Flat Tax Idea Is Rounded Out as It Gains Support

It is an idea for rebellious times, a grenade lobbed at the heart of a tax system that for many symbolizes all that’s wrong with politics as usual.

The proposed “flat tax,” increasingly spotlighted by presidential candidates and members of Congress, would in effect shove 7,000 pages of Internal Revenue Service regulations right into the shredder.

Today’s exotic jumble of loopholes and fine print--all the arcana of a tax code that even the specialists find hard to fathom--would be replaced by just a few, seemingly simple rules.

The overwhelming majority of deductions would be eliminated, and most wage earners would be taxed at the same single rate--perhaps in the range of 17% to 20%. Most deductions would disappear. Tax returns, flat-tax fans like to say, would fit on a postcard.

“This idea is catching fire. You can feel it,” said House Majority Leader Dick Armey (R-Tex.), whose 17% flat-tax proposal has become the focal point for debate. “The flat tax is in America’s future.”

In fact, towering barriers stand in the way of a true flat tax, a radical change that raises questions of fairness and threatens long-entrenched interests. The flat tax free-for-all is not expected to end before the 1996 presidential election.

But for all that, the flat tax has captured the imaginations of fed-up voters and is already influencing the political debate.

“The things that seem to strike a visceral chord with people are its fairness and simplicity,” said Daniel Mitchell, a senior fellow at the conservative Heritage Foundation.

Idea Catches Fire

Flat-tax fever even taps into concerns about sinking public morality, said Steven Wagner, vice president of Luntz Research, a Republican polling firm. Many Americans view today’s tax code as riddled with loopholes that benefit people with high-priced lawyers and accountants.

“It’s really incredible the extent to which this issue has taken off,” Wagner said.

Senate Majority Leader Bob Dole of Kansas, the front-runner for next year’s Republican presidential nomination, cites a “lower, fairer, flatter, simpler” tax code as one of his key goals. At least three other GOP presidential hopefuls, Sen. Phil Gramm of Texas, Sen. Arlen Specter of Pennsylvania and conservative commentator Patrick J. Buchanan, have spoken warmly about a flat tax.

Others, sensing widespread disgust with the tax code, are preparing even more radical overhauls. House Ways and Means Committee Chairman Bill Archer (R-Tex.) would scrap the income tax altogether and replace it with a national sales tax.

Tax reform is “the central economic issue of the ’96 campaign,” said Jack Kemp, a former congressman who was secretary of housing and urban development in the George Bush Administration. Kemp heads a national panel on tax reform that is expected to recommend a flat tax--or something close to it--later this year.

The Tax Code Maze

Flat-tax believers marshal many arguments for their cause. The tax code, they maintain, is a dead weight on the economy, its bewildering web of regulations a source of untold wasted time, effort and money.

The confusing requirements lead to mistakes, cynicism and tax avoidance, all of which siphon billions of dollars from national prosperity, the critics charge. Savers are penalized for their efforts and entrepreneurs are not given adequate incentives--and the nation’s standard of living suffers as a result.

“After seven decades of abuse by lawmakers, lobbyists, special interests and self-righteous income re-distributors, our tax code is a mess,” said Paul Beckner, president of Citizens for a Sound Economy, a conservative group that is pushing hard for a flat tax.

Few would disagree with at least some of those complaints, but many wonder whether a flat tax is the proper remedy.

Under Armey’s plan, a large personal exemption would protect low- and moderate-income households from a tax hike. A family of four, for example, would owe no taxes on its first $33,300 of income.

And the rich, who pay a 40% tax rate on some of their income, would enjoy a significant tax cut.

Who Will Pay?

If the rich get a big tax cut and the poor are shielded by an exemption, who’s left to pay the bills?

“If you’re lowering the tax burden at the two extremes, it only stands to reason that people in the middle are going to pay more, on average,” said Robert D. Reischauer, former head of the Congressional Budget Office and now a senior fellow at the Brookings Institution, a nonpartisan Washington think tank.

In fact, the precise impact remains unclear. An analysis by the Price Waterhouse accounting firm found that, on average, families with two children and annual incomes of $50,000, $75,000 and $100,000 would owe the government less money under a flat tax.

But an analysis by the scholars who invented the flat-tax plan suggests that the outcome could vary widely, with some families earning between $30,000 and $90,000 a year paying hundreds of dollars more per year, depending on how aggressively they now use tax shelters. (The academics’ plan assumed a 19% flat-tax rate and a less generous personal exemption than Armey has proposed.)

“There will be winners and there will be losers,” conceded Alvin Rabushka, co-author of “The Flat Tax,” with Robert E. Hall, his colleague at Stanford University’s Hoover Institution, a conservative think tank. But Rabushka added in an interview: “If there are going to be losers in the short run, that’s probably a small price to pay for dramatically improved living standards over the long run.”

