SPECIAL REPORT: THE FLAT-TAX PROPOSALS : A Flat-Out Change : Just Whom Would Tax Plans Help?

How’s this for an income tax system? Eliminate taxes on interest, dividends and capital gains. Throw out estate taxes. Get rid of all those complicated loopholes, credits and deductions. Impose a single low tax rate equating to maybe 17% of wages--no matter how much you earn. Have annual tax returns filed on a postcard.

Nirvana?

No. It’s the flat tax. And it’s getting lots of attention these days, thanks to presidential hopeful Steve Forbes, former Housing Secretary Jack Kemp and a few like-minded people in Congress who think the U.S. Tax Code has gotten so out of hand that it’s time to trash the whole thing.

Yet for all the emotional appeal--Americans like the idea of a simple system that does away loopholes and reduces the power of the feared Internal Revenue Service--experts maintain that it could hurt as many people as it helps.

For starters, it could significantly raise tax rates for members of the vast middle class--those people earning between about $50,000 and $75,000 annually. It could drastically reduce the value of your home. It might hurt your investments in municipal bonds. It could make the already staggering federal deficit bigger still. And it could cause unemployment and massive economic upheaval.

Then again, it might just make you richer.

The truth is, no one knows what the long-term effects would be of the plans several presidential candidates are now proposing. Never in the history of the industrialized world has a country burned its tax code and started anew. There are no models to go by. There is only informed speculation, based on varying theories of how the economy might react.

But in the short run, the implications of a flat tax for an individual family’s federal tax burden are fairly easy to calculate. The only trick is determining which flat-tax proposal might succeed. There are a number of possibilities.

Indeed, in the last year, at least half a dozen such proposals have been launched, revised, revamped and launched again. They have been brought forward by influential lawmakers such as House Majority Leader Dick Armey (R-Texas); Sen. Phil Gramm (R-Texas); Sen. Arlen Specter (R-Pa.); Rep. Richard A. Gephardt (D-Mo.); Sen. Sam Nunn (D-Ga.), and by Kemp and Forbes.

Although their proposals vary in many of the details, they all agree that today’s 40,500-page U.S. Tax Code has got to go. In its place should be a system by which each dollar earned gets taxed but once. That would be a dramatic change from current law, whereby some dollars escape taxation completely while others are taxed three and four times over.

Here’s what they’re proposing and how it would affect you:

The Armey Approach

Rep. Dick Armey was the first among this group of national politicians to weigh in with a flat-tax table in mid-1994. Because his plan was first, it is the most developed and detailed.

It’s also startlingly simple. Each taxpayer would get a generous personal exemption of $10,700--or $14,000 if you are a single head of household. Families would get additional exemptions of $5,000 for each dependent child.

These amounts would be subtracted from the family’s income. The remaining amount would be taxed at a 20% rate.

Two years after its passage, Armey proposes to reduce the rate to 17% and to index personal exemptions for inflation. That would mean each child’s exemption would be worth about $5,300 and each adult would get $11,350.

On an individual level, only wages would be taxable. You wouldn’t pay a tax on capital gains, nor on interest or dividend income. There would no longer be estate taxes due when you die.

Conversely, you would get no deductions for mortgage interest, state income and property taxes, charitable contributions, casualty losses, medical expenses or capital losses. The tax breaks for municipal bonds, child-care expenses and work-related expenses and relocation would be history.

How would this shake out for the average American?

If your income is fairly low or very high--or if you now take only the standard deduction--you would end up paying about the same or far less under Armey’s flat-tax system than you do now.

If, on the other hand, you’re a middle-class homeowner who gives to charity but doesn’t have much of an investment portfolio, you could end up paying substantially more.

