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Research Memorandum
March 1996 No. 11


Taxes, Flat and Otherwise

by Lawrence B. Lindsey

History as Fiction

I am always flabbergasted by revisions of 1980s history. One of the most amazing has to do with taxes and the rich. Itís a familiar narrative: The rich got richer as they benefitted disproportionately from President Reaganís tax cuts. This mantra has been repeated enough to become conventional wisdom, and itís dead wrong.

According to Income, Poverty, and Valuation of Non-Cash Benefits, a report published by the U.S. Census Bureau, while the wealthiest five percent of Americans saw their incomes rise between 1981 and 1992, their share of taxes went up even more. Look at the numbers: The richest Americans saw their share of the nationís income go from 16.5 percent to 18.6 percent, a rise of about one-eighth. But their share of the nationís taxes went from 37 percent to 48 percent, a rise of about one-quarter. So itís true that the rich got richer. But they also paid a bigger share of taxes.

Itís important to keep this fact in mind as Congress debates budget and tax policy. Because we may have reached the point that we cannot get more money by raising rates on the well-to-do.

Hereís some evidence to support that hypothesis. In 1992 we took in $476 billion in taxes. Letís compare that with 1993. That year we had economic growth of 4.3 percent (3 percent inflation and 1.3 percent real growth). A simple rule of thumb is that tax revenues go up about as fast as income goes up. Based on that assumption, depending on exactly how you derive your estimate, total tax revenue for 1993 should have been between $496 billion and $499 billion, assuming the same tax rates.

However, in 1993 we also had a tax hike. At the time, the Treasury Department and the Congressional Joint Committee on Taxation estimated that the higher rates would raise about $15 billion in additional revenue. Well, they didnít. Actual 1993 revenue amounted to $504 billion, an increase of only $5 billion-$8 billion. Itís quite clear that we reached a shortfall of 1993 income tax revenue relative to what had been predicted.

Tax rates went up, but tax revenues did not keep pace. Why? Because rich people have discretionary income that gives them an added degree of flexibility in how they report earnings and lossesócertainly much more flexibility than those in the middle class. When taxes go up, they are very likely to be in a position to report less income than they might when rates are lower. Americans with little or no discretionary income are unable to engage in similar strategies. Because rich people change their behavior in a high tax environment, higher rates don't necessarily yield substantial amounts of tax revenue. Given concerns about the deficit, it's no wonder Congress is trying to cut spending instead of raising more revenue.

Base Truths

Letís step back for a minute and examine what percentage of their incomes Americans are really paying to Uncle Sam.

The first thing we must do is understand the difference between the potential tax base and the actual tax base. Because taxable income is actually only half of the whole pool of individual income.

Letís look at 1992, the last year for which we have final numbers. That year the income for all Americans totalled about $5.2 trillion. Thatís the potential base. To get the actual base, we start subtracting.

First subtract about $355 billion in untaxed fringe benefits. (These include things like company cars and housing and expense reimbursements.) Subtract roughly $503 billion for untaxed interest income and subtract $83 billion from dividend income. (These amounts are subtracted because about 75 percent of interest income and 55 percent of dividend income end up in pension funds, IRAs and Keoghs and are thus not taxable.) Subtract $696 billion for transfer income (like welfare or social security payments) and $223 billion for other excluded income.

Now we have to add a couple of numbers back in: The first is tax on employee Social Security revenue and the second is for capital gains. After all these calculations, we arrive at a figure of about $3.7 trillion, a category referred to on Form 1040 as Total Income. (I highlight this because I will return to this number later.)

Under the Income Tax we have to subtract the amounts for itemized deductions, like gifts to charity, state and local taxes, and mortgage interest (which takes out $482 billion.) Taxpayers who donít have itemized deductions can take the standard deduction, about $6,000 for a married couple. These deductions amount to about $368 billion. In addition, personal exemptions in 1992 amounted to $524 billion.

After all is said and done we end up with an actual base of $2.4 trillion, less than half the size of the $5.2 trillion potential base we started with.

How Big is the Tax Base?

1992 Personal Taxes

 

 Billions of $

Revenue Sources

 

Personal Income

5,154

Capital Gains

116

Employee Social Security Tax

249

Unused Deductions & Exemptions

141

Exclusions

 

Fringe Benefits

355

Excluded Interest

503

Excluded Dividends

83

Excluded Transfers

696

Other Exclusions

223

Adjustments

30

Itemized Deductions

482

Standard Deduction

368

Personal Exemptions

524

Taxable Income:

2,396

If we are to collect $476 billion from personal income taxes (the actual amount collected in 1992) we must collect 20 percent of this base figure. If we taxed all personal income we would only need to collect 10 percent. Still, 20 percent ought to sound like a pretty low rate for many of us. But remember that we have a progressive system. What happens curently is this: About 65 percent of the base is taxed at a rate of 15 percent. To get to $476 billion, the other 35 percent has to be taxed at a rate of 30 percent. In fact, people with marginal tax rates of around 30 percent shoulder nearly 70 percent of the tax burden. (The way it works, of course, is that the wealthiest end up paying at about a 40 percent rate, while many middle class people end up paying somewhat less than 30 percent. The average of these two is about 30 percent.)

So letís think about our central question again. Have we reached the limit that higher tax rates can yield? We now have the very well-to-do paying 40 percent of their taxable income to Uncle Sam, plus another 2.5 percent in FICA, plus another seven percent in high tax states like New York. In essence, the richest people are sharing half of their taxable income with Uncle Sam. Many of the rest of us, including Federal Reserve Governors, are paying about 40 percent of our taxable income to federal and state authorities.

