Wednesday, December 7, 2011
James M. Bickley
Specialist in Public Finance
The President and leading Members of Congress have stated that fundamental tax reform is a major policy objective for the 112th Congress. The concept of replacing individual and corporate income taxes and estate and gift taxes with a flat rate consumption tax is one option to reform the U.S. tax system. 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. In the 112th Congress, two bills have been introduced that included a flat tax based on the concepts of Hall- Rabushka: the Freedom Flat Tax Act (H.R. 1040) and the Simplified, Manageable, and Responsible Tax Act (S. 820). In addition, Republican presidential candidate Herman Cain has proposed a tax reform plan that includes a modified H-R flat tax. This report analyzes the Hall- Rabushka flat tax concept. 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.
The combined individual and business taxes proposed by H-R can be viewed as a modified valueadded 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 subtractionmethod 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 sectorial 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, sectorial 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: November 29, 2011
Number of Pages: 32
Order Number: 98-529
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