THE FLAT TAX IT'S HOT IT'S NOW IT COULD CHANGE THE WAY YOU LIVE
By LOUIS S. RICHMAN REPORTER ASSOCIATE JOHN LABATE ANN REILLY DOWD

(FORTUNE Magazine) – The cataclysmic changes that sometimes rock the cozy world of Washington, D.C., usually begin quietly in the cities and towns of America, barely detected by pollsters and journalists. One such shock rumbled loudly across the Capital Beltway last November, when the Washington establishment woke on Election Day to find that the nation was really and truly fed up with business as usual. Right now we are witnessing another: the beginning of the end of the American income tax system.

Just a year ago the thought of trashing the tax code and replacing it with something completely different was an idea largely confined to late-night panel discussions on C-span. Today it's a broad political movement, gaining in popularity the way a hurricane gathers force as it heads for land. Grassroots organizations are springing up across the nation to spread the message. Revolutionary tax plans, sponsored by the leaders of Congress, are competing for attention, and virtually all the declared presidential candidates are lining up behind one or the other. The most radical of these plans, and by far the most popular, is the flat tax. "This," vows Dick Armey-the House majority leader and chief flat-tax cheerleader, pictured here-"will be the great debate of 1996."

It's easy to see why. Should the flat tax prevail, it won't just change the way you file your taxes or fine-tune your investment portfolio. It will change the way you live--from the way you work and invest to the way you think about the government. Gone would be the 437 opaque tax forms the Internal Revenue Service now uses, replaced by two--one for individuals and one for businesses--each the size of a post card. Gone would be the hundreds of thousands of tax accountants and lawyers who live off the tax system today--presumably into more socially and economically useful lines of work. Gone would be the whole dismal, tangled multitude of exemptions, loopholes, and special deals that punish success and reward consumption at the expense of saving and investment. The earliest a flat tax might be enacted is 1997 or 1998, but already financial markets are beginning to roil (see next story), and those most likely to be affected are weighing in.

Like any revolution, this one faces formidable obstacles, not the least of which will be the objections of many taxpayers who stand to lose under a flat tax. One group that would suffer, for instance--at least in the short run--is America's homeowners, not exactly a small or politically powerless bunch. State and local governments get it in the neck too, and the many special interests that would be affected, from tax preparers to oil barons, can be expected to fight this with everything they've got. Moreover, some of the intrinsic problems of the flat tax-- such as the sheer complexity involved in the transition--may prove so gnarly that they will doom the reform effort.

But don't underestimate the flat tax's chances just because these hurdles lie ahead. Among the major tax-reform plans being advertised in Washington today, the flat tax has the best political prospects (see box, "Voters Want Radical Reform"), the simplest--and therefore most salable--features, and the most committed supporters. It also holds plenty of promise for helping the economy. Indeed, the benefits that would flow from a more efficient, simpler, and pro-growth tax system could be truly colossal. The hundreds of billions of dollars now wasted on tax compliance and evasion would be put to productive use. There could be a renaissance of saving and investment in America, with interest rates permanently lower and national production, wealth, and employment all higher. These potential improvements may well prove attractive enough to convince a majority of the nation's voters that the existential leap to a flat tax is worth the attendant risks and pain. As Dick Armey puts it: "We're asking people to see how they would stand in a whole new world."

The other major tax-reform plans currently making the rounds are not without merit. They have many of the same features and goals as the flat tax. Common to all of them is the idea that income should be taxed once and only once, so as to end the punitive double taxation of equity that now hinders capital formation and stifles investment in the U.S. The other common feature is that instead of attempting to tax what people earn--what we've done traditionally in the U.S.--they try to tax what people spend, or "consume," as economists like to say. This notion is at the heart of a tax proposal sponsored by Senators Nunn and Domenici. Their reform plan, known as the USA Tax (for Unlimited Savings Allowance), would keep the current system of graduated income tax rates but exempt all savings--in effect, a "consumption tax." Still another approach, the retail sales tax backed by Indiana Senator Richard Lugar, would have much the same economic impact as the flat tax. It also has the virtue of taxing the underground economy, since criminals, who don't file tax forms, would be taxed when they consume goods and services. What's clear from all of these plans is that the hunger for change is deep and broad.

One voice that's been missing from the tax-reform debate: President Clinton's. Although he's talked little about the emerging tax plans in public, people who have heard him speak privately say he is paying close attention. Predictably, he worries about the fairness issue, but he is also said to be focused on the need to raise the nation's savings rate-one of the principal goals of the flat-tax backers.