And if we go back and look at the evidence from the 1993 tax rate increase, we are reminded that a 40-50 percent tax rate is about the maximum at which we can still collect substantial revenue. I came to the same conclusion in my book The Growth Experiment. It seems we have pushed the current income tax about as far as possible, and weíre still only collecting $476 billion out of $5 trillion.

The Flat Tax Society

Are there other strategies that will raise revenues or cut rates? Letís examine some possibilities.

Pure Flat Tax

The purest flat tax would tax all personal income as well as employee Social Security and capital gains. If we did that we would only need a rate of 8.6 percent to generate our $476 billion. The problem is that everyone would have to pay that rate, and about half of all tax payers are now paying something close to zero. Critics would undoubtedly consider a pure flat tax unfair.

Pragmatic Flat Tax

A more realistic flat tax would take as its base the roughly $3.7 trillion that I referred to before as Total Income. (Remember, this figure does not include income from dividends or interest sheltered in pensions, transfer payments, or other excluded income. It does include capital gains and employee Social Security income.) Letís also make fringe benefits taxable. This brings us up to about $4 trillion in taxable income.

Letís say we allow exclusions of $15,000 for single people and $30,000 for families. All of a sudden, we need a flat rate of 22 percent. Thatís the minimum rate we could have if we want to make sure poor and middle income people do not pay substantially higher taxes and still be revenue neutral. Some flat tax proposals get a lower rate with generous exemptions, notably that of Republican presidential candidate Steve Forbes, but these plans would reduce revenue unless counteracted by greater economic growth or other behavioral changes.

Politically Possible Flat Tax

Letís see what we get with another formula. Weíll begin again with Total Income, about $3.7 billion. This time weíll subtract revenues from taxes on mortgage interest and charitable contributions. Scale back the exemptions a little bit and we find we need a rate of roughly 24 percent. If we keep the same exclusions as the Pragmatic Flat Tax we need a rate of about 26 percent.

Consumption-Based Flat Tax

A lot of people are talking about a consumption-based flat tax. There are at least two ways of doing a consumption-based tax. One way is to exempt capital gains. So, under this sytem you would not be taxed on money you make from investments or earnings from your savings. You would pay tax on earned income but nothing else.

Another variation would be to exempt capital gains but then apply a tax to savings spent in later life. For a host of reasons I believe this is the more feasible option. The problem is that we now have retirees who have paid income taxes their entire life, and have paid taxes on savings income, on other types of interest and on dividends. If we tell that group they now have to also pay a new tax when they spend their savings they certainly will not like it. By changing this law we would, in effect, be hitting the current generation of retirees twice. So it would be a tough sell.

Still, I think this is probably the path of least resistance. In terms of present value, both plans are essentially the same. In the end though, with either plan, if we kept exclusions for fairness and exempted mortgage interest and charitible contributions, we would get a compensation-based flat tax of about 24 percent.

Consumption-Based Value Added Tax

Another approach is a value-added tax which would basically have all the money spent on consumption as its base. We might think of it as a sales tax, though it might be administered differently. To retain fairness, however, we would want to exclude things like housing, medical care and food. If we take those out, we end up with a 21 percent tax on whatís left.

In My End is My Beginning

All of these numbers point to one unfortunate conclusion. No matter what kind of tax code we adopt, we will still end up with the same 20-25 percent tax rate. We could lower that if we abandoned progressivity, of course, but there would be some serious political problems in doing so. Ultimately, the choice between a consumption-based tax and a pure flat tax really doesnít amount to much, because most dividends and interest income are not taxed in the present system anyway.

There is an interesting proposal by Senators Sam Nunn (D-GA) and Pete Domenici (R-NM). I mention it here because it illustrates how high our current tax rates really are. Nunn and Domenici have proposed a consumption-based tax with progressive rates. Itís similar to the plan above in that individuals would get a deduction for everything they save. It also raises the retiree problem I referred to. The difference in Nunn-Domenici is that they want no change in the distribution of the tax burden borne by each economic class of Americans. The middle class would pay the same aggregate amount they are paying now, as would the upper and lower classes. So this is definitely not a plan to soak the rich.

What Nunn and Domenici end up with is a top rate of 40 percent that kicks in when an individual has taxable income of $29,000. On top of that, the plan also includes an 11 percent value-added tax. I think this says something. This is very steep indeed, and yet it does not tax the middle class or the rich anymore than the present rates.

When you think of it like this you can understand why we have reached the end of the line in terms of higher rates. Middle class, upper middle class and well-to-do individuals are already being soaked. Somehow, though, we must get the deficit under control. Congress considers the situation so serious that even Medicare is now on the table. When we think of the alternatives, we begin to understand that spending cuts are the best way out of the deficit box.

 


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SUMMARY:
While a Citicorp/Wriston Fellow at the Manhattan Institute and a member of the economics faculty at Harvard University, Lawrence B. Lindsey wrote The Growth Experiment (Basic Books, 1990), described as the definitive argument for a supply side tax system. President George Bush appointed him to the Board of Governors of the Federal Reserve System in 1991. With tax reform emerging as a major issue in the Republican presidential primaries, Governor Lindsey's analysis is especially helpful in making sense of the alternatives. This piece has been adapted from a speech given at a Manhattan Institute Forum last summer. The ideas expressed are those of the author and are not intended to reflect the views of the Board of Governors of the Federal Reserve System.

 


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