Commentary | Trade and Globalization

Going Flat

Opinion pieces and speeches by EPI staff and associates.


Going Flat

By  Max B. Sawicky

Conservative activist Grover Norquist has essayed the daunting feat of putting a sober face on the Bush administration’s bacchanal of tax cuts. Where others see budget-busting largesse to the rich, he sees inexorable progress towards fundamental tax reform.

The Norquist ideal is the flat tax invented by Robert Hall and Alvin Rabushka and promoted by Steve Forbes: the famous tax you can do on a postcard. It is certainly a fundamental reform; whether it is desirable is a different matter. In either case, the rough beast of federal income taxation is slouching not towards the flat tax, but to something quite different.

Norquist cites five steps to fundamental tax reform: elimination of the Alternative Minimum Tax (AMT), the Estate and Gift Tax and taxes on capital gains, plus immediate depreciation of all capital expenditures, and fully-flexible Individual Retirement Accounts (IRAs) that permit sheltering all savings from taxation. Norquist claims that tax cuts enacted over the past three years fit the enlightened design embodied in his five-step program. Is he right?

Reducing the top marginal rates makes the bumpy income tax somewhat flatter, but the president also boasts of the new 10 percent bracket, the expanded, partially-refundable Child Tax Credit and extended marginal brackets for couples that reduce marriage penalties. None of these measures accord with the flat tax.

Instant depreciation is consistent with flat tax treatment of business income, but it goes along with the full taxation of profits. Profits include funds used to pay creditors. No politician has been caught favoring the taxation of interest paid by business firms.

What about IRAs? There is no provision for IRAs in the flat tax. In effect, the business firm is the IRA. Its investments — capital expenditures — are analogous to contributions and deductible to the firm; its returns — profits used to pay interest and dividends — are taxable. The individual pays no tax on interest, dividends or capital gains. Flat tax treatment of savings exactly parallels existing Roth IRAs, but without the income limitations. After-tax dollars can be used to buy tax-free financial assets. The flat tax does not need an IRA.

The president and Congress have been conspicuously silent about the AMT, aside from enacting limited, temporary relief from it. In the same vein, the 2001 tax cut repeals the Estate and Gift Tax by 2010, but revives it in 2011. So far, politicians have postponed a confrontation with the huge deficit implications of eliminating these taxes.

Properly speaking, going flat requires taxing what is presently untaxed, not just reducing taxes on what currently is taxed. Missing from Norquist’s five steps is the flat tax’s required abolition of a raft of popular deductions, income exclusions, and credits that don’t fit on the postcard. For instance, the popular deductions for home mortgage interest and state property taxes that tripped up presidential candidate Jerry Brown in 1992 are inconsistent with the flat tax. So too is the exclusion of wages used to pay for health insurance.

On the Norquist map of fundamental tax reform, mountains are leveled but valleys remain. Republicans are opposed on principle to any change in the law that entails a tax increase, but it is impossible to achieve the flat tax without some.

So what do recent tax cuts herald if not fundamental tax reform?

First, the obvious answer: reducing revenues for reasons unrelated to tax policy. Norquist is famous for hoping “to get government down to the size where we can drown it in the bathtub.”

Second, the ever-increasing concessions to “savings” — which means preferential or zero tax rates on capital gains, interest and dividends — shifts the tax burden to labor income. Our individual and corporate income taxes are devolving towards a wage tax.

Third, the increasing complexity of the system in its treatment of business and investment income widens opportunities to offset taxes on salary income for sophisticated taxpayers with complex financial affairs and hungry accountants. Those with high salaries will not merely escape income tax, but their investment income will benefit from negative taxation — shades of socialism for the rich.

At the end of the day, the system towards which we are pushed is tantamount to a single tax on wages under a manufactured budget crisis. (Using the payroll tax to raise all the income tax revenue would require a rate increase to about 40 percent.) Evidently, the plan is not “fundamental tax reform,” but a bankrupt national government.

Max B. Sawicky is an economist at the Economic Policy Institute.


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