A flat tax applied to personal income, straightforwardly defined, has a number of advantages over the current system. Administrative costs, compliance costs, and the marginal tax rate would be greatly reduced, while productivity, compliance with the tax laws, and work incentives would all increase. The result should be a strengthened economy; thereby permitting a still lower tax rate. Critics contend, however, that to maintain current tax collections, the flat rate must be set at a level that would increase the tax burden on most of the middle class (or at minimum increase the relative tax burden on the middle class).

The greater efficiencies realizable under a flat tax system might permit the development of a revenue neutral flat tax that did not raise middle class taxes. Nonetheless, current flat tax proposals remain vulnerable to the criticism that they would reduce the relative tax burden on the wealthy, while increasing it on the middle class.

Since the United States is a democracy, our present system’s tax burden probably tends to reflect the will of the electorate. To be politically viable, proposed tax reforms need to be structured so that they neither increase the deficit nor the tax burden on the middle class. Compared to the existing tax system, flat tax reform (if it to sidestep the objections of its opponents) should simultaneously accomplish each of the following objectives:

1.   Reduce administrative costs.

2.   Reduce compliance cost.

3.   Reduce economic distortions.

4.   Reduce marginal tax rates.

5.   Not increase the middle class’s relative tax burden.

6.   Maintain current rates of tax collections.

While the existing proposals would only achieve the first four objectives, a flat tax could be structured to achieve all six objectives.

Flat tax proposals differ in various respects. They do, however, have two common features: (1) They simplify and expand the definition of taxable income. (2) They replace the present system of increasing tax rates with a single rate for all income above some threshold. Most experts agree that a flat income tax rate of about 20 percent would maintain the present level of personal income tax collections. [U.S. Treasury Department. 1995. An Analysis of the New Armey-Shelby Flat Tax Proposal. Washington: U.S. Treasury Department, Office of Tax Analysis. In this revenue and distributional analysis of one flat tax proposal it is concluded that it would be revenue-neutral at a 20.8 percent rate. This report was also published in Tax Notes, vol. 70, no.4 (January 22, 1996), pp. 451-61.]

Limitations of Present Analysis

This paper is restricted to analysis of personal income and social security (FICA) taxes at the federal level. Although corporate, state, local and all other tax issues are important, they are not the subject of this paper.

I do not address in this paper precisely how taxable income should be defined. Clearly the broader the definition is,  the lower is the tax rate that can be set and, therefore, the less is the disincentive either to forego income producing opportunities or to attempt to shelter income from taxation (legally or otherwise). Accordingly, a flat tax works best if taxable income is defined very broadly. (Appendix A shows how taxable income might be defined.)

I also do not address in this paper the question of whether taxes are justified. A substantial literature argues that they are not. And yet we are taxed. In this paper I seek to explore a means of enhancing the effectiveness of the tax system as it interfaces (rather heavily) with the economy. Whether the current or any proposed tax system is justified is beyond the scope of this paper. Rather, my proposal starts with the debatable assumption that we are going to have a tax system that will generate revenues more or less in line with the current system. Then the question becomes how might that system be structured so as to achieve its objectives, raising revenue without unduly distorting productivity, more effectively.

Some have argued that maintaining the current level of tax collections is unnecessary.  Advocates of small government would have us combine a flat tax with spending cuts; thereby generating a flat tax that does not raise taxes on the middle class. Existing proposals would, however, still tend to increase the relative tax burden on the middle class. In any case, the issue of the appropriate size of government is beyond the scope of this paper. In it I only seek to demonstrate how a revenue neutral flat tax could be fashioned that leaves the relative tax burden unchanged. Those who prefer a smaller government could combine this basic approach to tax reform with spending cuts and a correspondingly lower tax rate.

Literature Review

"The modern idea for a flat tax can be traced back to Hayek. [Hayek, F. A., "Progressive Taxation Reconsidered," 1956 In Mary Sennholtz (ed) "On Freedom and Free Enterprise," pp. 265-284], Hayek argued that the marginal tax rate for the highest income level should be set equal to the overall level of taxation as a percentage of income. A few years later in "Capitalism and Freedom, The distribution of income," pp. 161-176, 1962, Milton Friedman wrote that "All things considered, the personal income tax structure that seems to me best is a flat-rate tax on income above an exemption, with income defined very broadly and deductions allowed strictly for defined expenses of earning income." [p. 174.]

Since this early beginning, an extensive literature has developed about the flat tax. A detailed annotated bibliography may be found at the National Center for Policy Analysis Idea House (http: www.ncpn.org/n/pi/taxes/flattax.html). Among the items listed in that bibliography are a number of articles discussing the high costs of the U.S. tax system and the success of the Hong Kong economy under a flat tax system.

