Why Flat Tax Isn't A "True" Flat Tax

2-23-96
Charles R. Enis, Associate Professor of Accounting
Penn State's Smeal College of Business Administration
(814) 865-1149

The idea of replacing the income tax with a flat tax has had its proponents and detractors for at least 15 years, but a Penn State researcher says that the flat tax concept making news now falls short of the real thing.

"A 'true' flat tax would eliminate all exclusions, deductions, exemptions, and credits," says Enis, who published papers on flat taxes as far back as 1984. "It would achieve the maximum simplicity and impose the lowest possible tax rate on individuals while raising roughly the same revenues as the current income tax system."

In the early 1980s, when a proposed 10 percent flat tax was a big political issue, a study by Enis and colleague Darryl L. Craig, now at the University of Wisconsin-Milwaukee, showed that a "true" flat tax would transfer substantial taxes from the rich to the poor. Enis says this result makes a "true" flat tax the benchmark against which alternative tax reform proposals should be compared.

Hypothesizing a flat tax of 12.72 percent, which would have raised the same amount of revenue as the income tax at the time of the study, Enis and Craig found that a substantial proportion of individual tax returns would experience a tax increase. This "true" flat tax would likely hurt low-income families, provide tax relief for high-income families, and divide middle-income families equally between gainers and losers. The major transfer of the tax burden would have been from the top 10 percent of income earners to the lower 70 percent of income earners.

"Under a 'true' flat tax of this sort, more families in the top group of income earners would profit from a lower tax rate than would suffer from the loss of loopholes," Enis says.

In a later study, Enis and Craig showed that adding a degressive feature -- such as exempting a specified initial level of income from taxation -- supplies a flat tax with some of the progressiveness seen in the income tax system. They also found that a degressive flat tax would shift tax burden from lower-income to upper-income and especially middle-income families. Recent flat tax proposals are more similar to a degressive flat tax than to a "true" flat tax.

The researchers' flat tax models eliminated tax free income, deductions, and credits and replaced multiple rates with a single rate.

Unlike the systems simulated by the researchers, the flat tax being championed by Presidential hopeful Steve Forbes and others would apply a 17 percent rate to all compensation and pension contributions. It would not tax other incomes sources, such as interest, dividends, and capital gains of individuals; and would allow a large personal exemption but no deductions.

The revenue neutral tax rate in the degressive flat tax simulated by Enis and Craig was 21.6 percent, which suggests that the rate proposed by Forbes is likely to result in a large revenue shortfall.

Furthermore, Enis points out that, unlike what has been suggested by Forbes, a flat tax does not require the elimination of the entire internal revenue code. Many provisions of the code were enacted to prevent abuse of the manner in which income is measured, timed, reported, and classified regardless of the rates or rate to be applied. Elimination of such safeguards will invite unbridled tax avoidance, Enis says.

Meanwhile, although individuals would not have to include interest and dividends in taxable income under recent flat tax proposals, such forms of income will not be completely tax free because businesses that distribute them will receive no deductions for the payouts.

"Disallowing these deductions and exempting related income from taxation will have the effect of taxing income at its source and eliminating double taxation on distributed corporate profit," Enis explains.

In addition, as described by Enis, a "true" flat tax would eliminate every loophole for taxpayers, including the cherished personal exemption. The tax liability would then be computed by applying a low unitary tax rate to the complete income base for all individuals.

"Although many features of a 'true' flat tax would streamline matters greatly for both taxpayers and the government, the elimination of most forms of tax shelters could discourage home ownership, gift giving, and retirement planning," Enis notes. "Still, it would probably achieve a lower rate than 17 percent, which could result in investors having greater disposable income available for these activities.

"It would also give individuals a clearer knowledge of their current and future disposable incomes for financial planning purposes."

**gwc**

Contact:
Gary W. Cramer
(814) 865-9481 (office)
(814) 231-0590 (home)
gwc104@psu.edu

Vicki Fong
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(814) 238-1221
vyf1@psu.edu