Want a 17% tax rate?

Steve Forbes may be a geek. But, as Rupert Cornwell explains, his idea for a single, flat-rate tax has made him the hot candidate of the presidential primaries. Diane Coyle asks whether it could work here.
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The Independent Online
Maybe the fiscal advisers of the Almighty should be credited with the idea. The notion of a flat tax, which according to some polls has made Steve Forbes the hot Republican candidate in the early stages of this year's presidential elections, is not new. If Mr Forbes, who is the front-running Republican candidate according to some polls, had set the rate of his proposal at 10 per cent, he could have called it the tithe - the Church's flat tax of medieval times. In the modern era, economic supply-siders and libertarians have frequently toyed with the idea. Back in 1992, the eccentric former governor of California, Jerry Brown, made a 13 per cent flat tax part of his campaign for the Democratic nomination. The derision was almost universal, but in the end Brown proved to be Bill Clinton's most tenacious challenger.

Today, on the opposite end of the political spectrum, the pattern is repeating itself. Mr Forbes, a multimillionaire magazine publisher whose first-hand campaign experience could be conveyed on a blank sheet of paper, has made a 17 per cent flat tax the centrepiece of a run for the White House, which seems less improbable by the day. Install a flat tax, says Mr Forbes, and an individual's tax return form will be downsized from a magazine to a postcard, the IRS (America's equivalent of the Inland Revenue) will lose much of its raison d'etre, and the special interest groups which clog the arteries of government demanding tax breaks and concessions would wither and die. The lobbyists who cram Washington pressing their interests would be out of jobs.

No one likes taxes but Americans hate them and, not surprisingly, they are listening to Mr Forbes's siren call. From nowhere, Mr Forbes has shot into the lead in the state of New Hampshire, scene of the first of the series of primary elections to select the Republican candidate.

Mr Forbes has pushed tax reform to the top of the national agenda. Two of his presidential rivals and a blue-riband Republican Congressional commission have endorsed variants of the idea. A third Republican candidate, Senator Dick Lugar of Indiana, would go further still: he would abolish income tax and replace it with a sales tax. Even Democrats concede it is time to simplify the tax code.

The Forbes plan would sweep away the income tax bands of 25 and 33 per cent, as well as the mountain of special exemptions for money given to charity. Most importantly, it would abolish exemptions for mortgage-interest payments.

In the place of the complex US tax system, there would be a single rate of tax of 17 per cent for all individuals and corporations. For families, the first $36,000 of income would not be taxed; so poor families would be taken out of the tax net altogether. There would be no tax on savings, dividends or other unearned income.

So far, so good. But the flat tax is double-edged. Unabashedly, Mr Forbes concedes that a flat tax means less tax - for everyone. From which it follows that, barring spending cuts of which even the most hawkish Republican dare hardly dream, the government budget deficit will increase. And if there is one thing the American public feels more strongly about than taxes it is balancing the budget.

The most authoritative estimate so far, from Alvin Rabushka and Robert Hall, two Californian academics who wrote a 1985 book on the subject, is that the "pure" version of flat tax advocated by Mr Forbes will raise the deficit by $182bn. If the Treasury is not to lose revenue, they say, the flat tax must be at 19 per cent, and the amount of income that goes untaxed must be fixed at $25,000.

Nonsense, Mr Forbes retorts. Freed of its burdens, the US economy would take off as never before, bringing a windfall for the Treasury that would more than compensate for revenues initially lost through the lower tax rate.

Alas, the US has been round a very similar course before. Ronald Reagan, whose optimism if not oratory Mr Forbes shares, was the last great proponent of supply-sideism, memorably if unavailingly dubbed "voodoo economics" by George Bush in that 1980 election campaign. Under Mr Reagan the economy grew, but so did the deficit. "Deja voodoo," mock the critics of the Forbes plan, hastening to point out for good measure that the biggest beneficiaries of a single tax band would be people like Mr Forbes, with an estimated fortune of $450m and substantial unearned income. In the words of Pat Buchanan, another Republican contender, its an idea dreamt up by "the boys at the yacht club".

Ah yes, says Mr Forbes, but with a flat tax the rich would lose the loopholes created to pander to their special interests. According to the Washington- based Tax Foundation, Americans who make $200,000 (pounds 133,000) or more a year pay tax of 28 per cent. Forbes would give them a big tax cut.

While helping the very well-off, the flat tax would hit the middle classes by removing the supreme perk of middle-class, home-owning America, the mortgage-interest deduction. By a two to one margin, according to a Time magazine poll, Americans disapprove. Yet another Republican candidate, Senator Phil Gramm of Texas, is therefore trying to trump Mr Forbes with a 16 per cent flat tax retaining the charity and mortgage deductions. It would send the deficit into the outer atmosphere.

