A Flat Tax to Restore Prosperity

Op Ed by Chris Edwards

The economy is struggling, millions of people are unemployed, and family incomes are stagnant. Meanwhile, American businesses face rising competition in world markets, yet the federal government keeps heaping more piles of taxes and regulations on them. There are a lot of reforms needed in Washington, but scrapping the current tax code is high on the list. The federal income tax system is a disgrace. It's 71,000 pages of complex and anti-competitive rules riddled with special interest giveaways. Our high income tax rates penalize the most productive people in society and encourage businesses to move their investments abroad. These days, car companies can find lower tax rates in Canada and computer chip companies can find lower tax rates in China. That makes no economic sense. America desperately needs tax reform, and the best idea I've seen is a low-rate "flat tax" on individuals and businesses. The academics have  studied the flat tax, and it's been road-tested in more than two dozen countries. A flat tax would make the economy boom-not just as a short-term stimulus, but as a long term way to improve U.S. living standards.


 

What Is a Flat Tax?               

A flat tax generally means a tax on individuals with a single statutory rate. The flat tax concept also embodies the ideas that special tax preferences should be abolished and people should be treated equally. The ideal flat tax structure was introduced in the 1980s by Robert Hall and Alvin Rabushka of the Hoover Institution. The Hall-Rabushka flat tax was championed in the 1990s by House majority leader Dick Armey and presidential candidate Steve Forbes. The flat tax has three key features:

  • Single Flat Rate. The flat tax has a single rate above a large basic exemption. That would treat people equally, encourage productive activities, discourage tax avoidance, and spur domestic investment.


     

  • Elimination of Special Preferences. The flat tax eliminates tax provisions that create narrow advantages for certain people and industries. That would promote economic growth by allowing resources to flow to the highest-valued uses. It would also simplify the tax code and reduce political corruption.


     

  • Pro-Growth Treatment of Savings and Investment. A flat tax would tax each source of income just once. By contrast, under the current income tax, some income is not taxed and other income—such as income from savings


    and investment—is taxed multiple times.

Hall and Rabushka set the flat tax rate on individuals and business at 19 percent, while Forbes and Armey set it at 17 percent. The flat tax adopts Roth IRA treatment for all personal savings—wages would be taxed when earned, but all after-tax earnings that were saved would accumulate tax-free. Large and small businesses would file the same simple tax return and pay the same flat rate on a simple cash measure of earnings.

The flat tax is not just a simple version of the current income tax. It is a consumption-based tax system because it uniformly removes a layer of taxation from saving and investment. For businesses, it allows an immediate and full deduction for all new investments in factories and equipment, which would be a huge boon to the economy.

A flat tax would be much simpler than the current income tax. For families, vast amounts of paperwork for special deductions and credits would be eliminated. For businesses, the flat tax would end some of the most complex parts of the tax code, such as depreciation deductions.

A flat tax would dramatically reduce marginal tax rates. Despite what liberal politicians often say, reduced tax rates are critical to maximizing economic growth. Most other countries have learned this lesson. The U.S. corporate tax rate—including the average state rate—is 40 percent, and the last time it was cut was way back in 1986. But since that year, the average rate in the 30 major industrial nations has plunged from 47 percent to just 26 percent today.

The top personal income tax rate in the 30 industrial nations plunged from 52 percent in 1990 to 42 percent in 2009. With state taxes, the top U.S. rate is also about 42 percent today. However, the federal rate is expected to be hiked next year, so our total top rate will be about 47 percent—substantially higher than the average of our trading partners. It’s absurd that politicians are putting our economy into such an uncompetitive position—America ought to have the best tax system in the world, not one of the worst.

 

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Flat Taxes around the World                

Hall and Rabushka set the flat tax rate on individuals and business at 19 percent, while Forbes and Armey set it at 17 percent. The flat tax adopts Roth IRA treatment for all personal savings—wages would be taxed when earned, but all after-tax earnings that were saved would accumulate tax-free. Large and small businesses would file the same simple tax return and pay the same flat rate on a simple cash measure of earnings.

The flat tax is not just a simple version of the current income tax. It is a consumption-based tax system because it uniformly removes a layer of taxation from saving and investment. For businesses, it allows an immediate and full deduction for all new investments in factories and equipment, which would be a huge boon to the economy.

