Ironing out the flat tax.

• Author: Weisbach, David A.

This article considers the design and implementation of the Flat Tax.(1) The Flat Tax consists of two parts, a tax on individuals and a tax on businesses. Individuals are taxed on wages and other employee compensation. Dividends, interest, and capital gains are not taxed to individuals. No personal deductions, such as the deductions for mortgage interest or charitable donations, are allowed. The individual tax is progressive at the lower end through a personal allowance or standard deduction, and flat thereafter.

The business tax is computed much like a VAT.(2) Businesses are taxed on the difference between gross receipts from sales of property or services and the cost of business inputs, wages, and retirement contributions. The tax provides current expensing of all business purchases, businesses may not deduct interest or dividends or other financial payments, and financial income is not included when received.

Flat Tax proposals offer few additional details. We do not know, for example, the rules for such everyday transactions as the formation or liquidation of a business or the sale of property on credit. Given the immense size and complexity of our economy, the simple outline of the Flat Tax offered by its proponents does not come close to legislation that could actually be enacted.

Without additional details, evaluation of the Flat Tax is difficult. Much of the appeal of the Flat Tax lies in its alleged simplicity--the vaunted postcard returns resonate with many. If the claims of simplicity are not correct, the Flat Tax may be significantly less attractive. Moreover, the efficiency claims for the Flat Tax rely in part on simple, clearly stated economic incentives and relative unavoidability. If, once implemented, the Flat Tax is complex and avoidable, the efficiency claims may falter.(3) And the fairness claims for the Flat Tax, regardless of their merit, become weaker if the tax is avoidable. In particular, an avoidable tax will have different distributive consequences (most likely more regressive) than the simple, unavoidable tax championed by proponents of the Flat Tax. The devil for the Flat Tax might truly be in the details. To date, however, no details of the design of the Flat Tax have been offered.

This article attempts to fill this gap by beginning the study of the design of the Flat Tax.(4) The article is organized around a central feature of the Flat Tax that has not previously drawn attention--something I call "openness." By openness I mean that deductions claimed by one taxpayer are not necessarily offset by inclusions of another (and vice versa). After explaining how the Flat Tax is open, I will explore five central design elements that are affected by openness. I will also briefly consider additional issues that must be resolved before implementing the tax.

This article will address only the design issues relating to the Flat Tax. It will not discuss the merits of an income tax versus a consumption tax.(5) Nor will it discuss important questions of economic efficiency or the equitable distribution of the tax burden under the Flat Tax, except as they arise from design problems. The transition to the Flat Tax will be discussed briefly, but mostly with respect to design issues, not efficiency or fairness concerns. In addition, the article will assume that the Flat Tax is enacted in relatively pure form, so that political compromises that introduce additional complexity are not discussed. These issues are all important but are well covered in prior literature.(6) The major hole remaining is the design of the system.

Although this article is written at the level of implementation rather than theory, there are two important underlying theoretical problems. First, suppose we identify an anomaly in the treatment of a transaction under the Flat Tax. Someone might be over- or under-taxed, or there may be an unintended incentive--maybe a loophole--that causes taxpayers to structure transactions inefficiently to avoid tax. The question is whether the tax should be amended to fix the anomaly or whether it should be left as is. This requires a trade-off between the administrative costs of fixing the problem and the inefficiency, unfairness, and revenue effects of leaving the anomaly. How these trade-offs should be made is not fully resolved.(7) The original designers of the Flat Tax, Robert Hall and Alvin Rabushka had a strong preference for simplicity as witnessed by the proposed elimination of all personal deductions. But they failed to identify a large number of issues, and decisions must be made on these issues. The recommendations here are based on my judgment about the costs of complexity compared to the costs of a given anomaly. These judgments may be completely wrong (although I don't think so), but the point of the article is not to recommend final resolution of the issues but rather to identify the issues that must be dealt with in designing the Flat Tax and to evaluate the costs of solutions.

