CRS Analyzes Replacing Current Tax System With Flat Tax

The President and leading Members of Congress have stated that fundamental tax reform is a major policy objective for the 112^th Congress. In the 111^th Congress, four bills were introduced that included a flat tax based on the concepts of Hall-Rabushka. In the 112^th Congress, new legislation may be introduced to levy a flat tax. The concept of replacing the current U.S. income tax system with a flat rate consumption tax is one option to reform the U.S. tax system. The term "flat tax" is often associated with a proposal formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover Institution. This report analyzes the idea of replacing the U.S. income tax system with this type of consumption tax. Although the current tax structure is referred to as an income tax, it actually contains elements of both an income and a consumption-based tax. A consumption base is neither inherently superior nor inherently inferior to an income base.

The combined individual and business taxes proposed by H-R can be viewed as a modified value-added tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension receipts. Part or all of an individual's wage and pension income would be tax-free depending on marital status and number of dependents. The business tax would be a modified subtraction-method VAT with wages (and salaries) and pension contributions subtracted from the VAT base, in contrast to the usual VAT practice.

The analysis of the flat tax proposal is covered by the following four topics that sometimes overlap: broad economic issues, narrow sectoral economic issues, simplicity, and international comparisons. First, broad economic issues relate to economic effects of the flat tax on the entire economy: equity, efficiency, international trade, price level, interest rates, and revenue. Second, sectoral economic issues deal with specific industries or sectors of the total economy: differential effects on businesses, charitable organizations, housing, financial services, pensions and insurance, health care services, and state and local governments.

Third, tax economists, government leaders, and taxpayers are interested in the simplicity of a tax system, and the current income tax system is complex. A positive aspect of the proposed flat tax is the ease with which the individual and corporate tax systems could be integrated. But, the complexity of the current tax code is partially due to attempts to achieve greater equity or to improve economic efficiency, and there are often tradeoffs between simplicity, equity, and efficiency. It can be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax; by the time a consumption tax becomes enacted, it may become complicated. Fourth, there are major distinctions between recent consumption tax proposals for the United States and the current tax systems of other developed nations. Numerous aspects of the H-R flat tax proposal have not been fleshed out and many important policy issues have yet to be analyzed.

It is worth noting that numerous aspects of the H-R flat tax proposal have not been fleshed out, and important policy issues have yet to be analyzed.

This report will be updated as issues develop, new legislation is introduced, or as otherwise warranted.

                               Contents

The President and leading Members of Congress have stated that fundamental tax reform is a major policy objective for the 112^th Congress. The concept of replacing the current U.S. income tax system with a flat rate consumption tax is one option to reform the U.S. tax system. The term "flat tax" is often associated with a proposal formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover Institution at Stanford University. In 1981, they proposed the replacement of the federal individual income tax and the federal corporate income tax with a flat rate consumption tax. In early 1995, Hall and Rabushka published the second edition of their book titled simply The Flat Tax.¹ In 2005, Dr. Hall provided some additional insights into his flat tax proposal.² In the 1990s, much research was conducted on the flat tax because it received extensive political debate and widespread media coverage.

This report explains and evaluates the Hall-Rabushka proposal for three reasons. First, since four bills were introduced in the 111^th Congress that included an H-R flat tax, new bills including an H-R flat tax may be introduced in the 112^th Congress.³ Second, the Hall-Rabushka proposal concerns many issues relevant to other tax reform proposals. Third, unlike a number of other reform plans, the H-R proposal has sufficient detail to permit examination, although numerous aspects of the proposal have yet to be fleshed out.⁴

The report begins with discussions of the concept of an income tax base versus a consumption tax base, and three types of broad-based consumption taxes. Next, the justification and operation of the proposed H-R flat tax are explained. Lastly, selected policy issues are examined, including both broad and narrow economic issues, simplicity, and international comparisons. The broad economic issues relate to the economic effects of the flat tax on the entire economy, for example, equity, efficiency, and international trade. The more narrow economic issues deal with specific industries or sectors of the total economy, such as housing or charitable organizations.

The easiest way to understand the differences between the income and consumption tax bases is to define and understand the economic concept of income. In its broadest sense, income is a measure of the command over resources that an individual acquires during a given time period. Conceptually, an individual can exercise two options with regard to his income: he can consume it or he can save it. This theoretical relationship between income, consumption, and saving allows a very useful accounting identity to be established; income, by definition, must equal consumption plus saving.

Should the tax base be income or consumption? Is one inherently superior to the other? How do they stack up in terms of simplicity, equity, and efficiency? There appears to be insufficient theoretical or empirical evidence to conclude that a consumption-based tax is inherently superior to an income-based tax or vice versa.

The prevailing procedure is to treat the purchase of capital inputs (plant and equipment) the same way as the purchase of any other input; that is, the purchase price is deducted at the time of purchase. This tax treatment of capital purchases is equivalent to expensing.

