In search of efficiency, equity, and a balanced budget

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In search of efficiency, equity, and a balanced
budget
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What are the distributional consequences of
substituting a flat tax system for ourexisting
tax system?
What is the question?
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What are the distributional consequences of
substituting a flat tax system for ourexisting
tax system?
What is the question?
Is the flat tax fair?
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We analyze individual taxpayer differencesthe
flat tax will not have the same effect on all
taxpayers across income classes or within a given
income class.
Our contribution to the debate
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We analyze individual taxpayer differencesthe
flat tax will not have the same effect on all
taxpayers across income classes or within a given
income class.
Our contribution to the debate
The effect depends on individual
characteristics 1. income sources 2. use of
itemized deductions 3. number of exemptions
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Why estimates of individual gains/losses are
needed
Our contribution to the debate
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Why estimates of individual gains/losses are
needed
Our contribution to the debate
The current personal and corporate taxes
tax wages heavily and business income lightly.
The flat tax would reverse this inequity and
benefit the great majority of Americans whose
income comes almost entirely in the form of
wages Hall Rabushka (1995
92-93).
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All wage earners would pay less tax under our
flat tax than under the current system.
Hall Rabushka (1995 i).
Our contribution to the debate

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All wage earners would pay less tax under our
flat tax than under the current system.
Hall Rabushka (1995 i).
Our contribution to the debate
A more accurate statement would be
Many wage earners would pay less explicit tax
under our flat tax than under the current
system.
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Distinction between pay and bear

• Under current law, a family of four making
  36,800 a year pays about 3,100 in federal
  income tax. Under Armeys plan, that family
  would pay nothing. So much for being tough on
  low-and middle-income taxpayers.
• Mike Deupree, Cedar Rapids Gazette, September 7,
  1995

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MFJ/Single Example Regular Less Flat Tax
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In a nutshell

• Flat Tax System
• Business tax

• Current Tax System
• Business taxed lightly

Business Taxes
Business Taxes
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Main Results 1988/1991 Benchmark Case

• 71/65 of taxpayers lose.
• 113/ 111 billion of tax burden is transferred
  from the 28/34 who win to those who lose.
• One-sixth of the total federal income tax burden
  is thus redistributed.
• Although there are winners and losers in each
  decile, losses outweigh gains in all but top
  decile.

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Whats wrong with what we have?

• 70 of taxpayers claimed the standard deduction
  in 1990-1993
• 40 of taxpayers filed Form 1040A or Form 1040EZ
  in 1990-1993
• But intricacies abound
• passive loss rules
• NOL trafficking rules
• transfer pricing rules

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Whats wrong with what we have?
A disgrace to the human race.
President Jimmy Carter
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Whats wrong with what we have?
A disgrace to the human race.
President Jimmy Carter
Bleep bleep bleep..................
Rush Limbaugh
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How should we change the system?
Substitute a flat tax.
Representative Armey
Freedom Fairness Restoration Act of
1994 Freedom Fairness Restoration Act of 1995

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How should we change the system?
Substitute a flat tax.
Representative Armey
Freedom Fairness Restoration Act of
1994 Freedom Fairness Restoration Act of 1995

Armeys legislation is based on work done by Hall
and Rabushka, beginning in 1981.
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How should we change the system?
Substitute an unlimited savings allowance (USA)
tax.
Sam Nunn Pete Domenici, April, 1994

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How should we change the system?
Substitute an unlimited savings allowance (USA)
tax.
Sam Nunn Pete Domenici, April 1994
Substitute a flat tax.
Arlen Specter, February 16, 1995

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How should we change the system?
Substitute an unlimited savings allowance (USA)
tax.
Sam Nunn Pete Domenici, April, 1994
Substitute a flat tax.
Arlen Specter, February 16, 1995
Substitute a flat tax.
Dick Gephardt, July 14, 1995

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How should we change the system?
Substitute an unlimited savings allowance (USA)
tax.
Sam Nunn Pete Domenici, April, 1994
Substitute a flat tax.
Arlen Specter, February 16, 1995
Substitute a flat tax.
Dick Gephardt, July 14, 1995
Substitute a sales tax.
Richard Lugar

