Flat Tax
Principles and Issues
2 Hall-Rabushka flat-tax reform
This section provides a brief overview of the flat-tax reform proposed by Professors Robert E. Hall and Alvin Rabushka, both of the Hoover Institution. The tax reform developed by Hall and Rabushka is based on a single rate of taxation for all sources of income and represents a fundamental change in the way governments would collect tax revenue. The proposal achieves simplicity, economic efficiency, and fairness, the traditional measures of effective taxation, while collecting the necessary revenues required to finance government. One could think of their proposal as the ideal tax system towards which we should strive. Those wishing to pursue the proposals of Hall and Rabushka in greater breadth and detail will find their works on the Internet at the Hoover Institution (www.hoover.org) and the American Enterprise Institute (www.aei.org) as well as in most major bookstores and libraries.
Differentiating the flat tax from the single-rate tax
In discussing tax reform, it is again important to recognize the stark difference between reform based on a flat tax and the replacement of multiple tax rates with a single tax rate. The reforms to personal income tax announced in the Province of Alberta in 1999 will replace the multiple tax rates applied to personal income with a single tax rate. Similarly, the tax reform recently proposed by the Canadian Alliance would replace the multiple federal statutory personal income tax rates with two rates initially, and, near the end of their first mandate, with one rate. However, the replacement of multiple tax rates with a single rate is but one step in the process of broad-based tax reform based on a flat tax model. In fact, the replacement of multiple tax rates with a single rate can be viewed as a tax reform separate and distinct from reforms based on a flat tax.
Hall-Rabushka flat tax
A number of tax reforms have been proposed in the United States including a national sales tax and the replacement of the current graduated system of income tax with a flat tax. Prominent American political leaders, including the Majority Leader of the House of Representatives, Dick Armey, have formulated comprehensive programs for tax reform based on a flat tax. The foremost proposal for a flat tax, however, is also one of the earliest: Hall and Rabushka first proposed a comprehensive flat tax in 1985 and their proposal has subsequently formed the basis for a host of others.5
The principles upon which Hall and Rabushka's flat-tax proposal (hereafter Hall-Rabushka) rest are simplicity, efficiency, and fairness. That is, in formulating their reformed tax system, Hall and Rabushka attempted to fashion a system that would increase simplicity, efficiency, and fairness.
One of the essential aspects of a flat-tax system is the taxing of all types of income once and only once. Under the current system, in both the United States and Canada, certain types of income, such as some fringe benefits, are not taxed at all, while other sources of income such as dividends and capital gains are taxed more than once or at differing rates.
The other essential aspect of a flat tax is that income should be taxed uniformly, with no rate differentials between different types of income. In other words, income from dividends, or wages, or pensions should be taxed at the same single rate. In the case of the United States, Hall-Rabushka recommended replacing the current 5 personal federal rates (15%, 28%, 31%, 36%, and 39.6%) and the various business tax rates with one single, 19% federal tax rate.
Individual income tax
One frequently overlooked aspect of Hall-Rabushka is its rejection of alternative taxes such as a national sales tax or value-added tax. Both scholars reject the alternatives because of the difficulty of exempting lower-income individuals and families from taxation. Under Hall-Rabushka a significant number of lower-income families pay absolutely no income tax. In fact, under Hall-Rabushka the exemption for a family of four in 1995 was $25,500 (CDN$32,986). In other words, a family of four with total income less than US$25,500 would pay no income tax and families with income above the exemption would pay 19% tax on the amount in excess of the exemption.
While the most significant reforms under Hall-Rabushka occur in taxation of corporate or business income, reforms are nonetheless present for personal income tax. Under Hall-Rabushka, only wages, salaries, and pension benefits are deemed personal income and subject to personal income tax. Income from dividends, capital gains, interest, or fringe benefits are not subject to personal income tax because they are already taxed at the corporate or business level. Recall that, under Hall-Rabushka, whether income is taxed at the personal or business level is irrelevant since all income is taxed at the same rate.
The phrase "postcard-size tax returns" was coined partially in connection with the Hall-Rabushka plan. Individuals and families would simply sum their income from wages, salaries, and retirement benefits and subtract the personal exemption to calculate their taxable income. This amount is then multiplied by one rate (19%) to determine the individual or family tax bill for the year. The amount withheld is then compared to the amount owed to calculate whether a refund is owing from, or a payment is owing to, the federal government.
This system has no tax credits, deductions, or additional exemptions. In other words, the myriad of tax credits and deductions present in the current systems and the attendant complicated and time-consuming paperwork are eliminated under Hall-Rabushka.
Business income tax
Another important aspect of Hall-Rabushka and, indeed, most flat-tax proposals is that they offer an integrated approach to tax reform. That is, they aim to reform not only personal income tax but also corporate or business income tax. Hall-Rabushka assesses tax on all business income after deducting the cost of inputs, salaries, wages, pensions, and investment in plant and equipment.
Although the corporate tax rate is lowered in order to satisfy the requirement for one rate of taxation, more revenue is generated by broadening the tax base through the elimination of tax-based incentives for business, taxing certain benefits that currently escape taxation, and removing interest deductibility.