Hall-Rabushka Flat Tax

First, Hall and Rabushka maintain that there is a need for tax simplification. They argue that the complexity of the current federal individual and corporate income tax systems results in excessive administrative and compliance costs.⁹

Second, Hall and Rabushka argue that a consumption tax is superior to an income tax because " . . . individuals would be taxed on what they take out of the economy (when they spend money to consume), not on what they produce (reflected in working and saving)."¹⁰ They claim that

As will be discussed in more detail, some economists dispute H-R's justifications for a flat tax.

If a bill is proposed in the 112^th Congress, based on the H-R concept it would include much higher "personal allowances" for taxpayers and dependences than proposed by H-R for 1995, as described in the subsequent sections of this report.

Except for pension contributions, all fringe benefits would be included in the firm's tax base. "The employer's [Social Security] contributions would be treated like other fringe benefits -- it would not be deductible from the business tax."¹⁶ Government employees and employees of nonprofit organizations would have to add to their wage tax base the imputed value of their fringe benefits, because activities of government entities and tax-exempt organizations would be exempt from the business tax.

All purchases of plant and equipment would be immediately expensed (deducted from gross income). There would be no depreciation expenses for previously purchased plant and equipment. There would be no recovery of cost of goods sold (existing inventory) -- a firm selling off inventory would not be able to deduct the cost.

A standard subtraction-method VAT would rebate negative amounts of VAT that might occur when a firm's subtractions exceed its revenue -- for example, when a firm invests a large amount but has low sales. Under the H-R business tax, any negative tax would be carried forward to the next year with interest paid on the carry-forward.

Self-employed individuals would usually find it advantageous to file both a business tax return and an individual tax return. From their business operations, they would be able to pay themselves a salary, and thus use the personal allowance to exclude some income from taxation. For example, a married couple operating a business could exclude up to $16,500 in salary from taxation.

All owners of rental real estate would be required to file the business tax return.¹⁷ "The purchase price [of rental property] would be deducted at the time of purchase, and the sale price would be taxed at the time of sale."¹⁸

Selected Policy Issues

The H-R tax presented policy issues that fall into four broad categories: broad economic issues, more narrow sectoral economic issues, simplicity and international comparisons.

For 1991, H-R compared taxes on adjusted gross income consisting only of wage income with a hypothetical tax payments from the wage tax for a typical family (a married couple with 1.1 dependents). H-R concluded that currently the typical family with wage income below about $10,000 does not pay significant individual income tax on that income and would pay no flat tax on wages. The typical family with wage income between $10,000 and $30,000 would pay less under the flat wage tax than they currently pay in income tax. But, the flat wage tax would be slightly higher on average for the typical family in the $30,000 to $90,000 range. The typical family with wage income over $100,000 would pay less under the flat wage tax.²¹

But, H-R pointed out that there are limits to the preceding comparison.

Because of the substantial data problems in attempting to measure the incidence of the flat tax compared to the current individual tax, H-R conclude that

In summary, the current income tax system is progressive but the incidence of the H-R flat tax is uncertain. There is no general agreement concerning the vertical incidence of the proposed shift to the H-R flat tax -- whether it would reduce or increase tax progressivity.

For households, two out of three major decisions would not be altered by this hypothetical consumption tax. First, this consumption tax would not alter choices among goods because all would be taxed at the same rate. Thus, relative prices would not change. In contrast, other taxes, such as excise taxes, which change relative prices, would distort household consumer choices by encouraging the substitution of untaxed goods for taxed goods. A hypothetical income tax on all income would be neutral in this respect.

Second, a flat tax does not affect the relative prices of present and future consumption. In contrast, the individual income tax affects the relative prices of present and future consumption because the income tax is levied on income which is saved, and then the returns on saving are taxed.

A household's work-leisure decision, however, would be affected by a flat tax or any other tax on either consumption or income. Since leisure would not be taxed, any tax increase would fall on the returns to work. Hence, under either an consumption or an income tax the price of leisure is reduced relative to the consumption an individual could finance with an extra hour of labor.

For a firm, the flat tax would not affect decisions concerning method of financing (debt or equity), choice among inputs, type of business organization (corporation, partnership, or sole proprietorship), and goods to produce. Other types of taxes may affect one or more of these types of decisions.

Because consumption is a smaller base than income, to raise the same amount of tax revenue, a consumption-based tax would require a larger increase in marginal tax rates than would an income tax. Distortions caused by these higher marginal rates could offset (or even exceed) other neutral advantages of the flat tax. Hence, whether an income tax system or a flat tax system is more efficient is unknown.³¹

National saving consists of government saving, business saving, and personal saving.³³ Any tax increase or reduction in federal expenditures would be expected to reduce government dissaving, and consequently, raise national saving.³⁴ Thus, whether a flat tax increases or reduces revenue is relevant to its effect on national saving.