Second, in evaluating claims of administrative costs and complexity, there is no easily defendable baseline for comparison. Theoretically, one would compare either absolute or marginal administrative costs of each system. But in practice it is convenient to compare one system to another. Most of the comparisons in this article are to the current income tax. The reason is that most people have some sense of the administrative costs and complexities of the current system, so comparing the Flat Tax to the current system provides information. In considering tax reform, other important comparisons would be to other potential reforms, such as a simplified income tax or a VAT.

The Flat Tax proposed by Hall and Rabushka is a tax on consumption, not income. Part I of this article, therefore, gives background on consumption taxes and the basic mechanic's of the Flat Tax. Part II introduces the concept of openness and shows how the Flat Tax is open domestically and internationally. Part III considers five major design issues that stem from the openness of the Flat Tax. Part IV gives a very brief discussion of other design issues that will have to be resolved to implement the Flat Tax. Part V evaluates the design and provides a conclusion.

1. BACKGROUND

   1. Consumption Tax Basics

      This Part provides background on consumption taxes in general, not limited to the Flat Tax. This background is necessary for understanding the Flat Tax. All of the material provided in this Part can be found in prior literature.(8)

      The goal of a consumption tax is to capture all consumption in the economy. Instead of measuring consumption directly, say through a tax on consumption purchases, consumption can be derived from income. Income in a given period is equal to the sum of a taxpayer's consumption and his change in savings during that period. By simple algebra, consumption is equal to income less the change in savings (i.e., minus savings plus dissavings).

      The change in savings in a given period is equal to the difference between amounts saved and amounts withdrawn from savings to be used for consumption. We can measure tiffs difference by measuring difference in receipts from the sale of investments and the outlays for the purchase of investments. Net receipts in a period means that the taxpayer withdrew savings to consume and net payments means the taxpayer saved. As a result, we can tax consumption by measuring cash flows, including receipts, and deducting outlays (other than consumption outlays). A tax following this pattern is called a personal cash-flow consumption tax.

      One important consequence of this logic is that the major difference between an income tax and a consumption tax is the timing of basis recovery. In an income tax, there is no deduction for savings. Instead, investments are given tax basis which is recovered when the investment is recovered (e.g., through depreciation or on sale). In a cash-flow consumption tax, basis is recovered immediately through a deduction for outlays (i.e., investments are expensed).

      A second consequence of this logic is that, under certain assumptions, a consumption tax does not tax (exempts) the yield on investments. The intuition is that the immediate deduction in the cash-flow consumption tax creates tax savings, which can be invested. When the investment is sold, the taxpayer must pay tax on the full amount realized, but the tax is exactly equal to the invested value of the original tax savings.

      Example Suppose a taxpayer earns $100 and wants to invest it. Assume the taxpayer has two choices: an investment that is immediately deductible but which is fully taxed on sale, and an investment that is not deductible but whose yield is exempt. Assume the tax rate is forty percent and that the pre-tax return on investments during the relevant time period is fifty percent. If the taxpayer invests in the asset with the exempt yield, the taxpayer must first pay tax on the $100 earnings. Thus, the taxpayer must pay a tax of $40 and has only $60 to invest. The $60 will earn a fifty percent return, or $30, which is not taxed. Withdrawing the initial $60 invested is tax free, leaving the taxpayer with $90. If the taxpayer invests in the deductible investment, the taxpayer can invest the full $100. The $100 will earn a fifty percent return giving the taxpayer $150. When the cash is withdrawn from the investment, the taxpayer must pay a tax of forty percent of $150, or $60, leaving $90. Thus, the immediately deductible investment and the yield-exempt investment leave the taxpayer in the identical place, with $90.(9) A cash-flow consumption tax allows immediate deductions for all investments and, therefore, under the assumptions, exempts the yield on investments. Thus, we can replicate a cash-flow consumption tax by simply not taxing the yield on assets but also not allowing a deduction for purchases. This method of taxation is called yield-exemption. The Flat Tax uses yield exemption for...