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How should we change the system?
Substitute an unlimited savings allowance (USA)
tax.
Sam Nunn Pete Domenici, April, 1994
Substitute a flat tax.
Arlen Specter, February 16, 1995
Substitute a flat tax.
Dick Gephardt, July 14, 1995
Substitute a sales tax.
Richard Lugar
Substitute a flat tax.
Patrick Buchanan, September 5, 1995
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How should we change the system?
Substitute an unlimited savings allowance (USA)
tax.
Sam Nunn Pete Domenici, April, 1994
Substitute a flat tax.
Arlen Specter, February 16, 1995
Substitute a flat tax.
Dick Gephardt, July 14, 1995
Substitute a sales tax.
Richard Lugar
Substitute a flat tax.
Patrick Buchanan, September 5, 1995
Replace it with a much simpler tax regime.
Robert Dole, September 1995
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Armeys proposed legislation
Replace individual and corporation income
taxes with a two-part flat tax
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Armeys proposed legislation
Replace individual and corporation income
taxes with a two-part flat tax
1. Individual wage tax Wages and pensions less
tax-free threshold
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Armeys proposed legislation
Replace individual and corporation income
taxes with a two-part flat tax
1. Individual wage tax Wages and pensions less
tax-free threshold
2. Business tax Revenue from sale of goods and
services less purchases of inputs wages,
salaries, and pension expense sales-related
taxes and fees
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Business flat tax base
Armeys (based on Hall Rabushka) definition
Revenue from sale of goods and services
less purchases of inputs wages, salaries,
and pension expense sales-related taxes and
fees
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Business flat tax base
Armeys (based on Hall Rabushka) definition
Revenue from sale of goods and services
less purchases of inputs wages, salaries,
and pension expense sales-related taxes and fees
Dunbar Pogue definition
Non-deductible compensation plus business cash
flow
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Hall Rabushka - 1988Flat Revenue Estimates
Business Flat Tax

• 4,900
• - 312
• - 188
• -2,525
• - 635
• 1,240
• 19
• 236

• Gross domestic product
• Indirect business tax
• Income included in GDP but not in tax base
• Wages, salaries, and pensions
• Investment
• Business-tax base
• Business flat tax

Based on the U.S. National Income and Product
Accounts.
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Hall Rabuska - 1988Flat Revenue Estimates
Wage Flat Tax

• Wages, salaries, and pensions
• Family allowances
• Wage-tax base
• Wage flat tax

• 2,525
• 1,093
• 1,432
• 19
• 272

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Hall Rabushka - 1988Flat Revenue vs Current
Revenue

• Business flat tax
• Wage flat tax
• Total flat tax
• Current personal tax
• Current corporate tax
• Total current tax

• 236
• 272
• 508
• 412
• 96
• 508

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Hall Rabushka - 1988Flat Revenue vs Current
Revenue

• Business flat tax
• Wage flat tax
• Total flat tax
• Current personal tax
• Current corporate tax
• Total current tax

• 236
• 272
• 508
• 412
• 96
• 508

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Dunbar Pogue - 1988Business Flat Tax Base

• 360.7
• 404.8
• 765.5
• 326.9
• 1,092.4
• 21.13
• 230.8

• Business Cash Flow - 1040s
• Business Cash Flow - C Corps
• Disallowed Compensation
• Business Flat Tax Base
• Business Flat Tax

Based on the U.S. National Income and Product
Accounts for 1988 and SOI aggregated data for C
corporations.
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APPENDIX III Computation of Flat Business
Tax (Billion)
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APPENDIX V Computation of Nondeductible
Compensation
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Dunbar Pogue - 1988Flat Revenue Estimates
Wage Flat Tax

• Wages, salaries, and pensions
• Family allowances
• Wage-tax base
• Wage flat tax

• 2,444.9
• 1,177.6
• 1,267.3
• 21.13
• 267.8

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Dunbar Pogue - 1988Flat Revenue vs Current
Revenue

• Business flat tax
• Wage flat tax
• Total flat tax
• Current personal tax
• Current corporate tax
• Total current tax

• 230.8
• 267.8
• 498.6
• 407.3
• 91.3
• 498.6

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Dunbar Pogue - 1988Flat Revenue vs Current
Revenue

• Business flat tax
• Wage flat tax
• Total flat tax
• Current personal tax
• Current corporate tax
• Total current tax

• 230.8
• 267.8
• 498.6
• 407.3
• 91.3
• 498.6

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Incidence assumptions
Taxes on labor compensation costs (wages,
pensions, benefits, and payroll taxes) are borne
by the recipients of wages and benefits.
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Incidence assumptions
Taxes on labor compensation costs (wages,
pensions, benefits, and payroll taxes) are borne
by the recipients of wages and benefits.