Another issue concerns the personal savings rate. But there is no conclusive theoretical or empirical evidence that a consumption tax will increase the savings rate and consequently the level of national savings. According to economic theory, a rise in the after tax rate of return would have two conflicting effects. First, each dollar saved today results in the possibility of a higher amount of consumption in the future. This relative increase in the return from saving causes a household to want to substitute saving for consumption out of current income (substitution effect). Second, a higher rate of return on savings raises a household's income; consequently, the household has to save less to accumulate some target amount of savings in the future (income effect). Thus, this income effect encourages households to have higher current consumption and lower current saving. These two conflicting effects mean that economic theory cannot determine the effects of the rate of return on the savings rate.

Highly stylized life-cycle models show that a flat tax would cause a substantial increase in the savings rate, but these models are extremely controversial.³⁵ These stylized models add a third effect for a consumption tax. Unlike a mere exclusion of tax on the return, the consumption tax allows an up-front deduction for savings, but requires the payment of tax on both principal and return when consumption occurs in the future. Thus, individuals need to save today to pay these taxes due in the future; they can do so while still consuming more today because of their large tax cuts. Thus, while the young may consume some part of their tax cut, the old reduce their consumption by much more, and the overall effect is to increase aggregate savings in the economy. But these stylized life-cycle models rely on somewhat idealized assumptions, such as all taxpayers having perfect information and certainty that the tax system will not change during their lifetimes. If these idealized assumptions are relaxed, then the results are not conclusive that switching from an income tax to consumption tax would increase savings.³⁶

Whether a revenue neutral flat tax increases or reduces a household's marginal tax rate, it would have conflicting effects on the number of hours worked by that household. Households with a lower marginal tax rate would have an incentive to substitute work for leisure because of the relative rise in the value of work to leisure (substitution effect). Conversely, a household would have an incentive to reduce its hours worked because it needs to work fewer hours in order to achieve a given standard of living (income effect). For households with a higher marginal rate, the substitution effect would tend to decrease work effort but the income effect would tend to increase work effort. A household's marginal rate affects its substitution effect but its average tax rate affects its income effect. Thus, as assessed by current economic theory, a flat tax could decrease, increase, or not change a household's hours worked. In any case, many economists believe that, on the basis of theoretical considerations and empirical studies, the current income tax system does not significantly affect the aggregate number of hours worked.

H-R argue that currently tax-favored entities such as pension funds prefer investing in low risk activities often secured by readily marketable assets. H-R maintain that their flat tax would eliminate tax preferences including the interest deduction, and therefore, redirect investment into innovative enterprises based on new ideas.⁴⁰

But in response to all the efficiency arguments, it can be argued that it is not appropriate to compare a perfect consumption tax in concept with an imperfect real income tax system. There are steps that might improve the present system that stop short of a flat tax -- for example, the current individual income tax and the corporate income tax could be integrated or, current tax preferences could be eliminated or curtailed, thus producing a more neutral income tax.

But H-R provide no model on which their estimate is based. As discussed in preceding sections, many tax economists do not believe that changes in the tax code can significantly affect either the savings rate or the work-leisure decision. Also, most capital accumulation models have a much longer period to return to steady state than seven years. For example, to increase net output by 3% through increased savings, the capital stock would have to increase by about 12%. Since the capital stock tends to grow at the growth rate of the economy -- say 2% a year -- the savings rate would have to nearly double for that seven-year period to increase the capital stock by that much.

In contrast, young, fast growing corporations with little debt and low depreciation expenses would collect less under the business tax than they pay under the current corporate income tax. All new investment in plant and equipment would be immediately expensed. Because of their low level of outstanding debt, the loss of the interest expense would be of little concern to these corporations.

H-R use examples to demonstrate that there would be a dramatic change in the amount of taxes collected by different corporations. According to H-R, in 1993, General Motors (GM) paid about $110 million in corporate income taxes. In 1993, GM's interest expense and depreciation outweighed its new investment: GM had interest expenses of $5.7 billion and depreciation deductions for past investment of $9 billion but only about $6 billion in new investment. Thus, under the H-R flat tax, for 1993, H-R estimate that GM would have remitted taxes of $2.72 billion, over 24 times its actual corporate tax liability.⁴⁸

In contrast, H-R examined the corporate income tax return of the Intel Corporation. In 1993, Intel paid $1.2 billion in corporate income taxes. Intel had no debt and thus no interest expenses and invested heavily in new plant and equipment. Thus, under the proposed flat tax, Intel would have remitted only $277 million for 1993, less than one-fourth its actual corporate income tax liability.⁴⁹

The elimination of depreciation expenses would create a special transitional problem. Managers of a business would be reluctant to purchase plant and equipment in the year before the flat tax would go into effect because they would be able to write off only one year of depreciation. If managers of this business simply waited a year, the entire investment outlay could be written off, that is, expensed. Hence, the approval of the flat tax could result in a sudden decline and then a sharp rise in investment after the flat tax was operational. Furthermore, managers of many existing businesses may consider it "unfair" to change the rules and deny depreciation expenses for past investment.

