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Why the flat tax is wrong for America.

A number of tax proposals are being touted in Washington, D.C., under the moniker of "flat tax." These proposals are part of the process of reengineering our burdensome tax code.

Proponents of the flat tax point to their respective plans as a fairer and simpler way to raise revenue. These plans are designed to make the annual chore of tax preparation much easier and far less costly.

Although no significant details have been proposed and it is unlikely any meaningful legislation will be discussed or voted on in Congress for at least 12 to 24 months, the concept of a flat tax is gaining popularity with the general public, state legislatures and newspaper editorial boards.

The national debate over the flat tax is only beginning. The dissenting voices seem to be made up of "special interest" groups--the real estate industry, charitable organizations, tax attorneys and tax accountants. The general public is expected to soon join the national debate when it becomes understood that the various flat tax proposals will significantly increase the tax burden of Americans earning less than $100,000 per year.

The most heavily promoted flat tax plan exempts interest, dividends and investment gains from tax. A family with $50,000 of investment income may pay no income tax under these proposals, while a working family with the same $50,000 of income generated by one or two working family members will pay substantial income tax.

The general public is not aware that these flat tax proposals are for income tax purposes only; Social Security taxes will continue to be a burden in addition to the flat tax. Many low- and middle-income individuals pay more Social Security tax than income tax. The flat tax will not replace the Social Security tax system.

Over the past generation, America has moved toward and embraced what can be termed a "Western European-style Social Safety Net." This safety net includes Social Security, Medicaid, school lunch programs, aid to families with dependent children, youth work programs and general welfare. As America has moved toward Western European-style social programs, the number of individuals receiving funds from the government, many as their main means of support, has increased.

With these points in mind, the current flat tax proposals are wrong for America for a number of reasons:

[] The flat tax will significantly benefit individuals who do not work for a living. The unemployed, under employed and the rich will benefit. Those working in society will be asked to bear an even larger share of the Federal tax bill.

[] The flat tax may create a number of catastrophic side effects. The banking industry relies heavily on residential real estate as security for home loans and secondary mortgage lines of credit. A number of proponents and opponents of the flat tax agree that home values may drop 15% to 20% as a result of the current proposals. A recent DCI/McGraw Hill, Inc. study projects a 15% drop in home values as a result of some of the flat tax proposals.

[] The flat tax may create a huge burden for state and local governments that rely on public financing through the sale of bond issues at rates discounted to market because of their tax-favored status. Proponents of the flat tax believe that mortgage and other rates may fall to municipal bond levels once the flat tax has been implemented. This belief is firmly grounded in the experiences of other countries: current mortgage rates of 8.5% in England, where home mortgage interest is only partially deductible; 8.5% to 10% in Canada, where home mortgage interest is nondeductible; and 7% to 8% in Germany, where home mortgage interest is nondeductible. These are not substantially different from U.S. mortgage rates.

[] The general public does not want a new tax system that could create a crisis for financial and municipal sectors and impose higher taxes on most working Americans, while granting large reductions in taxes for wealthy Americans.

The national debate should not be limited to only one type of change such as the flat tax. The objective of the flat tax system--fairness and low-cost tax preparation-could be better achieved and America could be made stronger by implementing a plan that might look like the following: Part I: Triple the current standard deduction and double current personal exemptions. These two simple changes would have the impact of removing more low-income Americans from the tax rolls, while reducing the cost and complexity of annual tax preparation for many Americans.

In fact, by tripling the standard deduction and doubling the personal exemptions, most taxpayers whose earnings consist of wages, interest and dividends would never be required to file tax returns again. Today's technology would make them nonfilers who receive an automatic refund or tax bill by mail. Filing income tax returns would be a thing of the past for these individuals. They could hire a tax professional only if they wanted someone to review the government's calculations.

Part II: Reduce the current income tax rates by a meaningful number, perhaps as much as one-third. This would leave the current system somewhat intact. The be-nefit of Part II would be threefold:

1. There would be a reduced danger associated with the unintended economic side effects of scrapping the system entirely (as described previously).

2. The current system's positive aspects-chiefly, progressive rates and certain tax-enhanced programs, such as the child care credit, jobs credit and low-income housing credit-could be preserved.

3. Lower rates would stimulate production by making work worthwhile again. Lower rates would stimulate job creation and investment by not penalizing entrepreneurs for creativity and risk-taking.

Part III: In the rush toward Western European-style social benefits, the United States has been slow in imposing Europe's style of paying for those benefits. This has helped create a huge national deficit. Embracing these benefit programs without paying for them has also hurt America in other ways, as needed infrastructure investments have not been made for roads, schools and other municipal and state projects.

A solution is the fairest flat tax of all-a national sales tax of 5% to 7% on all goods and services except food and medical services. The appeal of this new tax includes:

[] Everyone pays something.

[] The wealthy would pay more because they spend more.

[] The underground economy (income illegally not reported for income tax purposes) would be taxed, since even those people would pay the national sales tax as they spend their money.

[] This type of tax may increase the national savings rate because it taxes consumption, not earnings.

[] European countries have recognized the need to collect something from everybody as their social programs have multiplied. Europe has accomplished this via a value-added tax (VAT) while keeping their income tax system in place.

The national sales tax is preferable to a VAT because it is not a hidden tax. it is also substantially less costly to implement.

In summation, Americans would be better served by implementing a system that is fairer and less costly to administer. A plan similar to the three-part one discussed would make work a more attractive career choice, increase production and job creation, be fairer by requiring everyone to pay something and would not be a tax bonanza to the wealthy.

It is our hope that the reengineering of America's tax system will be a patient, open and complete debate.
COPYRIGHT 1995 American Institute of CPA's
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Author:Mitchell, Ronald A.
Publication:The Tax Adviser
Date:Dec 1, 1995
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