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The Tax Restructuring Phenomenon: Analytical Principles and Political Equation

National Tax Journal
September, 1995
By Ernest S. Christian

INTRODUCTION

There is a high likelihood that the federal income tax of today will soon be replaced by a new American tax system.1 The long reign of federal income tax has had an enormous impact on the daily lives and behavior of 250 million Americans. It is thoroughly embedded in their consciousness. Abandoning it in favor of a new tax system will be a historic event that will have far-reaching consequences for generations to come. As bad and unpopular as the present Internal Revenue Code is, it will not be an easy task to enact a proper replacement. It is not hard to construct a tax system that would be both simpler and better than the present one. It is, however, not so easy to construct a tax system that the American people will accept and that will actually be enacted into law. It is even harder to enact a new American tax system that is based on core principles of enduring merit that will continue to serve the nation as political and economic circumstances change in the future.

The two leading competitors to replace the present income tax are the Flat Tax and the USA Tax.2 Either would be vastly superior to the present incumbent. Both are highly sophisticated in the sense of minimalism. The art of using the fewest and simplest elements to achieve the greatest effect. While structurally different, both approaches derive from the same analytical roots. Both share many of the same goals. Both have many of the same consequences, most particularly with respect to simplification and in eliminating the bias against saving and investment. In fact, the USA Tax is a version of the Flat Tax and vice versa. By evaluating the similarities as well as the differences, the purpose here is to put both in perspective and to speculate about how these two seemingly separate paths toward tax restructuring may merge into one (see Figures 1 and 2).


BUSINESS-LEVEL TAXES: PARTICULAR SIMILARITIES AND DIFFERENCES

Both the USA Tax and the Flat Tax would replace the present corporate income tax with a new form of annual business tax that includes U.S. sales revenues and deducts amounts paid to other businesses. Both would eliminate the present distinction between incorporated and unincorporated businesses, and both would uniformly apply the business tax to partnerships and proprietorships, as well as to corporations of all types. Neither would allow a deduction for dividends paid and neither would includin income dividends received. Both would disallow the present law deduction for interest paid and both would exclude interest received. Both would abandon the depreciation concept and would, instaed, allow capital purchases to be expensed (See Table 1).


Up to this point -- except for the tax rate -- the Flat Tax and the USA Tax at the business level are identical, but there is more to the story. Businesses also pay compensation to employees, and it is here that big differences between the USA Tax and the Flat Tax start to emerge. The Flat Tax allows a deduction for direct compensation paid to employees. The USA Tax does not. On the other hand, the USA Tax allows a business a tax credit for the FICA payroll tax it pays on employee wages. The Flat Tax does not. Because the USA Tax allows no deduction for either direct or indirect compensation to employees, it is border adjustable for exports ant imports. Because the Flat Tax allows a deduction for direct compensation, it is not border adjustable for exports and imports. The USA Tax provides appropriate transitronal rules for business capital assets and inventory acquired prior to the effective date of the new tax system. Apparently, the Flat Tax does not, although it could and may do so when fully drafted and introduced in legislative form (see Table 2).

At an 11 percent business tax rate, the USA Tax is (designed to raise about the same aggregate amount of revenue (inclusive of the employer payroll tax) from the business sector as present law. If the 11 percent rate rernains constant year-toyear as the amortization deductions for pre-effective date capital and tnventory costs decline, the USA Tax will, over time, moderately increase the aggregate amount of taxes collected at the business level-especially if the tax on net imports is attributed entirely to domestic business firms instead of being attributed in part to the foreign-sited capiital and labor factors that produced and sold those imports. A business tax ra!e that gradually declines from roughly 11 percent to roughly 9 percent in the out years would have an entirely revenue-neutral result at the business level over time. Because labor services comprise roughly 80 percent of gross domestic product (GDP), about that same proportion of business tax revenues under the USA Tax comes from the output value of labor. The remainder comes from a combination of net (in excess of cost) returns to capital invested after the effective date, giross returns to old capital in excess of transitional amortizatron deductions, and from net Imports.