H-R offer, as an option, allowing managers of businesses to continue depreciating investments made before the introduction of the flat tax. This would require, however, a higher tax rate to offset the resulting loss in revenue, and there would be a reduction in economic efficiency.⁵⁰ But, the higher tax rate would be temporary, since depreciation expenses would diminish over time.⁵¹ Furthermore, the flat tax would be more complicated if depreciation was permitted.

Also, the flat tax would eliminate tax preferences available to specific industries. For instance, oil producers currently receive a tax break on "intangibles" which allows them to write off most of their drilling costs. In addition, oil independents use the percentage depletion allowance to write off a percentage of their receipts. Thus, the oil producing companies probably would collect more under the business tax than they currently pay in corporate income taxes.

Hence, the financial structure and tax preferences of different industries would result in differential shifts in tax liabilities between the current corporate income tax and the proposed business tax.

Hall and Rabushka argue that interest rates would decline, and consequently the loss of these tax advantages could be offset by homeowners refinancing their mortgages. H-R predict that their flat tax would reduce interest rates by "at least a fifth."⁵⁹ H-R point out that in 1994 interest rates on municipal bonds were about one-sixth less than comparable taxable bonds. But H-R assert that taxable bonds also receive tax preferences; for example, if they are held in pension funds, the tax is deferred on interest income.⁶⁰ Hence, H-R assert that "interest rates could easily fall to three-quarters of their present levels after tax reform; rates on tax-free securities would then fall a little as well."⁶¹ H-R maintain that their flat tax would encourage new investment which could cause some rise in interest rates, therefore, "as a safe working hypothesis . . . [they] assume interest rates [would] fall in the year after tax reform by about a fifth."⁶²

But their analysis did not incorporate the expanding influence of international movements of capital. Today's capital markets are truly global. Owners of financial capital can quickly transfer their funds among countries in order to maximize their expected returns. Consequently, whether or not the flat tax would lower interest rates is unknown.

Hence, many families with large interest payments and property tax payments might be unable to continue making their mortgage payments. These families might be forced to sell their homes. Furthermore, the sudden elimination of these preferences might cause a sudden drop in the value of the average house.⁶³ A decline in housing values would be a loss for sellers but a benefit to buyers.

H-R acknowledge that the elimination of interest deductions would result in winners and losers during transition. They state:

Hall and Rabushka claim that it would be easy to measure the value-added of financial intermediaries and insurance companies.⁶⁷ But, developed nations have found that it is so difficult to measure value-added of financial institutions and insurance companies that they generally exempt these businesses from their VATs.⁶⁸

Under the H-R flat tax, firms would have less of an incentive to provide compensation in the form of health care for employees. Furthermore, individuals with catastrophic health care needs (in excess of 7.5% of adjusted gross income) would not receive a tax preference.

Hence, the H-R flat tax would tend to reduce the rate of growth in the demand for health care which in turn would lower the rate of inflation of health care services from what would otherwise occur.

The mere possibility of passage of the Armey flat tax plan, which was similar to the H-R proposal, reduced the value of outstanding municipal bonds at that time.⁷³ Many managers of municipal bond funds blamed discussions about flat taxes for the negative cash flow which "plagued municipal bond funds throughout 1995."⁷⁴ Thus, if the H-R flat tax becomes law, individuals owning municipal bonds may experience large capital losses. Furthermore, state and local governments may have to pay higher interest rates on new debt issues because municipal securities would no longer have a tax advantage over other debt issues.

Some economists dispute the wisdom of providing a tax subsidy to municipal bonds. Thus, the flat tax's removal of the subsidy may be beneficial.

But it would be possible to levy a flat tax with an income base, simply by retaining depreciation and inventory accounting. The corporate and individual income tax systems could be integrated while retaining an income base -- what makes integration simple is the flat rate.

Six additional issues are relevant to the complexity of the proposed flat rate tax. First, the current income tax system is complex. The federal tax code and the federal tax regulation are lengthy and continue to expand. Many taxpayers spend much time, money, and effort complying with the current income tax system. The complexity of the tax code and the fear of the Internal Revenue Service (IRS) have caused many taxpayers to pay for professional assistance.

Nina E. Olson, National Taxpayer Advocate, wrote the following:

• According to a TAS [Taxpayer Advocate Service] analysis of IRS data, individuals and businesses spend about 6.1 billion hours a year complying with the filing requirements of the Internal Revenue Code. And that figure does not include the millions of additional hours that taxpayers must spend when they are required to respond to IRS notices or audits.

