Ethics & Public Policy Center

A Flat Tax That is Good for Families, Not Just for Business

Published in Family Policy, November-December 1998 on November 16, 1998



Exactly fifty years ago in the face of a huge budget surplus, a Republican Congress prevailed over the veto of a Democratic president to enact the most family-friendly tax cut in history. Congress raised the personal exemption to $600—the equivalent of $7,000 today—and introduced “income splitting” between husband and wife, resolving the marriage penalty that would reappear in later years. The legislation not only provided financial incentives for marriage and penalties for divorce, but effectively kept most middle-class families in the lowest tax bracket or shielded them from the income tax altogether. Coupled with the family-oriented structure of the Social Security system—low payroll taxes and family-based benefits—the dramatic tax measures of the late 1940s helped usher in a golden family age known as the Fifties. For the first time in more than a century, the first-marriage rate rose, the divorce rate dropped, and the within-wedlock birth rate climbed, according to social policy expert Allan Carlson.1

Although history rarely repeats itself, Congress found itself in a similar situation this year. The federal government ran a $71 billion surplus, the first one since President Nixon’s inaugural year and the largest budget surplus in American history. Republican congressional leaders, however, did little to advance the kind of family-friendly tax reform plan that would have honored their 1948 forefathers. Even worse, every time the Congressional Budget Office raised its forecast—its most recent report projecting a $1.6 trillion cumulative surplus through fiscal year 2008—the Republicans scaled back whatever tax-cut plans they had proposed.2 In the end, the Party of Lincoln was forced to kowtow to a disgraced president, signing on to a budget deal that calls for $21 billion in new spending in 1999, consuming more than one-fourth of next year’s projected $80 billion surplus.

Even when they are not spending, some Republicans are preparing to hoard tax revenue. Senators Phil Gramm and Pete Domenici, for example, have called for the creation of a prodigious federal “reserve” fund, investing the projected surplus in private securities to “protect” Social Security, a proposal the Wall Street Journal describes as “a heap of conceptual baloney.”3 Like the weather that descends on the capital every summer, this typical Washington hot air clouds the fundamental issue on the horizon: the need for substantial relief for the American taxpaying family. That is unfortunate since what Robert J. Samuelson calls “the ‘surplus’ surplus”4 has removed the main obstacles that had put a damper on tax cuts during the deficit years, setting the stage for an unprecedented window of opportunity for serious tax reform.

In light of Republican timidity, social conservatives ought to join forces with economic conservatives in a full court press to demand comprehensive budget and tax reforms to keep federal spending from rising; already, federal taxes are the highest since World War Two, representing 20.6 percent of the Gross Domestic Product. In doing so, social conservatives must not forget their unique agenda: to push for tax reform that is, in the spirit of 1948, just as good for families—especially those with children—as it is for business. They will need to highlight the anti-family bias in the existing tax code as well as in the well-intended Republican tax alternatives, shaping the legislative debate into targeting specific relief toward working families who are investing in the most important capital of the country—the children of the next generation.

 

Human Capital and the Home Economy

 

For starters, keeping faith with 1948 requires the appreciation of the special role of what Allan Carlson calls the home economy vis-a-vis the market economy. As Carlson observes, American tax policy grossly undervalues economic activity that takes place in the home—the sharing of goods and services among family members with little regard to cash calculations. To the extent that the home economy thrives, so does the market economy, where transactions occur through money and where competition and efficiency drive decisions.5 Carlson writes:

 

Every marriage creates a new home economy. These little economies are largely undetected in our measurement of the gross national product, just as they are usually beyond the reach of tax collectors. But they are vitally important. If they thrive, the well-being of children and of society as a whole improves.6

 

Carlson is not the first scholar to call attention to the home economy. Nearly forty years ago, the economist Thomas W. Schultz, who later won a Nobel Prize for highlighting the critical role that “human capital” played in the growth of the United States and the dramatic postwar recoveries of Germany and Japan, expressed a related concern. To Schultz, even the family-friendly tax code of the 1950s needed improvement because it largely ignored the reality of “human capital” as a critical factor in national well-being:

 

Our tax laws everywhere discriminate against human capital. Although the stock of such capital has become large, and even though it is obvious that human capital, like other forms of reproducible capital, depreciates, becomes obsolete, and entails maintenance, our tax laws are all but blind in these matters.7

 

Schultz thought it was odd that the tax code, in granting far more incentives and credits for property than for working families, treats real estate, machines, and equipment far better than it does men, women, and children. If that were true in his day, it is even more so today, despite the Taxpayer Relief Act of 1997, which introduced a long-overdue $500 per child tax credit. As the feminist legislator Patricia Schroeder used to say, Congress has given bigger tax breaks for breeding racehorses than raising children.8

A character played by Cary Grant in the 1951 film, People Will Talk, lucidly explained the problem Schultz described. In one scene, “Dr. Praetorius” finds himself discussing the income tax with a farmer named Higgins and the farmer’s brother, Arthur.

