Flat tax proposal is getting serious consideration

Published: March 01, 1996, By MacArthur, Malcolm D.

Just a year ago the proposal to replace the current income tax with a simplified "flat tax" was considered a radical tax reform scheme floated by a couple of Stanford Univ. professors. Recently it has been brought to center stage by Republican presidential candidate Steve Forbes, who has made the proposal the focal point of his campaign, and by other Republican presidential hopefuls. The proposal, which would appear to benefit converters, is now far ahead of other tax reform proposals in terms of congressional support and popular appeal.

Under the current tax system, which imposes a stair step of rates on taxpayers that increase as their income rises and allows for a multitude of deductions and exclusions, a flat tax essentially would tax rich and poor taxpayers at the same rate on income beyond a minimum threshold. To hold down the tax rate, flat tax plans eliminate or severely limit the exemptions and deductions offered to individuals and businesses in the current code.

Indeed, the biggest difficulty with the flat tax is in determining what income should be subject to the tax and what deductions should be allowed. For individuals, many if not most of the common deductions would have to be eliminated in order to build a sufficiently large taxable base that would permit a reduction in the marginal rate. This would mean getting rid of deductions that many individuals consider sacrosanct, such as the deduction for mortgage interest, charitable deductions, and real property taxes.

Which deductions ultimately would be eliminated would be a matter of political debate, but the theory is that all would be cast aside in favor of a broad standard deduction. In general, interest income, dividends, rents, royalties, and capital gains would be excluded from income.

Under most flat tax proposals there would be a deduction for the cost of business "inputs," meaning the actual amount paid for goods, services, and materials, whether or not resold during the taxable year.

Other deductions would include employee compensation other than fringe benefits and the cost of tangible, real, and personal property used in the business. The cost of intangible property, such as trademarks, copyrights, and contract rights, would not be deductible.

Most converters would probably benefit from a flat tax, because they have a heavy investment in equipment. They would be able to recover the full investment in such equipment as they made it, rather than depreciate it over a period of time.

Moreover, converters would have significant deductions as a result of their large expenditures for materials used in the converting process.

Whether or not the flat tax ultimately benefits a company will depend on whether its effective tax rate will be lower. Some propose that the flat tax rate be set at 17%, but many others contend it would have to be at least 20% in order to generate sufficient income.

Whether the tax would be good or bad ultimately will depend on the rate and the deductions permitted and how that rate compares with the effective rate a company now pays. Most believe that businesses in general would benefit, but that remains to be seen.

Other proposals are pending for a consumption tax or some other form of value-added tax. Two presidential candidates - Senators Arlen Specter (R-PA) and Richard Lugar (R-IN) - support a national sales tax. Others, including House Ways and Means Committee Chair Bill Archer (R-TX), advocate taxing individuals and corporations based on what they spend - a consumption tax - rather than on their income. Neither of these proposals has been set forth in detail.

Proponents of the flat tax say it would wipe out loopholes, vastly simplify the tax filing procedure, and spur investment in economic growth by ending what they see as the current system's tendency to punish success by taxing rising income at progressively higher rates.

Opponents say there is scant evidence that such a tax would bolster economic growth. And some say that the flat tax proposals offered thus far would dramatically lighten the tax burden of big corporations and the rich at the expense of the middle class.

Converters should be alert to this subject and, at the appropriate time, express their views to Congress.