The Flat Tax

HOOVER CLASSICS

The Hoover Classics series will reissue selected books of lasting merit and influence from the list of previous Hoover Institution Press publications. The aim of the series is to engender new interest in these titles and expand the readership to a wider audience—in some cases, to a new generation. Additionally, it is hoped that by extending the life of these books, they will continue to contribute to free discussion and debate on important issues of public policy and historical understanding.

The Flat Tax, by Robert E. Hall and Alvin Rabushka, is the inaugural selection in this series.

The Flat Tax

SECOND EDITION

Robert E. Hall

and

Alvin Rabushka

HOOVER INSTITUTION PRESS

Stanford University Stanford

California

The Hoover Institution on War, Revolution and Peace, founded at Stanford University in 1919 by Herbert Hoover, who went on to become the thirty-first president of the United States, is an interdisciplinary research center for advanced study on domestic and international affairs. The views expressed in its publications are entirely those of the authors and do not necessarily reflect the views of the staff, officers, or Board of Overseers of the Hoover Institution.

www.hoover.org

Hoover Institution Press Publication No. 423

Copyright © 2007 by the Board of Trustees of the Leland Stanford Junior University

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without written permission of the publisher.

First edition, 1985

Second edition, 1995

14   13   12   11   10   09   08   07      9   8   7   6   5   4   3   2   1

Manufactured in the United States of America

The paper used in this publication meets the minimum requirements of the American National Standard for Information Sciences— Permanence of Paper for Printed Library Materials, ANSI Z39.48-1992.

The paperback edition of this book was previously catalogued by the Library of Congress as follows:

Library of Congress Cataloging-in-Publication Data

Hall, Robert Earnest, 1943–

The flat tax / Robert E. Hall, Alvin Rabushka. —2d. ed.

         p. cm. — (Hoover Institution Press publication ; no. 423)

    Includes bibliographical references and index.

    ISBN-10: 0-8179-9312-6 (pbk. : alk. paper)

    [ISBN-13: 978-0-8179-9312-2 9 (pbk. : alk. paper)]

1. Flat rate income tax—United States.

I. Rabushka, Alvin II. Title.

HJ4652.H185    1985

336.2′05—dc20                                  95-5188

ISBN of 2007 hardcover re-issue: ISBN-13: 978-0-8179-9311-5 (cloth: alk. paper)

ISBN: 9780817993139 (electronic)

Contents

The Flat Tax's Silver Anniversary

Preface

1. Meet the Federal Income Tax

2. What's Fair about Taxes?

3. The Postcard Tax Return

4. The Flat Tax and the Economy

5. Questions and Answers about the Flat Tax

Notes and References

Appendix: A Flat-Tax Law

About the Authors

Index

The Flat Tax's

Silver Anniversary

FIRST PROPOSED 25 years ago, the flat tax has proven most influential in the unlikeliest of places: state capitals—and the capitals of other nations.

On December 10, 1981, Robert Hall and I first published on the editorial page of the Wall Street Journal our proposal to replace the federal income tax with a low, simple, flat tax. The article, titled A Proposal to Simplify Our Tax System, displayed the iconic postcard that became the symbol of the flat tax. Our system was so simple that an individual or business could file a federal income tax return on a postcard-sized form.

The flat tax picked up considerable steam in the United States during the next few years, culminating in President Reagan's Tax Reform Act of 1986. Two rates of 15 and 28 percent replaced multiple tax brackets with a top rate of 50 percent. From that point, the flat tax lost momentum. In 1990, in exchange for spending cuts that failed to materialize, President George H.W. Bush signed the Omnibus Budget Reconciliation Act that included a 31 percent rate on the rich. On August 10, 1993, President Clinton signed a similar act, which passed the Congress by exactly one vote in the House of Representatives, adding two further brackets of 36 and 39.6 percent.

When control of Congress passed into Republican hands in 1995, House majority leader Dick Armey put the flat tax back into the limelight. Armey, Steve Forbes, and other political leaders talked up the flat tax during the next few years, but it never came to the floor of the House or Senate for a vote.

Ideas, however, have a way of cropping up again in unexpected places. Against the advice of Western economists, the newly independent country of Estonia enacted a flat tax effective January 1, 1994. It set the rate at 26 percent to balance its budget. It has since lowered the rate on several occasions, and the tax is scheduled to fall to 20 percent in 2009. Estonia has also abolished its corporate income tax, only imposing the same flat rate on distributed dividends. Estonia's budget has been in surplus since 2001.

Estonia set off an avalanche of flat taxes: in 1995 by Latvia (25 percent) and Lithuania (33 percent, to be reduced to 24 percent before the end of the decade). But the big story was Russia, which adopted a 13 percent flat tax, down from a top rate of 30 percent, effective January 1, 2001. In the four-plus years since it was adopted, real ruble revenues, adjusted for inflation, have more than doubled.