“Got more deductions than I thought,” Higgins explains.

“Most of my equipment don’t cost me a thing, writing it off year by year—what’s it called, Arthur?”

“Depletion and depreciation,” Arthur says.

“Yeah, that’s it. Means it’s running down—don’t work as good as it did.”

“One thing about teachers and writers and such,” observes Dr. Praetorius, “they have less bother with their income tax than farmers and oil-well owners.”

“Is that so? Why?” Higgins demands.

“Because their equipment is talent, and a highly developed mind. And when they run down and don’t work so good as they did their depletion and depreciation can’t be written off their income tax.”

 

The Middle-Class Squeeze

 

Dr. Praetorius could have gone on to explain that all income in the economy comes from two sources: human and nonhuman capital. Workers generate about two-thirds of gross national income, while property generates about one-third of gross national income.9 But for tax purposes, labor and property income are measured quite differently. Property income (such as interest, dividends, and retained profits) is taxed after deducting costs for maintenance, obsolescence, and depreciation; workers’ incomes are taxed without any deduction for the equally real costs of maintenance, obsolescence, and depreciation of their “human capital.”

Some supply-side critics, like Jude Wanniski of Polyconomics Inc., claim the distinction between human and nonhuman capital is an abstraction. Tax breaks and incentives for business, he says, are indirect incentives for families; the more a business can write off expenses for taxes, the more it can pay in salary and benefits to workers.10 While Wanniski’s insight has some merit, the reverse is equally true: the more families invest in rearing and educating children, the greater the long-term economic benefits to business and the economy as a whole. Nor does Wanniski answer the question dear to families: if businesses can write off the cost of machines, why cannot working parents write off the cost of keeping body and soul together?

The federal income tax falls more heavily on employment income because a much smaller share of gross property income is subject to federal tax. As a result, middle-class families end up carrying a disproportionate share of the federal tax burden since their income is heavily dependent on employment. This long-standing discrepancy of taxing human capital more than nonhuman capital has intensified since Schultz’s time. The federal tax burden has shifted from the income tax—which falls mostly on workers—toward the payroll tax, which falls exclusively on workers and is assessed at a dramatically higher rate than in the 1950s, when it was less than 2 percent. Today, more than 60 percent of American workers pay more in payroll tax than federal income tax.

Granted, the federal tax burden as a portion of the Gross Domestic Product has remained relatively constant since World War Two (about 19 percent; although it stands today at 20.6 percent). But when broken down between employment and business income shares of national income, the tax burden on the former has risen from about 17 percent to 22.4 percent, while the tax burden on the latter has fallen from about 30 percent to about 14 percent. In effect, while workers earn about two-thirds of gross national income, they now pay nearly four-fifths of all federal taxes.

Though the shift has been gradual, most families started experiencing what has been called the middle-class squeeze by the 1980s. On the one hand they hear news of economic growth (a roaring stock market, low inflation, and low-unemployment); on the other hand they experience the reality of trying to stretch paychecks to meet living and child-rearing expenses. Even as gross family income has increased to keep pace with economic growth, actual take-home pay of many workers has dropped. If economic trends continue and gross family income continues to rise (lifting more middle-class families into the 28 percent income tax bracket and higher), the squeeze will only tighten. If payroll taxes rise to 24 percent by the year 2030 as recommended by the trustees of the Social Security system, many families will face a marginal federal tax rate of more than 50 percent.

 

Bringing Property Income into the Tax Base

 

How can federal policy resolve this dilemma so that middle-class families who are raising and educating their children keep more of the money they earn? How can Congress reform the tax code so that families enjoy the same kind of tax incentives—whether generous write-offs, depletion allowances, or depreciation—that businesses have enjoyed for years? One way is to expand the tax code with pages and pages of incentives for families. This has been tried with ‘ limited success over the years through narrowly targeted credits, special exemptions and tax-deferred accounts for education, housing, and retirement. To avoid further complicating an already mammoth tax code, a far better approach is to start from scratch with a simple, flat tax that treats labor and property income alike.

Treating labor and property income alike means scrapping the host of write offs and credits that businesses now enjoy, such as deductions for depreciation of capital. Only deductions for maintenance costs for both workers and business assets would be permitted. Maintenance costs for the worker involve the costs of keeping body and soul together. At a bare minimum, deducting “worker maintenance” means exempting a poverty-level income from taxes, including both Social Security and income taxes.

