Fix, don't flatten, the tax code
In response to the IRS debacle: Pro-growth tax reform, yes. The flat tax, no.

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Article Highlights

  • If the sluggish US economy wasn’t reason enough for tax reform, the ongoing IRS scandal should be.

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  • A flat tax — a longtime policy goal for many on the right — isn’t the realistic answer to tax reform.

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  • The flat tax embodies principles that are great starting points for tax reform, but it shouldn’t be the destination.

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If the sluggish U.S. economy wasn’t reason enough for tax reform, the ongoing IRS scandal demonstrates how a devilishly complex tax code enables government mischief.

But the flat tax — a longtime policy goal for many on the right — isn’t the realistic answer to either problem.

Flat-tax advocates see headlines about an out-of-control IRS as a chance to put the idea back on the public-policy radar in way it hasn’t been since the 1990s.

“This is why you need a flat tax,” Wall Street Journal economics writer Stephen Moore told Fox News recently. “If you get rid of two-thirds to three-quarters of the deductions and exemptions and carve-outs of the tax system, you’re not going to need all these IRS agents . . . snooping into your financial records.” Publisher and former Republican presidential candidate Steve Forbes, who made the tax proposal famous in his 1992 presidential-primary bid, said, “The power of the IRS derives from the complexity of the tax code. . . . With a simple flat tax you have single rate, deductions for adults and children, and that’s it. . . . Simplicity is the best enemy of the abuse of power.”

For one, a simpler tax system doesn’t mean a more pro-growth one. Look at President Barack Obama and congressional Democrats, who would like to eliminate and limit deductions in order to raise effective tax rates, especially by closing “loopholes” for unpopular industries. Simplicity, by itself, doesn’t necessarily provide a path to smaller and less intrusive government. But by eliminating almost all tax exemptions and installing a single rate, flat taxers argue, America would have a code both less susceptible to corruption and more amenable to economic growth.

It’s an elegant, compelling model that might work splendidly if you were creating a tax code ex nihilo. Flat-tax fever swept across Eastern and Central Europe after the end of the Cold War, when finally independent nations were rebuilding their own economies, and the model has been quite successful, for the most part.

America, however, is in a much different place. Millions of individuals and businesses have made long-term plans based on expectations that the tax code will remain more or less the same. Half the nation, thanks to all those deductions and credits, pays no income tax. And, perhaps most important, an aging population means that the cost of health-care entitlements will grow rapidly, even if health-care inflation slows.

That all means it’s unlikely the U.S. can keep spending down at historical levels of 20 percent to 21 percent of GDP while also maintaining a floor for defense spending at 4 percent of output. The best a group of AEI scholars could manage was limiting spending to 23 percent of GDP by 2035 — and even that left the debt-to-GDP ratio a third higher than the average between World War II and the Great Recession.

And whenever flat-tax theory has been translated into real-world proposals for the U.S., the results have been problematic. Flat-tax proposals by Newt Gingrich and Rick Perry during the 2012 Republican presidential campaign slashed federal tax revenues by nearly $500 billion to $1 trillion a year, which should give pause to even the most fervent supporters of dynamic scoring. Making such plans revenue-neutral, when top rates would fall on wealthy Americans, would mean raising taxes on someone else — such as millions of middle-to-low income Americans. The Heritage Foundation would replace income, payroll, and excise taxes with a 28 percent flat tax. It claims the plan would leave the distribution of the tax burden unchanged, but the proposal would also raise revenue of just 18.5 percent of GDP.

Then there’s the uncomfortable political reality that the flat-tax concept has never been popular with voters. A 2011 Wall Street Journal survey found that not even a majority of GOP voters favored the idea. A poll by the Hill the same year found 58 percent of Americans favored a graduated income-tax system, about the same as the Journal poll.

One solution is to take the essentially flat consumption tax devised by economists Robert Hall and Alvin Rabushka and give it a progressive rate structure. Or we could combine a consumption tax with a flat income tax on wealthier Americans, as suggested by Yale’s Michael Graetz. Both ideas are also flexible enough give needed tax relief to parents. (Call it a “human-capital gains” tax cut.)

The flat tax embodies pro-growth, supply-side principles that are great starting points for tax reform, but it shouldn’t be the destination.

— James Pethokoukis, a columnist, blogs for the American Enterprise Institute.

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About the Author

 

James
Pethokoukis
  • James Pethokoukis is a columnist and blogger at the American Enterprise Institute. Previously, he was the Washington columnist for Reuters Breakingviews, the opinion and commentary wing of Thomson Reuters.

    Pethokoukis was the business editor and economics columnist for U.S. News & World Report from 1997 to 2008. He has written for many publications, including The New York Times, The Weekly Standard, Commentary, National Review, The Washington Examiner, USA Today and Investor's Business Daily.

    Pethokoukis is an official CNBC contributor. In addition, he has appeared numerous times on MSNBC, Fox News Channel, Fox Business Network, The McLaughlin Group, CNN and Nightly Business Report on PBS. A graduate of Northwestern University and the Medill School of Journalism, Pethokoukis is a 2002 Jeopardy! Champion.


     


    Follow James Pethokoukis on Twitter.

  • Email: James.Pethokoukis@aei.org

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