Here's how the flat tax would work under the Armey plan--considered the front-runner among several different flat-tax proposals: Individuals would be initially taxed at a rate of 20%, falling to just 17% two years after the new law is enacted, on their wage, salary, and private pension income less a household deduction amounting to $36,800 for a married couple with two children. Business filers would report as taxable income their gross revenues, from which they would deduct payments of wages, salaries, and pensions; purchases of goods, services, and materials; and all investments in capital equipment, buildings, and land. The difference would be taxed at the same flat rate individuals pay. That's it. The whole scheme is so stripped of complexity that both individual and corporate taxpayers would be able to file their returns on a ten-line post-card-size tax form.

While the flat tax bears a superficial similarity to the current income tax, the two systems couldn't be less alike. No longer would individuals pay tax on what they earn on their savings--including all dividends, capital gains, and interest income. Homeowners would no longer be allowed to deduct their mortgage interest payments. Also ended would be the deductions permitted under today's tax code for payments of state income taxes, local property taxes, or charitable contributions.

Corporations, too, would fare far differently. They would be allowed to expense all their investments, which would free them from mind-numbingly complex computations of depreciation allowances, one of the most burdensome features of the current tax code. At the same time, they would no longer be permitted to deduct interest payments on debt, effectively putting the tax treatment of debt and equity on an equal footing--but also potentially putting highly leveraged companies on the endangered-species list. And while all wages and salaries would be deductible, employers would have to pay the full freight of social security payroll taxes and such fringe benefits as health, life, and disability insurance, which would no longer be tax exempt.

One politically charged point in the debate to come will be the issue of how a flat tax would shift the tax burden among income groups. Many taxpayers will worry that replacing today's graduated rates on higher-income earners will give an unfair windfall to the rich. That's partly true: The "rich" will pay less under the flat tax as the top marginal rate is chopped in half. And although the Armey plan promises a tax cut for all, it's likely that some middle-class households would see their tax bill rise modestly in the short run. But leaving it there puts a lot of weight on a narrow definition of fairness. For one thing, many middle-income taxpayers suspect, with good reason, that wealthy people don't always pay those high marginal rates. As the economist Adam Smith noted some 220 years ago: "The certainty of what each individual ought to pay is, in taxation, a matter of such great importance that a very considerable degree of inequality is not near so great an evil as a very small degree of uncertainty." The flat tax would snare even the most tax savvy, and that's a big selling point.

And it is progressive. For starters, the large personal and family deductions provided in the Armey plan would exempt nearly half of all American families from paying any federal income tax at all. It's also worth noting that as the top marginal tax rates were lowered from 70% to 33% during the 1980s, the total share of federal taxes paid by the most affluent 5% of all Americans jumped from 35.4% in 1981 to 43.5% a decade later, as the well-off found less reason to hide their earnings from the tax man.

Under the Armey plan, a married couple who earn $50,000 a year and have two children would be able to claim the $36,800 standard deduction and pay a tax of 20%, or $2,640, on the balance, for an effective tax rate of 5.3%. A similar family with annual wage and salary earnings of $150,000 would owe $22,640 in taxes, or 15% of their total income. Of course, people who clip coupons and cash dividend checks--a population comprising mainly the retired elderly living off income that was taxed when they worked--would pay no federal tax. Says economist Stephen Entin of the Institute for Research on the Economics of Taxation in Washington: "It's hard to find a definition of 'fairness' more compelling than the idea that every citizen is treated equally."

The loudest clamor against the flat tax will come from homeowners, realtors, and builders, who would get hammered as the flat tax does away with deductions for mortgage interest payments and local property taxes. If not negotiated with skill, this issue could well be the flat-tax movement's Achilles' heel. How big a hit will homeowners take? An analysis by the economic consulting firm DRI/ McGraw-Hill estimates that the market value of all homes could drop by 15% if the tax was introduced without a phase-in period. The brunt of the blow would be borne by those in middle- and upper-income groups. The flat tax could well cause mortgage interest rates to drop by a full percentage point, which would shore up prices. But even so, the DRI economists calculate that--were the flat tax enacted with no phase-in period--the price of a $150,000 home could fall to $113,571, a decline of 24%.

Middle-class voters who have most of their money tied up in home and hearth will scream blue murder. Nor will they be soothed by economists' armchair arguments that the government's roughly $80-billion-a-year tax subsidy to owner-occupied housing has led to a vast overbuilding of the nation's housing stock. Roger E. Brinner, DRI's chief economist, figures the plunge in housing value would wipe out more than $1.5 trillion of householders' net worth. The collapse of the housing market and new-home construction, Brinner predicts, would slice 1.2% off GDP the year after the flat tax passed, and 1.6% in the second year-although, as the charts at the end of this story show, the flat tax would give GDP a boost from year three onward.

