Simply Reforming the Income Tax

Published October 25, 1995

Congress finally seems ready to face the fact that the U.S. tax system needs serious reform. Income tax rates are oppressively high and filing is tortuously complicated. The battle cry of tax reformers is “fairness, economic growth, and simplicity.” If carefully crafted, a flat tax–such as the 17 percent flat-rate tax proposed by House Majority Leader Dick Armey–can accomplish all three goals.

The most common objection to the flat tax is that it is “unfair.” In a free society, however, fairness means equality under the law. A tax system that is truly fair would dictate that taxes should be applied uniformly, and should not discriminate on the basis of income.

In a free society all people, rich and poor alike, are entitled to the fruits of their labor. The implication is that everyone should keep as much of his or her income as possible. From this perspective, too, a low-rate flat tax is more fair than a progressive tax with high marginal rates.

Fairness is not the only issue involved in tax reform. The economic implications of taxation are understood only vaguely. Tax economists, quick to point out that “people aren’t taxed, activities are,” recognize that taxation penalizes some activities relative to others. A tax on cigarettes, for example, discourages smoking, while tariffs discourage the purchase of imports.

Similarly, our current progressive tax system discourages economic growth. Income taxes penalize income-generating activity–i.e., productive activity–by reducing the rewards associated with work, saving, and investment. The fewer the rewards to be gained by doing something, the less of it will be done and the higher the marginal tax rate, the fewer the rewards for productive activity. Not surprisingly, the result is lower rates of economic growth.

The current tax system especially penalizes saving and investment by taxing their rewards more than once. If someone earns $100 and decides to save it at a simple annual interest rate of 10 percent, that person would realize a gain of $10 one year from now. But that $100 is currently taxed at the rate of 50 percent (including social security), reducing his $100 investment to $50, and his return to saving to just $5. The $5 interest is also taxed as regular income, and so is reduced by half again, to just $2.50. This is true for all returns to saved income, including dividends and capital gains. Dick Armey’s flat-tax proposal recognizes this problem by eliminating investment income from the tax base.

Finally, the flat tax is also commendable when it comes to simplicity. As its supporters point out, tax forms would be no larger than a postcard. That is because there would be very few deductions. But without appropriate safeguards, such as a constitutional amendment capping tax rates, the flat tax’s simplicity could also pose its biggest threat. A broad tax base means that small increases in the tax rate could generate large amounts of revenue for the government. Politicians would face a strong temptation to raise the rate from its initial 17 percent. Citizens could find themselves facing a very high tax rate with no available tax shelters. We must keep in mind that simplicity for the taxpayer also means simplicity for the tax collector.

Nevertheless, a low, flat-rate income tax would be a substantial improvement over the current federal income tax. It would be more fair, by restoring equal treatment under the law. It would boost economic growth, which means more jobs and higher wages. And it would radically simplify the task of compliance, saving taxpayers millions of hours of paperwork each year. Rarely do politicians have the opportunity to do so much good by doing something so simple.

Roy Cordato is Lundy Professor of Business Philosophy at Campbell University and a policy advisor to The Heartland Institute. Nothing in his Heartland Perspective should be construed as reflecting the opinions of The Heartland Institute, or as an attempt to aid or hinder the passage of legislation.