amount of consumption in the future. This relative increase in the return from saving causes a household to want to substitute saving for consumption out of current income (substitution effect). Second , a higher rate of return on savings raises a household's income; consequently, the household has to save less to accumulate some target amount of savings in the future (income effect). Thus, this income effect encourages households to have higher current consumption and lower current saving. These two conflicting effects mean that economic theory cannot determine the effects of the rate of return on the savings rate.

Highly stylized life-cycle models show that a flat tax would cause a substantial increase in the savings rate, but these models are extremely controversial. 37 These stylized models add a third effect for a consumption tax. Unlike a mere exclusion of tax on the return, the consumption tax allows an up-front deduction for savings, but requires the payment of tax on both principal and return when consumption occurs in the future. Thus, individuals need to save today to pay these taxes due in the future; they can do so while still consuming more today because of their large tax cuts. Thus, while the young may consume some part of their tax cut, the old reduce their consumption by much more, and the overall effect is to increase aggregate savings in the economy. But these stylized life-cycle models rely on somewhat idealized assumptions, such as all taxpayers having perfect information and certainty that the tax system will not change during their lifetimes. If these idealized assumptions are relaxed, then the results are not conclusive that switching from an income tax to consumption tax would increase savings. 38



Work Effort

H-R maintain that their flat tax would reduce the marginal tax rate of most taxpayers. Taxpayers would have a marginal rate of either zero or 19%. H-R estimate that as a result, their flat tax would increase total hours of work in the U.S. economy by 4%. 39 Hence, "total annual output of goods and services in the U.S. economy would rise by about 3%, or almost $200 billion." 40

Whether a revenue neutral flat tax increases or reduces a household's marginal tax rate, it would have conflicting effects on the number of hours worked by that household. Households with a lower marginal tax rate would have an incentive to substitute work for leisure because of the relative rise in the value of work to leisure (substitution effect). Conversely, a household would have an incentive to reduce its hours worked because it needs to work fewer hours in order to achieve a given standard of living (income effect). For households with a higher marginal rate, the substitution effect would tend to decrease work effort but the income effect would tend to increase work effort. A household's marginal rate affects its substitution effect but its average tax rate affects its income effect. Thus, as assessed by current economic theory, a flat tax could decrease, increase, or not change a household's hours worked. In any case, many economists believe that, on the basis of theoretical considerations and empirical studies, the current income tax system does not significantly affect the aggregate number of hours worked.



Investment

H-R maintain that taxing all investment at a uniform rate would improve the efficient allocation of capital and raise the return on capital investment. The current system does have major distortions in the taxation of capital income such as the double taxation of corporate income, the preference for debt financing, and the favorable treatment of owner occupied housing. In addition, H-R cite an analysis by Alan J. Auerbach, an economics professor at the University of California at Berkeley, that the current tax system has a bias in investment toward equipment and away from structures, and consequently, eliminating this bias would raise gross national product (GNP) by 0.8%. 41

H-R argue that currently tax-favored entities such as pension funds prefer investing in low risk activities often secured by readily marketable assets. H-R maintain that their flat tax would eliminate tax preferences including the interest deduction, and therefore, redirect investment into innovative enterprises based on new ideas. 42

But in response to all the efficiency arguments, it can be argued that it is not appropriate to compare a perfect consumption tax in concept with an imperfect real income tax system. There are steps that might improve the present system that stop short of a flat tax --for example, the current individual income tax and the corporate income tax could be integrated or, current tax preferences could be eliminated or curtailed, thus producing a more neutral income tax.



Growth

According to H-R,
Tax reform along the lines of our simple tax will influence the American economy profoundly: Improved incentives for work, entrepreneurial activity, and capital formation will substantially raise national output and the standard of living. 43

H-R estimate that their flat tax would raise annual output by 6% after the economy has fully adjusted to the tax change which would be a period of seven years. 44 This 6% increase in output would consist of a 3% rise due to increased work effort and a 3% rise due to a combination of added capital formation and better entrepreneurial incentives. 45

But H-R provide no model on which their estimate is based. As discussed in preceding sections, many tax economists do not believe that changes in the tax code can significantly affect either the savings rate or the work-leisure decision. Also, most capital accumulation models have a much longer period to return to steady state than seven years. For example, to increase net output by 3% through increased savings, the capital stock would have to increase by about 12%. Since the capital stock tends to grow at the growth rate of the economy --say 2% a year --the savings rate would have to nearly double for that seven-year period to increase the capital stock by that much.