Some compromise of the flat tax's purity, however, could help appease irate homeowners. Although Armey doesn't wrestle with the issue, the true fathers of the flat tax--Robert Hall and Alvin Rabushka, who have been shaping the idea for 14 years at Stanford's Hoover Institution--have tried to. They would allow taxpayers to continue to deduct 90% of the value of their outstanding mortgage interest. Since rates would be falling, homeowners would thus be eager to renegotiate their loans. But the problem they will have is that the mortgage interest deduction would expire--their next mortgage would come with no tax advantages. The revenue loss from grandfathering existing mortgages would be made up by adding to the tax liability of mortgage lenders. A simpler modification that does far more violence to the flat-tax idea would be to continue or cap the current mortgage interest deduction and accept a higher tax rate as the consequence.

Another potentially troublesome flaw in the pristine theory of the flat tax lurks in the Armey plan's elimination of the business exemption for most fringe benefits, especially employer-paid health care. Flat-tax enthusiasts like Harvard University economist Dale Jorgenson argue that employers, who look at the total cost of compensation, would simply increase their employees' cash compensation, leaving them free to purchase their own health insurance. In theory, the workers would then become more price-conscious consumers of medical services than they are under today's employer-paid system. Says Jorgenson: "The right tax policy leads to the right solution to the nation's health care inflation problem."

Maybe. But what if workers--particularly those modestly paid folks who would face no tax under the Armey plan--choose to pocket the cash instead of paying health insurance premiums? Dallas Salisbury, president of the Employee Benefits Research Institute in Washington, worries that they might expect the government to pay for their health care when they need it. Presumably some system to avoid the problem could be created, but it's clearly going to be a thorny issue.

Even if the flat-tax backers can overcome these huge challenges, they would still have to reckon with significant transition problems as the new law is phased in. Perhaps the knottiest will be how to treat the substantial unused depreciation allowances businesses have on their books--allowances that the flat tax would not permit. The value of such unused depreciation claims today totals some $520 billion, a tidy sum that companies were counting on applying against their gross income to save paying the current corporate statutory tax rate of 35%.

What to do? Were Washington to disallow the deductions, every CEO-laden corporate jet in America would commence strafing Capitol Hill. Just as unlikely, Congress could permit the claims to be treated as new investment and expensed. But then the federal deficit would balloon, killing any chance of balancing the budget. One alternative would be to continue to permit companies to write off depreciation on past investments until it is used up. But even that concession would cost the Treasury $104 billion in lost revenue. To make up the shortfall without increasing the deficit, DRI's Brinner estimates that the flat-tax rate would have to be three percentage points higher.

Indeed, Armey's 20% rate is already too low to match current tax revenues. Achieving so-called revenue neutrality and accommodating any further compromises would push the flat-tax rate well above the level where the pinch of taxes could begin once again to influence business planning. It would also revive lobbyists' pleading for yet more exemptions and allowances. Washington analysts think that trading off a higher rate to placate interest groups could quickly erode the political support for reform. Big problems, to be sure. But as the political success of Reaganomics has made clear, the popular appeal of an economic proposal has more to do with its promised benefits than with its perceived shortcomings.

Here the flat tax delivers in abundance. Let's begin with the pure gains from efficiency. The simplicity of the flat tax would cut way down on the extravagant effort Americans now make to comply with the 8,101-page tax code and supplements. In a book entitled Costly Returns, economist James Payne of Sandpoint, Idaho, estimates the nation's bill for tax record-keeping, audits, filing costs, tax attorneys, and accountants--plus the potential output lost from investments and labor discouraged by today's high marginal tax rates. The total tab: an astonishing $593 billion. To put it another way, that's more than 8% of total GDP, twice as much as last year's entire defense budget, and $240 billion more than all 1996 Social Security outlays.

American business would flourish under a simpler tax code. Fast-growing, capital-intensive companies and new entrepreneurial startups--the kinds of businesses that create lots of good, high-wage jobs--will be among the biggest winners. Because their capital spending needs are large relative to their revenues, they will benefit mightily from the freedom to expense their investments. They should also be able to tap a deeper pool of equity from investors who will no longer be subject to capital gains tax. Says economist Gary Robbins, president of Fiscal Associates, an economic consulting firm in Washington: "Given a lower cost of capital, U.S. companies may discover that it's profitable to manufacture flat-panel computer screens without a huge government subsidy or to mass-market consumer electronics products they cannot compete in today."