Another excellent resource is: Hall, Robert E., and Alvin Rabushka, 1995b, "The Flat Tax," second edition, Stanford, California: Hoover Institution Press. It was also  published as a special supplement to Tax Notes (August 4, 1995) at http://wwwhoover.stanford.edu/PRESSWEBSITE/FlatTax /notes.html. See Appendix B for a detailed listing of flat tax resources.

Current Flat Tax Proposals

Existing proposals produce a flat income tax rate but leave Social Security (including Medicare) tax rates regressive. Thus, a flat income tax (FEDTAX) coupled with a nonflat (regressive) Social Security tax (FICA) would lead to a regressive overall tax structure. At 2002 rates (used exclusively hereafter) the combined employer/employee pension and Medicare contributions are set at 15.3 percent for income subject to FICA below $84,900 and 2.9 percent (Medicare only) for income above that amount. Thus, a two-income family could pay the 15.3 percent FICA rate on up to a combined income of $169,800.

Quite clearly, the employee pays that portion of FICA that is deducted from his or her salary. The employee also bears most or more likely all of the cost of the employer's FICA payment. Accordingly, we may reasonably view the employee as bearing the entire FICA payment.

The marginal total tax rate (MTTR) takes both FEDTAX and FICA into account. A 20 percent flat tax coupled with the current FICA rates would yield the following MTTRs: For income subject to both FEDTAX and FICA (wages, salary, tips, and self employment income) the taxpayer would incur an MTTR of about (20+15 = 35 percent) on income below $84,900 and (20+3=23 percent) for income above that level. A two-income household could incur the 35 percent rate up to a combined income of $169,800. Not only would such a structure be regressive, it would also increase the tax burden on the middle class while substantially reducing the burden on those with higher incomes. (See the calculation of marginal and average tax rates in Appendix C.)

The Current Tax System

The federal income tax rate  rises with taxable income from 0 percent, to 10 percent, 15 percent, 27 percent, 30 percent, 35 percent and 38.6 percent. ( In 2002, rate declines are scheduled in subsequent years.) The complete schedule of marginal tax rates is, however, far more complicated. Even setting aside such issues as filing status and what determines taxable income (i.e. what can be subtracted from gross income as an adjustment or deduction), the typical taxpayer must deal with a complex tax system involving the interaction of at least three different tax regimes and tax rates based on at least four different income concepts.

In addition to the impacts of FEDTAX and FICA, low income taxpayers may be eligible for an earned income credit (EIC). Thus one's tax liability (or possible eligibility for a government payment) may depend upon the net impact of the relevant FEDTAX, FICA and EIC rates. The alternative minimum tax (AMT) adds yet a fourth tax regime and a fifth income concept. The AMT only comes into play, however, for taxpayers with relatively high total incomes and disproportionately large amounts of otherwise nontaxable income. Accordingly, we shall hereinafter ignore these complications. We shall also ignore the complexities created by provisions for the special treatment of capital gains as well as the existence of tax credits for such things as child and dependent care, the elderly and the disabled as well as for foreign taxes paid.

The applicable rates for FEDTAX, FICA and EIC are each based on distinctly different income concepts and in the case of the FEDTAX rates, at least two separate income concepts. Specifically the EIC is based on the taxpayer's earned income and number of dependents. The FICA, in contrast, is applied to the taxpayer's income subject to FICA, which is similar, but not identical, to earned income. The FEDTAX rate is largely determined by the taxpayer's taxable income. At higher income levels, however, the effective rate is also impacted by the phase outs of the tax shelter provided by exemptions and deductions, which in turn are determined by the taxpayer's level of adjusted gross income.

Income subject to FICA includes wages, salaries, tips, and self employment earnings. Earned income differs from income subject to FICA in that it also includes non-taxable earned income such as 401K contributions and military housing and subsistence.

Gross income is the sum of income subject to FICA and income from other sources such investments, trusts, and estates. Adjusted gross income is determined by subtracting adjustments (IRA, Keogh, alimony payments, etc.) from gross income. Taxable income is the result of subtracting deductions and the allowance for exemptions from adjusted gross income. Above certain adjusted gross income levels, however, only a portion of the unadjusted amount of deductions and exemptions may be subtracted. The complications continue even once taxable income is determined. A number of tax credits may come into play under various circumstances. These further complications are ignored in this paper.