International Trade

The Hall-Rabushka flat tax is not border adjustable. That is, unlike a credit-invoice method valueadded tax, for example, the H-R tax is not levied on all imports and rebated on all exports. Popular perception holds that this lack of border adjustability would increase this nation's balance-of-trade deficit. Economic theory, however, holds that border tax adjustments have little current effect on the balance-of-trade because the balance-of-trade is, in part, a function of international capital flows. Any changes in the product prices of traded goods and services brought about by border tax adjustments would usually be offset by exchange rate adjustments. 46



Price Level

The H-R flat tax proposal would not require any change in the price level. Wage income and pension receipts are taxed at the individual level while capital income minus net investment and fringe benefits (except pension contributions) are taxed at the firm level. Thus, the flat tax proposal would not require a change in the price level to prevent an economic contraction (unlike a VAT), except for the small effects due to taxing fringe benefits. 47



Interest Rates

Most economists believe that the H-R flat tax (or a similar proposal) would lower interest rates, but a minority of economists maintain that interest rates could rise. 48



Revenue

Policymakers are concerned about three aspects of a tax's revenue yield: adequacy, stability, and countercyclical effects.



Adequacy

The H-R flat tax would replace the personal income and corporate income taxes. This drastic change raises the issue of the adequacy of the revenue yield. Revenue forecasting is, at best, a necessary but inexact government undertaking. Revenue forecasts of income tax revenues often have been too low or too high. Thus, there is a justifiable concern that in an abrupt transition to a flat tax the initial revenue yield could be far too low or too high compared with the amount forecasted. Any drastic unexpected decline or rise in tax revenue could be destabilizing to the economy.



Stability

Consumption is more stable than personal income since people attempt to maintain their living standards during recessions (save less) and save more during periods of prosperity. Business income (and hence business income taxes) usually rises dramatically during an economic expansion, but usually declines precipitously during a recession. Because the flat tax excludes business income, it would result in more stable total tax revenues over the business cycle than an income tax system.



Countercyclical Effects

The current income tax system is an automatic stabilizer; that is, without any discretionary action by policymakers, the income tax system tends to maintain aggregate demand in the economy (by reducing tax revenues) during recessions and curtailing aggregate demand (by increasing tax revenue) during booms. The countercyclical effects of a flat tax would be much weaker since revenues would be more stable over the business cycle. But the importance of these tax effects are diminished in the modern world of highly mobile capital.



Sectoral Issues

As previously indicated, more narrow economic issues deal with specific industries or sectors of the total economy. Seven are discussed in the subsequent sections: differential effects on businesses, charitable organizations, housing, financial services, pensions and insurance, health care, and state and local governments.



Differential Effects on Businesses

As noted previously, if there is no price accommodation, the general burden of the H-R flat tax will fall on wages and old capital. At a more discrete level, the business tax proposed by H-R would have differential effects among corporations depending on their financial characteristics and their industry. 49 Many large, established, slow-growing corporations with large depreciation expenses and high interest expenses would be collect much higher business taxes than they pay under the current corporate income tax. These corporations would be unable to deduct depreciation for plant and equipment purchased prior to the enactment of the flat tax. Also, they would be unable to deduct interest costs on their outstanding debt. Furthermore, existing inventory costs would not be recovered. Firms selling off inventory or selling assets would face a large tax burden especially if debt financed. 50

In contrast, young, fast growing corporations with little debt and low depreciation expenses would collect less under the business tax than they pay under the current corporate income tax. All new investment in plant and equipment would be immediately expensed. Because of their low level of outstanding debt, the loss of the interest expense would be of little concern to these corporations.

H-R use examples to demonstrate that there would be a dramatic change in the amount of taxes collected by different corporations. According to H-R, in 1993, General Motors (GM) paid about $110 million in corporate income taxes. In 1993, GM's interest expense and depreciation outweighed its new investment: GM had interest expenses of $5.7 billion and depreciation deductions for past investment of $9 billion but only about $6 billion in new investment. Thus, under the H-R flat tax, for 1993, H-R estimate that GM would have remitted taxes of $2.72 billion, over 24 times its actual corporate tax liability. 51

In contrast, H-R examined the corporate income tax return of the Intel Corporation. In 1993, Intel paid $1.2 billion in corporate income taxes. Intel had no debt and thus no interest expenses and invested heavily in new plant and equipment. Thus, under the proposed flat tax, Intel would have remitted only $277 million for 1993, less than one-fourth its actual corporate income tax liability. 52

The elimination of depreciation expenses would create a special transitional problem. Managers of a business would be reluctant to purchase plant and equipment in the year before the flat tax would go into effect because they would be able to write off only one year of depreciation. If managers of this business simply waited a year, the entire investment outlay could be written off, that is, expensed. Hence, the approval of the flat tax could result in a sudden decline and then a sharp rise in investment after the flat tax was operational. Furthermore, managers of many existing businesses may consider it "unfair" to change the rules and deny depreciation expenses for past investment.

H-R offer, as an option, allowing managers of businesses to continue depreciating investments made before the introduction of the flat tax. This would require, however, a higher tax rate to offset the resulting loss in revenue, and there would be a reduction in economic efficiency. 53 But, the higher tax rate would be temporary, since depreciation expenses would diminish over time. 54 Furthermore, the flat tax would be more complicated if depreciation was permitted.

