FLAT TAX PROVISION (ISSUE)

A flat tax taxes everybody at the same tax rate. A graduated tax taxes at different tax rates. In the late-1990s flat tax proposition generated heated discussions not only about the legitimacy of the flat tax but also about the income tax itself and the Internal Revenue Service (IRS) that administers, regulates, and enforces it. That the system needed reforming was clear to almost every U.S. citizen. It was riddled with exemptions for everything under the sun. Most economists acknowledged that it stifled investment and entrepreneurship and that it was difficult to understand. But the pressing question was what should be done.

The Founding Fathers were opposed to any politics based on income differences because they feared it would lead to class distinctions in the law. They believed that comity and tolerance among the states and classes were the preconditions for a unified country. They forbade direct taxes unless apportioned among the states in order to prevent states from ganging up and placing the tax burden on outvoted regional interests. They preferred taxes, such as import tariffs and excise taxes, that are reflected in the price of a good and paid indirectly by consumers.

The revulsion that people felt toward direct taxation prevented the enactment of a federal income tax until the American Civil War (1861–1865). As the Union broke apart, so did constitutional scruples about income taxation. In 1861 Congress enacted the first federal income tax, at a rate of three percent on net incomes over $800 and 1.5 percent on income from government bonds. The next year Congress passed another income-tax law. This one strengthened enforcement powers. The Revenue Act of 1862 also included explicit progressive taxation, applying higher rates to higher incomes. The rate schedule taxed incomes between $600 and $10,000 at three percent, between $10,000 and $50,000 at five percent, and over $50,000 at 7.5 percent. Although the income tax provided almost $350 million in war financing, the public never liked it. Several anti-income-tax leagues were formed and public discomfort led Congress to repeal the first federal income tax in 1870.

Agitation in the West in reaction to hard economic times was the impetus for the second federal income tax. In the generation after the Civil War, the West was pitted against the Northeast over the money supply and tariffs. Westerners resented having to make mortgage payments for their farms and ranches to Wall Street financiers and having to buy goods from New England industries protected by high import tariffs, while they had to sell their commodities in the competitive market and absorb high railroad shipping rates. The anger swelled when economic downturns caused commodity prices to fall, especially in the late 1880s, culminating in the formation of the Populist Party in Omaha, Nebraska in 1892. Populists advocated ending the gold standard, reducing tariffs, and implementing a graduated income tax.

The Populists represented a threat to the Democrats, who had captured the White House and both houses of Congress in 1892 on a platform of lower tariffs. Although the Populist Party won only nine percent of the presidential vote, Populist ferment did not subside. Were it not for Democratic support for segregation, party strategists knew, many Southern votes would have gone Populist. The income tax became the instrument to keep Populist-inclined voters in the Democratic camp.

The income tax reappeared in 1909, when President William Howard Taft (1909–1913) wanted an increase in tariffs. To get the tariff through, Taft and Senate Finance Committee Chairman Nelson W. Aldrich agreed to accept the income-tax amendment to the Constitution because they did not think it would be ratified by the state legislatures, of which Republicans controlled a majority. But they underestimated the progressive swing in the country and the split in the Republican Party between Taft and Theodore Roosevelt (1858–1919). On February 3, 1913, Delaware, New Jersey, New Mexico, and Wyoming put the amendment over the top.

The states followed the federal example and by 1970 almost all of them had their own income tax. In the late 1990s, although the rich paid a disproportionate share, the bulk of the income-tax revenues came from the middle class. In the beginning the income tax was explicitly directed at the rich, and even at the end of the twentieth century any across-the-board reduction in marginal income-tax rates was denounced by some as "trickle-down" economics. But the income tax ceased to be an elite tax during World War II (1939–1945), when the need for revenues caused the rich man's tax to be applied to 64 percent of the population. Since then, middle-class U.S. citizens have found themselves taxed at rates once thought excessive even for millionaires.

With countless loopholes, an army of income tax bureaucrats in the IRS, complex instructions, increased taxation year by year, and the poor and middle-classes forming the bulk of the tax burden, U.S. citizens agreed that something had to be done. The only real question was what to do about it. Modeled on a tax blueprint first developed in the mid-1980s by Stanford University economists Robert Hall and Alvin Rabushka, the flat tax provision gained considerable momentum in the late 1990s. According to proponents, it would abolish virtually all deductions and loopholes, terminate tax withholding, end the double taxation of savings and investment, shorten the income-tax form to the size of a postcard, and eliminate the capital-gains and estate taxes.

Flat taxes combine a consumer-income scheme tax which taxes at the household level and a value-added tax (VAT) that taxes at the business level. Income from employment is taxed at its destination (households); income from capital, net of investment, is taxed at its source (businesses). The business part of the tax is similar to a VAT. But besides subtracting its input costs and investment from total sales, each company deducts its labor costs as well. Labor income is then taxed at the same rate as at the household level. In effect, a flat tax of this kind is just another variant of a consumption tax. Proponents claimed that it was easy to implement and that it offered the best of both worlds (VAT and consumer-income tax).

