Four Common Myths about the Flat Tax

David Allen /

America’s tax code is riddled with problems.

Policymakers have offered various solutions over the years in the hope of alleviating these burdens. One of the most common proposals has been the flat tax. First envisioned in 1985 by Robert Hall and Alvin Rabushka of the Hoover Institution at Stanford University, the flat tax combines a threshold (i.e., exempt) amount with a single rate of tax on all income above it. While multiple variations of the flat tax have been put forth, each recommends the following: a single, low rate on personal and business income that only taxes income earned in the United States, no taxation on death or savings, immediate expensing of business investments, and the removal of unwarranted credits, deductions, and exemptions.

A flat tax would offer a wealth of benefits. A lower rate on income will encourage work and saving. The elimination of taxation of overseas income will promote business activity here at home. Removing higher marginal tax brackets and taxes on capital will collectively spur investment and economic growth, meaning higher incomes for all. Moreover, ridding the tax code of its complex credits and deductions would drastically reduce compliance costs and minimize corporate cronyism.

Despite these merits, there are several common misconceptions surrounding the flat tax. Earlier this week, Forbes magazine’s editor in chief and two-time presidential candidate Steve Forbes came to The Heritage Foundation to dispel some of these myths.

  1. It will help the rich at the expense of the poor. Ultimately, everyone will be better off under a flat tax, as the ensuing economic growth increases wages and creates job opportunities across the board. Additionally, most flat taxes exempt from the tax incomes under the poverty level, to ensure that the poorest members of society are protected. Americans—most of whom pay for help filing their tax returns—also stand to benefit from the simplicity the flat tax would introduce. Taxpayers spent 1 billion hours completing forms and filing returns in 2010. When monetized at the low value of $10 per hour, that’s an annual cost of $61 billion. All would be better off not having to navigate the myriad complexities of our tax code—except perhaps tax accountants and the IRS.
  2. Charitable contributions will decline substantially. Some flat tax plans (though not all) cut out the tax deduction for charitable giving, which opponents claim will cause donations to plummet. While in theory this may seem reasonable, it is misguided. The deduction is sensible because people should not have to pay tax on income they neither spend nor save. However, the key economic factor determining the level of donations is income, not tax breaks. As our economy has grown over the past four decades, charitable giving has remained remarkably consistent, even in the aftermath of major changes in the tax code. The Tax Reform Act of 1986 eliminated the “above-the-line” tax deductibility of charitable contributions that had allowed all taxpayers to deduct charitable contributions from taxable income between 1981 and 1986. Pundits predicted that philanthropy would suffer as a result, but their fears were never realized. Taken together, contributions in inflation-adjusted dollars rose by 19.1 percent between 1985 and 1989, primarily due to strong economic growth. The bottom line is this: The best way to increase donations is to put more money in people’s pockets, which the flat tax is specifically designed to do.
  3. The housing market will crumble if the mortgage deduction is removed. Again, this argument sounds logical at first, but it ignores some effects that the flat tax would have on interest rates and capital. The flat tax would not only remove the mortgage deduction; it would also remove tax on interest. Because lenders would no longer have to pay taxes on the interest revenue received from borrowers, they would no longer raise the interest rates they charge borrowers to reflect the tax they pay on their interest income. This can be seen from the lower interest rates charged today on tax-exempt municipal bonds. Borrowing decisions remain unchanged because the after-tax cost of borrowing remains the same.
  4. If there is a single rate, it will be easier for Congress to raise taxes in the future. Some contend that since the flat tax incorporates only one rate, raising the burden on taxpayers is only a one-step process. On the other hand, having one rate applied to a broad base may discourage a future tax increase as it would affect everyone equally. A single rate also ensures added transparency when Congress debates tax changes. Our incomprehensible tax code provides officials many outlets for hiding tax increases. With a simple flat tax, stripped of deductions and credits, it will be very difficult for Congress to implement tax hikes in a subtle manner. This is undoubtedly a benefit, as it holds our leaders more accountable.

Although different flat tax plans vary, the underlying principles remains the same: (1) do away with the bracket structure and impose one single, lower rate on everyone above an exempt income amount; (2) remove politically motivated credits and deductions to maximize simplicity and cut back on cronyism; and (3) eliminate the bias against savings and investment, overseas income, and U.S. production to minimize economic distortions and deadweight loss.

Congress should strongly consider adopting these prudent and badly needed reforms.

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