At a 20 percent tax rate, the Flat Tax could substantially increase business taxes and the percentage of total tax revenues that IS collected from the business sector Absent transitional adjustments, immediately after enactment of the business tax, revenues will come from gross returns to old capital investment that will decline year-by-year, net (in excess of cost) returns to new capital investment, and output value of labor as measured by indirect compensation.

As is standard in such exercises, the foregoing general projections of revenue results assume the same levels of future capital investment and GDP growth as would be the case if the present income tax continued in effect. Proponents of the Flat Tax and the USA Tax would expect GDP to grow more rapidly after the present income tax is replaced. The USA Tax would, in all cases, continue to collect from the business sector about the same percentage of the total taxes as under present law.

THE INDIVIDUAL-LEVEL TAXES: PARTICULAR SIMILARITIES AND DIFFERENCES

Both the Flat Tax and the USA Tax would replace the present federal income tax on individuals. Both are designed to eliminate the bias against income that is saved and both are intended to be less complex and less intrusive than the present personal income tax. When viewed in traditional and somewhat superficial terms of income definition, deductions allowed, rates of tax, and credits against tax, the USA Tax and the Flat Tax do, however, present markedly different pictures as shown in Table 3.

The Flat Tax has a single nominal rate for individuals (here illustrated as 20 percent). Under the rigid constraint imposed by the basic structure of the Flat Tax, the individual tax rate must always be exactly equal to the business tax rate. The USA Tax in 5.722 has three nominal rates that vary somewhat by filing status as shown in Table 4.

Both the Flat Tax and the USA Tax have family (personal) exemptions and dependent exemptions that effectively modify the nominal rate (rates). In the case of the Flat Tax, these exemptions appear to be as set forth below, although they may be modified when the Flat Tax is fully articulated in legislatrve bill form.

Joint return ........................... $26,200
Single filer ............................. $13,100
Head of household ................ $17,200
Per dependent ....................... $5,300

The USA Tax in 5.722 has the following exemptions:

Joint return .................................... $7,400
Single filer ..................................... $4.400
Married/separate ........................... $3,700
Head of household ........................ $5,400
Per filer and dependent ................. $2,550

As evidenced by the fact that they are substantially larger, the exemptions play a much more significant role under the Flat Tax. Because the flat exemptions decrease as a percentage of income as income rises, they are the way by which the Flat Tax achieves some degree of graduation on an effective rate basis. However, because only wage income is included and taxed on the individual tax return, it is only on wage Income that the tax is graduated.

Assuming a joint return with no children, various effective rates of tax on wage income are shown in Table 5. (If one or more $5,300 dependent exemptions were also included, the effective rates would also vary among taxpayers with the same wage incomes.)

Thus, despite the nominal flat rate, the Flat Tax is not a proportionate tax insofar as wage income is concerned and, in fact, is significantly graduated in the range of income that includes nearly all wage earners-going from 5 percent at $35,000 to 18 percent at $262,200. The Flat Tax is flat only at the bottom end of the income scale (0 percent up to $26,200 in Table 5) and at the top of the income scale (19 percent, plus a fraction, above $524,000 in Table 5).





Under the theory and construct of the Flat Tax, it is also flat and proportional on nonwage income such as interest, dividends, and gains without regard to amount, The graduated Flat Tax on wage income and the flat Flat Tax on nonwage income can both been seen in a simple comparison.

Example I: A retired couple whose savings (stock) has earned a pre-tax dividend of $35,000 would “prepay” a 20 percent tax at the business level and receive an after-tax dividend of $28,000. An unretired couple who earned $35,000 of wages would pay tax at an effective rate of 5 percent and have after- tax income of $33,250 before taking into account the 7.65 percent FICA payroll tax. After payroll taxes, this couple would have take-home pay of $30,753.