Next came Serbia in 2003, with a comprehensive 14 percent flat tax on personal and corporate income. Taking a page from Russia's playbook, in 2004 Ukraine replaced its five-bracket income tax, ranging from 10– 40 percent, with a 13 percent flat tax. That year Slovakia also replaced its five-bracket tax, ranging from 10–38 percent, with a 19 percent flat tax on both personal and corporate income. Double taxation of corporate income was eliminated.

Georgia followed Slovakia with a 12 percent flat tax and Romania with a 16 percent flat tax on both personal and corporate income, both taking hold January 1, 2005. Romania's Finance Ministry reported that income-tax revenue for the first eight months of 2006 greatly exceeded estimates and that the state budget had a significant surplus at the end of July, amounting to 1.12 percent of the gross domestic product.

The flat tax continued to pick up steam in 2006, spreading beyond Central and Eastern Europe. On February 1, 2006, President Kurmanbek Bakiyev of Kyrgyzstan signed into law modifications in the country's tax code that established a 10 percent flat tax. It replaced the current corporate tax of 20 percent and the individual income tax with rates between 10 and 20 percent. Shortly thereafter, the president of neighboring Kazakhstan said his country would consider a flat tax in 2007.

Last July, the people of Macedonia voted to establish their own country. One of the main pillars of new Prime Minister Nikola Gruevski's 100-point reform program was a flat tax, which came into being in January 2007 at 12 percent—and is scheduled to diminish to 10 percent in 2008. It replaced a corporate tax rate of 15 percent and personal income tax rates that ranged between 15 and 24 percent. The purpose of the low 10 percent flat tax is to give Macedonia one of the lowest tax rates in Europe to help it emulate the success of Estonia, Latvia, and Lithuania, which experienced strong economic growth after the adoption of their flat taxes.

Also in July, the tiny island of Mauritius, located in the Indian Ocean about 1,500 miles off the southeast coast of Africa, approved its 2006–2007 budget. The signal feature of it is the advent, on July 1, 2009, of a 15 percent flat tax on personal and corporate income. That tax will replace the current personal income tax of two rates, 15 percent on taxable income to 25,000 rupees (about $800) and 25 percent on the rest. It will eliminate much of the complexity and many of the current deductions and credits in the current system. The 15 percent flat tax will also replace the existing 25 percent tax on corporate income.

In late May 2006, Kuwait indicated that it was studying a proposal to introduce an income tax at a flat rate of 10 percent. The draft law is to be studied by the cabinet and, if approved, sent to the country's Parliament for consideration.

In 2006, Mongolia's parliament enacted a far-reaching tax reform. Effective January 1, 2007, personal income is taxed at a 10 percent flat rate, with a tax-free allowance of MNT (Mongolia Tugriks) 84,000 ($866/ year). Previously, from May 1, 1997, personal income was taxed at three rates of 10, 20, and 40 percent, with the top rate reduced to 30 percent in 2004, and an allowance of 48,000 MNT ($495/year). The decision to adopt a 10 percent flat tax reflected several important principles of tax policy: decreasing the tax burden on individuals, reducing the underground economy, broadening the tax base, increasing the efficiency of tax collection, and improving compliance by clarifying and simplifying the tax laws.

Several other developments warrant mention. Guernsey, a British Crown dependency in the Channel Islands off the west coast of France, has had for many years a 20 percent flat tax on corporate and personal income. Last July, its Parliament approved a zero corporate tax rate and capped the maximum tax on individuals at £250,000. The cap means that tax rates decline once taxable income exceeds £1,250,000, transforming the territory's flat tax into a degressive tax.

The new president of Mexico, Felipe Calderón, has pledged to introduce a flat tax to simplify Mexico's tax code and improve tax collection, which at just 11 percent of gross domestic product is insufficient to fund social development and improve the country's physical infrastructure.

In the United States, the federal income tax has been further complicated by something known as the alternative minimum tax (AMT). The AMT was originally enacted to prevent individuals from eliminating most of their federal income-tax liabilities through numerous deductions and tax shelters. Under the AMT, taxpayers pay the higher of either the AMT, assessed at a flat rate of 28 percent, or the regular income tax.

Something quite new and different has been happening at the state level. Before 2006, six states maintained flat-rate income taxes: Colorado (4.63 percent), Illinois (3.0 percent), Indiana (3.4 percent), Massachusetts (5.3 percent), Michigan (3.07 percent), and Pennsylvania (3.07 percent). Last year, Rhode Island and Utah adopted optional flat taxes of 5.5 and 5.35 percent, respectively. In contrast with the federal AMT, in which taxpayers must pay the higher of the AMT or regular income tax, state taxpayers in Rhode Island and Utah can choose to pay the lower of the flat tax without any deductions or the standard income tax with deductions. Other state legislatures are exploring similar optional flat taxes.