• If tax compliance were an industry, it would be one of the largest in the United States. To consume 6.1 billion hours, the "tax industry" requires the equivalent of more than three million full-time workers.

• Compliance costs are huge both in absolute terms and relative to the amount of tax revenue collected. Based on Bureau of Labor Statistics data on the hourly cost of an employee, TAX estimates that the costs of complying with the individual and corporate income tax requirements for 2008 amounted to $163 billion -- or a staggering 11 percent of aggregate income tax receipts.⁷⁷

Second, complexity may contribute to the gross income "tax gap" -- the difference between income taxes owed and the amount voluntarily paid in a timely manner -- which the Internal Revenue Service estimated is $350 billion for 2001.⁷⁹ In addition, widespread tax avoidance reduces tax revenues which, in turn, necessitates higher tax rates to raise a given amount of revenue. But, enforcement efforts and late payments reduced the gross tax gap by $55 billion for 2001. Furthermore, it can be argued that, in comparison to other developed nations, current U.S. tax compliance is satisfactory. Finally, a tax gap of unknown magnitude would occur under the flat tax.

Third, in comparison to the current income tax, a flat rate does little to reduce complexity because most taxpayers simply look up their tax liability in a table.

Fourth, it can be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax. By the time a consumption tax becomes enacted, it may become complicated, in part, because of lobbying by special interest groups. Furthermore, an initially simple tax may become complicated over time as it is revised.

Fifth, as an alternative to the flat tax, the current income tax system could be simplified by expanding the tax base which would require eliminating tax preferences and reducing marginal rates.

Sixth, the flat tax can, in some instances, be more complicated (rather than simpler) than the tax it replaces. For example, federal government employees and employees of non-profits would have to add to their wage base the imputed value of their fringe benefits.⁸⁰ Hence, a separate individual wage tax form would be necessary for these employees. The actual calculation of the imputed value of fringe benefits would be complicated. Another example is that H-R have not discussed tax issues concerning multinational corporations.

Second, all developed nations with VATs, except Japan, calculate their VATs using the credit-invoice method. The H-R flat tax proposal, however, would use the subtraction method of calculation for the business tax. The General Agreement on Tariffs and Trade (GATT Agreement) requires that for a consumption tax (including a VAT) to be rebated on exports, the tax must be levied on an item by item basis. Furthermore, the business tax is not levied on wage income. In contrast to most VATs, the business tax would not be border adjustable. Consequently, domestic firms would collect the business tax on their products sold domestically or exported but the business tax would not be collected on imported products. But, as previously discussed, economic theory has long recognized that border tax adjustments have no effect on the balance-of-trade because the balance-of-trade is a function of international capital flows.

Third, most other developed nations have much larger public sectors (government spending as a percentage of gross domestic product) than the United States. These countries offer a wider range of social benefits (such as national health care) in order to reduce inequality and lessen economic insecurity. Hence, these nations need greater tax revenues, and consequently, levy both broad-based consumption taxes and income taxes.

Conclusion

The President and leading Members of Congress have stated that fundamental tax reform is a major policy objective for the 112^th Congress. The concept of replacing the current U.S. income tax system with a flat rate consumption tax is one option to reform the U.S. tax system. The term "flat tax" is often associated with a consumption tax proposal formulated by Robert E. Hall and Alvin Rabushka, two senior fellows at the Hoover Institution. Since four bills were introduced in the 111^th Congress that included an H-R flat tax, new bills including an H-R flat tax may be introduced in the 112^th Congress.

The combined individual and business taxes proposed by H-R can be viewed as a modified value-added tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension receipts. Part or all of an individual's wage and pension income would be tax free depending on marital status and number of dependents. The business tax would be a modified subtraction method VAT with wages (and salaries) and pension contributions subtracted from the VAT base. (Under a standard subtraction-method VAT, a firm would not subtract its wages and pension contributions when calculating its tax base.)

Hall and Rabushka argue that replacing the existing individual income tax with their flat tax would be a major improvement for three reasons: the flat tax would be much simpler than the current complex income tax, consumption is a better tax base than income, and the flat tax would be much more efficient than the current income tax system.

This report's examination of the H-R flat tax proposal and their arguments supporting it looked at four topics: broad economic issues, narrow sectoral economic issues, simplicity, and international comparisons.

The broad economic issues concern the economic effects of the flat tax on the entire national economy. The flat tax would be shifted backwards onto owners of equities (old capital) and wage earners. The current income tax system is progressive but the incidence of the H-R flat tax proposal across income classes is unknown. The flat tax would reduce the tax burden on the young but increase it on the old.

Whether the proposed flat tax would be more or less efficient than the current income tax system is unknown. There is no conclusive theoretical or empirical evidence that the flat tax proposal would significantly affect savings, work effort, investment, or growth. A consumption base is neither inherently superior nor inferior to an income base.