Supporters argued that, like a VAT, a flat tax made the tax on capital income easier. Businesses do not have to worry about how their decisions affect the taxes of their myriad shareholders, each with different incomes and personal circumstances. Proponents claimed that there was no need to file countless forms certifying the amount of dividends that companies had paid out to each shareholder and they also claimed that the IRS was spared the chore of verifying how much people saved. Moreover, supporters claimed that a flat tax, like a consumed-income tax, was also easy to make progressive. Since labor income was taxed at the household level, the government could offer generous personal exemptions on a big chunk of each taxpayer's wages. It was estimated that a flat tax raising as much revenue as the existent system could combine a rate of 19 percent with an exemption of about $28,000 for each family of four (with other families getting bigger or smaller exemptions depending on their size). This would allow a family's average tax rate (i.e. its total taxes as a share of its total income) to increase with its income. Whereas the current graduated-income-tax system has multiple tax rates, the flat tax has only two: zero and, whatever the decided rate, say 19 percent. Although the flat-tax curve is not as steep as that for the current system, the tax burden still rises fairly sharply with income.

Supporters claimed that the flat tax may be the United States' best bet politically as well. They said that it would no longer be possible for politicians to confuse voters with mind-numbing details and competing forecasts. Voters would need to ask only two questions. How much income is excluded? And what is the tax rate? Political debate might then have a better chance of focusing on political issues.

Even with such optimism, the flat tax provision was in for a bumpy ride at the end of the last decade of the twentieth century. No matter how simple the scheme, arguments about taxes tended to become complicated. Opponents of the flat tax reform raised numerous flags. They claimed that it would benefit the rich at everyone else's expense. They claimed that because it fell on consumption, a flat tax bore heavily on the elderly and people in retirement. Unlike younger people, the retired tend to consume all their income. Indeed, most consume more than their income by running down their stock of savings. Any consumption-based tax therefore hits them especially hard. Opponents also argued that the flat tax did not sufficiently address investment income. At the very end of the century the fate of the flat tax provision was uncertain.

Topic overview

I think that we are seeing Americans becoming better educated about the flat tax, about its pluses and minuses. I mean, even the Democrats have suggested various versions of a flat tax. I'm thinking of Congressman Gephardt's tax proposal. . . . So, whether you agree with the details of Steve Forbes's plan or not, he's certainly forced that issue in the American political agenda. I think we'll be hearing a lot more about it in the next couple of years.

david yepsen, des moines register, on c-span, january 15, 1996

FURTHER READING

Armey, Dick. Flat Tax. New York: Fawcett Press, 1996.

Hall, Robert E. and Alvin Rabushka. Low Tax, Simple Tax, Flat Tax. New York: McGraw Hill, 1983.

——. The Flat Tax. Washington: The Hoover Press, 1996.

Hicko, Scott E. The Flat Tax: Why It Won't Work for America. Omaha, NE: Addicus Books, 1996.

Sease, Douglas R. and Herman. The Flat-Tax Primer. New York: Viking, 1996.

LAFFER CURVE THEORY

LAFFER CURVE THEORY. The Laffer Curve Theory states that tax revenues are related to the tax rate in such a manner that no revenue is generated at a tax rate of either zero or one hundred per cent, for at one hundred percent taxable activity would effectively cease; somewhere in between these tax rates lies the revenue-maximizing rate. Higher income taxes reduce the tax base by discouraging saving and labor supply. A reduction in after-tax income will reduce savings. An increase in the income tax rate changes the relative price of consumption and leisure, encouraging leisure. Beyond the maximum, higher rates would reduce income so much that revenues would decrease. Lowering tax rates indirectly encourages investment by increasing savings, potentially increasing income and thus tax revenues. The curve need not be symmetric or have a particular maximum. Professor Arthur Laffer and Representative Jack Kemp argued that a large reduction in U.S. income tax rates would reduce the deficit. This implied that previous policymakers were acting against their own true interests, imposing unpopular high tax rates that reduced the amount of revenue they had to spend. The Reagan Administration's tax cuts during the 1980s led to record large deficits, not to reduced deficits.

BIBLIOGRAPHY

Bosworth, Barry P. Tax Incentives and Economic Growth. Washington, D.C.: Brookings Institution, 1984.

Canto, Victor A., Douglas H. Joines, and Arthur B. Laffer. Foundations of Supply-Side Economics: Theory and Evidence. New York: Academic Press, 1983.

Dunn, Robert M., Jr., and Joseph J. Cordes. "Revisionism in the History of Supply-Side Economics." Challenge 36, no. 4 (July/August 1994): 50–53.

Robert W.Dimand