ROANOKE TIMES
Copyright (c) 1996, Roanoke Times
DATE: Sunday, March 10, 1996 TAG: 9603080030
SECTION: HORIZON PAGE: F-1 EDITION: METRO
SOURCE: ANDREW CASSEL/KNIGHT-RIDDER NEWSPAPERS
``FLAT TAX'' is the name proponents give to what would be the most sweeping overhaul of the federal income tax code in 80 years.
Unquestionably, under proposals being touted by GOP presidential candidate Steve Forbes, as well as a variety of think tanks, academics and interest groups, the nation would have a simpler tax code.
In place of the multitudinous forms and schedules, the plethora of deductions, exemptions and exclusions, the mountains of IRS regulations and tax-court rulings that now determine who pays what when, the flat-taxers would enact a far simpler set of rules with - this is the ``flat'' part - a single percentage applied to all taxable income across the board.
The flat-tax plans getting the most attention these days would wipe out a thousand little deductions and loopholes. In their place would be a few large ones.
First among these would be the large personal exemptions available to all taxpayers and their families. Under the Forbes plan, for example, each adult would deduct his or her first $13,000 in salary income, and an additional $5,000 for each dependent. A family of four would thus pay no tax at all on the first $36,000 it earns. Or, to put it another way, if the income is less than $36,000, there is no tax.
That means Forbes' proposed flat rate of 17 percent would actually be graduated because of the big up front deduction. For example, according to calculations supplied by financial planner Terry Siman, a single person earning $25,000 would pay about 8 percent of her salary in income taxes. A family of three with $42,000 in salary would pay 4.5 percent, while a four-person family with $100,000 would pay 10.9 percent. A married couple with three children and $250,000 in income would pay 14.2 percent in income taxes.
Critics say the level would have to be much higher than 17 percent to avoid budget deficits. Proponents argue that revenues would actually increase because there are no other deductions, especially for the rich.
Under Forbes' plan, dividends, interest and other investment income would all be nontaxable, on the theory that they consist of income that's already been taxed at the corporate level. The idea, at least as important to tax reformers as a flat tax rate itself, is to end so-called double taxation of investment income. It's supposed to lower the cost of capital for businesses, and also encourage Americans to invest more of what they earn and consume less.
``The elimination of the double taxation is good tax policy,'' argues Arthur Hall, chief economist of the Tax Foundation in Washington, a business-funded think tank for tax issues. ``Good tax policy shouldn't tax any stream of income more than once.''
Hall, like many economists, believes the current tax rules are biased against corporate dividends and other investment income. ``If you bias one kind of income in favor of another,'' he argues, ``then you distort the economy.''
Other analysts, however, say proposals like the flat-taxers' would cause real economic distortion.
Down on the ground, they argue, the landscape would look like this: An individual's income could be taxed at either of two rates - the ``flat'' rate (which might be anything from Forbes' 17 percent to 25 percent or more), or zero percent. That's actually a lot less flat, if ``flat'' is defined as a narrow difference between the bottom and top tax rates, than the current system, under which most people fall between the 28 percent and 36 percent brackets.
Under the flat-tax plans, everything would hang on whether an individual's income could be classified under the law as ``investment'' income, such as dividends, interest or capital gains. Villanova University tax-law professor James Maule explains what happens next:
``I can guarantee you there would be minds put to work trying to figure out how to turn your salary into investment income.''
Robert Sommers, a columnist and tax accountant in San Francisco, foresees a typical scenario: ``Say I have a business, and you work for me. If I pay you a salary, you'll pay taxes on that salary. So instead, I'll make you an owner, and pay you a dividend. Now you get the money tax-free.'' Employers could split the difference with their workers, taking back half of the tax savings for themselves, he said.
Flat-tax proponents counter that such games won't be all that widespread, and won't make much difference anyway. Because a business in that circumstance would pay out less in salaries, it would have more net income and thus pay higher taxes itself. But critics argue that businesses also would have lots of ways to dodge taxes, such as immediate deductions for capital expenditures that now are stretched over several years.
The end result, they fear, would be much higher tax bills for middle-class wage earners and much lower ones for the wealthy.
And that's only one of many fierce arguments sure to erupt if the flat-tax plan becomes a serious possibility. Every reform embodied in the plans - including the end of deductions for mortgage interest, charitable contributions and state and local taxes - would mean major changes for institutions that have become fixed parts of the American financial landscape.
``It truly is a new tax universe,'' says Hall. ``What we know in this universe may or may not be true in a flat-tax world.''
nEliminating inheritance and estate taxes, a feature of the Forbes plan, would end the need for elaborate ``estate planning'' tools such as trust funds and high-cash-value insurance policies. Huge segments of the financial-services business, which specialize in such things as tax-deferred annuities and charitable-gift plans, could disappear overnight. Colleges, museums and other institutions that depend on deductions to generate charitable gifts, would have to develop new strategies to lure givers.
nWith no taxes on all investment income, states and municipal governments would lose the advantages they now have in the bond market. Local governments would have to pay market rates to bondholders, affecting the cost of building everything from schools to sewers. That, in turn, could translate into higher state and local tax bills - which also would no longer be deductible from federal taxes. The change would hit hardest in high-tax states such as Pennsylvania, New York and New Jersey, which now enjoy an indirect subsidy in the deductions their residents get on their federal income taxes.
nWithout the need for special IRAs, tax-deferred annuities, and a host of other special financial arrangements, large numbers of insurance salesmen, accountants and lawyers would have to find other lines of work. ``The legal infrastructure for all of that stuff would evaporate. It would become obsolete,'' said the Tax Foundation's Hall. The national net cost of complying with the tax code, which he estimates at an annual $140 billion currently, would drop 94 percent to less than $9 billion, Hall says.
nEnding deductions for interest on mortgages would raise the effective cost of owning a house, which, in turn, would put downward pressure on home prices. Wharton School professor Susan Wachter estimates that the market value of existing houses could sink 10 percent to 15 percent in the year after a flat tax is enacted. The hardest-hit areas, again, would be the Northeast and the West Coast, where housing prices and mortgages are higher than elsewhere.
Wachter, a housing-market specialist, says such a drop in housing values would ripple out in the form of higher default rates, which would affect banks, and construction, because there would be less demand for new homes. Suburbs would feel it quickest, she said, because more suburban homeowners take mortgage deductions than do those in inner cities.
But large urban areas would find fewer low-income people qualifying for home loans, because they would be unable to deduct either mortgage interest or property taxes.
The flat-tax plan as currently outlined, ``would represent a reversal of the current 60-year national policy of encouraging homeownership,'' Wachter testified before the congressional committee studying tax reform last year. However, she said recently, that's not to say it's a bad idea.
``As a generality, the simpler the tax code, the better,'' she said. Any reform plan that emerges from the political and legislative process will alter many lives, but if it simplifies the overall tax code, it is likely to end up helping more than it hurts.
``It's a step off into the unknown, but it's a positive step,'' Wachter said.
IF YOU WANT TO KNOW MORE about how your own tax bill would change in a flat-tax world, a page on the Internet offers both detailed explanations and a handy online calculator for comparing your situation. The address is:
http://ibc.wustl.edu/~hugh/armey.cgi
LENGTH: Long : 150 lines ILLUSTRATION: PHOTO: (headshots) Forbes, Armey, Buchanan. color. Graphics:by CNBCharts. 1. The way it is now. 2. Paying the tax bill. 3. The Forbes
Plan. 4. The Armey Plan. 5. The Buchanan Plan. color.