Executive Summary

Tax reform is Washington's latest answer for the discontent Americans feel with national politics and their own economic prospects. Several presidential hopefuls have promised to replace the current system with a new flat tax or a national retail sales tax, and others would substitute a new consumption-based income tax. Among the various proposals, the flat tax in particular has gained a following, probably because it purports to use tax reform to change politics as well as the economy. As we will see, its advocates claim too much. In fact, their analysis of the current tax system is often wrong. Their promise to reform politics is largely empty. And the policy would probably leave the country worse off, both socially and economically, than it is now.

The three basic measures of a sound tax system and sensible reform are simplicity, growth, and equity; none of the current reform strategies meet all of these tests. The key to the initial popularity of a flat tax is the first measure, its radical simplicity. It would abolish almost all tax deductions, credits, and exclusions in both the personal and corporate income taxes. Make no mistake, such simplification is sound economics. The less the tax code influences how people and firms consume, save, earn, and invest their income, the more efficiently America's markets can allocate the economy's resources. And by broadening the tax base, simplification allows us to raise the same revenues with lower tax rates and lower tax rates, like lower taxes, are almost always better for an economy.

The public is drawn to drastic tax simplification, however, because it sees it as an attack on the quiet arrangements and tacit corruptions that allow powerful industries and wealthy people to secure special tax treatment. Even so, the flat tax plans offered by Rep. Richard Armey or Steve Forbes would not deliver such political reform. While they would repeal scores of special provisions used today by profitable businesses and wealthy people to shelter part of their income from tax, they wouldn't end the privileged tax status of the well-heeled. That's because both plans would replace those special provisions with new and much broader tax exemptions covering all personal income derived from interest, dividends, or capital gains, and all business income used for capital investment.

Flat tax advocates defend these blanket exemptions by shifting the argument from political reform to the second measure, economic growth. Sharply progressive tax rates, they insist, discourage the most productive people from working and saving more, which in turn reduces growth for everyone. The flat tax's answer has two parts. First, it would eliminate the personal tax on income from savings and replace progressive tax rates with a single flat rate on the income from labor. Second, it would channel new savings to traditional capital investment by allowing firms to deduct the full cost of new purchases of plant and equipment.

This defense relies on faulty data and flawed economics. The data, first, refute the claim that the current federal tax burden is sharply progressive. Taking all forms of federal taxation into account personal and corporate income taxes, payroll taxes, and excise and estate taxes middle class families already pay roughly what they would under a pure flat or proportional tax, or a little less. The federal tax burden on the most affluent people is only modestly greater. Even for the richest 1 percent of Americans, more than 70 percent of the taxes they pay represent merely their proportional share of the costs of government.

Second, the 1980s demonstrated that tax cuts for various forms of personal savings and business investment have little effect on overall saving and investment rates. In 1995, despite more than $120 billion in direct tax incentives for personal saving, the U.S. personal savings rate remained less than 5 percent. And even if such tax incentives did work as flat taxers claim, that wouldn't guarantee higher national growth. Studies of what makes the U.S. economy grow have found repeatedly that technological innovation and improvements in the skills of the work force are six-to-seven times more important than business investment in plant and equipment in promoting higher growth and incomes. As a result, the flat tax growth strategy has a serious problem of scale: To achieve a permanent 1 percentage point increase in economic growth, we would have to nearly triple our current national savings rate.

In an upcoming report, the Progressive Foundation will offer a growth-oriented strategy for tax reform designed to stimulate not simply savings but economic innovation, efficiency, and productivity. In this report, we will examine and analyze the current system and the principal proposals to change it through the optic of tax equity and fairness.

The terms of tax fairness

Fairness in the tax system matters because tax collection depends vitally on voluntary compliance. Paying taxes is also most Americans' chief point of contact with their government, and probably their closest approximation to a common civic experience. Yet, some analysts today dismiss equity issues and, with increasing boldness, insist that regardless of their effects on fairness, all tax cuts are desirable because government's right to tax is less than fully legitimate.

Behind this disdain for tax fairness lies a critique of democracy itself. It posits that the economic choices of individuals are morally superior to the political decisions they make as a community because in some important sense people are "natural" while governments are merely "artificial." Those who make this case misunderstand markets as well as democracy. Society probably cannot maintain itself without individual property rights, but the economic activities that produce property occur within a fabric of relationships shaped by the social and political institutions that people create for themselves. Individuals exercise their economic choices, then, within associations and corporations, which are creatures of the law, and so also, of the political decisions of communities.

Without a doubt, most people don't enjoy paying taxes. But in a democracy like ours, people contribute private resources to provide the public goods they deem appropriate as a community, including helping those unable to make their way by themselves. In America, paying taxes embodies a civic relationship of mutual responsibility, and people's obligation to pay them is as legitimate as any other public duty.

Among those who do not question a citizen's obligation to pay taxes, there are two broad views of the meaning of tax fairness. Fairness under a proportional or flat tax emphasizes equality: Everyone should be subject to the same tax rules, and therefore, everyone should pay taxes at the same tax rate and bear the same relative tax burden. By contrast, fairness under a progressive tax system stresses people's different circumstances: All people should pay taxes according to their ability to do so, and therefore, the tax system should exempt the poor and apply to everyone else tax rates and relative tax burdens that increase with income.

Conservatives generally believe that a flat tax will best protect people's individual liberty, because by burdening everyone equally, it creates the broadest constituency possible for limiting government's demands on individuals. Moreover, because a truly flat tax imposes an equal economic burden on everyone, it does not affect the market's distribution of income. This provides the basic measure of a genuine proportional tax: Each person and each income group claims the same share of national income after paying taxes as it did before paying them. And this is thought to be just because, from a conservative's vantage, markets distribute income based on how hard and well people work.