Consider a hypothetical family led by a couple we’ll call Paul and Pam Lincoln. They earn $60,000 between them, and they have two small children. The Lincolns’ itemized deductions include $15,000 in mortgage interest expenses, $4,000 in state income and property taxes, and $1,000 in charitable contributions. They also contribute $5,000 annually to a child-care account that pays baby-sitting expenses for the Lincoln offspring on a before-tax basis. And they reported $1,000 in capital gains. In all, their taxable income amounts to $26,000 under current law. They pay $3,904 in tax.

If Armey’s flat tax were imposed tomorrow, they would pay $5,720--$1,816 more than they do today. That’s simply because they can’t deduct their child-care expenses, their mortgage interest, their charitable contributions or their state taxes--and their taxable income soars as a result.

If, on the other hand, Paul and Pam earned less in wages and more in capital gains--or if they had fewer deductions, they might end up better off under Armey’s plan than today’s system.

For example, if they didn’t have the home, they probably wouldn’t itemize deductions. They’d get only the benefit of the $5,000 in child-care tax breaks, plus the standard deduction. In all, they’d pay $5,764 in federal income tax--$44 more than they’d pay under Armey.

If the Lincolns were a one-income family and didn’t qualify for the $5,000 child-care tax break either, they would be paying $7,089 in federal income taxes now. In this instance, they’d save a tidy $1,369 if the U.S. adopted the Armey approach.

Flat by Forbes

Steve Forbes, millionaire magazine publisher-cum-presidential candidate, also has a simple formula for a flat tax. You’d get a personal exemption of $13,000 if you’re single, $26,000 if you’re married filing jointly. You’d get another $5,000 in personal exemptions for each dependent child.

As with Armey’s approach, there would be no tax on interest, dividends, capital gains or inheritance. There would be no deductions, either.

So what would happen to the Lincolns? They’d pay $4,080--just $176 more than they do today. But, again, if they didn’t have all those deductions, their current tax bill would be higher. They’d end up substantially better off under Forbes.

But the biggest winners under this--and most other flat-tax systems--would be people who have the most money.

Consider the hypothetical Jackson family--Andy, Adele and their teenage twins Sue and Lou. The Jacksons bring home $150,000 in wages, report $50,000 in capital gains and earn $30,000 in interest and dividends. In all, their gross income amounts to $230,000.

Under current law, they get deductions for mortgage interest, charitable contributions and state taxes, but the value of their deductions is limited by rules that restrict write-offs for high-income filers. In all, deductions and personal exemptions shave $52,741 from their taxable income, but they pay a high marginal rate. The bottom line: They owe $45,553 in tax.

Thanks to the low rates and tax exemptions for investment income, the Jacksons would pay just $19,380 under the Forbes plan--$26,173 less than they pay today.

The Gramm Plan

Sen. Phil Gramm, whose political aspirations had been eclipsed by the popularity of Forbes’ flat-tax proposal, rushed out with his own flat-tax plan last week. It would preserve deductions for mortgage interest, charitable contributions and still offer a rate of 16%.

Americans would have to pay taxes on interest and dividends, though. And they’d even pay tax on capital gains. However, future capital gains would be indexed to inflation, so your taxable gain would be less than your total capital gain.

The effect on the Lincolns? They would pay just $2,080 in tax--a stunning $1,824 savings from current law. All of the Lincolns’ friends, neighbors and acquaintances would save too. In fact, no matter how you run the numbers, everybody--except a few low-income folks who currently claim the earned income tax credit--would save money under Gramm.

However, in the same six-page document that spells out the tax savings, Gramm promises to eliminate the nation’s multibillion-dollar annual budget deficit.

How will he cut the deficit while bringing in less in tax revenue? He’d cut spending. But, more important, the flat tax would make the economy grow and help people prosper, says a senior Gramm aide. Individuals and companies would earn so much more under the Gramm system that the government will get billions in additional revenues. Unemployment would drop; personal income would soar; mortgage interest rates would plunge into the 4% range for the first time in generations, Gramm says in campaign literature.

A tall order for a small tax.