Also, the flat tax would eliminate tax preferences available to specific industries. For instance, oil producers currently receive a tax break on "intangibles" which allows them to write off most of their drilling costs. In addition, oil independents use the percentage depletion allowance to write off a percentage of their receipts. Thus, the oil producing companies probably would collect more under the business tax than they currently pay in corporate income taxes.

Hence, the financial structure and tax preferences of different industries would result in differential shifts in tax liabilities between the current corporate income tax and the proposed business tax.



Charitable Organizations

Currently, taxpayers who itemize can deduct the value of contributions they make to qualifying charitable organizations. 55 The H-R flat tax would eliminate this charitable deduction which would likely cause charitable donations to decline. But H-R claim that the decline in charitable contributions would be small. 56 Their claim, however, is controversial. 57 For example, Professor Charles T. Clotfelter and Richard L. Schmalbeck estimated that the Armey flat tax proposal (which is based on the H-R proposal) would significantly reduce charitable contributions. 58



Housing

The flat tax would eliminate the mortgage interest deduction and the property tax deduction. 59 These deductions are controversial. Supporters argue that they promote home ownership and home improvement, which have positive spillover effects. Opponents argue that these preferences have little effect on the rate of home ownership and primarily benefit higher income families. 60 Furthermore, critics claim that these preferences have led to an overinvestment in housing. For example, the Competitive Policy Council, a bipartisan panel established by Congress, warned that Americans are hurting their competitiveness "by overinvesting in their houses and underinvesting in the kinds of new products and technologies that generate higher wages and salaries." 61

Hall and Rabushka argue that interest rates would decline, and consequently the loss of these tax advantages could be offset by homeowners refinancing their mortgages. H-R predict that their flat tax would reduce interest rates by "at least a fifth." 62 H-R point out that in 1994 interest rates on municipal bonds were about one-sixth less than comparable taxable bonds. But H-R assert that taxable bonds also receive tax preferences; for example, if they are held in pension funds, the tax is deferred on interest income. 63 Hence, H-R assert that "interest rates could easily fall to threequarters of their present levels after tax reform; rates on tax-free securities would then fall a little as well." 64 H-R maintain that their flat tax would encourage new investment which could cause some rise in interest rates, therefore, "as a safe working hypothesis ... [they] assume interest rates [would] fall in the year after tax reform by about a fifth." 65

But their analysis did not incorporate the expanding influence of international movements of capital. Today's capital markets are truly global. Owners of financial capital can quickly transfer their funds among countries in order to maximize their expected returns. Consequently, whether or not the flat tax would lower interest rates is unknown.

Hence, many families with large interest payments and property tax payments might be unable to continue making their mortgage payments. These families might be forced to sell their homes. Furthermore, the sudden elimination of these preferences might cause a sudden drop in the value of the average house. 66 A decline in housing values would be a loss for sellers but a benefit to buyers.

H-R acknowledge that the elimination of interest deductions would result in winners and losers during transition. They state:
If Congress decides that a transition measure to protect interest deductions is needed, we suggest the following. Any borrower may choose to treat interest payments as a tax deduction. If the borrower so chooses, the lender must treat the interest as taxable income. But the borrower's deduction should be only 90% of the actual interest payment, while the lender's taxable income should include 100% of the interest receipts. 67

This transition option would grandfather in existing interest deductions; thus, borrowers would benefit at the expense of lenders. The proposal also would apply to new loans. For the housing industry, many homeowners would be protected from the forced sale of their homes, but mortgage lenders would suffer financially. Furthermore, this transition proposal would add complexity to the flat tax. It is important to recognize that part of the effect of H-R in discouraging demand for housing arises from the opportunities for a higher return from other investments. 68



Financial Services

The primary service of financial institutions (banks, savings & loan associations, credit unions, etc.) is intermediation; that is, aggregating funds of depositors and providing credit to borrowers by making loans or purchasing debt instruments. Core services provided by financial institutions are not identified by explicit fees. Instead these services are implicit in the interest spread between the rates paid depositors and the rates charged on loans to borrowers or received on purchased debt instruments. For an insurance company, the value-added is approximately equal to premiums received from policyholders for risk protection. But life insurance often includes a savings component, which is difficult to separate from risk protection. 69

Hall and Rabushka claim that it would be easy to measure the value-added of financial intermediaries and insurance companies. 70 But, developed nations have found that it is so difficult to measure value-added of financial institutions and insurance companies that they generally exempt these businesses from their VATs. 71



Pensions and Insurance

Pensions are favored under current tax law because they are effectively tax exempt (treated on a consumption-tax basis). While firms would still have reasons to provide pensions, proposals that would extend this treatment to all investments would make pensions relatively less attractive, and might discourage their use. If some individuals now save more through a pension plan than they would on their own, overall savings could be adversely affected as well. 72 Currently tax-favored insurance policies (e.g., whole life insurance) would also become relatively less attractive. 73



Health Care

Under current law, there are numerous tax preferences for health care spending. The most significant is that "an individual is entitled to an itemized deduction for expenses paid during the tax year for the medical care of the individual, the individual's spouse, or a dependent to the extent that such expenses exceed 7.5% of adjusted gross income." 74 Under the H-R flat tax, all tax preferences for health care would be eliminated including the itemized deduction.