• Taxes on capital income are borne by
• the recipients of that income.

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Incidence assumptions
Taxes on labor compensation costs (wages,
pensions, benefits, and payroll taxes) are borne
by the recipients of wages and benefits.

• Taxes on capital income are borne by
• the recipients of that income.
• Interest income recipients bear the tax paid
• by business on disallowed interest expense.

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Incidence assumptions
Taxes on labor compensation costs (wages,
pensions, benefits, and payroll taxes) are borne
by the recipients of wages and benefits.

• Taxes on capital income are borne by
• the recipients of that income.
• Interest income recipients bear the tax paid
• by business on disallowed interest expense.
• Dividend income recipients bear the tax paid
• by corporations on balance of corporate
  income.

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Incidence assumptions
Taxes on labor compensation costs (wages,
pensions, benefits, and payroll taxes) are borne
by the recipients of wages and benefits.

• Taxes on capital income are borne by
• the recipients of that income.
• Interest income recipients bear the tax paid
• by business on disallowed interest expense.
• Dividend income recipients bear the tax paid
• by corporations on balance of corporate
  income.
• Flow-through income recipients bear the tax
• paid on balance of flow-through income.

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TABLE 2 Estimated Flat tax Bases and Rates
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TABLE 3 Distributional Effects of Switching to a
Flat Tax
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TABLE 5 Change in Tax Shares Flat Tax Minus
Existing Tax
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TABLE 6 Winners and Losers under the Flat Tax
System 1988
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TABLE 6 (contd) Winners and Losers under the
Flat Tax System 1991
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TABLE 7 Winners and Losers under the Flat Tax
System
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TABLE 8 Estimated Flat Tax Bases and Rates for a
Modified Flat Tax
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TABLE 9 Change in 1988 Tax Shares Modified Flat
Tax Minus Existing Tax
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Winners and Losers under the Flat Tax System Top
Decile (Tax in billions, and Gain (Loss) Per
Winner (Loser) in actual )
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Winners and Losers under the Flat Tax System Top
Decile
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Table 6 Sources of Tax Change Current System -
Flat System
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TABLE 7 Sources of Tax Change Current System -
Flat System
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Distribution of Average Tax Rate
Average Tax Rate Frequency Cum
Freq Cum 0 15,853,571 16.3
15,853,571 16.3 15 57,322,367 58.9
73,175,938 75.2 97,278,312 100.0
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Distribution of Exemptions
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Derivation of Flat Wage Income from Regular
Taxable Income
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Derivation of Flat Wage Income from Regular
Taxable Income
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APPENDIX III Computation of Flat Business
Tax (Billion)
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APPENDIX III (contd) Computation of Flat
Business Tax (Billion)
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APPENDIX IV Computation of Interest Paid by
Domestic Business ( Billion)
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APPENDIX IV (contd) Computation of Interest Paid
by Domestic Business ( Billion)
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APPENDIX V Computation of Nondeductible
Compensation
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Distribution of High Income Taxpayers
AGI up to Sample TPs Cum
40,000 75,471,412 77.58 77.58 50,000
8,124,737 8.35 85.94 75,000 8,769,473
9.01 94.95 100,000 2,469,613
2.54 97.49 200,000 1,738,184
1.79 99.28 500,000 533,491
0.55 99.82 1,000,000 111,563
0.11 99.94 1,000,000 59,840
0.06 100.00 97,278,313 100.00
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Computation of Expanded AGI
AGI 2,986,703,664,690 Exempt interest
32,145,896,402 IRA deductions
11,615,487,691 Keogh deductions
6,531,608,755 Sch C losses
16,987,584,649 Sch F losses
11,836,359,733 Rent/royalty losses
27,315,497,500 S corporation losses
15,108,632,987 Partnership losses
28,593,136,657 Other losses
40,226,245,431 3,177,064,114,495 Negative
EXPAGI 1,218,119,162 EXPAGI 3,178,282,2
00,000
