The Flat Tax is Good, but Common Sense is Better

A Review of the Second Edition of The Flat Tax by Robert E. Hall and Alvin Rabushka (Hoover Institution Press, 152 pages, $14.95 paperback), and published in the The Money Review. November 1996: 22-24.

Hall and Rabushka present a very clear and convincing argument for a "flat tax," an income tax with a single rate and very few deductions like that proposed by Malcolm "Steve" Forbes during the 1996 Republican Presidential primary elections. They argue that the current income tax system wastes hundreds of billions of dollars by diverting resources away from more productive uses. However, their argument is mainly an economic one and neglects some of the very important political forces that determine the full impact of a government policy on the quality of life.

The Flat Tax is Standard Economics but not Good Common Sense

Hall and Rabushka explain that our current tax system has two problems - two problems that might be solved with their flat tax. First, the current system is very complicated. The complications lead to the emergence of specialists such as tax accountants and lawyers who devote their careers to help the rest of us understand and comply with the tax code. A simpler tax system would obviate the need for these specialists who then could be employed as physicians, teachers, computer programers, entrepreneurs and other socially productive occupations. How many resources are wasted as a consequence of the complexity of the tax code? Hall and Rabushka take the reader through some calculations and cite a compelling example - the fact that H & R Block's stock soared 20% in response to the passage of the 1993 tax increase (page 6). Their use of the H & R Block example shows that they are talking about real money and is an example of their simultaneously entertaining and informative writing style.

A second problem with the current income tax system is its high "marginal" tax rates, the rates at which people pay taxes as their taxable incomes grow. The high marginal rates greatly discourage work, saving, entrepreneurial effort, and even honesty. Hall and Rabushka show, for example, how the combination of the Individual Income and Corporate Income taxes result in a tax rate on entrepreneurial success of 60%! With such a high tax rate, it seems obvious that there are fewer business startups, fewer investment projects and fewer jobs than there would be if the tax rate on entrepreneurial success were lower.

Although economists are notorious for disagreeing among themselves, Hall and Rabushka are not alone in their enthusiastic advocacy of a flat tax. Twelve prominent economists - including several Nobel Laureates - contributed to a recent Wall Street Journal editorial (2/22/96) supporting a flat tax. It is the great potential for a flat tax to reduce complexity and "distortions" of economic activity that is its great appeal to economists. With the strong advocacy of economists, why is the support of noneconomists for a flat tax so weak? Economists assume without question that a flattening of the income tax would be "revenue neutral" - it would not increase the size of government and therefore permit the lowering of marginal tax rates that generate the benefits mentioned above. A common sense objection that has been voiced by noneconomists from my wife and my parents to Howard Stern and Rush Limbaugh rejects the unrealistic "revenue neutral" assumption made by so many economists. An efficient flat tax is too much for a politician to resist. A flat tax might begin with lower rates but, with its few deductions, it would be an incredibly powerful revenue machine. Politicians would invent new spending programs, raise the flat tax rate, and create a much more massive government.⁽¹⁾ A virtue of a flat tax - its ability to raise massive amounts of revenue at low rates - is also its vice.

Historical Experience with Flat Taxes

Although it is obvious that the Hall and Rabushka flat tax is simpler than the current tax system, it is not a purely logical conclusion that lower marginal tax rates would greatly encourage work, saving, entrepreneurial activity, and even honesty. Hall and Rabushka realize this and provide a fascinating discussion of historical experiences with lower marginal tax rates. They show how that, in three episodes (the end of World War I, the Kennedy tax cuts, and the Reagan tax cuts) cuts in marginal tax rates were followed by more work, more saving, more entrepreneurial activity, more reporting of income, and even payment of more taxes by affected taxpayers.

After reading the Hall and Rabushka account of the three episodes, readers of The Flat Tax will agree that lower marginal tax rates encourage work, saving, entrepreneurial activity, and perhaps even tax collections.⁽²⁾ But is it necessary that a flat tax will result in lower marginal rates? The Hall and Rabushka book is therefore incomplete without a discussion of historical experiences of the effect of flat taxes on government spending and marginal tax rates.