A Consistent Set of Tax Rate Computations 

      The income concept that applies varies with the income level. That is, the overall tax rate shifts with the level of taxable income at one point; adjusted gross income at another point; and the level of income subject to FICA at yet another point. Moreover, the rate of change for one income concept does not necessarily correspond to the rate of change for another income concept. Thus, a one dollar change in adjusted gross income may correspond to a one dollar change in taxable income, no change in taxable income, or anything in between.  A table that reports realistic tax rates for different levels of a common income concept is much more meaningful than one that ignores how the definition of income changes. To generate such a table, however, one must hypothesize how the various concepts of income relate to each other. Specifically, information is needed regarding the taxpayer’s:

1. proportion of gross income subject to FICA; 

2. percentage of gross income excludable as adjustments; 

3.  filing status and number of dependents; 

4. income subject to FICA earned by other family members; 

5. percentage of income that is deductible. 

That is one need to derive a taxable income number from a gross income total.

Each of these factors will vary from taxpayer to taxpayer. For this analysis assumed as representative is:  

1. All of gross income is subject to FICA.

2. Five percent of gross income is excludible as adjustments.

3. Married filing jointly with four exemptions

4. One taxpayer earning 60 percent of the wages of the second

5. Deductions equal to 20 percent of gross income

The above admittedly arbitrary assumptions are designed to reflect representative circumstances. These assumptions are in line with the aggregate statistics collected by the Internal Revenue Service. (See Internal Revenue Service, Statistics of Income Bulletin, Spring 1996, Washington, D.C., 1996.) This structure reflects steady state relationships as opposed to short term incremental adjustments. The specific assumptions are explained as follows: The vast majority of income for most taxpayers is in the form of wages, salaries and self employment income and, as such, is subject to FICA. Hence assumed is all such income is subject to FICA. Adjustments include such diverse payments as IRA and Keogh contributions, one half of self employment tax, alimony payments, moving expenses and penalty on early withdrawal of savings. Such adjustments tend to be a modest percentage of the total for most taxpayers. Assumed is 5 percent. While family sizes vary across the population, a relatively high percentage of filers are married (eligible to file jointly) with a couple of children. Actually, the average taxpayer reports only two exemptions. This analysis is not designed to capture the precise average of taxpayers. Rather, the purpose of this exercise is to mirror the tax liability of a typical taxpaying unit as its income and deductions vary.  Additionally a high percentage of families have two wage earners, one of whom has significantly more experience and/or education than the other.

One family member will generally earn significantly more than the other. The 60 percent assumption is arbitrary but not unreasonable. Sixty percent is in line with the ratio of female to male income levels.  Finally the assumption that 20 percent of total income is deductible is based on the following considerations. The primary itemized deduction are: 

1. state and local income taxes which, above a certain threshold level, may tend to increase more or less proportionately with income; 

2. mortgage interest and property tax which increase with the value of one's home in turn tends to increase (more or less proportionately) with income; 

3. investment interest tends to increase proportionately with wealth and income;

4. charity contributions tend to increase more or less proportionately with income.  

For homeowners the following percentages of income for itemized deductions seem not unreasonable.  

Thus, in the steady state an increase in gross income tends to correspond to a more or less proportional increase in deductions. I assume the rate of deductions increase is about 20 percent of the increase in gross income. This assumption is conservative. According to FEDTAX 1993 statistics total deductions equaled about 23 percent of adjusted gross income. A more detailed analysis would allow for different percentages of deductions at different levels of gross income. For present purposes, however, this 20 percent deductible rate assumption seems not unreasonable.

The percentage of total income subject to adjustments and not subject to FICA tends to be higher for higher than for lower income groups. Similarly, the percentage of taxpayers who itemize and the percentage of itemized deductions claimed tends to increase with income levels. The special treatment of capital gains (capital gains income as percentage of total income tends to rise with income levels) further reduces the progressivity of the income tax. For the sake of simplicity (the tax code described herein is still quite complex) these complications are ignored. These additional complexities tend to reduce the relative tax rates on higher income groups below the levels reported herein. In other words a still more realistic table would show marginal tax rates to be less progressive than shown here. Table 1 (below) reports total and average tax rates for the end point of each income range.  

Table 1

Marginal and Average Tax Rates for Various Levels of  Income

Where:

            S = subsidy

Average = total tax ¸ total income with FICA gross up  

Table 1 reveals a very interesting picture. The marginal tax rates vary substantially. The highest marginal rate (41.62 percent) is encountered for incomes in the range of $22,437 to $34,578 where the taxpayer is subject to both FICA and FEDTAX while losing EIC. Interestingly, however, the next highest marginal rates are all in the low 30s. Specifically the MTTR is in the range of 32 percent or 33 percent for the following income ranges $14,107 to $22,437 (32.79 percent); $84,254 to $146,231 (33.72 percent); $240,210 to $360,217 (32.10 percent - 32.97 percent); and above $412,367 (31.78 percent).