The tax code currently does this haphazardly and insufficiently. Standard deductions and personal exemptions can shield below-poverty working families from the income tax, but not from the regressive payroll tax. The Earned Income Tax Credit, introduced in 1975, was basically intended to offset the burden of the payroll tax for low-income working families. But human maintenance costs vary with family size, which the EITC mostly ignores; the credit is the same whether a family has one or two adults, or has two or six children. As a result, some families are exempt from taxes on human maintenance, but most working families are not. Like the widow’s mite in the New Testament, working families are taxed, not on their surplus, but on their sustenance.

The failure to even acknowledge, let alone address, the discrepancy in the present tax laws between property and employment income is the Achilles’ heel of all the Republican tax proposals, including those recommended by Dick Armey, Bill Archer, and Steve Forbes. While these initiatives admirably seek to simplify the tax code, they do not and will not solve the middle-class squeeze (see “The Republicans’ Grand Old Problem”). In the name of “economic growth,” the Republicans attempt to shift the tax base away from income to consumption, which squeezes the middle class even more.

On the surface, the shift to a consumption tax base sounds appealing, even virtuous. Who can object to taxing people on what they take out of society (consumption) and not on what they contribute (income)? Actually, the issue is not that simple. The current proposals define consumption inconsistently and archaically so that the maintenance of, and investment in, human capital–like raising and educating children–is taxed as consumption, as “taking out of society”. On the other hand, a business that purchases a company car is considered to be “contributing to society.”

A consumption-based tax has other weaknesses of which the middle class ought to be aware. Not only does it continue to shift the federal tax burden away from property to employment income; it also places the tax burden smack in the middle of the income scale, as families at either end of the income scale are largely unaffected. Families at the bottom receive a disproportionate share of their income from government transfer payments, which are generally exempt from taxation; families at the top of the income scale receive more than half of their income from property. But families in the middle earn their income mostly from employment. So while the existing federal tax burden is progressive, the burden of a consumption-based tax is dome-shaped when fully phased in—low at the bottom of the income scale, low at the top, and high in the middle. Fiddling with tax rates or personal exemptions provides only a partial solution because the problem stems from removing property income from the tax base.

Republican strategists would be wise, politically and economically, to avoid the rhetoric of the consumption tax and to seek a completely new paradigm: broadening the existing income tax base by including a greater share of property income. A broader tax base would be more progressive than the current tax code with its multiple layers of taxation (offsetting the exclusion of more than one-half of all property income from taxation), justifying the adoption of a flat tax to those who fear it would be regressive. Treating property and employment income equally would be most effective with a Social Security tax cut. This approach would be a win-win for the Republicans. IT would achieve their desire for serious tax reform which simultaneously correcting the very real public perception that they are the party of big business and do not care about the typical American family.

The Family Flat Tax

 

A family-oriented tax plan would involve the replacement of the existing personal and corporate income tax with a simple flat tax of about 16 percent assessed on the Gross Domestic Product. This would differ from a tax on consumption spending because it disallows deductions for spending on investment property. Therefore, all consumption and investment spending in the Gross Domestic Product would be taxed.

Ideally, the tax would be collected only through business (similar in structure to proposals that call for a national sales tax) on gross business receipts, minus purchases from other businesses. Most households would not have to prepare or file tax returns. But because the Gross Domestic Product includes family spending on human capital maintenance, families would be entitled to an Earned Personal Tax Credit, based upon number of family members, for a portion of the federal and Social Security taxes assessed on their employment income. If the credit was not fully applied to their paychecks, families would need to file a return for a refund. Families realizing capital gains would also be required to file a return.

If the public is not ready for such a wholesale break from the current system, a more conservative approach would resemble the current tax system: requiring individuals to pay the tax on their wages and pensions, minus the Earned Personal Tax Credit, while exempting wages and pensions from the business tax. This more complicated approach would require the filing of annual returns by most families. But it deals with transitional issues better, retaining, for example, the mortgage interest deduction as long as the lender is taxed on the interest. Because most economists believe interest rates would drop under tax reform, such an option would ensure that outstanding mortgage holders benefit from the decline in interest rates. This plan also could retain deductions for charitable contributions—which, unlike most existing tax deductions, have a quasi-public purpose and encourage private sector solutions to social problems.