Amid the smoke and thunder, only one prediction can safely be made: the flat tax will not be enacted in anything like the mooted form. Many Republicans oppose it, so do the bulk of the Democrats. Forbes's lasting contribution might be to hasten a simplification of the tax code. That and possibly throwing open the Republican race to fight Bill Clinton.

RC

Pay tax at a rate of only 17p in the pound, whatever your income. Sounds appealing? The idea of a flat tax is the brainchild of the radical right across the Atlantic, yet Britain's tax system is already much closer to a flat tax. It is that which makes the argument for adopting it here less compelling.

A flat tax means a much lower rate for everyone - individuals and companies alike - paid for by the abolition of special allowances and exemptions. Its message is alluring: by simplifying the tax system you can lower the overall rate of tax and, in the process, liberate the entrepreneurial spirit of a nation.

A flat tax is proportional. It takes the same share of people's income at all levels. Even if you earn pounds 100,000, the next pounds 1,000 you earn would be taxed at 17 per cent. By contrast, under a progressive system such as Britain's, that extra pounds 1,000 would be taxed at 40 per cent.

The other main point about a flat tax is that a generous basic allowance would keep low-income families out of the tax net altogether. Under the Forbes plan, families earning less than $36,000 would not pay tax at all. Apart from that, however, there would be no exemptions for savings, pensions, mortgages or healthcare plans. The money saved by abolishing these exemptions would fund the cut in the basic rate of tax.

Ironically, Britain is closer to Forbes's tax nirvana than America. "Britain already has a flat tax with an exemption for the low-paid," says John Kay, an economist with the consultancy London Economics. Even though there are three times as many higher-rate taxpayers as in 1979, only 5 per cent of taxpayers pay the top rate of 40 per cent. The lower rate of 20 per cent introduced by Kenneth Clarke in 1994 has complicated the tax structure, but the bulk of most people's income is taxed at the basic rate of 24 per cent. In addition, there are far fewer exemptions in Britain whose abolition could fund a significantly lower flat tax rate.

The case for going the whole hog for a flat tax would have two strands. One would be to make it easier for people to work out their tax bill while also closing loopholes which allow them to avoid paying their due.

Jonathan Leape, a London School of Economics tax expert, says downsizing the tax avoidance industry which feeds off a more complicated system is a powerful argument for simplification. "Tax avoidance is a sheer loss to the economy. It employs people in activities that add no value at all," he says.

The second rationale for a flat tax is that it would improve incentives to save. At present, the British save out of their after-tax income and then are taxed on the returns to their saving. They pay the taxman less if they spend instead of save: this is an incentive to do the former.

Making saving more attractive is one of Forbes's aims. Yet in Britain we do not have anything like the penalties to saving that they have in the USA. According to Andrew Dilnot, director of the Institute for Fiscal Studies: "We are moving towards a tax rate of zero on savings." Savings plans such as Tessas are tax-free and some forms of saving in Britain - pensions and housing - even get a subsidy.

It is because the British tax system is relatively simple and does not penalise saving that a flat tax has little attraction here. The other main argument against it is that it would most benefit the richest by delivering a big tax cut for those on high incomes.

"The only motivation for a flat tax in the UK is wanting to cut tax rates for those on high incomes," says Mr Leape.

That, of course, is precisely the aim of the British right. "What remains contentious in Britain is whether there should be a higher rate," says Barry Bracewell-Milne, tax expert for the Institute of Economic Affairs, a free-market think-tank. In America, he says, there is a tradition of hostility to progressive taxation. The notion that the tax system should be used to redistribute money from the well-off to the poor has little hold in the US. In Britain it still does.

Conservative plans would make the British tax system more like a US-style flat tax. The Conservatives have made a 20 per cent basic rate their aim and would also like to reduce the higher rate. Labour's plans would make the tax system more progressive but also more complicated. Shadow Chancellor Gordon Brown has announced plans to cut tax for those on low incomes to 10p in the pound. Many suspect Labour would also increase the higher rate of income tax. Either move would make the structure of tax rates more progressive than it is now, but even that would not change the broad outline of the simple structure and low tax rates of the British system.

As far as tax goes, America still has some catching up to do.

DC

US taxes: the basics

There is no PAYE system. Income Tax is self-assessed. About 98 per cent of Americans work out their own income tax, completing an annual tax return.

In most states Americans pay taxes to their state government as well as the federal government in Washington. Deductions and exemptions are labyrinthine and vary from state to state.

The average tax bill for each American will be $4,701 this year, 7 per cent higher than last year and 72 per cent greater than 10 years ago, according to the Tax Foundation think-tank.

In 1994 the average American paid 22.4 per cent of income in federal taxes and 11.8 per cent in state and local taxes.

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