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Ramifications of a flat tax--shifting the burden to the middle class.

Article Excerpt
Abstract An alternative to the current US tax system would be a flat tax. According to its supporters, the flat tax would decrease the complexity of the tax system. Opponents contend that the flat tax will shift the tax burden to the middle class. The current research tested the claim that the flat tax will shift the tax burden to the middle class by developing simulations of two flat tax proposals, the Steve Forbes Plan and the Hall and Rabushka Plan, and then examining the change in the tax burden for different income levels as compared to the current tax system. The results show that both plans shift more of the tax burden to middle income class taxpayers than under the current US tax system.

Keywords Flat tax Tax system Middle class Steve Forbes Hall and Rabushka

JEL M00

Introduction and Purpose

Much recent attention by Congress, economists, and the press has focused on the budget deficit. Ostensibly, the economy and Congress balanced the budget in 1998. However, since that time the budget deficit has risen to over a trillion dollars. Because the income tax is a major source of funding for the federal budget, the tax system is constantly under criticism and review.

Most observers agree that the current US tax system needs changing. The more important question is What is the best way to change the tax system? Among the stated reasons for a change in the current US tax system is a need for more efficiency, equity and simplicity. In addition to those deficiencies, the current tax system has also been criticized for "artificially and unnecessarily suppressing living standards." (1)

Two major weaknesses in the current tax system are the complexity of the law and the concern that much of the tax burden falls on the middle class. Over the years many proposals have been made to change the current policies. One change, which has received support, is a consumption-based tax or a flat tax. A flat tax had been proposed as early as 1981, but received little interest. However, during the 1995 legislative year both Representatives Armey and Shelby, and Senators Nunn and Domenici introduced flat tax proposals in Congress. (2) According to its supporters, the flat tax would decrease the complexity of the current tax system and should decrease the tax liability for many taxpayers. Hall and Rabushka (HR; 1995, pp. 92-93) concluded "The current personal and corporate taxes tax wages heavily and business income lightly. The flat tax would reverse this inequity and benefit a great majority of Americans, whose income comes almost entirely in the form of wages."

Projections of the flat tax proposals indicate that they will not produce any more tax revenue than the current system, and in fact Summers (1996) suggests that some versions of the flat tax would actually produce less money than the current system. Summers (1996) argues that the tax rate would need to be over 20% for a flat tax to be revenue neutral. Therefore, the change in the tax law will not by itself decrease the budget deficit and may in fact increase it. What the change should do, according to its supporters, is stimulate the economy. As the drill goes: a decrease in tax rates should increase investment, thus leading to a stimulation of the economy, thereby increasing overall revenue, which in turn will increase overall tax receipts, which will decrease the budget deficit. Using this theory, revenue would increase while decreasing the actual tax rate, a goal that is very important to Congress.

Opponents of the flat tax contend that it is a zero sum game and that the tax burden will only shift under the current flat tax proposals. According to these critics, the flat tax will shift the tax burden from the high income and low income taxpayers to the middle class taxpayer. According to studies performed by Enis and Craig (1984, 1990) and Dunbar and Pogue (1998), approximately 70% of all taxpayers would have their tax liability increase and a majority of the tax burden would shift from the upper 20% of taxpayers to the lower 60%. Also according to these studies, the largest tax increase would occur in the middle income class. The prior studies only examined the Armey-Shelby flat tax proposal. The current research examines the effect of two different flat tax proposals, the Steve Forbes (SF) Plan and the Hall and Rabushka Plan. If the results of the current study are similar to those found in prior research, it could be concluded that all the current flat tax proposals have a bias against the middle income class.

According to other critics of the flat tax, a decrease in tax rates will not create a substantial increase in economic growth. Stokey and Rebelo (1995) and Lucas (1990) both found that tax reform would have little or no effect on growth rate. Summers (1996) also noted that the economy will not grow as proponents of reform predict, based on prior experience with tax changes. Summers (1996) also notes that a flat tax system may not be as simple as its supporters claim due to transition issues that must be addressed and the...