The Agenda

A Better Flat Tax

As you can tell from his excellent posts in this space, Josh Barro is not a fan of Herman Cain’s 9-9-9 plan for economic growth. Neither is Ramesh Ponnuru, who made the case against Cain’s reform proposal at Bloomberg View. Indeed, Josh and Ramesh make a strong case that Cain’s profound confusion about his own plan should prevent him from being taken seriously as a presidential contender. 

But because I am a glutton for punishment, I do want to float another tax reform proposal that I sense neither Josh nor Ramesh would endorse. Recently, Texas Gov. Rick Perry’s presidential campaign signed on Steve Forbes as an advisor, and it seems that Perry is on the cusp of releasing a flat tax proposal. We don’t know the precise details of Perry’s flat tax proposal yet, but one assumes that it will bear some resemblance to the Hall-Rabushka flat tax, which, in my view, has a lot going for it. 

In the past, I’ve endorsed David Bradford’s X tax, which is very similar to the Hall-Rabushka flat tax, the main difference being that it has graduated rates for wage income. Part of the appeal of a graduated consumption tax is that while a graduated income tax creates work disincentives as one climbs up the income ladder, a graduated consumption tax actually ratchets up the incentive to save and invest as income increases. 

That said, the Hall-Rabushka flat tax might be preferable on grounds of allocative efficiency. One serious problem, however, is that a single-rate tax on income above a generous deduction — say, $40K — combined with a regressive payroll tax would wind up tilting the tax burden away from the wealthy.

And so in 1998, Alvin Rabushka proposed a reform that would tackle the Social Security payroll tax and the personal income tax and the corporate income tax:

The package I propose would change the payroll tax into a flat tax by eliminating the income cap. What might be the effects of such a provision? In 1996 the payroll tax raised roughly $379 billion. If all wage income had been taxed, based on preliminary Internal Revenue Service income data, this figure would rise by $64 billion, to $443 billion. If income from dividends, interest, and capital gains were also subject to the Social Security tax, receipts would increase by an additional $68 billion.

Eliminating the cap—effectively raising taxes on upper-income Americans—would make it possible to reduce the payroll tax rate by nearly 2 percent without reducing the overall flow of revenue into the system—or cutting anyone’s benefits. Two percent is the figure that proponents of partial privatization cite as a starting point for giving low- and middle-income households the chance to build private retirement accounts. Adding capital income to the equation would permit a reduction of 3.3 percent. All this would be possible without reducing Social Security benefits.

Now let’s turn to tax reform—either the flat tax or a national sales tax, with a rate of 20 percent or less. Critics of such plans say they would give a tax break to the wealthy because the top rate would fall from 39.6 percent to 20 percent or less. The current tax system is highly progressive. IRS data show that during the period 1981–96, the share of taxes paid in a given year by the top 1 percent of individual taxpayers ranged between 20 and 32 percent of all federal income taxes. The top 5 percent paid between 35 and 50 percent. (These numbers give only a rough idea of relative tax burdens because it’s difficult to determine who bears the burden of corporate taxes, which today account for about a fifth of total federal income taxes.) …

[A] modification of the payroll tax, as I have proposed, in conjunction with replacing the current, multibracket, complicated income tax with a flat tax or a sales tax, would represent a fair solution. A reduction in marginal income tax rates on wealthy households would be offset by higher Social Security taxes on them.

I’d still prefer an X tax, but this would certainly represent a better approach to tax reform than leaving the Social Security payroll tax in place. If Perry embraces this plan — lift the cap on the Social Security payroll tax, cut it, and embrace a Hall-Rabushka flat tax — I’d be thoroughly impressed, and he’d be in a far better position to meet legitimate objections from the center-left. 

Another issue, which Josh has raised in the past, is that the federal tax system should mitigate the impact of regressive taxes at the state level, particularly since state and local governments have good reason to impose a less steeply progressive tax burden (because, inter alia, it’s easier for people to move from jurisdiction to jurisdiction at the subnational level). This merits further discussion, hence my next post.

As Rabushka and others have argued, it seems reasonable to suggest that we look to taxes and expenditures to evaluate the progressivity of government’s combined impact on the citizenry. Focusing only on taxes might give us a misleading portrait of the landscape. One problem is that public expenditures, at all levels, are not doing enough to benefit the poor. Those of us on the right are inclined to think that this is because public sector institutions, e.g., K-12 public schools, are highly inefficient.