Although primarily related to graduation versus proportionality under the Flat Tax, example 1 also helps to illustrate the “prepayment” concept on the basis of which the Flat Tax excludes nonwage income from the individual tax return. The theory is that after paying and deducting wages to employees, and paying and deducting the cost of its capital equipment, the corporation had taxable income of $35,000 on which it, on behalf of the retired couple, paid a 20 percent or $7,000 tax. Example 1 further illustrates that while the 20 percent nominal rate may be the real rate on dividends and other nonwage income, the real marginal rate under the Flat Tax on each additional dollar of wage income is, in most cases, higher than 20 percent. Because the Flat Tax allows no credit for the 7.65 percent FICA tax paid by employees, the real marginal rate on wage income up to $61,500 is 27.65 percent.

As a consequence, the real effective rates of tax on wage income are also higher than previously illustrated in Table 5 in the case of a joint return. When restated assuming only the basic exemption of $26,200, the results are in Table 6.

Because the USA Tax allows a credit for the 7.65 percent FICA payroll tax, its nominal rates (19, 27, and 40 percent on a joint return in 1996) are inclusive of the payroll tax and are, therefore, the real marginal rates. A useful comparison to the Flat Tax is set forth as follows:

A somewhat different comparison can also be made between the rate (rates) of tax on wage income under the Flat Tax and the USA Tax. If the FICA payroll tax is ignored (on the ground that it will continue to be paid in all events), the additional rate of the Flat Tax on all wage income is 20 percent. On the other hand, the additional rate of the USA Tax on wage income up to $61,500 is in each case 7.65 percentage points less than the applicable nominal rate. The additional rates (joint return in the case of the USA Tax) are illustrated as follows:

Although the foregoing comparison of additional rates may be used to illustrate another way of loioking at the payroll tax credit allowed by the USA Tax on wage income, the fact remains that the actual rates on a USA Tax joint return are 19, 27, and 40 percent, and these rates are inclusive of the payroll tax.

These rates, and the comparable rates for individuals In other filing status, apply uniformly to nonwage income (such as dividends and interest) as well as to wage income. Unlike the Flat Tax, which uses the yield-exemption approach to eliminate the tax bias against savings, and where, as a conselquence, the individual tax return only includes wage income, the USA Tax individual tax return includes both wage income and nonwage income. At the individual level, both types of income are taxed exactly at the sarne progressive rates.

Because the USA Tax Includes and taxes at the individual level earnings on income that has previously been saved and, therefore, become “capital,” the USA Tax uses the traditional approach of allowrng a deduction for saving, In order not to tax both the income tlhat is saved and the earnings on savings. The Flat Tax allows no deduction for saving because it uses the yield-exemption approach, which excludes earnings on savings.

While the familiar deduction approach under the USA Tax and the less familiar yield-exemption approach both eliminate the tax bias against saving and although the return on savings is, all else equal, the same in both cases, the cash flow results to the saver in the year the saving occurs are not the same. Ignoring the payroll tax, the different curreht-year cash flow results are easily seen iin a simple comparison.

Example 2: By working overtime, a two-earner couple earns an additional $1,000 that is taxable at 20 percent under the Flat Tax and that comes within either the 19, 27, or 40 percent tax bracket under the USA Tax. They desire to save $1,000. Under the Flat Tax, which allows no deduction for savings, they must pay an additional $200 of tax. In order to save $1,000, they must cut back their current standard of living by $200. Under the USA Tax, which allows a deduction for saving, they pay no additional tax and can save the full $1,000 without reducing their current standard of living.

The USA Tax and the Flat Tax have different aggregate revenue results, counting the individual taxes and business taxes together. In total, the USP Tax is revenueneutral relative to present law and maintains about the same split between individuals and businesses as under present law.

In contrast, the proponents of the Flat Tax apparently intend that it reduce aggregate revenues by about $40 billion in the first year. Some preliminary estimates by the Treasury have suggested substantially higher revenue losses at a 20 percent rate, but those estimates are disputed. In the absence of a fully articulated Flat Tax in legislative bill form and official revenue estimates, the split between individuals and businesses is unclear, but it would appear that over time the business share would increase and the individual share would decrease, relative to present law and relative to the USA Tax.

The USA Tax is neutral with respect to the distribution of the tax burden by expanded family income class. As shown in Table 7, the USA Tax maintains and makes slightly more “progressive” the present law distribution.