Under the H-R flat tax, firms would have less of an incentive to provide compensation in the form of health care for employees. Furthermore, individuals with catastrophic health care needs (in excess of 7.5% of adjusted gross income) would not receive a tax preference.

Hence, the H-R flat tax would tend to reduce the rate of growth in the demand for health care which in turn would lower the rate of inflation of health care services from what would otherwise occur.



State and Local Governments

State and local governments would be affected by the proposed H-R flat tax. These effects fall into three categories: municipal bonds, deductibility of state and local taxes, and states' tax structures. 75



Municipal Bonds

Currently, interest on municipal (state and local) bonds is exempt from federal corporate and individual income taxes. This tax exemption has raised the market value of municipal bonds. As noted above, the effect of the H-R proposal on interest rates is disputed. But, if interest rates decline only slightly, or not at all, the H-R proposal would cause outstanding municipal bonds to decline sharply in value because of the elimination of the tax exemption.

The mere possibility of passage of the Armey flat tax plan, which was similar to the H-R proposal, reduced the value of outstanding municipal bonds at that time. 76 Many managers of municipal bond funds blamed discussions about flat taxes for the negative cash flow which "plagued municipal bond funds throughout 1995." 77 Thus, if the H-R flat tax becomes law, individuals owning municipal bonds may experience large capital losses. Furthermore, state and local governments may have to pay higher interest rates on new debt issues because municipal securities would no longer have a tax advantage over other debt issues.

Some economists dispute the wisdom of providing a tax subsidy to municipal bonds. Thus, the flat tax's removal of the subsidy may be beneficial.



Deductibility of State and Local Taxes

Currently, individuals who itemize can deduct most state and local taxes. This is a form of revenue sharing. For example, if a state raises its income tax, individuals who itemize save on their federal income taxes an amount equal to their marginal federal income tax rate multiplied by the increase in their state income tax payments. The H-G flat tax would eliminate this tax preference. This tax preference is particularly valuable to high income individuals in high tax states such as New York. This tax preference has been controversial, and some tax economists have recommended that it be curtailed or eliminated. 78



States' Tax Structures

Since the flat tax is a consumption tax, the federal government would be competing directly with states' sales taxes, their primary revenue source. But most states also levy an income tax which is their second main source of revenue. States with income taxes generally base their tax bases on the federal income tax base, with slight variations. If the federal government replaces its income taxes then the continuation of current state income taxes would impose high compliance costs on individuals and businesses since these taxpayers would have to continue to calculate their income tax liabilities. States would also have high administrative costs. But states probably would react by dropping their taxes on net income and adopting a consumption-based tax that would piggyback on the new federal consumption tax base, thereby retaining the administrative and compliance benefits that flow from conforming to the federal tax base. 79



Simplicity

H-R argue that their flat tax proposal would reduce drastically the current complexity of the U.S. tax system. Tax preferences would be eliminated. Tax integration and simple returns would result from their consumption tax.



Integration and Measuring Capital Income

Since new investment would no longer be taxed, the flat tax would also eliminate problems the current system encounters with measuring capital income: capital gains, attempts to distinguish between real and nominal income, depreciation procedures, and debt versus equity financing. A positive aspect of the proposed flat tax is the ease with which the individual and corporate tax systems could be integrated. Thus, a change that economists have long advocated for its economic efficiency could be accomplished in a simple way.

But it would be possible to levy a flat tax with an income base, simply by retaining depreciation and inventory accounting. The corporate and individual income tax systems could be integrated while retaining an income base --what makes integration simple is the flat rate.



Simple Returns and Other Simplicity Issues

H-R emphasize that, because their flat tax system is simple, the two tax forms "can fit on postcards." 80 The flat tax returns require little information and only a few simple calculations, but critics argue that there are numerous underlying complications.

Six additional issues are relevant to the complexity of the proposed flat rate tax. First , the current income tax system is complex. The federal tax code and the federal tax regulation are lengthy and continue to expand. Many taxpayers spend much time, money, and effort complying with the current income tax system. The complexity of the tax code and the fear of the Internal Revenue Service (IRS) have caused many taxpayers to pay for professional assistance.