Perhaps the movement to optional flat taxes in the states will breathe new life into support for a federal flat tax, but one with a rate of 19 percent that Robert Hall and I first proposed—or even lower. Certainly not the AMT's 28 percent!

Alvin Rabushka

The David and Joan Traitel Senior Fellow

at the Hoover Institution

2007

Preface

SINCE 1981, when we first introduced our flat-tax plan, we have talked about it on more than a thousand occasions. These include hearings before the Joint Economic Committee, the Senate Finance Committee, and the House Ways and Means Committee; discussions with dozens of members of Congress; briefings at the Department of the Treasury and with the White House staff; seminars and lectures at dozens of universities and colleges; interviews with hundreds of newspaper and magazine reporters and television crews in the United States and overseas; dozens of appearances on call-in radio shows around the country; and countless speeches before a variety of professional and civic organizations. We have heard tirades of criticism of the current federal income tax and received much praise for our flat-tax alternative. We have also heard every possible objection to our flat-tax plan and have tried to answer each of them. We remain convinced, as ever, that the adoption of the flat tax would give an enormous boost to the U.S. economy by dramatically improving incentives to work, save, invest, and take entrepreneurial risks. The flat tax would save taxpayers hundreds of billions in direct and indirect compliance costs. It would also shift billions of dollars from investments that reduce taxes to those that produce goods and services.

This book sets forth the flat-tax plan we have developed. It is, we believe, the most fair, efficient, simple, and workable plan on the table.

Under our flat tax, all income would be taxed once and only once, at a uniform low rate of 19 percent. Our plan is fair to ordinary Americans because it would permit a tax-free allowance of $25,500 for a family of four. The family would pay a tax of 19 percent on its earnings above that allowance. Millions of U.S. residents would no longer pay any income taxes. All wage earners would pay less tax under our flat tax than under the current system.

Our flat tax would eliminate the distortions of the present tax treatment of business. It would replace a hodgepodge of depreciation schedules with an effective investment incentive, a first-year write-off. It would reduce the current corporate tax of 35 percent to 19 percent. It would eliminate double taxation of business income by ending taxation of dividends and capital gains.

Our flat tax adheres to the principle of a consumption tax: people are taxed on what they take out of the economy, not on what they put in.

Our flat tax is not an academic abstraction. We have designed tax forms, rewritten the Internal Revenue Code, and worked out all the practical details. The flat tax has withstood the scrutiny of leading experts on taxation and has been endorsed enthusiastically by many of them. Both the New York Times and the Wall Street Journal have endorsed our flat tax. Both Republicans and Democrats have introduced it as bills in previous sessions of Congress.

Opponents of the flat tax have charged that it would imperil homeowners and the real estate industry, reduce charitable contributions, and provide a windfall to the rich. These are charges we take seriously. We will show that they are mistaken. Adopting the flat tax would improve the overall performance of the economy. Housing and charitable giving would flourish. Everyone's after-tax income would rise.

All designers of rival tax plans agree that the tax base must be broadened and that tax rates must be lowered. Our flat tax meets the tests of efficiency, equity, and simplicity better than every other plan that has been proposed.

In the previous edition of our book, we thanked those individuals and organizations that helped us formulate our ideas, promote the flat tax, and bring it before Congress and other public officials. To those previous acknowledgments, we add the following: Bruce Herschensohn, who made our flat-tax proposal a centerpiece of his 1992 California campaign for the U.S. Senate; Congressman Dick Armey (and his legislative assistant, Andrew A. Laperriere), who introduced a variation of our flat tax in the 103rd Congress; and Malcom S. Forbes Jr., who has remained a staunch supporter of our flat tax for many years. Bruce Bartlett graciously supplied us with an extensive bibliography; Christopher Wilkins and Christopher Sleet provided invaluable research assistance.

The Hoover Institution has supported every phase of our work, and we are grateful to be able to work in its world-class facilities. We want to thank Director John Raisian for his many kind words each time he has introduced either or both of us at numerous institution events.

1. Meet the Federal Income Tax

The tax code has become near incomprehensible except to specialists.

Daniel Patrick Moynihan, Chairman, Senate Finance Committee, August 11, 1994

I would repeal the entire Internal Revenue Code and start over.

Shirley Peterson, Former Commissioner, Internal Revenue Service, August 3, 1994

Tax laws are so complex that mechanical rules have caused some lawyers to lose sight of the fact that their stock-in-trade as lawyers should be sound judgment, not an ability to recall an obscure paragraph and manipulate its language to derive unintended tax benefits.

Margaret Milner Richardson, Commissioner, Internal Revenue Service, August 10, 1994

It will be of little avail to the people, that the laws are made by men of their own choice, if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood; if they be repealed or revised before they are promulgated, or undergo such incessant changes that no man, who knows what the law is today, can guess