Busting the Flat Tax Fallacy
Republican presidential candidate Rand Paul has proposed a 14.5 percent flat tax on all American individuals and businesses. He repeatedly claims his plan would "blow up the tax code" and "pull America out of the slow-growth rut of the past decade," underscoring the audacity of such a policy. He concludes with an assurance that the plan's execution will see the American economy roar. But the key to fiscal growth is not as easy as implementing a flat tax.
Paul's tax plan, as with many flat tax proposals, is not a pure flat tax. He includes a tax exemption for the first $50,000 of family income and the maintenance of mortgage and charity write-offs.
In addition, Paul proposes a 14.5 percent "business activity tax" that would operate much like a European Value Added Tax or VAT. Despite its widespread popularity among OECD nations, VATs serve as a pernicious form of taxation, harming American consumers through increased prices and broader tax bases.
Unlike a conventional sales tax that is only charged at final sale, VATs are charged in small amounts along the entire supply chain. Ironically, the "business activity" component of Paul's proposal will be primarily borne by consumers, as corporations charge higher prices to customers in order to shoulder increased costs. Furthermore, due to their subtle nature, VATs tend to grow over time, as 20 of the 29 OECD nations with VATs have raised their rates.
Paul's policy has deep roots in American history. The government has twice flirted with the flat tax, both in the 19th century. Due to the rapid evolution of the American economy however, there is not much to glean from a single digit flat tax rate for incomes over $4,000.
A flat tax would simplify a system characterized by convoluted loopholes and incomprehensible deductions. In a given year, U.S. taxpayers and businesses devote 7.6 billion hours to comply with the IRS's 3.7 million-word code.
To analyze the feasibility of Paul's tax proposal, one could look at tax cuts enacted by previous administrations. Granted, comparing a simple tax reduction with an entirely new flat tax plan seems like a gross conflation of fiscal policy. Yet, on a certain level, Paul's tax plan is achieving the same ends as previous tax reductions, just with a reduction in the corporate tax rate and the outright elimination of the payroll tax.
Consider the tax cuts enacted under the Coolidge administration during the 1920s. Dubbed the Mellon tax cuts, these reductions slashed federal income taxes from 73 percent (for income over $200,000) in 1921 to 50 percent in 1923. Simultaneously, taxes paid by the top income earners rose from $300 million to $700 million. Rather than decrease government revenue, lower taxes bolstered federal earnings by an additional $1.2 billion.
Similar to the Mellon tax cuts, the Reagan tax cuts reduced the top tax rate from 70 percent in 1980 to 28 percent in 1988. These policies coincided with real GDP growth of 3.9 percent over the course of the 1980s. Not only did this help the United States escape the stagnation and inflation experienced during the "Stalemated Seventies," but it also opened the door for a legitimate discussion of flat tax policies both domestically and abroad.
Since 1981, 20 countries have implemented flat tax policies with varying tax rates. Barring some exceptions, the new flat tax jurisdictions are former Soviet bloc countries.
Some argue that the relationship between flat tax policy and economic prosperity is one of correlation, not causation. However, comparing former Soviet republics with flat tax systems to those with progressive tax systems shows otherwise.
The Baltic States (Estonia, Latvia, and Lithuania), Mongolia, and Turkmenistan, all have flat taxes and VATs. Since implementing flat taxes in the mid-1990s, the collective growth rate for the Baltic States, 4.74 percent, is larger than that of the progressively taxed Poland. Additionally, this rate is double that of the westerly oriented Scandinavia region.
Mongolia's GDP has grown at an annual rate of 9.4 percent since its flat tax initiative in 2007. The IMF reports that per capita income has quadrupled in the past decade. Similarly, with a flat tax Turkmenistan's GDP has grown at an annual rate of 11.2 percent over the past decade.
Russia has a flat tax, but it also has serious problems of expropriation of property. It attempts to seize control of private corporations through tax claims and silence CEOs that dissent from government policy. This reduces the return on investment and discourages people from risking their capital.
America presents an environment with a relatively strong amount of economic freedom. While prior tax cuts helped the American economy, the benefits that could arise through flat tax are incalculable. The outright elimination of the payroll tax and other federal taxes such as gift and estate taxes would extricate Americans from some of the government's most onerous laws.
One serious problem with Paul's plan is that it is not funded and would increase the deficit. It is possible that reductions in government spending, compounded by sound economic growth ushered in by the flat tax plan, would expand the American economy. However, even when factoring in potential economic growth, this proposal would still cost the government almost a trillion dollars over the next decade, according to the nonpartisan Tax Foundation. Paul's plan is expected to increase economic growth by 9.4 percent over the next ten years, but also cost the government about $960 billion over the same period on a dynamic basis. If growth projections do not pan out as expected, the cost of Paul's plan could swell up to almost $3 trillion.
Rand Paul's plan is a step in the right direction of tax simplification. But, when combined with the 14.5 percent business activity tax, it will not lower rates as much as advertised. The tax rate on income that is spent, rather than saved, will be 29 percent, not 14.5 percent. Furthermore, the plan will not truly solve America's fiscal problems unless politicians can reform entitlement spending.
Joseph Mitrani is a contributor for Economics21
Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning eBrief.