No comparable income class distribution table has been put out by the proponents of the Flat Tax, and one needs to be circumspect in making comparisons on this sensitive subject, but it seems to be the case that the Flat Tax would significantly redistribute a percentage of the tax burden from upper income groups to middle and lower middle income groups and, therefore, by traditional standards, be “regressive” even though the Flat Tax is somewhat graduated. For example, and stated somewhat differently, the Treasury has indicated that proposals along the lines of the Flat Tax would amount to a 7 to 17 percent increase in federal taxes for families with incomes under $200,000 and a 26 percent decrease in federal taxes for families with incomes above $200,000. Quibbles about the precise percentages are not important. These estimates may be somewhat off the mark but they probably do indicate the general direction of the shift in tax burden that occurs under the Flat Tax.

OVERVIEW: STEPPING BACK FOR ANOTHER LOOK

Against the background of long experience with the present federal income tax, the Flat Tax presents a startling contrastno deductions instead of many, not even for charity and home ownership. There are no credits, not even child care. The Flat Tax uses a single rate that applies to the rich and the poor alike and everyone in between. Only wage earners file personal tax returns. There is not even a line on the tax return for interest and dividends. On the positive side, of course, there is the idea that the tax return filed by most Americans might be only the size of a postcard. Furthermore, relieving the tax bias against saving may be the key to a much more prosperous future for this generation of Americans and the next. That is hard to argue with.

Repealing all deductions and having a flat tax rate might seem fundamental to the Flat Tax and the positive goals it is intended to achieve. From some perspectives, that may be true. Many proponents of the Flat Tax would say so. From other perspectives, there is nothing fundamental about having or not having a few deductions, or about one instead of two or more rates of tax. For example, from the perspective of the highly flexible structure of the USA Tax, the deduction and rate aspects of the Flat Tax are merely policy choices. They are important ones in terms of the consequences to affected persons such as charities and homeowners, but they are choices nevertheless. The flexible structure of the USA Tax can readily accommodate either multiple rates or a single flat rate. In fact, relative to steeply progressive tax rates in the past, the multiple rates in 5.722 are actually fairly flat. The USA Tax in 5.722 has only three rates and as a practical matter has only two rates of major significance. The top rate kicks in fairly quickly and, as a consequence, the income brackets to which the two lower rates apply are not very wide. In addition, judged by historical standards, the higher of these two principal rates is not all that much greater than the lower (e.g., in 1996, 40 percent compared to 27 percent on a joint return).

Similarly, the flexible structure of the USA Tax could easily accommodate a policy choice to have no personal deductions in the traditional sense. In fact, along with the deduction for personal saving, which is critical, the USA Tax only allows a few basic deductions. The charitable contribution deduction is not the source of any appreciable complexity, and certainly the home mortgage interest deduction is not complex at all. All anyone has to do is transfer one number from the statement furnished by the rnortgage lender onto the tax return. In fact, the Flat Tax, itself, will almost certainly retain the home mortgage interest deduction for existing mortgages. Otherwise, many families, especially young couples, would no longer be able to afford the mortgage payments on houses already purchased and contractually committed to prior to the enactment of the Flat Tax. Repealing the home mortgage interest deduction for new families in the future may have some substantial consequences, but a simpler tax return with fewer lines will not be one of them.

Given the fact that the few deductions retained by the USA Tax are not complicated, and given that having one tax rate instead of two or three rates has almost nothing to do with simplification, why then is the Flat Tax so rigid in that regard and why do its propo ents focus so heavily on these aspects? There must be some other reason. The same question can be asked about using the yield-exemption approach to eliminate the tax bias against saving, instead of the more familiar and likely more politically palatable deduction approach under the USA Tax. The Flat Tax appears to totally exclude interest, dividends, and gains froth tax, and to tax only wage income. That appearance may be hard to dispel and his rife with possibilities for both genuine misunderstanding and political demagouery. In addition, it can be said, with some degree of truth, that the different current-year cash flow results under the USA Tax make it more attractive to new savers, whereas the yield-exemption approach is most attractive to those people dho already have savings.