The H-R flat tax would not be border adjustable. Current economic theory holds that border tax adjustments have little effect on the balance-of-trade because the balance-of-trade is largely a function of international capital flows.

The H-R flat tax proposal would not require any change in the price level. Most economists believe that the H-R flat tax would lower interest rates, but a minority of economists maintain that interest rates could rise.

Revenue forecasting is an inexact, if necessary, science; hence, there is a considerable concern that the initial revenue yield from the flat tax could be far too low or too high. Over the business cycle, total tax revenues would be more stable under a flat tax than under an income tax system.

Narrow sectoral economic issues concern specific industries or sectors of the total economy. The six microeconomic issues discussed were differential effects on businesses, charitable organizations, housing, financial services, health care, and state and local governments. Most of these discussions related to the elimination of an existing income tax preference.

The simplicity of the proposed flat tax is emphasized by Hall and Rabushka. A positive aspect of the proposed flat tax is the ease with which the individual and corporate tax systems could be integrated.

The complexity of the current tax code is partially due to attempts by policymakers to achieve greater equity or improve economic efficiency. In comparison to the current income tax, a flat rate, per se, does little to reduce complexity because most taxpayers simply look up their tax liability in a table. It can also be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax. By the time a consumption tax can be enacted it may become complicated. As an option to the flat tax, some observers maintain that the current income tax system could be simplified by expanding the tax base.

International comparisons of tax systems indicate that there are major distinctions between recent consumption tax proposals for the United States and the current tax systems of other developed nations. Although the United States is the only developed nation without a broad-based consumption tax at the national level, other developed nations adopted broad-based consumption taxes as adjuncts rather than as replacements for their income based taxes. Notably, all developed nations with VATs, except Japan, calculate their VATs using the credit-invoice method. The H-R flat tax proposal, however, would use the subtraction method of calculation for the business tax. Finally, most other developed nations have much larger public sectors (government spending as a percentage of gross domestic product) than the United States. These nations need greater tax revenues, and consequently, levy both broad-based consumption taxes and income taxes.

It is worth noting that numerous aspects of the H-R flat tax proposal have not been fleshed out, and important policy issues have yet to be analyzed.

Appendix. Tax Forms Under the Flat Tax

 

Figure A-1. Individual Wage Tax

 

 

 

 

Figure A-2. Business Tax

 

 

 

Author Contact Information

² Robert E. Hall, "Guidelines for Tax Reform: The Simple, Progressive Value-Added Tax," in Alan J. Auerbach and Kevin A. Hassett, eds., Toward Fundamental Tax Reform (Washington, DC: The AEI Press, 2005), pp. 70-80.

³ Three bills based on the Hall-Rabushka proposal were introduced in the 110^th Congress. Former House Majority Leader Richard K. Armey introduced flat tax legislation based on the Hall-Rabushka proposal, his most recent bill being introduced in the 107^th Congress. His proposed flat tax bills have been frequently analyzed by economists. In 1996, presidential candidate Steve Forbes advocated a flat tax based on the H-R concept. For a explanation of his proposal, see Steve Forbes, Flat Tax Revolution (Washington, DC: Regency Publishing, Inc., 2005), 216 p.

⁴ For a description of current tax reform proposals, see CRS Report R41591, Tax Reform: An Overview of Proposals in the 112th Congress, by James M. Bickley.

⁵ For a comparison of the flat tax concept with other consumption tax concepts, see Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate over Tax Reform, 3^rd ed. (Cambridge, MA: The MIT Press, 2004), pp. 233-271.

⁶ For a comprehensive examination of the value-added tax, see CRS Report R41602, Should the United States Levy a Value-Added Tax for Deficit Reduction?, by James M. Bickley.

⁷ These factors of production have specific meanings to an economist. Labor consists of all employees hired by the firm. Land consists of all natural resources including raw land, water, and mineral wealth. Capital is anything used in the production process, which has been made by man. The entrepreneur is the decision maker who operates the firm.

⁸ For a comparison of the credit-invoice method and the subtraction method, see Itai Grinberg, "Where Credit is Due: Advantages of the Credit-Invoice Method for a Partial Replacement VAT," presented at the American Tax Policy Institute Conference, Washington, D.C., February 18, 2009, 41 p.

⁹ For an examination of the administrative and compliance costs of the current income tax system and the flat tax, see William G. Gale and Janet Holtzblatt, "Measuring the Impact of Administrative Factors under Tax Reform," Proceedings of the 1998 Annual Conference of the National Tax Association, pp. 341-349.

¹⁰ Hall and Rabushka, p. 40.

¹¹ Ibid., p. 41.

¹² Copies of tax forms for the individual wage tax and the business tax are shown in the Appendix.