Previous Proposals

Meanwhile, Sens. Sam Nunn and Pete Domenici (R-N.M.) introduced an alternative plan earlier this year. Instead of a flat tax, they proposed a new deduction for saving. If you earned $100,000 and saved $50,000 of that, you would pay tax only on the $50,000 that you spent.

Sen. Richard G. Lugar (R-Ind.) proposed a national retail sales tax to replace the current system. Sen. Arlen Specter proposed a 20% flat tax that would have slightly smaller personal exemption amounts than some of the other plans, but that would allow for a limited amount in mortgage interest and charitable contribution deductions. Rep. Richard Gephardt introduced a plan that would tax some people at a 10% rate but would tax higher-income filers at a higher rate.

For various reasons, all these plans appear “dead in the water,” says Arthur Hall, senior economist at the Tax Foundation, a nonpartisan tax research group headquartered in Washington.

In fact, the only other flat-tax plan that appears to be going anywhere isn’t a plan at all. It’s a report, issued earlier this month, put together by a commission headed by Jack Kemp that merely recommends that America replace its “impossibly complex, outrageously expensive, overly intrusive, economically destructive and manifestly unfair” income tax system with a flat tax.

Kemp Commission

Kemp’s commission, formally known as the National Commission on Economic Growth and Tax Reform, is worth mentioning because it got to the heart of why so many politicians are so quick to trash a tax system they have spent the last 50 years constructing. The report also helps explain why many experts are highly skeptical about the prognosis for a simple flat tax.

In a nutshell, Washington has read and embraced a book called “Low Tax, Simple Tax, Flat Tax,” written by economics professors Robert E. Hall and Alvin Rabushka. The authors maintain that today’s system discourages savings and wastes resources--human and otherwise--by promoting uneconomical activity solely for the purpose of avoiding taxes. A simpler system, with fewer loopholes, could generate sufficient revenue to operate government even at lower tax rates. Better yet, it could usher in brisk economic growth.

Says Kemp in the commission report: “If you tax something, you get less of it. If you subsidize something, you get more of it. The problem in America today is that we are taxing work, savings, investment and productivity, and we are subsidizing debt, welfare, consumption, leisure and mediocrity.”

Nevertheless, the report says encouraging home ownership, charitable contributions and retirement savings is important. Members of the commission add that you can’t ignore the impact that federal tax policy has on the states.

Accommodating these worthy goals costs money and creates a certain amount of complexity, of course. But any serious discussion of a flat tax has to take social policy into account, the Kemp commission says.

Therein lies the rub.

“It has always been accepted that one of the purposes of the tax law is to encourage behavior that’s acceptable and discourage behavior that’s not,” says James F. Ivers, professor of taxation at American College in Pennsylvania. It’s unlikely that Congress would opt to eliminate these incentives, he adds. But if you simply pass a single rate and leave the deductions alone, “you haven’t changed much. You simply have one rate instead of five.”

Moreover, if you allow the deductions but have high exemptions to protect the poor and low rates to help the rich, somebody in the middle is bound to get squeezed, Hall says.

“When you talk about a flat tax, everybody wants to wave a postcard,” says Jerold Cohen, chairman of the tax section at the American Bar Assn. and a partner at the Atlanta law firm of Sutherland, Asbill & Brennan.

“But are you willing to do it even if you have to pay 20% more in taxes? If the answer to that is yes, then maybe this tax system will work.”

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Winners and Losers

Just how would a flat tax affect individuals? The answer, of course, would depend on which plan were passed and the specific deductions and credits a taxpayer now claims. Here are a few simple examples based on current law and assuming a 17% flat tax, which would allow an $11,000 exemption per adult per household (up to $22,000) and a $5,000-per-child exemption. These assumptions represent what appears to be the middle ground between the leading flat-tax proposals.

* WAGES: $30,000 *

1. Bob Washington, single renter, no children. Currently claims the standard deduction of $3,900 and one personal exemption of $2,500.