The answer to these questions is clear. It is the same answer that explains why the Flat Tax does not contain explicit bordertax adjustments for imlports and exports, even though many who otherwise favor the Flat Tax idea consider these border adjustments to be an important goal of tax restructuring. All these results and rigidlties arise directly frpm the bifurcated structure of the Flat Tax. As shown by the schematics at the begipning of this paper, both the Flat Tax and the USA Tax are vertically bifurcated, viz, a tax is imposed at the business level tihen income is produced and a tax is imqosed at the individual level when income is received. That Flat Tax, but not the UISA Tax, is then also horizontally bifurcated, viz., at the business level only capital IIncome is included and taxed, and, at the individual level, only labor Income (wages and salaries) is Included and taxed. In contrast under the construct of the USA Tax, both labor income and capital income are included in the tax base at both the business level and the individual level.

The doubly bifurcated structure of the Flat Tax is highly rigid and constrains choices. For example, within that structure a deduction for charitable contributions could only be allowed against wage income, but if such a deduction is going to be allowed, it is anomalous for people with only interest and dividend income not to also get that deduction. Many of them are most likely to be the largest donors. Further, for example, the doubly bifurcated structure virtually mandates a flat rate. If progressive rates were applied, they could only be applied to wage income. However, in order for the average rate in a multiple rate system for wage income to produce the same revenue as a 20 percent flat rate, the top rate on wage income would be higher than 20 percent and higher than the 20 percent rate on nonwage income that is implicit in the prepayment concept of the Flat Tax where capital income is taxed only at the business level. Similarly, and for the same reasons, the present construct of the Flat Tax generally precludes use of the deduction approach to personal saving. In addition, border tax adjustments at the business level are precluded because the present construct of the Flat Tax requires that wage income be deducted at the business level because it is taxed at the full Flat Tax rate at the individual level.

ACHIEVING THE MAIN GOALS

The main goal of both the Flat Tax and the USA Tax should be to serve the national interest by actually enacting into law a simplified tax system that eliminates the tax bias against savings and enhances our ability to compete in international markets.

The main debate will be political, focused on whether the main goal will be achieved with or without changing the existing distribution of the tax burden between high-, middle-, and low-income groups as determined by the very inexact process and methodology of distributional analysis. That political debate will alone be enough of a problem without adding additional political barriers that arise out of the basic structure of the Flat Tax itself and without using a basic structure that can achieve the main goal only if the political debate is resolved in a certain way.

In order to isolate the main goals from the political debate about progressivity, and to ensure the enactment of a new American tax system in all events, the proponents of the Flat Tax should express it within the highly flexible framework of the USA Tax where labor income and capital income are taxed at both the business level and the individual level, and where the border tax adjustments can be made. The busrness-level taxes would be identical. At the individual level, there would be the following two, highly workable versions of the Flat Tax:

1. One with a single rate, no personal deductions (other than the savings deduction), and no payroll tax credit.

2. Another with two additional rates, a few personal deductions for charity, home mortgage interest, education, and so on (plus the savings deduction), and a payroll tax credit.

ORIGINS AND EVOLUTIONARY DEVELOPMENT OF THE FLAT TAX AND THE USA TAX

There are many intellectual parents. The concepts reflected in both the Flat Tax and the USA Tax have been written about by eminent scholars too many to cite. The real origins are, however, more fundamental and derive from the way the economy actually works-from the way real goods and services are actually produced, from the fact that this productive process is the source of all income, and from the way that individuals actually receive that income either as employment flows (wages and salaries as compensation for work) or as financial flows (interest and dividends, and so on as compensation for the use (of their capital and, ultimately, a return of that capital). When a tax is injected Into the economic process by which income is created, it must be collected either at the point of production (businesses) or at the point of receipt (individuals). If the tax is collected at the point of production, it must be based either on the labor component of production or the capital component of production, or both. If the tax is collected at the point of receipt, it must be based either on the employment flows to Individuals, or the financial flows to individuals, or both. Therefore, this basic structure and operation of the economy dictates the structure of any tax-whether it is called the Flat Tax, the USA Tax, or, generically, “X.” In fact, David F. Bradford has proposed a variation that he calls the X-Tax.3

The basic construct of the economy and the range of choices available to the architect of any tax can also usefully be depicted in the form of an X.

