Global Trend

The Flat Tax Cometh

There are 8 million words in the Federal Tax Code, and the IRS itself doesn’t even know what they all mean. That code supports an entire industry of lawyers and accountants. Taxpayers in America spend a cumulative 6 billion hours each year just trying to figure out how much they owe the IRS.

Talk about lost productivity! That is more time than it takes to manufacture every vehicle in America, including airplanes.

The fact is that our current tax system imposes enormous costs on our economy and keeps us from using all of our economic resources to improve our standard of living and increase economic growth.

To clear up this problem, President Bush appointed a commission to study tax reform. It’s co-chaired by both Republicans and Democrats to eliminate bias. The commission, whose report will be out in July, has a four-point agenda:

First, to flatten tax rates to encourage wealth-enhancing activities.

Second, to eliminate double taxation of savings and investments, leaving us more of both for economic productivity and growth.

Third, to make it easier to comply with the tax code and thus reduce losses to the system.

Fourth, to get the intrusive IRS out of our lives to the fullest extent possible.

The commission will also be looking into the utility of a national sales tax, a value-added tax, and a flat income tax. All these are forms of the so-called “flat tax,” which appears to be the next big thing.

But Americans didn’t invent the flat tax concept. In fact, during the past two decades, most industrialized societies have already moved more quickly than we have toward flatter tax systems. The number of tax categories in most countries has fallen dramatically, according to the Organization for Economic Co-operation and Development in Paris.

Hong Kong and the Channel Islands were among the first to adopt a completely flat tax system, attracting worldwide curiosity about the outcome. For Hong Kong, the outcome is crystal clear: A flat 15 percent tax has resulted in the highest growth rate of any nation on the globe over the past 40 years.

Observers were concerned that Hong Kong’s flat tax would be doomed by the Chinese tax system when Hong Kong was returned to the mainland. Instead, the Chinese have used tax-rate reductions and saving and investment incentives to move toward Hong Kong’s system, according to an article in The Weekly Standard. This, in turn, has helped to supercharge China’s astounding growth.

Eastern European countries were quick to follow Hong Kong’s lead, and their success is being eyed with keen interest both in Europe and here at home.

Some of the advantages of a flat tax system were obvious to these nations. A single rate levied across a broad base increases tax revenues, discourages people from tax evasion, and leaves more money in the consumer’s pocket, thereby boosting the economy. In addition, lower taxes attract foreign investors, according to an article in the Financial Times.

The government can also benefit because it does not have to raise taxes as much. It can reduce the number of tax exemptions and allowances to increase revenues further, a move that typically doesn’t meet with as much public outcry as a tax hike. In addition, a flat tax is easier and cheaper for the government to administer, and easier for the typical taxpayer to understand. People are less likely to try to avoid a tax that they can understand and that seems fair to them.

Starting in 1994 with Estonia, nine eastern European countries have adopted a flat tax system. The Republic of Georgia joined the flat-tax group this year, and all have been particularly aggressive, setting low, flat rates on personal income and often equally low corporate taxes. The consensus among economists is that the new systems have increased growth in eastern European economies.

Russia adopted a 13 percent flat tax in 2001 and saw its revenues increase by 25 percent the following year in the midst of furious entrepreneurial activity. That nation has enjoyed an average rate of growth of 8 percent each year since the flat tax was introduced. Russia collects more revenues with a flat 13 percent tax than it did when its progressive tax reached up to 70 percent.

The Polish government recently announced that it would institute an 18 percent flat tax by 2008. Depending on which party holds power at that time, the figure might be lower, but that country is virtually certain to join its eastern European cousins.

Although the arguments continue, it’s fairly obvious from the success of a flat tax in the vast majority of eastern European and Asian countries that have tried the system that it does, indeed, work.

Moreover, we don’t even have to go abroad for examples. There are plenty right here at home.

More than 25 percent of all states in America have a flat income tax, and more than half have flat corporate tax rates. Flat taxes, in fact, are already everywhere in our lives. Sales and excise taxes are flat. The gasoline tax is flat. Social Security is a flat tax. There are no exemptions or deductions. The Social Security tax applies to wages only ? not to interest dividends or capital gains. We’ve been living with flat taxes in the United States for decades, mostly unaware of how simple they are compared with the federal income tax.

President Bush has made a commitment to making fundamental changes in our tax code, including some form of “flatter taxation,” as an integral part of his second term agenda. This effort got a boost recently when Congressman Michael Burgess of Texas introduced HR 1040, the Freedom Flat Tax Act of 2005, as announced recently in the U.S. Fed News.

The aims of the bill are simple: to put in place a tax system that is simple to understand, and that treats all economic activity ? and all people ? equally. It prevents the federal government from taxing income more than one time on income earned. It taxes all income at one rate. And, to top it off, it’s optional. If you like the old system, you can still use it.

The Freedom Flat Tax, if enacted, will be phased in over three years. During the first two years, the flat rate will be 19 percent. Then it permanently drops to 17 percent. There are no deductions or loopholes, though there are some personal exemptions. Any business or individual can opt into this system, and because of that, if nothing else, it’s difficult to imagine that such a system wouldn’t be put in place.

Despite the seeming clarity of the Freedom Flat Tax Act of 2005, there is still heated debate about the whole concept of a flat tax. In part, this long-lived debate stems from the original concept of income tax, dating back to 1913. U.S. tax policy has traditionally been driven by the idea that the rich should be taxed a higher proportion of their income, because they somehow owe a special debt to a government that protects their wealth and to a society that has helped them prosper.

