Economics: What's the catch with a flat-rate tax?

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The Independent Online
A NUTTY millionaire who wants lower taxes for people like himself, or a man riding on the back of an idea whose time has come?

Steve Forbes, the multi-millionaire publisher of the financial magazine Forbes, has become the leading candidate to get the Republican nomination for the US presidency. That comes courtesy of a single issue campaign that America should replace its complex system of income tax - much like ours - with a flat rate tax.

Anyone who follows these early stages of an American presidential campaign will know that a lead in the polls at this stage is not so significant. But being a front-runner at this point, evidently well ahead of the veteran Republican candidate Bob Dole, is testimony to the power of the idea. And he is not alone in promoting the flat rate tax: he is supported by other leading Republicans. Even Bob Dole has called for a "flatter, fairer and simpler" tax system.

The idea is simplicity itself. Up to a certain point, people would pay no income tax at all. That point would depend on the family circumstances: in particular the number of children they had. On Mr Forbes' calculation, a family of four would pay no income tax if they earned less than $36,000 (pounds 23,500); and they would pay 17 per cent on everything beyond.

The actual rate and point where it starts are negotiable. Another Republican proposal, developed by Jack Kemp, cites a 16 per cent rate; others suggest 20 per cent. Obviously there is a trade-off between the starting point and the rate, but what is fascinating is the head of steam behind the idea. It is akin to the wave of cuts in the top income tax rates of the early 1980s: no developed country anywhere ended the 1980s with a higher top tax rate than it had in 1979.

So what is the real rationale? If it were simply that rich people wanted lower taxes, it could be swiftly dismissed. Virtually everyone wants to pay less in tax, but virtually everyone wants the services that governments supply.

The case is much more broadly based. It seems to stand on two legs: efficiency and fairness. The efficiency argument is essentially that if rates are cut, people will work harder, earn more and, most important, be prepared to declare those earnings to the taxman. So cutting rates boosts tax revenue in two ways. Some argue that the lower the taxes the faster the growth in the economy and hence the additional revenue accrued by government. Others focus on rates, arguing that the lower the rates, the more people will pay.

It is impossible to prove either proposition conclusively, though that has not stopped people trying. Gerald Scully, at the University of Texas in Dallas, has calculated that the economy grows fastest if the total share of GDP being taken by government is between 21 and 23 per cent. This is a lot lower than the mid-30s at present but high by US standards before the 1950s. It is substantially lower than targets of 35 per cent being talked about here by John Major. It is not, however, out of line with the tax take in the "tiger" economies of East Asia, which are growing very much faster than either the US or any of the European countries. Obviously, very high taxation will inhibit growth, but it requires an act of faith to argue that the optimal tax take is 22 per cent, or 35 per cent, or 40 per cent.

There is more evidence that cutting tax rates will increase revenue. The US experience in the 1980s is set out in the chart on the left, produced by Republican Jack Kemp's commission on taxation. It shows how cutting the top income rate from 70 per cent in 1980 to below 30 per cent coincided with an increase in the share of tax paid by the richest 1 per cent of earners: from about 16 per cent to 27 per cent. Under President Clinton, however, top tax rates have risen slightly, which seems at the margin to have increased revenues further.

Much the same pattern has occurred here. I have done a similar tally for the UK and this is shown in the right-hand graph. We cut our top rate on earned income from 83 per cent, to 60 per cent and to 40 per cent. The richest 1 per cent increased their share of income tax revenue from 11 per cent, to 14 per cent, to 16 per cent. The effect of tax cuts on on payments by the richest 5 per cent is even more striking: up from 24 per cent to 29 per cent, and finally to 33 per cent.

But while these figures are stunning, they are not conclusive. Part of the increased tax take results from a greater willingness to take income in money rather than other benefits, but part must come down to the fact that more highly skilled people earned relatively more, and the lower skilled relatively less during the1980s, a change that has still not received a proper explanation.

Enthusiasts for the flat tax can, therefore, use the cuts of the 1980s to support a case that lower tax rates encourage people to declare all their income, rather than devote energy to finding ways of avoiding tax. But the actual rate at which the flat tax would have to be levied to maximise revenue is still unclear.

However, the experience of the 1980s gives some force to the further argument: that a flat tax would be fairer. If previous simplification boosted the share of tax paid by the rich, simplify still further and maybe the rich will pay still more.

It is certainly very hard to defend the present complexities, for they create enormous loopholes through which the astute can slide. As our sister paper, the Independent, revealed recently, Rupert Murdoch's News International empire paid virtually no UK taxation during the 1980s despite making enormous profits. Gordon Brown recently pointed out that one-third of estates of more than pounds 1m paid no tax. In an increasingly mobile world, rich companies and rich individuals simply move their funds beyond the reach of any government that tries to tax them too highly. The less rich cannot do so.

This cannot be just. Much of the appeal of the flat tax is that, by eliminating all tax loopholes, it would actually be fairer. That is the motor that is pumping up support for Mr Forbes' campaign. It also gives him a response to people who claim this is a millionaire's ramp.

The argument for simplicity seems to me to be overwhelming but I have one grave doubt about the arithmetic. The actual tax rate might have to be rather higher than 17 per cent to maintain revenues. Maybe the flat tax is just another way of trying to cut back the role of government by denying it the money to do its job.

It so happens that I know Mr Forbes slightly, or rather knew him reasonably well in the early 1980s. He is delightful, clever, funny - not the goofy guy that he seems to be on TV. But one conversation sticks in my mind.

We were talking in New York about the Reagan tax-cutting plan. I had expressed my worry that it was irresponsible to cut taxes before the administration had any evidence it could also cut spending.

"You don't understand," he replied. "They can't cut spending first because the whole political process does not allow them to do so. But if you cut taxation, then you cut away revenue and that ultimately forces cuts in spending." In other words, the real motive behind those tax cuts was smaller government, not efficiency or fairness.

If that is what flat tax is about, it is a legitimate democratic choice if it is made clear. But that is not, in the main, what its supporters are saying. When the debate comes here, as it will, we need to be honest about it.