A potential component of a tax base appears at each of the four endpoints marking the extremities of the two intersecting lines in the form of an X, but there is, in a sense, some duplic:ation. The Employments Flows (4) are a reappearance at the Individual level of the Labor Component (1) at the business level, and (4) is equal in amount to (1) less any tax already collected out of (1) at the business level. Similarly, the Financial Flows (3) are a reappearance at the individual level of the Capital Component (2) at the business level, and (3) is equal iq amount to (2) less any tax already colllected out of (2) at the business level.

The foregoing construct is rigid and any tax system must be built around it. The only flexibility in the depign of a tax is in choosing to impose tax at all or only on some of the four possible points, in choosing to impose tax at uniform or varled rates on one, more, or all of the potential components of the tax base, and in choosing to specially define one, more or all of the potential cpmponents of the tax base. Even these choices are, however, not open ended. Great care must be exercised in order to avoid inconsistent treatments of “likes” and similar anomalies that cause undesirable economic or political consequences. The administrative consequences of choices and combinations of choices must also be taken into account.

Setting aside secondary matters such as the tax rates, and concentrating on fundamentals, there are four basic constructs that are highly pertinent to the origins and development of both the Flat Tax and the USA Tax.

  1. Basic Construct X-1. Collect all tax at the business level based on the Labor Component (1) of production and the Capital Component (2) of production.

  2. Basic Construct X-2. Collect all tax, in the sarne total amount, at the individual level based on the Financial Flows (3) and the Employment Flows (4).

  3. Basic Construct X-3. Collect the same total amount of tax, but collect it in part at the business level and in part at the individual level as follows. Tax the Capital Component (2) at the business level and tax the Employment Flows (4) at the individual level.

  4. Basic Construct X-4. The same as Basic Construct X-3 except that a partial tax at the business level is collected from both the Labor Component (1) and the Capital Component (2), and, at the individual level, a partial tax is collected from both the Employment Flows (4) and the Financial Flows (3).

The fundamentals of the Flat Tax are immediately recognizable in Basic Construct X-3 where there is a double bifurcation, both as between business and individuals, and as between Employment Flows and Financial Flows. Similarly, Basic Construct X-4 represents the USA Tax in primal form. The essential ingredients of a modified business cash flow tax or true tax on business value added (as distinguished from the VAT form of retail sales tax) can be found in Basic Construct X-l. Basic Construct X-2 contains the basic building blocks of a household-only cash flow tax.

ENDNOTES

1. As of May 1995, nearly all announced presidential candidates plus the Majority Leader of the Senate (also a presidential candidate), the Speaker of the House, the Majority Leader of the House, the Chairman of the Committee on Ways and Means, the Chairman of the Committee on Finance, and an array of other leading members of Congress have either introduced legislation to replace the income tax or have indicated substantial support for the general idea.

2. The Flat Tax is as generally described by Robert E. Hall and Alvin Rabushka and leading congressional proponents as of May 1995 [See Hall and Rabushka (1995)]. When fully drafted and introduced in legislative form, the basic structure of the Flat Tax may be modified; either as suggested in this paper or otherwise. The USA Tax is as contained in 5.722, which was introduced on April 25, 1995. A prototype for the USA Tax is explained in Christian and Schutzer (1995).

3 See Bradford (1986).

REFERENCES

Bradford, David F. Untangling the Income Tax. Cambridge, MA: Harvard University Press, 1986.

Christian, Ernest S. and George 1. Schutzer. “USA Tax System-Description and Explanation of the Unlimited Savings Allowance Income Tax System.” Tax Notes 66 No. 11 (March 10, 1995): 1482-1575.

Hall, Robert E. and Alvin Rabushka. The Flat Tax. 2d ed. Stanford: Hoover Institution Press, 1995.

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