For tax year 2000, a microsimulation model developed jointly by IBM and the IRS estimated the amount of time and money that individuals spend on federal tax compliance. 81 The authors found that "in tax year 2000, 125.9 million individual taxpayers experienced a total compliance burden of 3.21 billion hours and $18.8 billion." 82 This translates into an average burden of 25.5 hours and $149 per taxpayer. 83 Furthermore, for tax year 2003, 78.75 million individuals paid for the preparation of their returns. 84

The complexity of the income tax, however, should not be overstated. For example, for tax year 2006, the Internal Revenue Service reported that only 49.12 million returns out of 138.39 million returns were filed by individuals who itemized their deductions." 85 Also, the complexity of the current tax code is partially due to attempts to achieve greater equity or improve economic efficiency, and there are often tradeoffs between simplicity, equity, and efficiency.

Second , complexity may contribute to the gross income "tax gap" --the difference between income taxes owed and the amount voluntarily paid in a timely manner --which the Internal Revenue Service estimated is $350 billion for 2001. 86 In addition, widespread tax avoidance reduces tax revenues which, in turn, necessitates higher tax rates to raise a given amount of revenue. But, enforcement efforts and late payments reduced the gross tax gap by $55 billion for 2001. Furthermore, it can be argued that, in comparison to other developed nations, current U.S. tax compliance is satisfactory. Finally, a tax gap of unknown magnitude would occur under the flat tax.

Third , in comparison to the current income tax, a flat rate does little to reduce complexity because most taxpayers simply look up their tax liability in a table.

Fourth , it can be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax. By the time a consumption tax becomes enacted, it may become complicated, in part, because of lobbying by special interest groups. Furthermore, an initially simple tax may become complicated over time as it is revised.

Fifth , as an alternative to the flat tax, the current income tax system could be simplified by expanding the tax base which would require eliminating tax preferences and reducing marginal rates.

Sixth , the flat tax can, in some instances, be more complicated (rather than simpler) than the tax it replaces. For example, federal government employees and employees of non-profits would have to add to their wage base the imputed value of their fringe benefits. 87 Hence, a separate individual wage tax form would be necessary for these employees. The actual calculation of the imputed value of fringe benefits would be complicated. Another example is that H-R have not discussed tax issues concerning multinational corporations.



International Comparisons

There are three major distinctions between recent consumption tax proposals for the United States and the current tax systems of other developed nations. First , although the United States is the only developed nation without a broad-based consumption tax at the national level, other developed nations adopted broad-based consumption taxes as adjuncts rather than as replacements for their income based taxes. Congressional proposals would replace our current income taxes with consumption taxes, rather than use consumption taxes as adjuncts to our current income based system. Despite what is sometimes claimed, the United States would thus be moving into unchartered waters.

Second , all developed nations with VATs, except Japan, calculate their VATs using the creditinvoice method. The H-R flat tax proposal, however, would use the subtraction method of calculation for the business tax. The General Agreement on Tariffs and Trade (GATT Agreement) requires that for a consumption tax (including a VAT) to be rebated on exports, the tax must be levied on an item by item basis. Furthermore, the business tax is not levied on wage income. In contrast to most VATs, the business tax would not be border adjustable. Consequently, domestic firms would collect the business tax on their products sold domestically or exported but the business tax would not be collected on imported products. But, as previously discussed, economic theory has long recognized that border tax adjustments have no effect on the balance-of-trade because the balance-of-trade is a function of international capital flows.

Third , most other developed nations have much larger public sectors (government spending as a percentage of gross domestic product) than the United States. These countries offer a wider range of social benefits (such as national health care) in order to reduce inequality and lessen economic insecurity. Hence, these nations need greater tax revenues, and consequently, levy both broadbased consumption taxes and income taxes.



Conclusion

The concept of replacing our current federal income tax system with a flat rate consumption tax is receiving congressional interest. The term "flat tax" is often associated with a consumption tax proposal formulated by Robert E. Hall and Alvin Rabushka, two senior fellows at the Hoover Institution.

This report discusses the idea of replacing the current U.S. income tax system --which is a hybrid of an income and a consumption tax --with a pure consumption tax formulated by H-R.

The combined individual and business taxes proposed by H-R can be viewed as a modified valueadded tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension receipts. Part or all of an individual's wage and pension income would be tax free depending on marital status and number of dependents. The business tax would be a modified subtraction method VAT with wages (and salaries) and pension contributions subtracted from the VAT base. (Under a standard subtraction-method VAT, a firm would not subtract its wages and pension contributions when calculating its tax base.)

Hall and Rabushka argue that replacing the existing individual income tax with their flat tax would be a major improvement for three reasons: the flat tax would be much simpler than the current complex income tax, consumption is a better tax base than income, and the flat tax would be much more efficient than the current income tax system.

This report's examination of the H-R flat tax proposal and their arguments supporting it looked at four topics: broad economic issues, narrow sectoral economic issues, simplicity, and international comparisons.

