Flat tax, sales tax or VAT?

• Author: Zimmerman, Christopher
• Position: Value-added tax; tax reform proposals - Cover Story

IS RADICAL CHANGE FOR THE FEDERAL SYSTEM REALLY ON THE HORIZON? MAYBE - AND IF SO THE POTENTIAL IMPLICATIONS FOR STATE FISCAL SYSTEMS ARE ENORMOUS.

In the new political environment in Washington, many ideas previously viewed as pipe dreams are being taken seriously as blueprints for policy action. In no area is this truer than in tax policy, where some of the most sweeping changes ever contemplated are now getting more than passing attention. The sponsors of such proposals come from both parties, and in many cases hold key leadership positions. A recent article in Fortune magazine declares, "Right now we are witnessing . . . the beginning of the end of the American income tax system." (June 12, 1995)

Is the political climate ripe for radical change? Consider this: The chairman of the Ways and Means Committee speaks of "pulling up the income tax system by its very roots" by repealing the 16th Amendment to the U.S. Constitution. The House majority leader would like to end income tax withholding. A prominent U.S. senator and presidential candidate proposes to abolish that most hated federal agency, the IRS. Alice Rivlin, President Clinton's budget director, is a relatively recent convert to the idea of shifting to consumption taxation.

Senate Majority Leader (and presidential aspirant) Robert Dole has joined House Speaker Newt Gingrich in appointing a commission to be headed by former Congressman and Housing Secretary Jack Kemp to assess the various proposals.

What's driving these radical tax reform proposals? Analyst Stephen Moore of the Cato Institute makes the case succinctly: "First, the U.S. tax system reduces economic growth through punitive tax rates on savings and investment. Second, the needless complexity of the tax code imposes large costs on American businesses and workers." Though both these premises may be subject to dispute, they are reflected in most of the proposals, nearly all of which have as basic goals the promotion of savings by shifting taxation to consumption and simplification of the current tax system.

Some proposals are based on the idea of radically simplifying the federal income tax, "flattening" the rate structure and eliminating deductions, while others would replace the income tax with some sort of consumption tax.

THE 4 PROPOSALS

Major proposals have been put forward by members of Congress; several have already been introduced, but others have yet to be drafted as, legislative language. There are four basic approaches: the "FLAT" TAX, the CONSUMPTION-BASED INCOME TAX, the VALUE-ADDED TAX or "VAT" and the NATIONAL SALES TAX.

1 FLAT TAX IDEAS

The flat tax approach is aimed principally at simplifying the current federal income tax. Since its inception, the federal income tax has been a "progressive" tax, using a graduated rate structure so that the marginal rate of taxation increases with income - the more you earn, the greater the percentage of your income you pay in tax. Over time, exemptions proliferated, and the actual base of the tax has become quite complicated.

In its purest form, a flat tax would be an income tax levied at one rate on all income. In practice, all proposals have some "zero bracket," a threshold level of income below which no tax is owed. Beyond this base level, one marginal rate applies.

The most prominent proposal of this kind now in Congress comes from House Majority Leader Richard Armey of Texas, who originally introduced a flat tax bill in 1994. A similar bill has been introduced by Pennsylvania Senator Arlen Specter, a presidential candidate. Individual wage income would be taxed at a rate of 20 percent with a basic standard deduction ranging from $12,350 to $24,700 depending on filing status, and generous treatment of savings and investment. The proposal would repeal the withholding from wages of income taxes. Mortgage interest and charitable contributions would not be deductible under the Armey plan, though the Specter bill retains these popular deductions. Both plans would end the deductibility of state and local taxes, and of interest on state and local government bonds. The federal corporate income tax would be replaced with a type of VAT.

A Democratic alternative is Congressman Richard Gephardt's "10 percent" tax proposal. With this modified flat tax, the House minority leader returns to the themes of the "FAIR" tax bill he promoted 10 years ago with New Jersey Senator Bill Bradley. (That bill, along with the Kemp-Roth proposal, led to the 1986 Tax Reform Act that reduced rates, simplified the rate structure and eliminated many exemptions. In the end, this reform did not achieve the radical simplification early advocates had sought.) Under this plan, most...