Several observations on the relationship between flat taxes and marginal tax rates could have been made, but were not. Hall, Rabushka and I would agree that Social Security "Contributions" are an excellent example of a flat tax (page 77). After all, social security taxes wages and salaries at a single rate with no deductions. The social security tax currently has tax rates that are less than 20% yet it brings in almost as much revenue as the individual income tax.⁽³⁾ Consistent with the common sense rejection of the "revenue neutral" assumption (and not discussed by Hall and Rabushka), the introduction of the flat social security tax at a 1% rate in 1937 was associated with a massive expansion in government spending and, so far, almost twenty tax rate increases!⁽⁴⁾

Hall and Rabushka should have also discussed the experiences of other countries with flat taxes. A brief analysis of the International Monetary Fund's International Financial Statistics suggests that the "revenue neutral" assumption is unrealistic - countries that rely most heavily on flat taxes have the largest governments. Japan, Bolivia, and Ecuador obtain less than 25% of their government revenues from payroll and sales or value-added taxes (two of the examples of flat taxes used by governments today) and their governments appropriate less than 25% of national income. The U.S., Mexico, and Brazil obtain between 25% and 50% of their government revenues from payroll and sales or value-added taxes while their governments appropriate between 25% and 50% of national income. The French, Swedish, and German governments rely heavily on payroll and income taxes for their revenues while those governments appropriate more than half of national income.

Why Are Political Forces Ignored?

Why do Hall and Rabushka study three tax cutting episodes but fail to document the history of the U.S. Social Security Tax and to look at the cross-country relationship between flat taxes, marginal tax rates, and government spending? One answer is that their book is a piece of political propaganda rather than a scholarly argument and, as such, omits facts that inconveniently weaken their argument. However, Hall and Rabushka's excellent scholarly records, the vast agreement that they enjoy from prominent economists, and some of the text from The Flat Tax suggest another answer. They flirt with the idea on page 102 that taxes and spending are determined in "political equilibrium," but - although they note on page 2 that the form of taxation has historically been associated with the degree of "protest" by taxpayers, on page 48 that a flat tax makes it much easier for advocates of spending programs to be successful and on pages 21-22 that politicians love to raise taxes - do not pursue the idea that a change to a flat tax might change the political situation. Hall, like so many economists, ignores politics because he lacks the tools to analyze political behavior. Just as a dairy farmer might suggest butter rather than margarine, economists are prone to advocate their product rather than the product of a competitor. It should be no surprise when an economist emphasizes economic issues and de-emphasizes political issues even when the latter are important for the problem at hand.⁽⁵⁾

A solution to dubious salesmanship is to allow each salesman to sell both competing products. If the dairy farmer produced both butter and margarine, he would be less likely to overexaggerate the virtues of butter. A similar merger of economics and politics has been initiated by Nobel Laureate James Buchanan. Using the tools of economics to understand political behavior, Buchanan dispenses with the standard "revenue neutral" assumption and derives the common sense result: a flatter tax may lead to the growth of government.⁽⁶⁾ When the merger of traditional economics with politics is complete, you can expect reliable advice from economists on a broader range of issues. Until then, rely on your common sense when it comes to the flat tax.

Casey B. Mulligan
Department of Economics
University of Chicago
June 1996

1. Even if a flattening of the income tax did lead to a lower marginal tax rate, the new spending programs would undoubtably be perceived my many taxpayers as wasteful and unfair which would, contrary to the claims of Hall and Rabushka, probably increase dishonest tax avoidance by taxpayers.

2. Some readers may remember the historical counterexamples surrounding World War II (not discussed by Hall and Rabushka). I show in my "Pecuniary and Nonpecuniary Incentive to Work in the U.S. during World War II" (Discussion Paper Series, Population Research Center, University of Chicago, 1995) that tax rates were dramatically increased from 1941 to 1942 and from 1942 to 1943 yet work effort, savings and tax collections increased. Dramatic tax rate cuts - larger than the Kennedy and Reagan tax cuts - took effect in 1946 and again in 1948 while work, savings and tax collections fell.

3. In fiscal year 1994, the Individual Income Tax collected $543 billion while the Social Security tax collected $461 billion (U.S. Council of Economic Advisors, Economic Report of the President, 1996).

4. Robert J. Barro and Chaipat Sahasakul, "Average Marginal Tax Rates from Social Security and the Individual Income Tax" (Journal of Business. 59(4), Part 1, October 1986, pp. 555-66).

5. However, it is a surprise that Rabushka's political science background did not result in an extensive discussion of the political forces affecting the tax system.

6. You can read Buchanan's argument in his book The Power to Tax (with Geoffrey Brennan). Gary Becker and I extend Buchanan's argument and build a mathematical model of the politics of spending and taxes in a recent research paper "The Case for Inefficient Taxes" (working paper, Department of Economics, University of Chicago, June 1996).