The problem with that notion is that it’s been pushed too far. Today, it creates a disincentive to create jobs and wealth. Why make more money, if most of it is just going to be taken away from you? Better yet, why not park a yacht at the local marina and write it off as a business expense? That isn’t good for the economy.

The general public seems to understand this. When surveyed, most Americans say that a flat tax is the fairest system of all. They like the idea, and they are ready for the change. Still, this hasn’t silenced the critics, who say a flat tax favors the rich. But again, that’s one appeal of the Freedom Flat Tax bill: If you don’t like it, don’t use it.

The idea of the optional Freedom Flat Tax was first floated by Stephen Moore, the Cato Institute’s director of fiscal policy studies and contributing editor of the National Review. And its adoption could effectively silence the debate, because either people would use it or they wouldn’t.

A tax return would require sending in a single post card. The Trends editors believe that only a small minority of individual taxpayers will opt for the alternative of hiring an accountant, filling out complicated forms, compiling endless receipts, and generally scrambling around to find every last loophole in the present tax system ? all the while worrying that if you get it wrong, the IRS is going to come breathing down your neck.

And in fact, that’s a very real fear for many taxpayers who are trying to abide by the existing law. The number of taxpayers earning at least $100,000 a year who were audited in fiscal 2004 rose by a whopping 40 percent over the previous year. About 195,000 of those high-income individuals were audited last year, up from nearly 139,400 in fiscal 2003. And, according to an article in Investment News, they incurred a record cost of $43.1 billion in responding to these audits.

One way around all of today’s confusion, and to get at the estimated 17 percent of U.S. GDP represented by the “underground economy,” is to levy a flat tax not against income but against consumption ? that is, to tax what you spend, not what you make.

Those who argue for this system say that income tax was never the Founding Fathers’ intent, and that it stifles growth because it’s essentially a tax on production. Anyone who has rushed to make last-minute business expenditures at the end of the taxable year for write-off purposes knows just how frustrating it can be. People are forced to make sub-optimal decisions by the tax code. In effect, it encourages Americans to throw away money frivolously, rather than to save or invest it.

As argued in Newsday, whether it means taxing income when you make it or when you spend it, the idea of taxing money only once and only at a single rate appears to be gathering support.

Given this encouraging trend, we offer the following five forecasts for your consideration:

First, the indirect flattening of the tax structure will certainly continue. The Congress and administration will chip away at the taxes on dividends and capital gains, which represent double taxation of corporate profits that have already been fully taxed once. Under laws passed by the last Congress, most investment gains are now taxed at a somewhat reasonable 15 percent. These and other measures, such as eliminating the estate tax, will serve to decrease the progressive nature of traditional tax codes.

Second, the administration will push for more generous “savings accounts” that could shelter thousands of dollars of deposits each year from taxation on investment gains. This will mean no more double taxation on that income. Moves like this, which are pro-growth, will only reinforce the measures President Bush has already established to create a bulwark from which to move toward a flat tax system.

Third, the Trends editors believe taxes on dividends and capital gains will gradually be pushed downward until they are eliminated. In the event that a consumption tax, like the European model, is adopted, those gains will only be taxed when they’re spent ? and then at a flat rate, as with the so-called “Value-Added” taxes. Under such a system, all savings would be sheltered from the IRS and only taxed when they’re spent. Similarly, last-minute “business expenses” incurred to generate deductions would disappear, and the money would go, instead, into savings and investment, boosting the economy.

Fourth, until a universal flat tax is in place, the administration will keep working to close the special interest tax loopholes that distort the tax code. With all the loopholes closed, a flat tax rate of 18 percent would produce the same amount of revenue we have today.

Fifth, despite millions that are being spent by special interests to block it, a flat tax ? whether on income or consumption ? will become a reality as more and more evidence accumulates from other nations that have adopted it. Already, Harvard economist Dale Jorgenson has shown that a flat tax rate would increase national income by 5 to 10 percent on a permanent basis. Those huge economic gains would raise the average family income in the United States by several thousand dollars a year and promote the type of growth that will shrink the deficit. Not only will a flat tax be impossible to resist for this reason, but in the end, it will be the only way to compete in a global economy where nearly everyone else is reaping its economic benefits.

References List :
1. The Weekly Standard, September 13, 2004, “Bushs Stealth Flat Tax,” by Stephen Moore. ⓒ Copyright 2004 by News Corporation. All rights reserved.2. Financial Times, March 29, 2005, “Advocates of Flat Tax Point to Success in Eastern Europe,” by Robert Anderson, Christopher Condon and Vanessa Houlder. ⓒ Copyright 2005 by The Financial Times Limited. All rights reserved.3. U.S. Fed News, March 2, 2005, “Rep. Burgess Reintroduces Freedom Flat Tax Act of 2005.” ⓒ Copyright 2005 by Hindustan Times. All rights reserved.4. Investment News, December 6, 2004, “Experts Favor Tax Cuts Over Flat Rate or Sales Levy,” by Mark E. Battersby. ⓒ Copyright 2004 by Crain Communications, Inc. All rights reserved.5. Newsday, November 30, 2004, “Topping Bushs Domestic Agenda; Flat Tax, Sales Tax Unlikely,” by Jonathan Weisman and Jeffery H. Birnbaum. ⓒ Copyright 2004 by Newsday, Inc. All rights reserved.