Hall-Rabushka precludes businesses from deducting the cost of interest, dividends, fringe benefits, and any other payments to owners as expenses. The rationale for excluding these types of deductions and, thus, forcing the business to pay tax on them is to ensure that they are taxed only once. The income individuals and families receive from business is exempt from personal taxation because it has already been taxed at the corporate or business level. Hall-Rabushka is, therefore, a comprehensive tax system that assesses all types of income equally and singularly.
Interest deductibility and depreciation expenses
Two of the major reforms in Hall-Rabushka are the exclusion of interest costs and depreciation expenses as deductible expenses. Interest income is no longer deemed to be taxable income for individuals or families under Hall-Rabushka because it is taxed as business income. This fundamental change in the way businesses are taxed eliminates the preferential treatment accorded debt relative to equity financing. Currently, payments based on debt instruments, such as bonds, are tax deductible while payments based on equity investments, such as dividends, are not. By eliminating interest payments as tax deductions, Hall-Rabushka eliminates preferential treatment of debt.6 This is one of the many economic efficiencies gained under Hall-Rabushka.
Perhaps the largest single reform under Hall-Rabushka is the elimination of depreciation expenses. Businesses are currently able to write-off, or deduct, the cost of investing in new plants and equipment on an incremental basis. That is, each year over a period determined by government, business is permitted to deduct a percentage of the total cost of purchasing plants and equipment. Under Hall-Rabushka, the entire cost of investment (plant and equipment) is deducted as an expense in the year of purchase. Thus, depreciation schedules and the bureaucracy necessary to interpret them (accountants and lawyers) and to enforce them (government revenue officials) are eliminated or, at least, reduced in number. There would be no conflict over whether the purchase of certain types of equipment are investments or expenses since Hall-Rabushka considers all such expenditures as expenses.
Focus on consumption
One of the main, though often overlooked, benefits of Hall-Rabushka is that it effectively moves income tax away from a tax system based on income towards one based on consumption. Economists generally agree that the taxation of consumption is the most efficient manner in which to raise tax revenue (Jorgensen Yun 1991; Kesselman 1997; and Kneller, Bleaney, and Gemmell 1999). Hall-Rabushka creates a tax system based on consumption by excluding all investment activities. In essence, a consumption tax is levied on any income that is consumed, that is, spent rather than saved. The exclusion of savings (investments) under Hall-Rabushka also enables it also to eliminate the heavy taxation of returns to savings. Thus, not only are efficiencies gained by moving towards a more effective base of taxation (i.e., consumption) but considerable incentives are created for increased savings and the formation of capital.
Economic considerations
There are a number of important economic considerations associated with the implementation of Hall-Rabushka beyond achieving simplification in the tax system. The net economic effect of the reforms proposed by Hall-Rabushka include improved incentives for work, increased entrepreneurial activity, and greater formation of capital, leading to a substantially higher level of national output and standard of living.
Various aspects of the proposals included in Hall-Rabushka would lead to increases in the efficiency of capital formation. Although the current system sustains a relatively high level of capital formation, it does so by providing a number of tax-based incentives in the form of tax credits and subsidies that tend to redirect capital to less efficient uses. Specifically, the current system promotes debt-financed investment by permitting interest deductibility while penalizing equity-financed investment through double taxation of dividends and capital gains. The net result is less entrepreneurial activity and greater debt-financed (lower risk) investment. Auerbach and Kotlikoff (1987; cited in Hall-Rabushka) estimate that a flat tax would increase the ratio of capital formation to GDP from 5.0% to 6.2% and, as a consequence, increase GDP by between 2% and 4% within seven years.
There are also strong incentives for individuals to increase their work effort. Hall-Rabushka completely eliminates the effect of increasing marginal taxes except for the initial level at which taxation begins. That is, as individuals attain skills and begin to advance in the labour force, they do not face increasing rates of taxation. There is, therefore, no marginal disincentive to work harder and succeed as exists in the current system. Hall and Rabushka estimate that GDP will increase by approximately 3% simply due to the elimination of disincentives for work.
Finally, Hall and Rabushka conclude that there would be downward pressure on interest rates within a flat-tax regime. They specifically cite the 1/6 (17%) interest-rate differential present between tax-exempt municipal bonds and comparable taxable bonds. Evidence derived from their analysis suggests that interest rates would be lowered by roughly 25%. The reduction in interest rates would have a significant effect on the housing and investment market.
Conclusion
We have not, by any means, given a full description and assessment of Hall-Rabushka. However, it is important to note the comprehensive nature of this proposal and the far-reaching economic improvement that it offers. Hall and Rabushka present a clear, concise, and effective proposal for reform of taxation on personal income and on business income. They offer a road map for tax reform that increases simplicity, efficiency, and fairness in the tax system.
There are major differences between the broad-based and far-reaching tax reform that results from a flat-tax model of taxation such as Hall-Rabushka and the incremental reform that results from replacing multiple rates of taxation with a single rate. The replacement of multiple rates of taxation with a single rate, although an important tax reform, does not change the tax system in the fundamental way that a flat tax does. For instance, the replacement of multiple rates of taxation with a single rate does not eliminate the great number of deductions and tax credits present in the system nor does it eliminate the preferential treatment of certain types of income relative to others or the double taxation of other types of income.
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