Either way, the Family Flat Tax would set the amount of the Earned Personal Tax Credit from the aggregate earnings of American families up to the poverty line, estimated to be just under $5,000 per person. A credit against the flat income tax (16 percent) and the reduced payroll tax (12.2 percent) on this amount would be worth about $1,400 per person. For a man supporting his wife and three children with a 1997 median income of $28,808, the credit would be worth $7,000, enough to offset almost all federal taxes on his employment. That worker would have no Social Security or federal income taxes deducted from the first $25,000 of his paycheck; he would also receive a refund (that could be added to his paycheck) of $634 to recover part of the employer’s share of the payroll tax the worker has never seen. Under the current tax system, that same family pays $4,155 in federal income and Social Security taxes, a whopping $4,789 difference.11 For those earning more, the credit remains irrevocable no matter how high the income.

 

Prudent Social Security Reform

 

Critical to the Family Flat Tax is a long-overdue 20 percent cut in the payroll tax. Ever since President Lyndon Johnson placed Social Security in the budget in the 1960s, the program’s excess revenues have been used to disguise the federal deficit. Helped along with hefty tax increases over the years, the program generates nearly $120 billion per year more than it pays out in benefits, counting around $70 billion from tax revenue and nearly $50 billion in interest from its one-to-two year reserve.12 While the public believes that the money goes into a trust fund for future retirees, no such trust fund actually exists—the money is simply plundered by Congress and the president to fund other government projects and programs. In the not-too-distant future, payroll tax revenue is expected to fall far short of promised benefits, mostly because baby boomers have been raising fewer children than their parents, resulting in a relatively smaller work force than a generation ago. Unless the trend is reversed, payroll tax rates will rise sharply even under optimistic economic assumptions.

To address both problems, the Family Flat Tax calls for cutting the payroll tax immediately by 20 percent and reducing future benefits according to the number of years a worker paid the lower tax rate. For example, if an eighteen-year-old paid a 20 percent lower rate for fifty years, retirement benefits would be reduced 20 percent from current estimates. If a fifty-five-year-old worker paid the 20 percent lower tax for ten years, promised benefits would be reduced by 4 percent. Current workers could use the tax cut to invest in human or nonhuman capital.

These changes would reduce the long-term liabilities of the Social Security system and prevent future tax increases. Instead of doubling in real terms over the next several decades as currently projected, the level of retirement benefits would rise about 60 percent faster than inflation. Instead of replacing 42 percent of covered wages, Social Security benefits would stabilize at about one-third of covered wages. Finally, instead of doubling to 30 percent of taxable payroll, as a much smaller generation supports retired baby boomers, payroll taxes would never have to be raised beyond current levels. Social Security would therefore continue to provide a floor for retirement security without crowding out investments in child-rearing and education, family saving, and private insurance.

These Social Security reforms enable the Family Flat Tax to deliver the lowest marginal rates on working families of any tax reform plan. It also provides the most generous tax allowances for families, while providing them with a net tax cut on their employment taxes, precisely because it taxes a larger portion of property income than under current law.

The exact income tax rate, the criteria of the Earned Personal Tax Credit, and the size of the payroll tax cut can be fine-tuned somewhat. However, if the Grand Old Party wants to advance tax reform that provides substantial relief for middle-class families, its plan must contain two elements: first, it must treat property income and employment income the same way, particularly regarding maintenance and depreciation costs; and second. Social Security problems must be addressed to relieve the tax burden on workers and prevent a massive future rise in tax rates. By addressing these weaknesses in the current tax system, the Republicans could help usher in, like they did in 1948, another golden era of family growth and economic prosperity.


NOTES

1. Allan Carlson, “Toward a Family-Centered Theory of Taxation,” The Family in America (January 1998), pp.” 1-2.

2. Congressional Budget Office, “The Economic and Budget Outlook: An Update” (August 1998).

3. “Domenici-Gramm Socialism,” The Wall Street Journal, July 31, 1998, Sec. A editorial.

4. Robert J. Samuelson, “The ‘Surplus’ Surplus,” The Washington Post, May 20, 1998.

5. Allan Carlson and David Blankenhorn, “Marriage and Taxes: The Case for Family-friendly Taxation,” The Weekly Standard (February 9, 1998), pp. 24-27.

6. Carlson and Blankenhorn, p. 25. 7. Theodore W. Schultz, “Investment in Human Capital,” American Economic Review 51 (March 1961): 1-17.

8. Pat Schroeder, Champion of the Great American Family (New York: Random House, 1989), p. 142.

9. John W. Kendrick, “Total Capital and Economic Growth,” Atlantic Economic Journal 22 (March 1994): 1-18.

10. Jude Wanniski, “Humans vs. Machines vs. Taxes,” The Wall Street Journal, letter to the editor, November 16, 1995.

11. For median family income data and tax burdens, see Tax Foundation, Special Report #74 (November 1997), p. 3.

12. Congressional Budget Office, “The Economic and Budget Outlook for Fiscal Years 1999-2008.”

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