Making Flat Tax Work

To get the benefits, you have to get a flat tax system. So be practical...

FOR A number of years, conservatives have debated the merits of the "flat tax", and also the "fair tax", writes Nathan Lewis in his story first published at Forbes.

That amounts to a unified sales tax. Both plans are impractical as standalone solutions.

Instead, I propose that the flat tax fans focus on where income taxes are most important – the Federal government – while fair tax fans focus on where sales taxes are most important, which is state governments.

The combination of a unified flat income tax at the Federal level, and a unified sales tax at the state level, presents the best option for broad tax reform, while also producing the relatively high revenue/GDP ratios that are deemed necessary today.
 
Yes, I too would like the US government to have a much lower revenue/GDP – a topic that has been getting increasing attention. We should have that conversation. But, designing a dysfunctional tax system is not the way to get there.

The flat tax – a radical simplification of the income tax system, with a single rate likely in the high teens – has never been intended to be a total tax reform. It does not address payroll taxes, or state-level taxes, including existing sales and other taxes.

For a flat tax to serve as a primary tax system, the government's revenue needs would have to be a lot less, in terms of GDP. Hong Kong's flat-tax system, combined with property taxes, produces about 13% of GDP in revenue, without sales or payroll taxes. A "mandatory provident fund" system serves the role of a public pension system funded by a payroll tax.

The fair tax can be seen as an update to the original tax system of the Federal government before the creation of the income tax in 1913, and the payroll tax in 1936. Before 1913, the Federal government funded itself on a variety of tariffs and excise taxes such as a tax on alcohol, indirect taxes similar to a sales tax. The Federal tax revenue/GDP ratio was around 4%.

This system lives on today in a few places, notably the financial havens such as the Bahamas, which have no income taxes. The Bahamas use a broad tariff system that, since the island must import virtually all of its goods, is functionally similar to a sales tax. But, this system also produces a modest revenue/GDP, of 18.7% in the Bahamas, when combined with some other taxes such as a property tax.

The problem is that, to produce today's US revenue/GDP around 27%, the nominal rate for a "fair tax" would have to be around 30%. To that must be added state-level sales taxes, which may also be raised if state-level income taxes are also eliminated. You get a sales tax rate likely in excess of 40%, raising many issues of evasion, enforcement, and even "fairness" when corporate income is untaxed.

A system that could work well at a revenue/GDP of 12%, becomes a caricature at 27%.

Using a unified state-level sales tax also eliminates state income taxes – an important consideration for Federal flat tax reform. The advantage of a 17% Federal flat rate dissipates quickly when state income taxes are piled upon it, with California's highest rate at 13.3%. Plus, states could eliminate a bevy of junk taxes and fees, on telephones, hotels, restaurants, and many other things.

Several small steps are often better than one big leap. Republicans should push for a unified "fair tax" at the state level – and then unite around the flat tax at the Federal level. If we later move to a much smaller government, around 15% of GDP perhaps, we can then make our tax system even simpler and less burdensome.