¹³ Bureau of Labor Statistics, CPI Inflation Calculator, available at http://www.bls.gov/data/inflation_calculator.htm.

¹⁴ Hall and Rabushka, p. 77.

¹⁵ Ibid., p. 59.

¹⁶ Ibid., p. 77.

¹⁷ Ibid., p. 72.

¹⁸ Ibid.

¹⁹ For a brief discussion of these equity issues, see CRS Report R41602, Should the United States Levy a Value-Added Tax for Deficit Reduction?, by James M. Bickley.

²⁰ Hall and Rabushka, p. 93.

²¹ Ibid., p. 91.

²² Ibid.

²³ Ibid., p. 92.

²⁴ Ibid.

²⁵ Ibid., p. 93.

²⁶ The flat tax proposal of former House Majority Leader Richard K. Armey would have repealed the earned income tax credit (EITC), thus the Treasury's study includes a repeal of the EITC. If the earned income tax credit (EITC) were repealed, there would have been an increase in taxes (loss in negative tax) for those who had an EITC in excess of their tax liability. Hall and Rabushka did not mention the EITC in their book, and consequently, whether or not their proposal included a repeal of the EITC is not known.

²⁷ For a definition of Family Economic Income, see U.S. Treasury, Office of Tax Analysis, "New Armey-Shelby Flat Tax Would Still Lose Money, Treasury Finds," Tax Notes, v. 70, no. 4, Jan. 22, 1996, p. 454.

²⁸ Ibid., pp. 453-455.

²⁹ For a presentation of these assumptions about incidence, see U.S. Treasury, Office of Tax Analysis, "New Armey-Shelby Flat Tax Would Still Lose Money, Treasury Finds," p. 453.

³⁰ CRS Report 95-1141, The Flat Tax and Other Proposals: Who Will Bear the Tax Burden?, by Jane G. Gravelle.

³¹ For an analysis of the efficiency of a pure consumption tax versus a pure income tax, see Jane G. Gravelle, "Income, Consumption, and Wage Taxation in a Life-Cycle Model: Separating Efficiency from Redistribution," American Economic Review, v. 81, no. 4, September 1991, pp. 985-995.

³² Hall and Rabushka, p. 87.

³³ CRS Report RS21480, Saving Rates in the United States: Calculation and Comparison, by Craig K. Elwell.

³⁴ For an analysis of saving incentives, see CRS Report RL33482, Saving Incentives: What May Work, What May Not, by Thomas L. Hungerford.

³⁵ For example, see Don Fullerton and Diane Lim Rogers, "Lifetime Effects of Fundamental Tax Reform," in Economic Effects of Fundamental Tax Reform, Henry J. Aaron and William G. Gale, eds. (Washington: Brookings Institution Press, 1996), p. 321-352; and David Altig, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser, "Simulating Fundamental Tax Reform in the United States," American Economic Review, v. 91, no. 3, June 2001, pp. 574-595.

³⁶ CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax: Overview of the Issues, by Jane G. Gravelle.

³⁷ Hall and Rabushka, p. 84.

³⁸ Ibid., p. 86.

³⁹ Ibid., p. 87.

⁴⁰ Ibid., p. 88.

⁴¹ Ibid., p. 83.

⁴² Ibid., p. 89.

⁴³ Ibid.

⁴⁴ For a comprehensive analysis of this topic, see CRS Report 95-1141, The Flat Tax and Other Proposals: Who Will Bear the Tax Burden?, by Jane G. Gravelle.

⁴⁵ For opposing views on the effect of a flat tax on interest rates, see John E. Golob, "How Would Tax Reform Affect Financial Markets?," Federal Reserve Bank of Kansas City Economic Review, v. 80, no. 4, Fourth Quarter, 1995, pp. 19-39; and, Martin Feldstein, "The Effect of a Consumption Tax on the Rate of Interest," Working Paper No. 5,397, National Bureau of Economic Research, Cambridge, Massachusetts, Dec. 1995, 31 p. An analysis of various factors affecting interest rate changes is presented in CRS Report 96-379, The Flat Tax and Other Proposals: Effects on Housing, by Jane G. Gravelle. (Out-of-print report available from CRS on request.)

⁴⁶ For a comprehensive analysis of this issue, see Martin A. Sullivan, Flat Taxes and Consumption Taxes: A Guide to the Debate (New York: American Institute of Certified Public Accountants, 1995), pp. 125-149.

⁴⁷ This could be a quite a problem not only for many mature large corporations but also for many small businesses, farmers, and owners of rental properties.

⁴⁸ Hall and Rabushka, pp. 64-65.

⁴⁹ Ibid., pp. 65-66.

⁵⁰ Ibid., pp. 78-79.

⁵¹ Ibid., p. 79.

⁵² For an examination of this tax preference, see CRS Report RL34608, Tax Issues Relating to Charitable Contributions and Organizations, by Jane G. Gravelle and Molly F. Sherlock.

