In the face of this mess, a flat tax has so much appeal that I yearn to believe. But I have to sign on to the drawbacks laid out here last week by my colleagues Allan Sloan and Robert Samuelson (the plan’s numbers don’t add up; most of the tax cut goes to investors and the well-to-do; backers exaggerate the plan’s effect on growth).
On the positive side, the tax on individuals is pretty clean. There’s not much room for tax abusers to play games.
Business taxes are something else. “The loopholes are large enough to drive a truck through,” says certified public accountant and lecturer Vern Hoven of Missoula, Mont. The flat tax sounds blissfully simple: you’re taxed on your revenues minus “allowable costs,” with all other deductions blown away. But the devil is in the details. Hoven, who has a small-business clientele, says he’ll be building tax shelters for years. If so, the flat tax won’t raise as much money as advertised. Small business won’t be the only gamesters. Some huge corporations also may pay little or nothing.
Business taxation hasn’t been much of a factor in the tax debate. We’ve focused on what reform would mean for our personal returns. But how business adjusts to a flat tax would change our wages and our lives. There are big winners and losers here. Their tax-driven choices wouldn’t be always for the good.
Take the likely difference in tax between a business that makes big capital investments and one that doesn’t. The latter would be much more heavily taxed. That’s because of the way the flat tax treats capital expenditures, on land, buildings and equipment. Their entire cost can be deducted fight away (under current rules, you generally stretch out those deductions over many years). Upfront deductions are worth more than deductions taken over time, because they free up money for other purposes.
With good planning, any company with big capital expenditures–say, in modernization or expansion–could pay low or no federal tax. Startups would be sheltered, too. More of the tax burden would fall on firms with modest capital needs, such as service businesses that spend more on people than equipment.
Capital investment generally is to be desired, and this tax would trigger a ton of it. But it also encourages needless investing. “I’d check my clients at the end of the year,” Hoven says. “If they had a $40,000 taxable profit, I’d tell them to buy $40,000 in inventories to zero out the tax.” Other Hovens would do the same.
This pile of capital spending–some strategic, some purely for tax shelter– would certainly boost growth and jobs. But what happens when Hoven’s clients get overstocked and quit ordering? Business could fall off, workers be sent home. There’s a tendency toward boom and bust.
The flat tax fosters boom and bust in another way. In good times, firms make more capital investments which, under a flat tax, would reduce the tax they owed. In bad times, however, investment dries up–so tax bills would rise, putting a squeeze on business just when cash is scarce, says economist Shvetank Shah of the consulting firm, Price Waterhouse. The current tax system helps stabilize the economy by collecting less tax when business declines.
Leading versions of the flat tax end businesses’ writeoff for social-security contributions–a problem for labor-intensive firms, says Tom Ochsensehlager of the accounting firm, Grant Thornton. That’s an incentive to fire, not hire. The plan also hurts exporters, by wiping out their tax adjustments. Those firms may move jobs abroad.
Applying a flat tax to 1992 returns, Shah found tax hikes in the service industry. Ditto in manufacturing, because of low investments and the hit on exporters. Transportation, communications and utilities did fine. (Small businesses can test their own situations by getting the Flat Tax Worksheet, free with a stamped, self-addressed envelope from the California Society of Enrolled Agents, 3200 Ramos Circle, Sacramento, Calif. 95827.)
All of the flat-taxers’ high-growth projections, by the way, assume an instant transition to the new system. But there could be 10 years of pain along the say, Shah says. Consumption would drop, if people really saved more and spent less. Leveraged businesses might find it hard to carry their debts, after they lost the interest deduction. State tax systems would be upended.
In the real world, Congress would pass phase-in rules, so firms would lose deductions gradually. But then there would have to be a higher flat-tax rate, or lower personal exemptions, to raise enough revenue. Middle-class taxes would go up and who needs that?
Workers have a lot to lose, if businesses restructured along flat-tax lines. For example, your company could deduct retirement contributions but not money spent on any other benefits. That’s a death warrant for employer-paid health insurance. You might be given a raise and told to buy a policy yourself (if your health doesn’t qualify you for coverage, tough luck). Or your company plan might pay only the big bills, leaving the rest to you.
Tax shelters, however, could boom for business owners who are rich. Take a lawyer due $400,000 from her partnership, which she doesn’t need for groceries. She could buy a $400,000 rental condominium, deduct it from her business income and pay zero tax.
Businesses so inclined would find it easier to cheat. The IRS would have less of the information it needs to track them down. Flat-tax boosters think cheating would decline, because businesses wouldn’t mind paying their tax at a lower rate. Fat chance. Tax cheating rose with the Reagan cuts, because the opening was there.
Don’t get me wrong. I’d love to support a simpler and flatter tax. But the critic H. L. Mencken must have had something like this tax in mind when he wrote, “There is always an easy solution to every human problem–neat, plausible and wrong.”