Except for income below $14,102 the remaining marginal rates range from 26.79 percent to 28.73 percent. Moreover, these rates only show progressivity over the income range from $155,246 to $360,367. Above and below that range the marginal rates move regressively as often as they move progressively.

Unlike marginal rates, the average rates are progressive over most income ranges. Note, however, that from $146,232 to $412,367 the average rates are all in the range of about 26.5 percent to 29.5 percent. Indeed for income of $146,232 to $250,330, the average rates are all within 1 percent of 27 percent. At $412,367 the average rate only rises to about 29.50 percent. Even at the lower income ranges, the degree of progressivity is small. For $35,000 the average rate is around 17.5 percent  rising to around 21 percent for the $42,000 - $84,000 range. Thus, we already have rather flatish average tax system with a modest degree of progressivity at the lower rates. Indeed, when factors such as the tendency for higher income groups to have greater percentages of their incomes in the form of capital gains and municipal interest as well as a rising percentage of income not subject to FICA (e.g. interest and dividend income), the tax system is seen to be even less progressive than Table 1 suggests. In other words, we already have something approaching a flat (average but not marginal) tax rate system but with a very large degree of complexity and much higher are more variable marginal tax rates than are necessary to produce the amounts of revenues raised.

Table 1 indicates that our tax codes do a much better job of producing "fairness" than they do producing effective "work incentives." That is, the average tax rates for various income levels do exhibit a modest degree of progress­ivity, which probably corresponds to the electorate's sense of fairness. Marginal rates, in contrast, are much more variable and for many income levels much higher than they need to be. As a result our tax system fails to produce appropriate work and compliance incentives. High marginal tax rates discourage individuals from earning additional income while encouraging them to structure the income that they do earn so as to avoid or even evade taxes on that income. We should be able to do better.

A Flat Tax Proposal

A tax system can be structured to produce an overall flat rate for the combination of EIC, FEDTAX and FICA (including the employer's FICA payments). Thus one overall tax rate could be established for income broadly defined with a portion of the total paid to FICA and the rest to IRS. Such an approach has two significant drawbacks. First, it would not reflect most taxpayers' views that FICA payments yield much greater personal benefits than do their FEDTAX payments. Taxpayers tend to view their Social Security and Medicare benefits as "earned" by their FICA taxes notwithstanding the actuarial unsoundness of the system. Any benefits that taxpayers believe their income tax dollars "earn" are much less obvious or identifiable. The net burden on the taxpayer of a tax that earns the payer a benefit is less than one that does not. Furthermore, these perceived benefits from FICA payments are probably much greater for taxpayers with lower than those with higher income levels. Indeed, taxpayers with relatively low pre retir­ement incomes tend to rely much more on Social Security for retirement support than do those with higher pre-retirement incomes. Moreover, the ratio of FICA benefit payouts to FICA taxes paid in tends to be higher at lower income levels. Second, setting a flat overall tax rate would tend to shift the relative tax burden away from the middle class and toward the wealthy.  Such a shift is no more politically acceptable than a burden shift in the opposite direction.

Accordingly, I propose that the overall tax rate be set to produce a single flat tax rate for the combination of FEDTAX and the employee's direct FICA payments. Recall that a 20 percent rate for FEDTAX would not be expected to increase the deficit. Accordingly, we need only gross up the overall tax rate sufficiently above 20 percent to cover the employee's portion of Social Security revenues. Since most taxpayers do not reach the 2.9 percent FICA rate, the needed gross up is at least 1.45 percent but no more than 7.65 percent  (the two rates paid by the employee depending upon the level of income subject to FICA). Since most taxpayers do not reach the 2.9 percent FICA rate, I estimate the needed gross up to be approximately 5% percent (closer to 7.65 percent than 1.45 percent), which produces an overall flat tax rate of 25 percent. Clearly. the required rate would depend upon how broadly taxable income was defined. See Appendix A. See also Appendix D for a feasibility check on a 25% percent levy.

If we set the overall flat tax rate at 25 percent, taxpayers with income subject to FICA of less than $84,900 would (as under the present system) pay 7.65 percent to FICA and 17.35 percent to FEDTAX. Those whose incomes subject to FICA exceeded this level, would, at the margin, be subject to an FICA rate of 1.45 percent and an FEDTAX obligation of 23.45 percent.  Income not subject to FICA would also be taxed at 25 percent with the entire amount going to FEDTAX.