The broad economic issues concern the economic effects of the flat tax on the entire national economy. The flat tax would be shifted backwards onto owners of equities (old capital) and wage earners. The current income tax system is progressive but the incidence of the H-R flat tax proposal across income classes is unknown. The flat tax would reduce the tax burden on the young but increase it on the old.

Whether the proposed flat tax would be more or less efficient than the current income tax system is unknown. There is no conclusive theoretical or empirical evidence that the flat tax proposal would significantly affect savings, work effort, investment, or growth. A consumption base is neither inherently superior nor inferior to an income base.

The H-R flat tax would not be border adjustable. Current economic theory holds that border tax adjustments have little effect on the balance-of-trade because the balance-of-trade is largely a function of international capital flows.

The H-R flat tax proposal would not require any change in the price level. Most economists believe that the H-R flat tax would lower interest rates, but a minority of economists maintain that interest rates could rise.

Revenue forecasting is an inexact, if necessary, science; hence, there is a considerable concern that the initial revenue yield from the flat tax could be far too low or too high. Over the business cycle, total tax revenues would be more stable under a flat tax than under an income tax system.

Narrow sectoral economic issues concern specific industries or sectors of the total economy. The six microeconomic issues discussed were differential effects on businesses, charitable organizations, housing, financial services, health care, and state and local governments. Most of these discussions related to the elimination of an existing income tax preference.

The simplicity of the proposed flat tax is emphasized by Hall and Rabushka. A positive aspect of the proposed flat tax is the ease with which the individual and corporate tax systems could be integrated.

The complexity of the current tax code is partially due to attempts by policymakers to achieve greater equity or improve economic efficiency. In comparison to the current income tax, a flat rate, per se, does little to reduce complexity because most taxpayers simply look up their tax liability in a table. It can also be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax. By the time a consumption tax can be enacted it may become complicated. As an option to the flat tax, some observers maintain that the current income tax system could be simplified by expanding the tax base.

International comparisons of tax systems indicate that there are major distinctions between recent consumption tax proposals for the United States and the current tax systems of other developed nations. Although the United States is the only developed nation without a broad-based consumption tax at the national level, other developed nations adopted broad-based consumption taxes as adjuncts rather than as replacements for their income based taxes. Notably, all developed nations with VATs, except Japan, calculate their VATs using the credit-invoice method. The H-R flat tax proposal, however, would use the subtraction method of calculation for the business tax. Finally, most other developed nations have much larger public sectors (government spending as a percentage of gross domestic product) than the United States. These nations need greater tax revenues, and consequently, levy both broad-based consumption taxes and income taxes.

It is worth noting that numerous aspects of the H-R flat tax proposal have not been fleshed out and important policy issues have yet to be analyzed.



Appendix. Tax Forms under the Flat Tax

Figure A-1. Individual Wage Tax




Figure A-2. Business Tax





Author Contact Information

James M. Bickley
Specialist in Public Finance
jbickley@crs.loc.gov, 7-7794

1 The complete citation of this book is Robert E. Hall and Alvin Rabushka, The Flat Tax, Second Edition (Stanford, California: Hoover Institution Press, 1995), 152 p. (The first edition of this book was published in 1985.)

2 Robert E. Hall, "Guidelines for Tax Reform: The Simple, Progressive Value-Added Tax," in Alan J. Auerbach and Kevin A. Hassett, eds., Toward Fundamental Tax Reform (Washington, DC: The AEI Press, 2005), pp. 70-80.

3 For a description of current tax reform proposals, see CRS Report R40414, Tax Reform: An Overview of Proposals in the 111th Congress , by James M. Bickley.

4 For a comparison of the flat tax concept with other consumption tax concepts, see Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate over Tax Reform , 3rd ed. (Cambridge, MA: The MIT Press, 2004), pp. 233-271.

5 Robert E. Hall refers to his flat tax as "the simple, progressive value-added consumption tax."

6 For a comprehensive examination of the value-added tax, see CRS Report RL33619, Value-Added Tax: A New U.S. Revenue Source? , by James M. Bickley.

7 These factors of production have specific meanings to an economist. Labor consists of all employees hired by the firm. Land consists of all natural resources including raw land, water, and mineral wealth. Capital is anything used in the production process, which has been made by man. The entrepreneur is the decision maker who operates the firm.

8 For a comparison of the credit-invoice method and the subtraction method, see CRS General Distribution Memorandum, Value-Added Tax: Methods of Calculation , by James M. Bickley; available from the author.

9 An analysis of the concept of a consumed income tax is presented in CRS Report 98-248, A Federal Tax On Consumed Income: Background and Analysis , by Gregg A. Esenwein. (Non-distributable report available from CRS on request.)

10 For an examination of the administrative and compliance costs of the current income tax system and the flat tax, see William G. Gale and Janet Holtzblatt, "Measuring the Impact of Administrative Factors under Tax Reform," Proceedings of the 1998 Annual Conference of the National Tax Association , pp. 341-349.

