SPECIAL REPORT: THE FLAT-TAX PROPOSALS : Upsides and Downsides of Instituting a Flat Tax

Every time Congress mulls a major overhaul of the U.S. tax system, the idea of a flat tax comes up. It’s simple, economically beneficial and, at least in theory, nearly universally attractive.

Why, then, has the flat tax never taken off?

Because, for starters, tens of millions of Americans have a stake in maintaining the status quo. They have made decisions that were influenced by the current tax system. They bought houses knowing that they could capitalize on deductible mortgage interest. They locked away their savings in tax-favored retirement accounts. They bought tax-favored life insurance investments, municipal bonds, low-income housing. They gave to charity.

Eliminating these deductions overnight would undoubtedly cause massive upheaval. The National Assn. of Realtors claims it would slam property values, causing the average homeowner to lose 15% of the equity in his or her home nearly overnight. Rick Snyder, president of the California Assn. of Realtors, adds that so many people rely on a robust housing market for employment that about 400,000 nonagricultural jobs could be lost in California alone.

Moreover, public schools are financed through property taxes that are calculated as a percentage of assessed value, says California Controller Kathleen Connell. If real estate gets hit, so do schools.

And a system that encourages saving over spending--as flat-tax proposals do--could cut into sales tax revenues, another major source of financing for state and local governments, which provide residents with parks, sewers, roads and public transportation.

Loss of tax-favored status for municipal bond interest could cut into muni investors’ portfolio values by as much as 13%, estimates Joan Payden, president of the Los Angeles investment management firm Payden & Rygel.

Naturally, those who syndicate, buy and sell low-income-housing tax shelters would be hit. Presumably, legions of tax accountants and tax attorneys would need to find new work. And without deductions for charitable contributions, thousands of tax-exempt organizations would presumably receive fewer donations.

To pull the rug out from under millions of registered voters is impolitic to say the least. Moreover, some of the deductions were put into law for admirable reasons.

Who, after all, can argue against charity, homeownership and making housing available to the poor? Who wants to undermine public schools by taking away their source of financing?

Still, advocates of a flat tax say the system would prove so economically beneficial that it would lift all boats. In the long run, no one would be terribly hurt and most people would be better off, they say.

Maybe. But in the short run, there’s bound to be some upheaval and very real financial pain, says Connell. When politicians see the repercussions and try to blunt the pain, they introduce exceptions--loopholes--into the system, says Arthur Hall, senior economist at the Tax Foundation, a nonpartisan Washington-based tax research group. And suddenly, the flat-tax system becomes bumpy.

“The flat tax is a very elegant piece of work,” says Hall. “But it can unravel fast if you start making any exceptions.”