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Thursday, September 23, 2004

Andrew Sullivan, in speculating about what a second Bush term would look like, says "I'd love it if he made a real push for a flat tax..."

Andrew, the flat tax is a great idea whose time will never come.

Reasons? At the beginning of any analysis, the purpose(s) of enacting a flat tax have to be examined. The main selling point I have always seen is simplicity. The tax code has become far too complex, and is no longer comprehensible to the average taxpayer. Simplicity is a good thing, at least in the abstract. Our tax compliance system is, in reality, a voluntary one, and ease of compliance will increase compliance, or so it is claimed. So the question becomes, (a) is the objective of simplicity in the tax code achievable and (b) will the flat tax achieve it?

The answers: Probably not and not likely at all.

First, the US economy is the most complex in the world. Imposing a tax on that economy requires complex rules. Failure or refusal to enact complex rules will result in simplicity, and simplicity is a good thing. But the corollary to simplicity is unfairness. Simple is easy but, in specific situations, unfair. Complex is hard, but (if not entirely fair) fairer. And, given our system of voluntary compliance, a widespread perception of unfairness will be the system's death knell.

I'm a tax attorney (boo, hiss). People like me get paid to figure out ways to reduce a client's taxes. A simple flat tax will make my job simple. A complex flat tax (if that's not an oxymoron) will not solve the problem that the flat tax aims to solve: Complexity in the tax code. Even if, by some political miracle (see below), a flat tax was enacted, exceptions will creep back into the law as legislators try to combat the perceived unfairness resulting from the new tax in specific situations.

Second, the tax code, as it stands, contains hundreds, if not thousands, of provisions on which everyone, and I mean everyone, has relied and continues to rely. Deductibility of home mortgage interest and real estate taxes. Deductibility of IRAs/pension contributions. Deductibility of charitable contributions. Those provisions are ones that you and I rely on directly every day in deciding whether to purchase this home or that one, whether make this investment or that one, and whether and to what extent to support our favorite causes. And that short list doesn't even consider the provisions affecting us indirectly, such as the laws pertaining to depreciation, S corporations, partnerships, or the more esoteric provisions concerning trusts, insurance companies, banks or corporate reorganizations, all of which are extremely complex. A flat tax (at least one that would achieve its presumed goal of simplicity) would require the repeal or radical modification of most or all of those provisions. But each one of those provisions has a constituency which will oppose the repeal. Sometimes a very large and very powerful constituency in terms of either numbers or wealth (and thus lobbying clout). I am no politician, but my guess is that logrolling in Congress would result in keeping most of the provisions noted above intact, which, again, will cause the flat tax to fail to achieve its objective of simplicity.

Third, switching to a flat tax will have untold economic consequences. To take just one example, the deduction for home mortgage interest, if repealed, would result in a huge new supply of homes for sale. Millions of homeowners would no longer be able to afford their homes because the mortgage was no longer being paid with pre-tax dollars. All of those home would come onto the market, over a very short period of time. At the same time and for the same reason, the average home buyer's ability to purchase a new home will be reduced, in terms of the amount of money he can afford to spend. That would result in a drastic reduction in the value of real estate. It might not be a crash, but it sure would look like one in the short run.

Fourth, the bulk of the wealth of the average American is in the value of his home. Unless the deduction for home mortgage interest and real estate taxes is maintained, the flat tax will be perceived as an attack (even if not a deliberate one) on the wealth accumulated over the years by the average Joe. If you are going to maintain that deduction, the argument for eliminating others is significantly weakened.

All in all, I don't think a flat tax will happen, and if I am wrong and it does happen, I don't it will last.
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