11 Hall and Rabushka, p. 40.

12 Ibid., p. 41.

13 Copies of tax forms for the individual wage tax and the business tax are shown in Appendix .

14 Bureau of Labor Statistics, CPI Inflation Calculator , available at http://www.bls.gov/data/inflation_calculator.htm, visited Apr. 22, 2009.

15 Hall and Rabushka, p. 77.

16 Ibid., p. 59.

17 Ibid., p. 77.

18 Ibid., p. 72.

19 Ibid.

20 For a brief discussion of these equity issues, see CRS Report RL33619, Value-Added Tax: A New U.S. Revenue Source? , by James M. Bickley.

21 Hall and Rabushka, p. 93.

22 Ibid., p. 91.

23 Ibid.

24 Ibid., p. 92.

25 Ibid.

26 Ibid., p. 93.

27 The flat tax proposal of former House Majority Leader Richard K. Armey would have repealed the earned income tax credit (EITC), thus the Treasury's study includes a repeal of the EITC. If the earned income tax credit (EITC) were repealed, there would have been an increase in taxes (loss in negative tax) for those who had an EITC in excess of their tax liability. Hall and Rabushka did not mention the EITC in their book, and consequently, whether or not their proposal included a repeal of the EITC is not known.

28 For a definition of Family Economic Income, see U.S. Treasury, Office of Tax Analysis, "New Armey-Shelby Flat Tax Would Still Lose Money, Treasury Finds," Tax Notes , v. 70, no. 4, Jan. 22, 1996, p. 454.

29 Ibid., pp. 453-455.

30 For a presentation of these assumptions about incidence, see U.S. Treasury, Office of Tax Analysis, "New Armey-Shelby Flat Tax Would Still Lose Money, Treasury Finds," p. 453.

31 CRS Report 95-1141, The Flat Tax and Other Proposals: Who Will Bear the Tax Burden? , by Jane G. Gravelle.

32 For an analysis of the efficiency of a pure consumption tax versus a pure income tax, see Jane G. Gravelle, "Income, Consumption, and Wage Taxation in a Life-Cycle Model: Separating Efficiency from Redistribution," American Economic Review , v. 81, no. 4, Sept. 1991, pp. 985-995.

33 Hall and Rabushka, p. 87.

34 For an explanation of the components of national saving, see CRS Report RL32119, Can Public Policy Raise the Saving Rate? , by Brian W. Cashell.

35 For a comprehensive analysis of the U.S. saving rate, see CRS Report RS21480, Saving Rates in the United States: Calculation and Comparison , by Brian W. Cashell.

36 For an examination of this issue, see CRS Report RS22367, Federal Tax Reform and Its Potential Effects on Saving , by Gregg A. Esenwein.

37 For example, see Don Fullerton and Diane Lim Rogers, "Lifetime Effects of Fundamental Tax Reform," in Economic Effects of Fundamental Tax Reform , Henry J. Aaron and William G. Gale, eds. (Washington: Brookings Institution Press, 1996), p. 321-352; and David Altig, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser, "Simulating Fundamental Tax Reform in the United States," American Economic Review , v. 91, no. 3, June 2001, pp. 574-595.

38 CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax: Overview of the Issues , by Jane G. Gravelle.

39 Hall and Rabushka, p. 84.

40 Ibid., p. 86.

41 Ibid., p. 87.

42 Ibid., p. 88.

43 Ibid., p. 83.

44 Ibid., p. 89.

45 Ibid.

46 For an further explanation of this issue, see CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax: Overview of the Issues , by Jane G. Gravelle.

47 For a comprehensive analysis of this topic, see CRS Report 95-1141, The Flat Tax and Other Proposals: Who Will Bear the Tax Burden? , by Jane G. Gravelle.

48 For opposing views on the effect of a flat tax on interest rates, see John E. Golob, "How Would Tax Reform Affect Financial Markets?," Federal Reserve Bank of Kansas City Economic Review , v. 80, no. 4, Fourth Quarter, 1995, pp. 19-39; and, Martin Feldstein, "The Effect of a Consumption Tax on the Rate of Interest," Working Paper No. 5,397, National Bureau of Economic Research, Cambridge, Massachusetts, Dec. 1995, 31 p. An analysis of various factors affecting interest rate changes is presented in CRS Report 96-379, The Flat Tax and Other Proposals: Effects on Housing , by Jane G. Gravelle. (Non-distributable report available from CRS on request.)

49 For a comprehensive analysis of this issue, see Martin A. Sullivan, Flat Taxes and Consumption Taxes: A Guide to the Debate (New York: American Institute of Certified Public Accountants, 1995), pp. 125-149.

50 This could be a quite a problem not only for many mature large corporations but also for many small businesses, farmers, and owners of rental properties.

