Let’s Be Careful What We Wish for in Tax Changes
The flat tax is this year’s health-care reform, a political balloon that will deflate once the American people look into the details.
Right now the idea of everybody paying a flat 17% rate of income tax is drawing cheering crowds from one primary state to the next.
Politicians claim and people believe that a flat tax will be simple, cheap and efficient. Most people also seem to think it will lower their taxes.
But flat taxes, such as those proposed by candidate Steve Forbes and Rep. Dick Armey (R-Texas) would raise taxes for most middle-class taxpayers.
And a flat tax eliminating deductions for mortgage interest, charitable contributions and state and local income and property taxes would complicate life for many people.
It would not solve basic problems of high payroll taxes to fund Social Security and Medicare. For business, the flat tax would encourage investment in the long term but increase write-offs and layoffs in the short term.
Then why all the cheering? “Americans are infatuated with the idea; they think flat means low or flat means fair,” says Herbert Stein, chief economic advisor in the Nixon administration and now a fellow of the American Enterprise Institute.
But it doesn’t necessarily mean any of those things, and once that realization sinks in and organized opposition gets rolling, there will be a cooling of flat-tax fervor.
Yet public enthusiasm for tax reform is very strong. People want simplification of the complex system and relief from a mounting combination of income, payroll and state taxes. If they’re young, they resent the big tax bite from their paychecks; if they’re older, they resent taxes on interest and dividends that inhibit saving for retirement.
So it’s probable we’ll have tax reform of some sort in 1997--with perhaps a capital gains tax cut this year as part of the federal budget package.
But we should be careful what we ask for. Because the tax system now contains quiet subsidies for many taxpayers, and eliminating them will have unpleasant effects that politicians conveniently neglect to mention.
It has happened before. In 1986, a reform law rightly eliminated tax shelters. But the change of rules devastated commercial real estate for many years because the rules were changed so abruptly.
Similarly today, a flat tax would eliminate the home mortgage interest deduction. Long term that’s not a bad idea. Canada, Japan and other nations have high levels of home ownership without any interest deduction. Eliminating the U.S. deduction would bring $80 billion into the Treasury and cut the federal deficit in half.
But the transition would be brutal for many home
owners who have counted on the federal government sharing the cost, in effect, when calculating their ability to afford a mortgage.
State and local taxes, including property taxes that finance schools, would become more onerous without a deduction from federal taxes. States with income taxes would have to cut back services or taxes. As in exercise and diets, no gain without pain is the rule.
With a flat tax, businesses would no longer depreciate equipment. So disruptive write-offs of existing plant and equipment totaling $500 billion could greet the introduction of a flat tax.
And with fringe benefits no longer deductible, companies would either make employees pay fully for their medical, dental and other benefits or the government would class fringe benefits as taxable income. That would go a long way toward balancing the federal budget, but it would unbalance a lot of household budgets.
Bottom line on the flat tax is that figures look better than they are. With deductions and exemptions today, U.S. taxpayers on average pay 21% to 25% of their incomes in federal taxes. At 17% of differently calculated gross income, many taxpayers pay the government more.
Yet we need tax reform, if only to simplify a system so complex that Americans spend $590 billion a year on accountants, lawyers and tax preparers.
But the urgent reason for tax reform “is that we badly need to save more,” says Lawrence Stone, of Los Angeles’ Irell & Manella law firm, a former advisor to the Treasury and professor of tax law.
In an aging population, almost half the people over 45 have no retirement savings; the surplus in Social Security is diminishing faster than anticipated because of unforeseen costs of Medicare and American longevity. When Chancellor Bismarck introduced social security in 1889, the average German worker’s life expectancy was 48; when President Roosevelt signed the Social Security law in 1936, life expectancy was 56. Now U.S. life expectancy is 72, and the baby boomer who gets into his or her 50s can expect to live to 85.
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Right there is why we hear so many suggestions for changing the tax system. With a lot of nonworking years to finance from pensions and investments, taxes are being called upon to serve a new national priority.
As tax breaks favored housing and job creation for a younger population over five decades, now they will favor saving. Taxes on interest and dividends will be reduced or eliminated to allow savings to build up more rapidly.
Capital gains tax cuts will encourage aging homeowners to sell the house and loosen up equity for retirement.
The federal budget will have to be balanced to keep Social Security and Medicare fiscally sound. Flat tax or no, that means taxing fringe benefits and eliminating mortgage deductions, says Stein. Economist Robert Pollin of UC Riverside would lump payroll taxes with general withholding, to increase the Social Security take from upper-income taxpayers.
Such ideas will be part of the mix as tax reform gathers momentum next year, after the presidential election. The ultimate tax legislation will be an “amalgam” of current proposals to tax consumption but exempt investment income, says Washington tax expert Mark Bloomfield.
Taxes will be “flatter”--meaning fewer brackets, less complexity. But reform will be piecemeal, as is happening with health care. A drastic flat tax of the kind being talked about in political campaigns is unlikely and, if people really think about it, unwelcome.