A flat tax would be much simpler than the current income tax. For families, vast amounts of paperwork for special deductions and credits would be eliminated. For businesses, the flat tax would end some of the most complex parts of the tax code, such as depreciation deductions.

A flat tax would dramatically reduce marginal tax rates. Despite what liberal politicians often say, reduced tax rates are critical to maximizing economic growth. Most other countries have learned this lesson. The U.S. corporate tax rate—including the average state rate—is 40 percent, and the last time it was cut was way back in 1986. But since that year, the average rate in the 30 major industrial nations has plunged from 47 percent to just 26 percent today.

The top personal income tax rate in the 30 industrial nations plunged from 52 percent in 1990 to 42 percent in 2009. With state taxes, the top U.S. rate is also about 42 percent today. However, the federal rate is expected to be hiked next year, so our total top rate will be about 47 percent—substantially higher than the average of our trading partners. It’s absurd that politicians are putting our economy into such an uncompetitive position—America ought to have the best tax system in the world, not one of the worst.

Hong Kong, the Czech Republic and Slovakia, for example, do not tax capital gains. Slovakia applies just a single layer of taxation to corporate dividends at 19 percent, and Latvia exempts domestic dividends from individual taxation. In nearly all flat tax countries, the tax treatment of savings and investment is much superior to the treatment under the U.S. income tax.

 

The Past and Future of Flat Taxes                  

A lot of supposed experts used to argue that flat taxes were an interesting idea, but not practical in the real world. Hong Kong has had a flat tax since 1947, but that was considered to be a special case because of that jurisdiction’s colonial status. Jamaica has had a flat tax since 1986, but it was overlooked because it is a developing nation.

The ball really started rolling when the Baltic nations of Estonia, Latvia and Lithuania adopted flat tax systems in the 1990s. Estonia had the break-through reform with the introduction of a 26 percent flat tax in 1994. Prime Minister Mart Laar was wondering how to rescue the floundering Estonian economy and recalled reading that economist Milton Friedman had advocated a flat tax. He introduced Estonia’s flat tax as part of his broad reform agenda.

Estonia’s dramatic tax reform made its Baltic neighbors, Latvia and Lithuania, take notice. Those countries quickly adopted their own flat taxes. While all three Baltic nations initially introduced flat taxes with fairly high rates, those rates have been cut over time.

The next step in the flat tax revolution was Russia; it adopted a 13 percent flat tax in 2001. Russia also cut its corporate tax rate. Decades of class warfare went out the window and equal tax treatment for all was introduced. Russia’s tax revenue began rising after the introduction of the flat tax as tax evasion fell and the economy boomed.

In 2004, Slovakia joined the flat tax club with a 19 percent tax that was quite close to the flat tax ideal. The flat tax in Slovakia has been a big success, and the country has attracted large inflows of foreign investment. Slovakia’s reform played a key role in the subsequent decisions to adopt flat taxes in Romania, Bulgaria and the Czech Republic.

The nations that emerged from communism’s collapse are leaders in the flat tax revolution. After enduring decades of socialist policies, they apparently have little sympathy for tax systems based on class warfare. They want equal treatment, and that is the goal of the flat tax.

Another selling point of the flat tax is that it has spurred much greater tax compliance in some countries where black markets and tax evasion had been major issues. Under a low-rate flat tax, there is much less incentive to hide income from the tax authorities.

While there are still skeptics, every nation but Iceland that has adopted a flat tax has kept it. A number of flat tax countries were hit hard by the global recession of recent years, but the pro-growth tax systems they have in place should help these countries rebound quickly. It’s possible that some countries will undo their flat tax reforms in the future, but the durability of flat taxes so far is a testament to how well they work in practice.

Looking ahead, the big question is whether the flat tax can cross from the former communist world into Western Europe and North America. These higher-income nations would gain all the same benefits from the flat tax—stronger economic growth, lower tax avoidance, and fewer headaches for families and businesses from tax code compliance.

Maybe Americans weren’t ready for the flat tax when Steve Forbes ran with the idea in his presidential campaigns. But now that people are living through the nightmares of big tax increases in 2011, a supersized federal government under Obama, and a terrible private job market, they might embrace the candidate who grabs the flat tax torch in 2012.


Chris Edwards is director of tax policy studies at the Cato Institute and manager of www.downsizinggovernment.org.

 



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Grace said was taken to jail but was never booked nor was she was placed in a jail cell.

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