James M. Bickley
Specialist in Public Finance
The concept of replacing the current U.S. income tax system with a flat rate consumption tax is receiving congressional attention. The term "flat tax" is often associated with a proposal formulated by Robert E. Hall and Alvin Rabushka (H-R), two senior fellows at the Hoover Institution. This report analyzes the idea of replacing the U.S. income tax system with this type of consumption tax. Although the current tax structure is referred to as an income tax, it actually contains elements of both an income and a consumption-based tax. A consumption base is neither inherently superior nor inherently inferior to an income base.
As of March 22, 2010, four bills have been introduced in the 111th Congress that includes a flat tax based on the concepts of H-R. On February 12, 2009, Representative Michael C. Burgess introduced H.R. 1040, the Freedom Flat Tax Act. On May 4, 2009, Senator Lamar Alexander introduced a companion bill, S. 963, the Optional One Page Flat Tax Act. These bills would authorize an individual or a person engaged in business activity to make an irrevocable election to be subject to a H-R flat tax (in lieu of the existing tax provisions). On March 30, 2009, Senator Arlen Specter introduced S. 741, Flat Tax Act of 2009. On April 30, 2009, Senator Richard C. Shelby introduced S. 932, the Simplified, Manageable, and Responsible Tax Act. S. 741 and S. 932 would levy a flat tax modeled after the H-R proposal as a replacement for the individual and corporate income taxes, and the estate and gift taxes.
The combined individual and business taxes proposed by H-R can be viewed as a modified value added tax (VAT). The individual wage tax would be imposed on wages (and salaries) and pension receipts. Part or all of an individual's wage and pension income would be tax-free depending on marital status and number of dependents. The business tax would be a modified subtraction method VAT with wages (and salaries) and pension contributions subtracted from the VAT base, in contrast to the usual VAT practice.
The analysis of the flat tax proposal is covered by the following four topics that sometimes overlap: broad economic issues, narrow sectoral economic issues, simplicity, and international comparisons. First, broad economic issues relate to economic effects of the flat tax on the entire economy: equity, efficiency, international trade, price level, interest rates, and revenue. Second, sectoral economic issues deal with specific industries or sectors of the total economy: differential effects on businesses, charitable organizations, housing, financial services, pensions and insurance, health care services, and state and local governments. Third, tax economists, government leaders, and taxpayers are interested in the simplicity of a tax system, and the current income tax system is complex. A positive aspect of the proposed flat tax is the ease with which the individual and corporate tax systems could be integrated. But, the complexity of the current tax code is partially due to attempts to achieve greater equity or to improve economic efficiency, and there are often tradeoffs between simplicity, equity, and efficiency. It can be argued that it may be "unfair" to compare the current income tax system with some form of a "pure" consumption tax; by the time a consumption tax becomes enacted, it may become complicated. Fourth, there are major distinctions between recent consumption tax proposals for the United States and the current tax systems of other developed nations. Numerous aspects of the H-R flat tax proposal have not been fleshed out and many important policy issues have yet to be analyzed.
Date of Report: March 22, 2010
Number of Pages: 29
Order Number: 98-529
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Friday, April 2, 2010
James M. Bickley