The current tax treatment of corporate earnings discourages equity investment in general. Every dollar of earnings companies pay out as dividends today is taxed twice--once at the corporate level at a 35% rate and again at the individual level at a rate as high as 39.6%. The combined hit lifts the marginal tax on equity to a crushing 60%. Says Margo Thorning, chief economist at the American Council for Capital Formation, a public policy research group in Washington: "No other industrialized country imposes such a heavy burden on equity investment."

Under the flat tax, those leg irons hobbling America's most dynamic companies would come off. A flat-tax rate of just 20% paid by business could lower the cost of equity by one-third. For Hewlett-Packard, cheaper equity capital would be a windfall. H-P depends almost entirely on equity financing to make its risky high-tech investments because the company doesn't want to be saddled with the interest payments on borrowed funds should technology shift or the economy fall into recession. Says Dan Kostenbauder, H-P's general tax counsel: "Anything that would reduce our cost of equity would tilt the competition in our favor."

Smaller firms that now find it difficult to attract high-cost equity would also be big winners under the flat tax. Entrepreneur Stephen King, CEO of Tomah Products, a specialty-chemicals manufacturing company with 51 employees, thrills at the prospect. The sales of his $21 million company are growing by better than 15% a year. But because Tomah has a small asset base, it cannot offer lenders sufficient collateral to borrow what it needs to expand. King has been able to attract some scarce venture capital but had to pay a stiff price--a substantial portion of his own stake in the company--to get it. Says he: "Show me a tax system that would lower my cost of equity, and I'll back it in a minute."

Though moving to a flat tax would be a vast improvement for corporate taxation, one area where it falls a little flat itself is in the treatment of the income U.S. companies earn abroad. Currently the government taxes all U.S. corporate earnings on a worldwide basis. And while American companies may claim a credit for the taxes paid overseas, the IRS has devised such a complicated nexus of rules for computing it that the cost of rearranging the company's finances to qualify for the credit sometimes exceeds its value. In order to qualify for a tax rebate for the cars it sells in Europe, for example, Chrysler is considering establishing 15 subsidiaries--mainly to take better advantage of its European tax credits. Since a flat tax would fall only on a company's U.S. operations, American-based multinationals and exporters would be relieved of much of the administrative burden.

But that will still leave them at a disadvantage. Some 90 countries with which the U.S. competes rely on value-added taxes (VATs)--levies exacted on goods as they are sold at each stage of the production process--as a major source of business taxes. When companies based in those countries sell products abroad, their governments refund the VAT. But international trade agreements do not permit the U.S. to refund any of the flat tax that American exporters would pay--just as, under current law, no corporate income taxes are refunded to them. Chuck Hahn, the tax director for Dow Chemical, estimates that the tax advantage Dow's powerful global competitors enjoy cuts Dow's profits on sales outside the U.S. by three to four percentage points, a huge differential in this ruthlessly price-competitive industry. Once the short- and medium-term dislocations are over and all the phase-ins have passed, the impact of the flat tax on the U.S. economy could be breathtaking. By increasing efficiency, lowering compliance costs, boosting savings, and freeing up businesses to focus on products and profits instead of paperwork, the flat tax, proponents predict, would help the economy flourish in ways that it seldom has done in the past two decades. Since a lower flat rate on wages would allow individuals to keep more of their after-tax earnings, more Americans-particularly the nearly 30% of the labor force who now pay marginal tax rates of 28% or higher--would find it more rewarding to increase their work effort.

Long-term real GDP growth would increase by a full percentage point under the flat tax, according to estimates by Stanford University's Hall and Rabushka--back to the 3.5% rate of the postwar go-go years. DRI's model produces a similar result. Once the transition to the flat tax is complete, real GDP would be 0.9% higher per year, on average. Over time, a one-percentage-point differential in real growth spells the difference between macroeconomic mediocrity and excellence. Had real GDP grown one percentage point faster over the past 20 years, America today would be more prosperous to the tune of $1.2 trillion--nearly $10,000 for every household. That kind of payoff could make you overlook a lot of transitory shortcomings.

Implementation of a flat tax is still too far away for anyone to figure out precisely how it would change people's behavior. As the debate continues, you are likely to hear some dire forecasts of what the tax might do to America's economy. But the political fortunes of this movement aren't riding entirely on that sort of quantitative analysis. There is something far more fundamental at play in the tax theater today: a yearning for simplicity, fairness, and less bureaucracy. If the flat tax can live up to those wishes, it will succeed. F