On the other side of the debate, liberals generally believe that progressive taxes protect individuals better than a flat tax, by curbing concentrations of economic power that threaten the opportunity of others, and by providing poor families with the resources they need to live independently. From this vantage, people's incomes reflect not only their own efforts but also a universe of circumstances they cannot affect; therefore the market's distribution of income is not the final word on economic justice. True equality of opportunity becomes a social achievement, one that tax progressivity advances by changing the market's distribution of income. This provides the fundamental measure of a progressive tax system: After paying their taxes, those at the top are left with a smaller share of all national income than before, and those at the bottom a larger share than before.

Both approaches to fairness can claim some basis in economic theory. The economic logic for a pure flat or proportional tax rests on the basic market notion that people produce economic goods and services because they expect to reap economic benefits. All taxes reduce the benefits people receive from working and investing but, the argument goes, a flat tax should discourage work and saving the least because a system with only one tax rate will have the lowest possible top tax rate. In addition, a market will produce goods and services most efficiently when its resources are allocated through prices that directly reflect everyone's individual preferences and taxes should reflect the "prices" people would pay for the public goods provided by government. Since traditional public goods such as national security or public parks benefit everyone equally, efficiency dictates that everyone pay taxes at the same rate to finance them.

The economic theory behind progressive taxation begins by separating the tax system from the economy that provides its resources. By this view, people work and save because they need or want certain benefits. The existence of taxes does not change those needs or desires, and so should not discourage work and saving. Therefore, tax rates could reasonably rise with income without imposing additional economic costs. In addition, just as an efficient economy uses its most productive resources first, until the cost of using more of them equals the cost of using something else, so an efficient tax system should provide that all taxpayers bear an equal sacrifice. From this optic, tax rates should rise with income, so that an additional dollar of tax entails the same sacrifice by people at every income level.

By itself, economic theory cannot choose between the two cases, and hard economic evidence does not fully support either side. As near as we can tell, tax rates do affect work effort and savings, but only when the rate is very high, and then only to a modest degree. Moreover, the impact of high tax rates is even smaller when people can protect their income from these rates by claiming various deductions, exemptions, and exclusions and that's almost always the case. Yet, relatively high tax rates and tax burdens also cannot produce economic equality. Progressive taxes apply only to people's annual income, not to their accumulated wealth, and so have only modest effects on concentrations of economic power. Moreover, while high income people don't stop working or saving because their marginal tax rate is high they find ways to avoid it or live with it the transfers financed by their taxes can affect the work efforts of those receiving them. In any event, lifting tens of millions of low income people into the middle class by direct income transfers would require much higher taxes not just on the wealthy, but also on strapped middle class families.

Ultimately, progressive taxation has the better of the argument. Flat taxers may be right that it would be morally offensive to tax higher income people more heavily if differences in income reflected only how hard different people work. But income differences reflect much more than that, if only because people don't start in the same place. People are born with different talents and come to age in families, neighborhoods, and cultures with different resources to prepare them for market competition. And plain luck often plays a role.

America's wide-open markets accentuate the impact of all these factors, so that those with more ambition, self-discipline, and talent can prosper greatly. Bill Gates and his investors, for example, would not have enjoyed as great a success in other advanced countries because their markets and laws would not have provided so hospitable an environment. And once a person or family's economic success is secured, America's open markets allow them to increase the value of their wealth at a greater rate than in most other places. The economic benefits of free markets are large and obvious. But there are social costs, because our open markets and laws also produce harsher economic inequality than in other advanced countries an urgent issue today when economic inequality is increasing rapidly and for reasons that most working people can do little about.

Progressive taxes cannot undo this inequality or restore upward mobility to poor or middle class Americans not even progressive taxes to finance transfer programs. A progressive tax system, however, can protect poor and middle class families from bearing the higher tax burdens entailed in a purely flat or proportional system, and in this sense, ameliorate some of the distributional inequalities achieved through our markets but based on factors other than how hard different people work. And the additional burden of progressive taxation is a reasonable price to pay by those who in some respect start with more, for the privilege of prospering relatively more under America's laws and in her markets. Bill Gates and his investors have a responsibility to not merely bear an equal share of the burden, but a greater share because they enjoy a larger share of the benefits provided by these laws and markets.

Furthermore, when accidents of birth and luck affect people's ability to succeed through hard work, economics as well as social considerations can dictate that they receive the means and opportunity to participate more fully in the economy. At the very least, the tax burden to finance these efforts should be progressive at the bottom so that the tax system does not further impair the ability of low income people to participate. At the top, people with higher income can contribute, within limits, without harming the economy or their own basic freedom. In the end, progressive taxation can trade off the benefits of ensuring a broader distribution of opportunity against the modest costs of higher tax rates and higher tax burdens on some to finance it.

Who pays the taxes

As we will see, the current federal tax burden including the personal and corporate income taxes, payroll taxes, excise, and estate taxes is most clearly progressive at the bottom of the income ladder. The total burden is also progressive at the top, but only moderately so and much of that reflects income tax changes enacted in 1993. For the broad American middle class, the tax system is, on balance, more nearly proportional than progressive, barely affecting the share of national income held by most families. Finally, while everyone would like to pay less taxes, evidence suggests that a substantial majority of Americans would prefer a little more progressivity, so that low income families could pay a little less than they do today and very affluent families would pay a little more.

The current distribution of all forms of federal taxation can be summarized in the following five findings: