Should We Be Talking About a Flat Tax?

The economy has most certainly become the central discussion point for both the Obama and Romney campaigns during this election year.  With the addition of Congressman Paul Ryan to the Romney ticket in August, discussions of the Ryan Plan have reemerged.  Ryan has largely shied away discussing a flat tax option, although he did suggest a flat tax plan in the past, and found some merit it candidate Rick Perry’s optional flat tax plan last October.  On Tuesday, Ryan appeared on GMA where he argued with anchor George Stephanopoulos that a reduction of tax rates was necessary for economic growth.  With all the tax reform talk, it’s left me wondering if the Eastern European model of flat taxes will affect the political rhetoric before the November elections.

Since 1994, 24 countries (the bulk in Eastern Europe) have adopted a flat tax system.  This spread of the flat tax has been quite remarkable during the past 15 years, and it has contributed to the widespread economic growth throughout Eastern Europe.  Additionally, the flat tax in many of these countries has helped create a simple system of revenue collection that saves millions in implementation and collection costs.

Is the European model the ticket to U.S. financial recovery?  Let’s first consider the complexity of the U.S. tax code.  It is estimated that taxpayers and firms spend over 6 billion hours per year attempting to correctly file tax returns.  Not only does this figure represent the equivalent of millions of workers, but it also pulls billions of dollars out of more productive uses.  According to the IRS Taxpayer Advocates, who reported to Congress in 2010, the complexity of the American tax code is driven in part by the continual changes to the system as the federal government attempts to squeeze more and more out of taxpayers.  In the past decade there have been approximately 4,400 tax code changes resulting in an additional 3.8 million words to document the U.S. tax code.

It is clear that this complexity costs billions of dollars each year just for taxpayers to comply with the laws, yet it also costs the Federal government billions in tax fraud and avoidance.  Again, Eastern Europe provides a lesson here where compliance of Russian taxpayers increased by over 30% after the adoption of a flat tax system.

In addition to the massive waste of resources due to complexity, the American tax code is a drag on economic growth and progress.  U.S. households and firms make decisions with their resources that are based not on market returns but on tax sheltering and loopholes.  Foreign firms weigh the costs of locating in the U.S. based on a tax rate that is the second highest in the world.  Congress and the White House are continually using the tax code to regulate.  The tax code has become the primary means of legislation, and the continual additions and changes imposed on the tax system contribute to uncertainty and fear among firms which eventually lead to decisions that hinder economic development.

Objections to a flat tax almost always hinge on fairness rather than economic efficiency or outcomes.  A progressive tax is deemed “fair” because higher income earners pay a higher marginal tax rate, and thus any talk of a flat tax is immediately rejected by those who see unnecessary benefits to the rich.  Yet, with a flat tax the more you earn the more you pay (as with a progressive tax system) and with a true flat tax you no longer have the countless loopholes and deductions to hide behind.  A flat tax system is more “fair” by any economic measure as taxpayers do not have to spend time and resources gaming the system in order to shelter their income (a practice that certainly benefits the rich).

If America wants to move past the stagnation of the previous four years and begin to see consistent economic growth again, tax reform is necessary.  The examples in Eastern Europe demonstrate that flat tax reform is possible and can have a significant economic impact.  What these examples also show, is that strong executive leadership is a crucial component of any successful tax reform.  The Romney-Ryan ticket has a clear opportunity to set the agenda early and champion the necessary reforms to unburden American individuals and firms with an outdated, inefficient, and costly tax system.

Dr. Peter Frank is co-author of a recent study entitled “The Flat Tax: Has its Time Come?” which can be read in its entirety at www.jessehelmscenter.org.  Frank is also the Jesse Helms Free Enterprise Fellow at the Jesse Helms Center and a professor of economics at Wingate University.  You can reach him by email at PeterFrank@jessehelmscenter.org

The Messy Tax Code

As we enter the final days before IRS filing is due, many are considering the mind-numbing complexity of the U.S. tax code.  It is estimated that taxpayers and firms spend over 6 billion hours per year attempting to correctly file tax returns.  Not only does this figure represent the equivalent of millions of workers, but it also pulls billions of dollars out of more productive uses.  According to the IRS Taxpayer Advocates, who reported to Congress in 2010, the complexity of the U.S. tax code is driven, in part, by continual changes to the system as the federal government attempts to squeeze more and more out of taxpayers.  In the past decade there have been approximately 4,400 tax code changes resulting in 3.8 million words to document the American taxation system.  Since 1913, the tax code has ballooned from 400 to 72,536 pages in July 2011.  Worse yet, the blog Political Calculations expects that number to jump to 74,944 in 2012.

The irony of such an intricate tax system is that complexity is connected to compliance.  This is true both of honest taxpayers and evaders.  A recent report stated that IRS help centers provided wrong answers to taxpayer questions almost 30 % of the time.  Even the 90,000 plus IRS workers are unable to keep up with this ever-changing system.

The obvious question is why the complexity?  Why does the federal government try to increase revenue through such a complex set of rules?  The answer goes back to the fundamental role of government.  If the government wants more of something it subsidizes it, and if it wants less of something it taxes it.  A subsidy to the corn industry helps farmers grow more corn and more ethanol is produced.  A tax on imported sugar keeps sugar growers in America happy by keeping out global competition.  So, Congress uses the tax code to regulate the market in order incentivize specific behavior.  In other words, the complexity of the tax code is due to the unbridled desire for Congress to regulate.  The complexity is not a necessity to ensure Congress replenishes its coffers each year.

Congress loves to provide incentives to the tax code.  Any problem it wants to solve, use the tax code.  Any behavior it wants to change, use the tax code.  Any industry it wants to prop up or diminish, use the tax code.  President Obama’s stimulus package, which passed early in his presidency, added 300 pages to the tax code.  Manipulation of the tax code has simply become de facto government regulation.  This is not a new practice for Congress or the President.  Ever since the 16th Amendment, the federal government has increasingly used income taxes (on individuals and businesses) to regulate, but the ridiculous nature of this ever-increasing complexity is out of control.

Pursued by industry in order to impact individual incentives, federal tax deductions exist for children with an overbite who enroll in clarinet lessons and whaling captains can deduct ship repairs even though whaling in the U.S. is illegal.  The government also provides many additional deductions of impact healthy behavior from quitting smoking to doctor-ordered exercise.  While these may be a benefit to your health, is it prudent to add to the increasing complex system with additional changes, loopholes, and deductions?

Sadly, simplifying the tax code has become a partisan issue pitting those in favor of smaller government versus those who look to government to solve economic and social problems.  This is a mischaracterization of the issue.  Tax complexity is a massive waste of resources.  No matter if you are conservative or liberal, the billions of dollars invested in tax compliance are wholly unnecessary.  There may be differences on how to use the billions of dollars that would be saved with a simple system, such as a flat tax or a consumption tax, but all taxpayers should agree that 90,000 plus IRS workers and $430 billion spent each year on compliance is a colossal waste.  Now let’s convince Congress to change the system.