Monday, Jan. 29, 1996

IS THIS TAX FLAT UNFAIR?

By Dan Goodgame/Washington

IF THE FLAT TAX WERE A PERSON, it would be a little like Steve Forbes: straightforward and artless on the outside, more complex on closer examination. The political appeal of Forbes' flat tax--a single, 17% rate on all income above a generous personal exemption, and no deductions--lies in its apparent simplicity and its promise to close loopholes for the wealthy and well connected. The proposal has economic appeal as well: a simpler tax code could boost middle Americans' stagnant incomes, in part by freeing much of the $80 billion-plus that individuals and businesses now spend each year on tax compliance and avoidance.

But the spareness of Forbes' flat tax is deceptive. Yes, taxpayers would pay a single rate on their income above a certain threshold: for example, above $36,000 for a family of four. (And families below that threshold would pay no income tax.) But it is almost impossible to sort out fully the economic burdens that would result from the system's new rules. This much seems clear: the scheme Forbes is pushing in his television ads looks as if it would either swell the federal deficit or raise taxes on middle Americans while bestowing extra riches on the rich.

The public fascination with Forbes' plan is based on at least one large misconception: "People think that the flat tax, by closing loopholes, will make the rich pay more," populist Republican analyst Kevin Phillips observes. Voters sometimes bluntly tell Forbes that they like his tax plan because it would ensure that rich people like him, with fancy lawyers and lobbyists and accountants, paid at least as much as the average taxpayer. In fact the rich already pay more. The Joint Committee on Taxation, which is controlled by Republicans in Congress, says the best-paid 1% of Americans, who declare more than $219,770 in annual income, fork over 27% of it to the irs, in contrast to 5% paid by Americans earning the median income of $32,364. Forbes says he knows these numbers. But rather than correct his supporters, he nods and flashes that endearing smile.

As Forbes readily concedes when he is questioned, his flat tax would deliver a double windfall to the wealthy: it would slash taxes on top salaries more than a third and eliminate taxes on savings and investments, including dividends, interest on savings, capital gains, inheritances and Social Security benefits. A family earning $1 million a year, for example, would save $168,836 in taxes under the Forbes plan--a cut of 68%. Pollster Frank Luntz, who market-tested the House Republicans' Contract with America, says his surveys and focus groups show that middle Americans don't mind if the wealthy get a tax break as long as they get one too. Forbes agrees, and claims, "Everyone gets a tax break with the flat tax."

But if that's true, the flat tax would collect less money than the current system, at least in the short term. Robert Hall, a conservative Stanford University economist, who with his colleague Alvin Rabushka literally wrote the book on the subject (The Flat Tax, 1985), estimates that Forbes' scheme would widen the federal deficit by $182 billion a year--just when a majority of voters in both parties say they want a balanced budget before new tax cuts. Forbes, a believer in the quasi-theology called supply-side economics, assumes that tax cuts, even when financed by federal borrowing, will generate so much economic growth that they will quickly wipe out the deficit. He paints a vision of wealthy investors shifting their money out of T-bills and into new factories and inventions. It may not have worked that way in the 1980s, when top tax rates were slashed and the deficit soared, but that's the reason supply-siders are often described as optimists. Though he generally holds that "the deficit is not our biggest problem" and declines to specify spending he would cut, Forbes has taken to hedging his supply-side bet. He now asserts that a Republican Congress is far more likely to cut spending, especially on the military now that the cold war is over.