*--*

Current law Flat tax Interest income: $500 Not taxable Gross income: $30,500 $30,000 Deductions/exemptions: $6,400 $11,000 Taxable income: $24,100 $19,000 Tax: $3,713 $3,230

*--*

Flat-tax savings: $483

* WAGES: $60,000 *

2. Sam and Suzy Hamilton, married homeowners, no children. Currently claim itemized deductions of $20,000 and two personal exemptions of $2,500 each.

*--*

Current law Flat tax Capital gains: $1,000 Not taxable Gross income: $61,000 $60,000 Deductions/exemptions: $25,000 $22,000 Taxable income: $36,000 $38,000 Tax: $5,404 $6,460

*--*

Flat-tax cost: $1,056

* WAGES: $60,000 *

3. Paul and Pam Lincoln, married homeowners, two children. Currently claim itemized deductions of $25,000 and four personal exemptions of $2,500 each.

*--*

Current law Flat tax Capital gains: $1,000 Not taxable Gross income: $61,000 $60,000 Deductions/exemptions: $35,000 $32,000 Taxable income: $26,000 $28,000 Tax: $3,904 $4,760

*--*

Flat-tax cost: $856

* Wages: $150,000 *

4. Andy and Adele Jackson, married homeowners, two children. Currently have $51,000 in itemized deductions and $10,000 in personal exemptions. However, under the current tax code, the value of their deductions is actually less because the writeoffs are limited for high-income filers. They can claim just $47,541 in itemized deductions and their four personal exemptions are worth just $2,600.

*--*

Current law Flat tax Interest/dividends: $30,000 Not taxable Capital gains: $50,000 Not taxable Gross income: $230,000 $150,000 Deductions/exemptions: $52,741 $32,000 Taxable income: $177,259 $118,000 Tax: $45,553 20,060

*--*

Flat-tax savings: $25,493

Source: Philip J. Holthouse, Holthouse Carlin & Van Trigt, Los Angeles

**********

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Go Figure

How would a flat tax affect you? Here’s a work sheet to help you figure it out. The flat-tax figures are estimates based on details of the plans currently proposed. They assume a 17% rate, no deductions and personal exemptions amounting to $5,000 per dependent child, $11,000 per taxpayer.

To get started, you will need a copy of your most recent completed tax return. If your income and sources of income are relatively stable, it doesn’t matter whether the return is for the 1994 tax year or for 1995. However, if your financial situation has changed significantly recently, you should complete the work sheet after filling out your 1995 tax return.

1. Current tax as shown on your completed return (on Form 1040EZ, the figure on line 10; on 1040A, line 28; on 1040, line 54)

2. Wages (including estimated value of company-provided fringe benefits)

3. Exemptions (calculate below:)

Enter $11,000 per adult taxpayer (e.g., $22,000 married, filing jointly). Plus $5,000 per dependent. If single, head of household, enter $14,000 plus $5,000 per dependent. (Thus, a couple with two children would enter $32,000, or $22,000 for the adult filers plus $10,000 for the children.)

4. Subtract line 3 from line 2.

5. Multiply the result on line 4 by 0.17. This is the amount you would owe under a flat-tax system.

6. Compare line 5 to line 1. If line 1 is greater than line 5, subtract line 5 from line 1 and enter the amount you would save under a flat tax. If line 1 is smaller than line 5, subtract line 1 from line 5 and enter the additional amount you would pay with a flat tax.

Example(1)

1. Current tax: $5,479

2. Wages: $55,000

3. Exemptions: 22,000

4. Subtract line 3 from line 2: $33,000

5. Multiply the result on line 4 by 0.17: $5,610

6. Compare line 5 to line 1:

Net savings / cost: +/- $131

(1) Example assumes a couple earning $50,000 who estimate the value of their fringe benefits at $5,000. (If these are provided under a flat tax, they’re likely to be taxable.) They claim $13,500 in exemptions and itemized deductions.