Tax Research and Education: Flat Tax  
 Tax Research: Estimating Flat Tax Incidence and Yield

 

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Estimating Flat Tax Incidence and Yield: A Sensitivity Analysis

Summary

Amy Dunbar and Thomas Pogue. National Tax Journal, June 1998: 303-324.

 

This research estimates the distributional effects of replacing existing federal income taxes with a flat tax as proposed by Representative Richard Armey and Senator Richard Shelby. A 1996 study by the U.S. Treasury estimated that enacting the Armey-Shelby (AS) bill would increase the tax burdens of all but the highest income class. In contrast, Hall and Rabushka (1995), the most persistent and articulate proponents of a flat tax, have concluded: "The current personal and corporate taxes tax wages heavily and business income lightly. The flat tax would reverse this inequity and benefit the great majority of Americans, whose income comes almost entirely in the form of wages."

These sharply divergent views of the incidence of a flat tax motivate the present study. We identify some of the main issues that arise when estimating the effects of switching to a flat tax. Then for alternative assumptions about how these issues are resolved, we estimate the amount that each taxpayer in a representative sample would gain or lose if existing federal income taxes were replaced by the AS flat tax. We estimate the number of winners and losers in each income class as well as the aggregate gain or loss for the class as a whole. We also estimate gains and losses for modified, more progressive versions of the flat tax. Estimates are based on samples of individual taxpayers obtained from U.S. Treasury Statistics of Income files for years representing a high employment year (1988) and a recession year (1991).

Although the effects of switching to a flat tax cannot be estimated precisely, our main conclusions appear to be quite robust. Switching to the AS flat tax would increase the tax burdens of a majority of taxpayers, and it would significantly redistribute tax burdens, mainly from top-decile to other taxpayers. Lighter taxation of capital income would combine with the loss of tax-free fringe benefits to increase the tax burdens of more than three-fourths of the worker-taxpayers who receive most of their income from wages and salaries. The more generous standard deductions and exemptions included in the AS proposal would not protect lower income taxpayers from losses, since they would lose the earned income tax credit and bear the burden of the flat tax on non-pension fringe benefits and employers' share of payroll taxes.

This pattern of redistribution emerges even when the AS version of the flat tax is modified, as some have suggested, to allow both employers and employees to deduct their payroll taxes and employers to deduct all fringe benefit expenses. The flat tax would therefore be less progressive than the present system, even if it is significantly modified to favor lower income taxpayers.

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