I suggest no change in the Social Security system (at least as part of the reform of the present tax system). I do not mean to suggest that the Social Security structure is not in need of reform. Rather, I wish my proposal to be viewed as independent of what else might be done with respect to related issues. That portion of the tax collection now going to Social Security would remain the same, as would the levels of Social Security benefits. In addition to establishing a flat tax rate, some mechanism is needed to establish the threshold above which incomes become taxable. Such a mechanism could also be structured to provide the kind of work incentives that the EIC is supposed to provide.

I propose that each taxpayer receive a personal tax credit of $1,000 times the number of allowed exemptions. A taxpayer with four exemptions would have a $4,000 tax credit. At a 25 percent tax rate this credit would shelter the first $16,000 of income from both FEDTAX and the employee's direct FICA obligations. Only the employer's share of the FICA would be paid on this level of income. General revenues would be used to cover the employee's FICA obligations on that portion of his or her income that was sheltered by the personal tax credit.

The earned income credit in its present form offers the working poor an incentive to earn additional income up to a pre-specified level ($10,200 for a family of four). Above $13,100, however, the credits’ phase out coupled with the FICA and FEDTAX obligations produces a major disincentive to earn additional income. A more effective system is needed both to incentivise the very low income worker to earn additional income and avoid disincentivising the slightly less poor worker from earning additional income. Accordingly, I propose a system of cash payments for the working poor to be based on the unused tax credit. Specifically, the earned income payment (EIP) would equal the product of the unused credit times the ratio of the used credit to the total credit. A worker with four exemptions who earned $12,000 would utilize $3,000 of his or her $4,000 tax credit to offset what would otherwise be due in taxes. He or she would then receive a government payment equal to 75 percent ($3,000/$4,000) times the unused portion of the credit ($4,000 - $3,000 = $1,000). The resulting $750 (.75 x $1,000) would be paid to the individual in cash. Had this same worker only earned $8,000, the payment would have been $1,000 (50 percent of $2,000 in unused credit). So, by earning an additional $4,000, (i.e. earnings rise from $8,000 to $12,000) the worker would incur no additional tax liability and only lose $250 ($1,000 - $750) in cash payments. This earned income incentive structure would pay out an increasing subsidy up to the point where the worker's income equaled twice the total allowed tax credit. For a taxpayer with four exemptions, this EIP system would yield the maximum credit for an income of $8,000 (2 x $4,000).  Thereafter the subsidy would decline, but initially at a very modest rate. The rate of subsidy loss would always be less than the 25 percent rate for the MTTR for income above the level at which the credit is exhausted.

While the marginal tax rate is particularly relevant for work incentives, the average tax rate is more relevant for evaluating a tax system's fairness. Under the above proposal an individual with four exemptions would receive a subsidy payment (up to $1,000) and pay no tax (other than the employee's portion of FICA) up to $16,000 of earned income. The total tax obligation would accrue at 25 percent of the income in excess of $16,000. At $32,000 the family's total tax liability would be $4,000 or 12.5 percent of their income. At $48,000 the family's tax liability would rise to $8,000, which corresponds to an average tax rate of 16.67 percent. At $64,000, the tax obligation would be $12,000, which corresponds to an 18.75 percent average rate. At $80,000, the tax obligation would rise to $16,000 and a 20 percent average rate. The average tax rate would continue to rise thereafter approaching the 25 percent level asymptomatically. Table 1 illustrates these relationships. Note that the amount of $1,000 per exemption tax credit is arbitrary. The amount could as with the current system be set to rise with the price levels.  

Comparison with a Generic Flat Tax Proposal

As previously noted, prior flat tax proposals have focused on the income tax, leaving FICA rates uncharged. To be revenue neutral, such proposals needed to be set at a rate of about 20 percent (FEDTAX). Accordingly, I shall now compare my proposal with a generic flat tax proposal that has a 20 percent FEDTAX rate and the current FICA rates This generic proposal is designed to be representative of the typical flat tax proposal that we have seen to date. In this generic flat tax I also include a $1,000 per dependent tax credit and again assume that the family of four has two wage earners with the lower paid worker earning 60 percent of the income of the higher paid. I also assume the earned income credit stays in place as is. Given these assumptions, the family would pay no income tax on the first $20,000 of income (20 percent of $20,000 = $4,000 which is offset by the tax credit). They would however be subject to FICA and be eligible for the EIC where applicable. Table 2 (below) also includes calculations for this generic flat tax proposal for comparison.  

Table 2

Average and Marginal Tax Rates Under: