Flat Tax? Fair Tax? Broader Tax Base? Heartland Experts Discuss

Published November 10, 2011

Can any tax be fair?

Multi-billionaire Warren Buffett has been decrying what he says are unfair tax policies that let the “mega-wealthy” off easy, including himself.

His premise comes into question, however, when reviewing tax data. For 2011, households earning more than $1 million will pay, on average, 29.1 percent of their income in federal taxes. A household making between $50,000 and $75,000 will pay 15 percent of its income in federal taxes, including income taxes and Social Security and Medicare payroll taxes, according to the nonpartisan Tax Policy Center.

Nonetheless, President Obama has picked up on Buffett’s lament to call for a “Buffett rule”a minimum tax on persons earning more than $1 million a year. Yet Buffett himself has said millionaires are not mega-wealthy. A person with $1 billion, after all, has a thousand times as much money a someone with $1 million.

Is Flat the New Fair?
Stephen Moore of The Wall Street Journal recently took up the issue of tax fairness with a column headlined, “Flat Is the New Fair.” A flat tax would impose one rather than multiple tax rates based on income level, and it would get rid of most or all tax deductions, exemptions, and credits.

Republican Presidential contenders are also addressing tax fairness. The proposal with the most press recently has been Herman Cain’s “9-9-9” plan: personal income, corporate, and national sales taxes of 9 percent each.

Budget & Tax News asked Heartland Institute policy advisors who’ve done a good deal of thinking about taxes and the economy for their views on the tax fairness issue. Here’s what they wrote.

Ross Kaminsky, professional derivatives trader, publisher of Rossputin.com:

Living in an imaginary world where substantial tax reform is possible, both a flat tax and a Fair Tax have appeal. [Editor’s note: the “Fair Tax” would replace the federal tax system with a national consumption tax of 23 percent, similar to a sales tax, but with “prebates” to help taxpayers offset some of the tax burden.]

Fair Tax proponents make several major claims, most of which I find unconvincing, including that it will keep the government from “picking winners and losers” and that it will allow us to “eliminate the IRS.” Neither of those claims is true.

Beyond that, the Fair Tax would turn millions of small businesses, including online businesses in particular, into tax collectors for the federal government. If the nation decides to continue down a path of considering a national sales tax, such as Herman Cain proposes in his 9-9-9 plan, it is absolutely critical that the implementation of that tax—unlike in the 9-9-9 formulation—be done simultaneously with repealing the 16th Amendment (which allows the federal government to impose an income tax).

Hauser’s Law (which posits that no matter what income tax rates the federal government sets, the Treasury will not collect more than about 19.5 percent of national income) is only true in the United States because we do not have both a national sales tax and an income tax.

Manipulation, Black Markets

I strongly prefer a flat tax. It is much less burdensome to administer than a sales tax on every retail transaction. This burden should not be overestimated. And, despite pleas of the national sales tax crowd, it is likely to end up less subject to political manipulation than the Fair Tax would be.

In each case there will be questions of how to protect the poor. With a flat tax, some first number of dollars of income will not be taxable. With a Fair Tax, there will be a “prebate” with the government guessing how much money people spend on taxable items.

The flat tax does not have the black market-causing effects that a large national sales tax would have. Fair Tax proponents argue there won’t be a black market because final prices after the sales tax would be close to current retail prices due to companies being able to lower their base prices once the corporate income tax is eliminated.

However, the desirability of a black market is based only on the relative prices of that black market versus the regular market. And when you’re talking about a 23 percent difference in price, it is foolish to think there won’t be an enormous black market created. It’s also worth noting that this will drive consumers to buy things from other countries in situations where the transportation cost of items is less than 23 percent of the item’s cost.

Look at all the eBay sellers from Hong Kong. They’ll suddenly have a huge price advantage, given that they are already competitive even including the cost of postage. This, combined with the paperwork burden of collecting tax on every sale, means the Fair Tax would put many online businesses out of business. There is none of this problem with a flat tax.

The word “fair” is used a lot by the Left, though with them it is usually used in a way that a rational person would think means “unfair.”

Meaning of ‘Fair’

What is fair is to treat each American the same way, with the same opportunity (or lack thereof) for exclusions, exemptions, deductions, and so on. The flat tax, assuming we prevent another tax code metastasis around it, is more likely to be fair in that way. The Fair Tax’s “prebate” is just a recipe for expanding the welfare state and making the tax code even more progressive.