51 Hall and Rabushka, pp. 64-65.

52 Ibid., pp. 65-66.

53 Ibid., pp. 78-79.

54 Ibid., p. 79.

55 For an examination of this tax preference, see U.S. Congressional Budget Office, Budget Options (Washington, U.S. Govt. Print. Off., Feb. 2007), pp. 272-274.

56 Hall and Rabushka, The Flat Tax , pp. 99-101.

57 For an article on this issue, see William C. Randolph, "Dynamic Income, Progressive Taxes, and the Timing of Charitable Contributions," Journal of Political Economy , v. 103, no. 4, Aug. 1995, pp. 709-738.

58 Charles T. Clotfelter, and Richard L. Schmalbeck, "The Impact of Fundamental Tax Reform on Nonprofit Organizations," in Economic Effects of Fundamental Tax Reform , edited by Henry J. Aaron and William G. Gale (Washington, Brookings Institution Press, 1996), pp. 211-246.

59 For an analysis of possible policy changes under fundamental tax reform concerning the mortgage interest deduction, see CRS Report RL33025, Fundamental Tax Reform: Options for the Mortgage Interest Deduction , by Pamela J. Jackson.

60 U.S. Congressional Budget Office, Budget Options , pp. 267-268.

61 Steven Pearlstein, "Americans' Investing Focus Faulted," Washington Post , no. 284, Sept. 15, 1995, p. F3.

62 Hall and Rabushka, p. 94.

63 Ibid., p. 95.

64 Ibid.

65 Ibid.

66 For a view that argues that there will be serious effects, see Roger E. Brinner, Mark Lasky, and David Wyss, "Residential Real Estate: Impacts of Flat Tax Legislation," DRI Analysis, Summary Prepared for the National Association of Realtors, Lexington, Massachusetts, May 1995, 19 p. Also, for a critical view of this DRI study, see Rebecca S. Schaefer, "Ganging Up Again at 'Gucci Gulch': A Look at the DRI Flat Tax Study," Issues and Answers , Citizens for a Sound Economy, Aug. 15, 1995, 3 p.

67 Hall and Rabushka, p. 79.

68 An analysis of this issue is presented in CRS Report 96-379, The Flat Tax and Other Proposals: Effects on Housing , by Jane G. Gravelle. (Non-distributable report available from CRS on request.)

69 Charles E. McLure, Jr., The Value-Added Tax, Key to Deficit Reduction? (Washington: American Enterprise Institute, 1987), p. 135.

70 Hall and Rabushka, pp. 74-75.

71 McLure, pp. 135-138.

72 CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax: Overview of the Issues , by Jane G. Gravelle.

73 For an overview of the taxation of life insurance products and life insurance companies, see CRS Report RL32000, Taxation of Life Insurance Products: Background and Issues , by Andrew D. Pike and CRS Report RL32180, Taxation of Life Insurance Companies , by Andrew D. Pike.

74 For a comprehensive discussion of this tax preference, see Internal Revenue Service, Publication 502 --Medical and Dental Expenses, 2007.

75 An overview of the effects on the states of flat tax proposals is presented in CRS Report 95-1150, Consumption Taxes and State-Local Tax Systems , by Dennis Zimmerman (Non-distributable report available on request), and Robert P. Strauss, Administrative and Revenue Implications of Alternative Federal Consumption Taxes for the State and Local Sector (Washington: American Tax Policy Institute, July 6, 1997), 78 p.

76 Michael Stanton, "Correction for Possible Tax Reform Has Run Its Course, Managers Say," The Bond Buyer , v. 313, no. 29,686, July 7, 1995, p. 7.

77 Jon Birger, "Tax Reform Won't Do Much for State Funds, Moles Says," The Bond Buyer , v. 313, no. 29,717, Aug. 21, 1995, p. 6.

78 For an examination of this tax preference, see U.S. Congressional Budget Office, Budget Options , p. 269.

79 CRS Report 95-1150, Consumption Taxes and State-Local Tax Systems , by Dennis Zimmerman (Non-distributable report available from CRS on request).

80 Hall and Rabushka, The Flat Tax , p. 52.

81 John L. Guyton, John F. O'Hare, Michael P. Stavrianos, and Eric J. Toder, "Estimating the Compliance Cost of the U.S. Individual Income Tax," National Tax Journal , v. 66, no. 3, Sept. 2003, pp. 673-688.

82 Ibid., p. 682.

83 Ibid.

84 Internal Revenue Service, Statistics of Income Bulletin , v. 25, no. 3, winter 2005-2006, p. 208.

85 Internal Revenue Service, Statistics of Income Bulletin , v. 27, no. 4, spring 2008, available at http://www.irs.gov/tax_stats, visited Mar. 16, 2009.

86 For an analysis of the tax gap, see CRS Report R40414, Tax Reform: An Overview of Proposals in the 111th Congress , by James M. Bickley.

87 As already discussed, private businesses would pay the business tax on the fringe benefits of their employees except for pension contributions, which would be taxed at the individual level.