Still, even conservative economists and tax experts say middle-class Americans are not likely to make out as well under the Forbes plan as he promises. To raise as much revenue as the current tax system, the Hall-Rabushka plan starts at a 19% tax rate, 2 points higher than Forbes', and exempts much less income from taxation--$25,000 instead of $36,000. Hall and Rabushka estimate that under their proposal, taxpayers with incomes between $30,000 and $90,000 would pay slightly more in income taxes than they do now. That is in part because an unavoidable cost of the simplicity of a single-rate tax is lower tax collections from the wealthy, and that revenue must be recouped somewhere. In their plan, and in Forbes', the nonrich would probably lose in other ways as well. Because most businesses, shorn of special tax breaks, would face higher effective tax rates, they would probably pass along that cost as higher consumer prices. Denied a tax break for employer-provided health insurance, companies would either curtail those benefits or reduce wages. And under Forbes' plan, there would be no relief from the biggest tax burden that faces most workers: the 15.3% Social Security and Medicare payroll taxes.

Forbes' rise in the polls has led to a case of me-tooism among his G.O.P. rivals, several of whom quickly announced their flat-tax plans last week even while attacking Forbes' scheme as favoring, in Pat Buchanan's barb, "the boys down at the yacht basin." Buchanan and Senator Phil Gramm offered single-rate tax plans that would retain the popular deductions for mortgage interest and charitable contributions and would tax investment income. A long-shot candidate, self-made tire magnate Morry Taylor, asks why Forbes would charge him nothing on the $15 million he collected last year in stock profits but charge his workers full tax on their wages. Says Taylor: "It's nuts."

In this highly charged debate, a commission chaired by former Housing Secretary Jack Kemp (a Forbes mentor) last week ducked almost all specifics even while endorsing the idea of a single-rate flat tax. Meanwhile, tax reformers with other ideas are also stirring. Another G.O.P. presidential hopeful, Senator Richard Lugar, is pushing a national sales tax, which he says would allow him to abolish the irs while scooping up billions of dollars in unreported income from drug dealers and others who now don't pay income taxes--but do buy cars and groceries subject to a sales tax. The downside is that to raise as much money as the income tax, a national sales tax would reach a staggering 20%--a level that in other countries has prompted elaborate evasion schemes.

Lawmakers who favor another version of the sales tax--a European-style value-added tax, or VAT--hope to introduce legislation next month. And Senators Sam Nunn of Georgia and Pete Domenici of New Mexico want to keep progressive tax brackets while exempting from tax all savings and investment. Critics say their scheme rivals the Clinton health plan in complexity and incomprehensibility.

The White House is so tickled by the spectacle of Republicans bashing one another as tools of the rich that it is not inclined to get in their way. "This is class warfare Republican-style," Vice President Gore told TIME. Is a flat tax really such a godsend, he wondered, for the 70% of Americans who do not itemize and thus file a one-page form? As for the burden of complexity that the current system imposes on investors and companies: even proponents of radical tax reform concede that this country has never seen anything so tangled--or so likely to encourage an orgy of special-interest lobbying--as the writing of crucial "transition rules" that would be required to get from the current tax code to something entirely new. For example, capital-intensive companies like automakers would love the flat tax's immediate expensing of new plants that now must be amortized over several decades. But firms with lots of debt (like United Airlines, RJR Nabisco and Time Warner) would lose the tax subsidy for borrowing, and would work hard to slow the pace of change.

For Democrats, staying on the sidelines of the tax-reform debate might be smart politics for now, but it poses risks, perhaps as early as November. Last week's TIME/CNN poll shows that the public wants a simpler, fairer tax system that encourages savings and investment. Although these goals sometimes conflict, they can be balanced. It is possible, for example, to eliminate all deductions, exempt savings and investment from tax, and retain progressive tax brackets; tax expert David Bradford drafted just such a plan, still much admired by tax-reform aficionados, during the Ford Administration. Alternatively, some liberals have suggested a flat tax low enough to cut payments for all, combined with either a tax on accumulated wealth, which several European countries have, or a tougher tax on big inheritances. Steve Forbes wouldn't like either of those ideas. But give him this much: with his single-minded determination and $12 million in TV ads, he has given the debate a lively start.

--With reporting by John F. Dickerson and J.F.O. McAllister/ Washington

With reporting by JOHN F. DICKERSON AND J.F.O. MCALLISTER/WASHINGTON