It is not “fair” for nearly half the nation’s earners to contribute zero toward the cost of government, even while I stipulate that more than half of what the government spends is unconstitutional. Does someone who earns $25,000 a year really have so little stake in, for example, national defense, that he or she should be able to pay zero income tax?

Whether either tax reform would address the issue of free riders is an open question, especially given that nearly half of American income earners have no incentive to support anything that would no longer let them freeload off those who do pay tax.

Government Snooping

Fair Tax proponents also argue their plan is better because it keeps the federal government from knowing what we make and how we make it. I have sympathy for that argument. On the other hand, those who sell things at retail for a living would be in the same position; it’s just the rest of us who wouldn’t have to tell Big Brother about every penny we earn.

That disclosure to the federal government is, however, a price I would be willing to pay if it meant a system that is easier to comply with and more difficult for politicians to manipulate.

The main practical benefit of the flat tax is that it can be implemented without amending the Constitution. Passing an amendment to repeal the federal government’s authority to impose an income tax, which is to say repealing the 16th Amendment, would be the Mount Everest of political challenges, and that probably understates the difficulty.

Robert Genetski, economist and financial adviser, author of several books including Taking the Voodoo Out of Economics and A Nation of Millionaires, and operator of ClassicalPrinciples.com:

Ross does a fine job of discussing many of the pros and cons.

I view the “Fair Tax” as highly destructive at the levels usually discussed. There is also the potential for a flat tax to be destructive if the rate is set too high.

Both taxes have the potential to produce explosive growth and generate far more revenue than a static analysis would suggest. I doubt it’s much of a stretch to suggest politicians would find a way to spend whatever revenue comes their way.

Jim Johnston, senior economist (retired) at Amoco Corp., Heartland Institute board member:

The federal tax system is complicated. Having said that, I would quickly add that assuming there is no good reason for the complexity is not convincing, at least to me. Before one sets out to change the world, one ought to understand why the world is the way it is. 

There are at least two tax models vying for verification. One is that politicians have a free hand to give tax breaks in any amount and to any group without limit in order to improve the chances for reelection. A corollary is that politicians can and will punish unpopular entities with high taxes.

An implication is the government has the potential for being unlimited in size. While I have sympathy for trying to limit government, I do not see it being infinitely large. Moreover, I do not know what to cut and what to increase. And nobody else knows either. With all due respect to the academic work on the mortgage interest deduction, for example, I do not believe that homeowners with mortgages are under-taxed.  

Prices for Services

The other model sees taxes as prices for government services. The corporate and individual income tax systems are unevenly applied because the government services are also consumed unevenly. Social Security, for example, is mostly a benefit for low-income individuals and is largely levied on low-income taxpayers. 

The pioneering work on the tax price theory was done by Earl Thompson. It was published in the Journal of Political Economy in 1974. His theory recognized that national defense was the federal government’s largest budget item. He then observed that not all assets are vulnerable to appropriation by a hostile aggressor. Looking at the tax and budget systems at the time, he found that assets not vulnerable to appropriation were taxed at a low rate.

An interesting twist on this observation is that energy and mineral deposits are attractive to a hostile aggressor. But as they are recovered and consumed, the need to protect them is reduced. Thus, there is a rationale for expensing intangible drilling costs and depletion allowances. 

I do not know of any significant additional work on the tax price model since Thompson’s in the early 1970s. Therefore we lack guidance on which “tax loopholes” to remove. Putting this in the hands of an elite committee and the Congress with a very short time limit, suggests to me that substantial harm cannot be avoided.

Government Uncertainties

I think investors who could fund new capital with the $2 trillion in cash and short-term securities are also very much in doubt about what will be done before the election in 2012 and its long term economic effects. That is why, among other government uncertainties (financial and environmental regulation and monetary policy), businesses and individual investors are holding back. 

Broadening the tax base is a tax increase. Not enough is known at this time to do it right. What we do know is we are in a recession. Recovery will not be helped by increasing the tax base in a haphazard way. Indeed, recovery will be retarded, even with a reduction in marginal rates.

The best policy may well be to postpone tax reform to a later day when the economy is better and more analysis has been performed.