My latest column for the Christian Science Monitor. One of the perils of writing a monthly column is the multi-week lag between writing and publication. Rick Perry and Herman Cain were near the top of GOP contenders when I wrote this. Today? Not so much. But the ideas are still worth analysis. And Newt Gingrich is promoting a flat tax, although it hasn’t been a central part of his campaign thus far.
Tax reform has emerged as a key issue for GOP presidential hopefuls. Texas Gov. Rick Perry wants to scrap our current system and replace it with a 20 percent flat tax on individual and corporate incomes. Former Speaker of the House Newt Gingrich wants to do the same, but with even lower rates.
Then there’s pizza magnate Herman Cain. His “9-9-9” plan would replace today’s income and payroll taxes with a trio of levies: a 9 percent flat tax on individuals, another on businesses, and a 9 percent retail sales tax. But Mr. Cain’s ultimate vision is to eliminate anything remotely resembling today’s tax system in favor of a national retail sales tax, which proponents call the FairTax.
These three plans have much in common. Catchy names, for one. More important, they all focus on taxing consumption – what people spend – rather than income.
Equally important, however, is the way the flat tax handles investment income. Individuals would pay taxes on their labor income but not on capital gains, dividends, or interest.
That doesn’t mean capital income would escape taxation. Instead, the taxes would be collected at the business level. Businesses would pay taxes on all their income, regardless of whether it’s paid out as dividends or interest. They would also be allowed to write off the entire cost of new investments when they are made.
The net result of these rules is that people would be taxed only to the extent that they consume. In the words of Robert Hall and Alvin Rabushka, the economists who invented the flat tax 30 years ago, “people are taxed on what they take out of the economy, not on what they put in.”
The flat tax is thus a very close cousin to the FairTax and other retail sales taxes (which many Republicans like) and to value-added taxes (which they don’t). The logistics differ: A sales tax is collected on retail purchases, a VAT from businesses at each stage of the supply chain, and a flat tax from individuals and businesses. But the underlying economics work out the same: People get taxed only on their consumption.
There are good reasons to favor a simpler tax system that emphasizes taxes on consumption over income. Some policy experts across the political spectrum embrace exactly that approach to tax reform. But all these plans would be much less progressive than our current income tax, and that’s neither appropriate nor politically viable.
What we need are tax-reform proposals that would maintain progressivity while harvesting many of the benefits of simplicity and consumption taxation. The late Princeton economist David Bradford offered one simple approach: Add progressive rates to a flat tax. Columbia Law School Prof. Michael Graetz offered another: Pair a broad-based VAT with an income tax for folks with high incomes. These ideas might not have much traction among GOP primary voters. But they offer a much better starting point for reform than the plans on the table today.