Confounding a flat tax’s effect on households is the uncertainty over the tax rate that might prove politically acceptable. The Treasury Department reported earlier this year that a rate approaching 23% might be required just to generate as much revenue as the current system. That level would hit hardest at middle-income taxpayers.

Armey doesn’t try to equal current revenues. In the transition to a flat tax, he is promising a $40-billion tax cut--to be paid for by future federal spending cuts.

Fairness is in the eye of the beholder. “Inside the Beltway, fairness is defined as progressivity,” Mitchell said, or how tax rates are scaled relative to income. “Outside the Beltway, fairness is defined as: ‘Everybody plays by the same rules.’ ”

Then there is the matter of investment income. As many might see it, one aspect of Armey’s flat tax--no tax at all on capital gains and dividends--amounts to a windfall for the rich.

Flat-tax fans vehemently deny this. The current system, they say, wrongly taxes the same investment income over and over, such as when a corporation earns a profit and then pays some of that profit to shareholders in the form of dividends.

Ripple Effects

Under a flat tax, such “double taxation” would be eliminated, a change designed to boost the nation’s meager savings rate and help the economy.

“They say we’re letting wealthy stockholders off the hook. This is completely untrue,” Armey said.

It is also widely said that the IRS code is much despised. But its fine print has fierce defenders, a reality that makes major tax reform agonizingly difficult.

Take the deduction for mortgage interest, a decades-old tax break that is embedded not only in property values but in the psyche of America’s middle class. Removing that tax break could cut home values by as much as 15%, according to a study for the National Assn. of Realtors by economists at DRI-McGraw Hill, a forecasting service in Lexington, Mass.

That would mean $1.7 trillion in lost home equity. And not everyone is comforted by assurances that a flat tax would ease the pain by creating a windfall of economic growth and lower interest rates.

“The current flat-tax proposals have the potential to crush America’s nest eggs,” said John A. Tuccillo, chief economist at the real estate agents’ association.

Others wonder if the flat tax would jeopardize the financial well-being of local governments. If home values plunge, so will property tax revenues. There are other big ifs: What sort of financial fallout would there be if municipal bonds lose their tax-free status and state and local taxes can no longer be deducted from federal returns?

Robert D. McKnew, chairman of the Public Securities Assn., told Kemp’s panel that his group has “identified many more questions than answers” about a major tax overhaul.

Since its introduction in the early 1980s, the flat-tax concept has gone against the grain of politics as usual, drawing interest from various points on the political spectrum. One early advocate was Leon E. Panetta, then a congressman from California’s Central Valley. Now he is chief of staff in a White House that is chilly toward the idea.

Shift in Champions

Another Democrat, former California Gov. Edmund G. (Jerry) Brown Jr., seized on the flat tax as a rallying cry in his maverick bid for the party’s presidential nomination in 1992. At first, Brown’s liberal audiences responded warmly to the idea of a tax that seemed to combat special privileges and an age-old way of doing things.

But when critics charged that Brown’s tax program would shift much of the burden from the well-to-do to the needy, he failed to blunt the attack.

“He was wide open to the criticisms, and a good politician like Bill Clinton seized on them,” said Robert Pollin, a UC Riverside economist who advised Brown on the issue. “I was trying to clean it up, but it never really got anywhere.”

Pollin now questions whether a flat tax could deliver on all the benefits that its proponents envision. As a path to prosperity, “I don’t think it’s as important as other things,” such as education and improved global competitiveness, he said.

In any case, the nerve center for the flat tax has shifted from Brown’s anti-Establishment bandwagon to a lofty perch in the conservative Republican agenda, where strategists see it as a powerful tool for economic rebirth.

Growth, jobs, income gains, even a stronger stock market and shrinking federal budget deficit could arise from a flat tax, true believers say.

Just ask Arthur B. Laffer, the economist who helped frame Ronald Reagan’s “supply-side” economic philosophy and later advised Brown on the flat tax. Said Laffer: “It is the answer.”

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Flat Tax Comparison

How families with particular income levels--all from wages, none from investments--would fare under a flat tax of 19% compared with current tax law Families are assumed to have 1.1 dependents.

*--*

Income Current tax Flat tax $7,800 $7 $0 $12,500 $157 0 $17,500 $567 0 $22,500 $1,346 $525 $27,500 $2,020 $1,483 $35,000 $3,027 $2,894 $44,500 $4,375 $4,758 $60,000 $7,338 $7,734 $85,000 $12,786 $12,475 $130,000 $23,554 $21,028

*--*

****

A $75,000-a-Year Family

How the flat tax would affect a $75,000-a-year family of four with typical investment income and itemized deductions.

*--*

Current law Flat tax Salary $69,488 $69,488 Taxable investment income $5,512 0 Standard deduction 0 $21,400 Itemized deductions $15,800 0 Personal deductions $10,000 $10,000 Taxable income $49,200 $38,088 Income tax $8,706 $6,475

*--*

Sources: Robert E. Hall and Alvin Rabushka, “The Flat Tax.” Deloitte & Touche