Flatter Than Flat

What began as a promising step toward a less-destructive tax system has collapsed into a morass of uncertainty and complications. The original good idea was the flat-rate tax.

As first proposed, it was simplicity itself. Instead of today's hugely complex personal income tax—with progressively steeper marginal rates the higher your income, but with a bewildering array of deductions and exemptions that counteract the progressiveness while distorting the economy—everyone would pay a single flat rate, with no deductions or exemptions.

Well, politics has taken over. By now, Congress is faced with at least five major "flatter" tax proposals, not one of which embodies the simple ideal. All include at least some exemptions or deductions, thereby opening the door for political bargaining to include others, either now or in the future. Most include several tax rates, increasing with income, instead of a single flat rate. And most, including the horrendous Treasury Department trial balloon, also propose drastic revisions in corporate taxation, nearly all of which are likely to be harmful.

You can get some idea of the likely impact of these proposals by looking at who's for and who's against them. All sorts of liberals and neoliberals, still reflexively antibusiness, have come forward to praise the Treasury proposal (with its 28 percent increase in business taxation). Curiously, they have been joined by a few supply-siders, who have been blinded by its vague association with the original flat-tax ideal. Opposing these plans as likely to reduce investment and capital formation (especially the venture capital needed for starting entrepreneurial new firms) are such economists as Martin Feldstein and Murray Weidenbaum, supply-side writer George Gilder, the American Electronics Association, and numerous other business groups.

Many of these people have reminded us that the "corporate" income tax is a fiction. Consumers end up paying it, via higher product prices. But meanwhile, thanks to the crazy-quilt pattern of exemptions and credits, it "misallocates capital, diverts corporate behavior from more efficient activities, and imposes an excessive tax burden on capital," according to economist Bruce Bartlett of Polyconomics, Inc. Like many economists, Bartlett would scrap both the corporate income tax and the capital gains tax. The result, he predicts in a Heritage Foundation study, would be soaring investment as risk and innovation would no longer be penalized.

But such welcome and productive changes are not likely to emerge from the present political debate, which has cynically linked corporate tax "reform" with a move toward a "flatter" personal income tax. Yet as we've seen, none of the current proposals would achieve the original goal: to free the economy from the huge distortion of both personal and corporate decisionmaking by today's horrendously complex tax system. Perhaps it's time for a more radical approach.

As a preface, let me make clear that as a libertarian, I am opposed in principle to coercive taxation. Ultimately, I believe that the few legitimate functions of government could be paid for on a voluntary basis, by means of "user fees" (for example, the courts) and insurance-like premiums (for example, defense). But this sort of minimal government is far in the future. In the near term, it's legitimate to work at devising a tax system that is the least destructive of both economic decisionmaking and personal liberty.

One way to do that would be to replace both the personal and corporate income taxes with a flat-rate national sales tax. Depending on how it's defined, such a tax could produce the same (static) revenue as today's income taxes (about $400 billion) at a rate of between 15 and 33 percent.

The major objection to such a shift would be that a sales tax is "regressive," rather than "progressive." But the principle of a flat rate applying to everybody has been largely accepted in the debate on a flat-rate income tax. And since we know that consumers are the ultimate payers of the corporate income tax, having them pay directly rather than indirectly is not really much of a change.

But consider what a difference such a shift would make in economic behavior. There would finally be a level playing field for business decisions. Firms could write off capital investments in the year of purchase or depreciate them for as long as they liked—the decision would be made for economic, not tax, reasons. A national sales tax would be a pure consumption tax; there would be tremendous incentives for savings and investment (as in Japan). The tax-shelter industry would disappear—no more cattle-feeding deals, no more yachts or corporate jets bought because of write-offs, etc. With capital gains taxed at zero, and increases in personal income taxed at a zero marginal rate, venture capital and entrepreneurship would reach unprecedented levels.

From a political standpoint, a shift from income taxes to a national sales tax would provide a powerful restraining force against future tax increases. Why? Because every single voter would see and feel the federal sales tax every single day of the year. Instead of being hidden—by withholding or by being disguised as a corporate tax—a sales tax is highly visible and painful. And that is precisely how a tax should be, if our interest is to keep the politicians from sneaking through periodic increases.

Finally, perhaps most important of all, the abolition of income taxes in favor of a sales tax would mean the abolition of the Internal Revenue Service and all of its threats to personal liberty and privacy. And there would be further economic benefits, as all the IRS employees and the legion of private tax preparers would have to find productive work.

Thus, a vastly more productive, and freer, society is within our reach. But it will not come about by tinkering with the present tax code in the name of a "flatter" tax.