⁵³ Hall and Rabushka, The Flat Tax, pp. 99-101.

⁵⁴ For an article on this issue, see William C. Randolph, "Dynamic Income, Progressive Taxes, and the Timing of Charitable Contributions," Journal of Political Economy, v. 103, no. 4, Aug. 1995, pp. 709-738.

⁵⁵ Charles T. Clotfelter, and Richard L. Schmalbeck, "The Impact of Fundamental Tax Reform on Nonprofit Organizations," in Economic Effects of Fundamental Tax Reform, edited by Henry J. Aaron and William G. Gale (Washington, Brookings Institution Press, 1996), pp. 211-246.

⁵⁶ For an analysis of possible policy changes under fundamental tax reform concerning the mortgage interest deduction, see CRS Report RL33025, Fundamental Tax Reform: Options for the Mortgage Interest Deduction, by Pamela J. Jackson.

⁵⁷ U.S. Congressional Budget Office, Budget Options Volume 2, (Washington, U.S. Govt. Print. Off., August 2009), pp. 190-191.

⁵⁸ Steven Pearlstein, "Americans' Investing Focus Faulted," Washington Post, no. 284, September 15, 1995, p. F3.

⁵⁹ Hall and Rabushka, p. 94.

⁶⁰ Ibid., p. 95.

⁶¹ Ibid.

⁶² Ibid.

⁶³ For a view that argues that there will be serious effects, see Roger E. Brinner, Mark Lasky, and David Wyss, "Residential Real Estate: Impacts of Flat Tax Legislation," DRI Analysis, Summary Prepared for the National Association of Realtors, Lexington, Massachusetts, May 1995, 19 p. Also, for a critical view of this DRI study, see Rebecca S. Schaefer, "Ganging Up Again at 'Gucci Gulch': A Look at the DRI Flat Tax Study," Issues and Answers, Citizens for a Sound Economy, Aug. 15, 1995, 3 p.

⁶⁴ Hall and Rabushka, p. 79.

⁶⁵ An analysis of this issue is presented in CRS Report 96-379, The Flat Tax and Other Proposals: Effects on Housing, by Jane G. Gravelle. (Out-of-print report available from CRS on request.)

⁶⁶ Charles E. McLure, Jr., The Value-Added Tax, Key to Deficit Reduction? (Washington: American Enterprise Institute, 1987), p. 135.

⁶⁷ Hall and Rabushka, pp. 74-75.

⁶⁸ McLure, pp. 135-138.

⁶⁹ CRS Report RL32603, The Flat Tax, Value-Added Tax, and National Retail Sales Tax: Overview of the Issues, by Jane G. Gravelle.

⁷⁰ For an overview of the taxation of life insurance products and life insurance companies, see CRS Report RL32000, Taxation of Life Insurance Products: Background and Issues, by Andrew D. Pike and CRS Report RL32180, Taxation of Life Insurance Companies, by Andrew D. Pike.

⁷¹ For a comprehensive discussion of this tax preference, see Internal Revenue Service, Publication 502 -- Medical and Dental Expenses, 2010.

⁷² An overview of the effects on the states of flat tax proposals is presented in CRS Report 95-1150, Consumption Taxes and State-Local Tax Systems, by Dennis Zimmerman (Out-of-print report available on request), and Robert P. Strauss, Administrative and Revenue Implications of Alternative Federal Consumption Taxes for the State and Local Sector (Washington: American Tax Policy Institute, July 6, 1997), 78 p.

⁷³ Michael Stanton, "Correction for Possible Tax Reform Has Run Its Course, Managers Say," The Bond Buyer, v. 313, no. 29,686, July 7, 1995, p. 7.

⁷⁴ Jon Birger, "Tax Reform Won't Do Much for State Funds, Moles Says," The Bond Buyer, v. 313, no. 29,717, August 21, 1995, p. 6.

⁷⁵ CRS Report 95-1150, Consumption Taxes and State-Local Tax Systems, by Dennis Zimmerman. (Out-of-print report available from CRS on request).

⁷⁶ Hall and Rabushka, The Flat Tax, p. 52.

⁷⁷ Nina E. Olson, Written Statement Submitted at the House Ways and Means Committee Hearing on Tax Reform, January 20, 2011, pp. 2-3. Ms Olson testified at this hearing.

⁷⁸ Internal Revenue Service, Statistics of Income Bulletin, v. 29, no. 3, winter 2010, available at http://www.irs.gov/taxstats.

⁷⁹ For an analysis of the tax gap, see CRS Report R41582, Tax Gap, Tax Enforcement, and Tax Compliance Proposals in the 112th Congress, by James M. Bickley.

⁸⁰ As already discussed, private businesses would pay the business tax on the fringe benefits of their employees except for pension contributions, which would be taxed at the individual level.