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Expanded AGI vs AGI Decile Ranking
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Tax Incidence Nondeductibility of Benefits
Employers pay wage W and benefits B. Currently,
the after-tax cost of B is (1-t)B. If benefits
are nondeductible, the cost is B. Thus the
increase in cost is tB.
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Tax Incidence Nondeductibility of Benefits
Given the increase in benefit costs, the amount
that employers are willing to pay in wages for
any given quantity of labor falls.
To offset the increase in B, W must fall by
(1-t) W tB
W tB
1-t
which is the amount the demand curve must shift
down.
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Tax Incidence Nondeductibility of Benefits
Wages must decrease by more than the increase in
benefit costs, tB. The wage cost is
(1-t)W. Thus a decrease in W results in a
decrease in wage cost of only (1-t) .
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Tax Incidence When Labor Supply Is Inelastic
Wages
S
Value marginal product of labor minus fringe
benefits (B)
W
D
Labor hours
The demand curve for labor can be drawn only for
a given assumption about the amount of benefits B.
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Tax Incidence When Labor Supply Is Inelastic
Disallow the deduction for fringe
benefits. Demand for labor falls.
S
VMPL minus fringe benefits (B)
D
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Tax Incidence When Labor Supply Is Inelastic
Wages
S
VMPL minus fringe benefits (B)
W
t 1-t
B
W
D
Labor hours
Because employees do not reduce amount worked the
employers can shift the tax back to the employees
by reducing wages to W.
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Tax Incidence When Labor Supply Is Elastic
Wages
S
VMPL
VMPL minus fringe benefits (B)
t 1-t
W
B
W
D
Labor hours
With fewer workers employed, the marginalworker
is worth more and VMPL rises. Some of the taxes
are borne by others e.g., consumers and/or
owners.
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Tax Incidence Nondeductibility of Interest
Assume total supply of funds is a fixed amount.
Q QT QE
Current tax system Taxable borrower equilibrium
Flat tax system
(1-t)R i
Taxable lender equilibrium
(1-t)i iE
i iE
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Tax Incidence Nondeductibility of Interest
Assume total supply of funds is a fixed amount.
Q QT QE
R
i
iE
(1-t)R
Demand for funds
i0
(1-t)i0
iE(1-t)i0
QE
QT
Loaned/ Borrowed
Taxable Market
Exempt Market
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Tax Incidence Nondeductibility of Interest
Current tax system Taxable borrower equilibrium
Flat tax system
(1-t)R i
Taxable lender equilibrium
(1-t)i iE
i iE
Thus R in taxable market drops to (1-t)i0, which
is iE under current system.
No other changes.
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Tax Incidence Nondeductibility of Interest
Assume the total supply of funds is not fixed at
Q.
Current tax system Taxable borrower equilibrium
Flat tax system
(1-t)R i
Taxable lender equilibrium
(1-t)i iE rs
i iE rs
rs required after-tax rate of return
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Tax Incidence Nondeductibility of Interest
QE
Q
The curve S shows rs for each quantity of funds
supplied. S - DE shows supply of funds available
to taxable market after demand for funds by
exempt market has been met.
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Hall Rabushka - 1993Flat Revenue Estimates
Business Flat Tax

• 6,374
• - 431
• - 217
• -3,100
• - 723
• 1,903
• 19
• 362

• Gross domestic product
• Indirect business tax
• Income included in GDP but not in tax base
• Wages, salaries, and pensions
• Investment
• Business-tax base
• Business flat tax

Based on the U.S. National Income and Product
Accounts.
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Hall Rabuska - 1993Flat Revenue Estimates
Wage Flat Tax

• Wages, salaries, and pensions
• Family allowances
• Wage-tax base
• Wage flat tax

• 3,100
• 1,705
• 1,395
• 19
• 265

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Hall Rabushka - 1993Flat Revenue vs Current
Revenue

• Business flat tax
• Wage flat tax
• Total flat tax
• Current personal tax
• Current corporate tax
• Total current tax

• 362
• 265
• 627
• 510
• 118
• 627

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Major Tax Legislation 1981-1988

• 1981 - ERTA
• 1982 - TEFRA
• Increased employment and excise taxes
• Reduced ITC changed depreciable lives
• 1983 - Interest and Dividends Tax Compliance Act
• 1984 - Deficit Reduction Act
• Restircted leasing benefits
• Increased lives on buildings from 15 to 18 yrs.
• 1985 - COBRA
• 1986 - Tax Reform Act
• 1987- Omnibus Budget Reconcilation Act
• 1988 - Technical Misc Revenue Act

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