Flat tax - flat wrong? - Letter to the Editor

National Review, Dec 19, 1994 by Richard K. Armey

What in the world have you done to Larry Kudlow? In an otherwise fine article on GOP tax proposals [Oct. 241, he suddenly parted with the "many free-market types" who support my flat tax and fired the charge that my plan will "wreck the housing market."

My plan calls for a flat tax rate of 17 per cent with no deductions other than highly generous personal allowances ($13,100 for individuals, $26,200 for married couples, plus $5,300 for each dependent child). Investment income is taxed only once, at its source, rather than two or three times, which is the case now. In effect, while lowering overall tax rates, the plan offers taxpayers the equivalent of an unlimited IRA and an elimination of the capital-gains tax.

This can't help fueling the real-estate industry--first, because the housing market is closely tied to rising wages and a growing economy, and second, because it will vastly improve capital formation, on which the industry's health depends. Without today's lunatic double taxation of savings, the capital pool will expand dramatically, which will lower interest rates, increase housing demand, and buoy real-estate prices at or above their current level. Far from being "wrecked," the housing market will prosper in the flat-tax boom.

As for individual taxpayers who might be nervous about losing their home-mortgage deduction, anyone with a pencil can quickly see they get a much better deal with the flat tax. Take a family of four making $50,000. If they're typical, they might take $23,700 worth of deductions under today's code ($10,000 in personal exemptions, $7,700 for housing interest, $3,500 for state and local taxes, and $2,500 in charitable contributions) and pay high rates on the rest of their income. Under my flat-tax plan, however, they would deduct a larger amount ($36,800) and pay a lower rate after that. Few such families will miss their itemized deductions while they are pocketing substantial tax cuts ($800 in this example).

Today's tax code is as much a tool for social engineering as it is a method of raising government revenue. It's an offense against free-market economics. I have great respect for Larry Kudlow's opinions, which are normally unerring. I expect to convince him to come home and support a fair, neutral flat tax.

Dick Armey

Member of Congress

Washington, D.C.

While I agree with the theoretical tax-policy principles of simplicity, fairness, and rate reduction I remain unconvinced of the political or economic desirability of Dick Armey's current flat-tax proposal. In his example, Mr. Armey underestimates the impact of repealing the state and local tax deduction, which includes the homeowners' property tax as well as state and city income taxes.

I also believe that ending the mortgage-interest deduction would be quite painful, including the steep transition cost of refinancing mortgages in a period of rising interest rates. The combination of these two deduction eliminations would damage home values severely. Remember, the mortgage deduction and the state and local tax deduction were designed in part to equalize regional differences. The flat tax would remove this benefit, and effectively would tax taxes.

Additionally, since the Gingrich/Armey Contract with America includes a middle-class tax credit for families with children, does the flat-tax proposal mean to repeal this credit after one year? A flat tax must end all existing credits and deductions. Wouldn't this prevent tax credits or deductions to reform health care? Or the tax-credit proposals in the Contract for family adoption and senior citizens' dependent care? What's more, should people making less than $36,800 be totally exempt from income taxes? Might this not create a tax-free constituency that could be exploited by a future liberal Congress in order to raise taxes on those who still pay them?

Then again, what of the payroll tax? This is surely the greatest barrier to full-time employment for middle-class workers and family-owned businesses. Unless Social Security and Medicare are fully reformed in the years ahead, today's payroll tax of 15.3 per cent could easily rise to 20 or even 25 per cent during the first quarter of the next century. Yet there is no mention of the payroll tax in the flat-tax proposal.

Finally, a good many taxpayers remember well the broken promises following the 1986 Tax Reform Act. Numerous deductions and credits were eliminated, in return for lower income-tax rates. However, since then tax rates have increased sharply from 28 per cent to 40 per cent, income thresholds have been lowered, the number of tax brackets has increased from two to five, and the number of deductions continues to shrink. In a perfect world a repeat of post-1986 on an even grander scale would not be a potential hazard. But we do not live in a perfect world. This is why I am opposed to repeal of existing deductions; it is the people's money, not the government's. And the government cannot be trusted.

Right now, I would be perfectly content to see passage of the more moderate tax proposal embodied in the Contract, bolstered by a rollback of the Bush-Clinton tax-rate increases. Should revenue score-keepers find this package to be deficit enhancing, then we must find additional restraints in federal spending to pay for it. As Mr. Armey and I both believe, maintaining the lowest possible budget share of the economy, along with appropriate tax incentives to reward the extra hour worked, dollar invested, or risk taken, is the surest recipe to maximize economic growth. Then we can have a long sit-down in order to study ways and means to a more perfect tax policy.