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February 23, 2006
Rhetoric Meets Reality in the Democratic 'Flat Tax'
Joseph J. Thorndike

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Rhetoric Meets Reality in the Democratic 'Flat Tax'

Joseph J. Thorndike is a contributing editor with Tax Analysts.

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The Democrats have a tax plan. Thank goodness for small miracles.

In late October, Senate Finance Committee member Ron Wyden, D- Ore., introduced the Fair Flat Tax Act of 2005, an important contribution to the nation's nascent debate over tax reform. In December, House Ways and Means Committee member Rahm Emanuel, D-Ill., introduced companion legislation. Both lawmakers insist that the Fair Flat Tax is not a statement of Democratic orthodoxy. And there are certainly other contenders for that distinction.

Still, the bicameral initiative from two influential taxwriters commands respect. It's gotten some good press, most notably from Washington Post columnist David Broder and Newsweek's Eleanor Clift. Liberal bloggers have been generally lavish in their praise.

And why not? There's a lot to like in the Fair Flat Tax -- just not the name. Or its anachronistic emphasis on tough-minded reform of the corporate income tax.

What's in a Name?

In naming their tax plan, Wyden and Emanuel have settled on a distinctly unlovely formulation, grasping at a dubious Republican talisman. Theirs is not a flat tax, and calling it one obscures its several virtues.

"Flat tax" is a slippery term, with different meanings in different contexts. But in current U.S. political discourse, flat taxes are understood to share at least two characteristics. First, they tax all income above a generous exemption at a single rate. Second, they eliminate all or almost all deductions, credits, and other preferences. And third, most are levied on consumption, not income.

The Fair Flat Tax does none of those things. It would reduce the number of tax rates from six to three: 15 percent, 25 percent, and 35 percent. That's not flat. The plan would also eliminate many loopholes and preferences, which sounds a lot like a flat tax. But it retains many others, including child credits; deductions for home mortgage interest and charitable giving; some tax-preferred savings vehicles for healthcare, education, and retirement; and various preferences for senior citizens, members of the military, veterans, and disabled taxpayers. And it grants all taxpayers a new, refundable credit for 10 percent of their state and local taxes. None of that sounds very flat to me.

Finally, the Wyden-Emanuel plan would repeal existing preferences for dividends and capital income. "Wealth and work should be treated equally," the sponsors declared in a February 17 Wall Street Journal op-ed. Treating all income equally would allow financial markets to allocate investment capital more efficiently, they insist, eliminating politically engineered distortions.

That may qualify as some sort of "flattening," but it doesn't sound much like the flat tax championed by Robert Hall, Alvin Rabushka, Steve Forbes, and Dick Armey. Which is the point, of course.

But it's a mistake to play semantic games like this. As blogger Matt Singer complained on the liberal Sirotablog, "Rhetorically we've already ceded the debate." Stealing an issue doesn't have to involve stealing the language of your opponents. Indeed, that sort of poaching can weaken the case for an otherwise good idea, making it sound like a washed-out version of other, bolder, more radical proposals bearing the same name.

If you're going to steal Republican words, you don't need to steal those words. The flat tax has enjoyed some popular interest over the years, but none of it has been durable. Support tends to evaporate when the details come to light.

When asked by pollsters, Americans still seem to like graduated rates. In an NBC poll last April, respondents chose the current rate structure over a flat rate system by 55 percent to 39 percent. Polls, of course, can be made to say almost anything, and poll results on tax issues are particularly opaque and malleable. But one thing seems clear: The flat tax is no rhetorical magic bullet.

Traditional Tax Reform

According to Wyden and Emanuel, fewer loopholes and simplified rates would translate into a tax cut for most Americans making less than $150,000. At the same time, they say, it would raise more than $100 billion in new revenue over the next five years. Along the way, it also manages to abolish the alternative minimum tax for individuals.

Like other reformers climbing onto the flat tax bandwagon, Wyden and Emanuel focus on the return. The Fair Flat Tax would require a "simple, one-page Form 1040." That's more complexity than most other versions of the flat tax. But then the tax isn't really flat. Whether a one-page form with 30 lines is simple enough to excite voters remains to be seen. It's no postcard, that's for sure.

Wyden and Emanuel are eager to highlight the distinguished lineage of their plan, cloaking it in all the moral authority of the 1986 tax reform law. Since that landmark legislation, they argue, thousands of special interest provisions have found their way back into the tax code. The Fair Flat Tax would clean up that mess, restoring the system to a more pristine condition. "The tax code would receive what it desperately needs," they claim, "a good cleansing."

In fact, the Wyden-Emanuel plan has an even longer pedigree. Like the 1986 act, it's derived from the postwar tradition of incremental reform, including its pivotal trade-off: lower rates in exchange for a broader base. With Stanley Surrey as its patron saint, that compromise -- and the reform agenda that flows from it -- dominated tax policy circles for the latter half of the 20th century. The Fair Flat Tax falls squarely in that tradition -- most of the time.

A Break With Tradition

On the corporate side, the Fair Flat Tax breaks new ground, seeking to broaden the base without lowering rates. It would raise rates for some companies, even as it eliminated many preferences. It would eliminate provisions that benefit one business sector over another as well as those promoting inefficiency in the healthcare system, the sponsors contend.

In exchange for all that, the Fair Flat Tax would offer corporations . . . nothing. It does promise to simplify the corporate tax system, reducing its attendant compliance costs. But corporate rates would be set at a flat 35 percent, equal to the highest rate now on the books.

Now let's be clear: We all support a crackdown on corporate tax shelters. (Well, most of us do; some antitax zealots on the Republican right seem to regard aggressive tax avoidance as a form of civil disobedience.) And finding more revenue in the corporate income tax would make deficit hawks happy.

But it's unrealistic to expect simpler, tougher, heavier corporate taxes to pay for sweeping tax reform. In general, Democrats are too sanguine about the prospects for beefing up the corporate income tax. The levy is an artifact of a different era. Conceived in a world defined by borders, both political and economic, it has struggled in the modern, globalized world of mobile capital.

As my colleague Martin A. Sullivan has pointed out, the corporate tax is not dead -- at least not yet. European countries have taken the lead in efforts to rescue it, eliminating numerous loopholes and preferences, while simultaneously lowering rates. As a result, rates have fallen, but revenue has risen. (See Tax Notes, Jan. 30, 2006, p. 440, Doc 2006-1557, or 2006 TNT 20-8.)

Wyden and Emanuel understand that sort of trade-off, making it central to their case for individual tax reform. But they abjure the compromise when applied to corporations. Last week, in an interview with Tax Analysts' Heidi Glenn, Wyden defended the decision as a matter of fairness. "Thirty-five percent ensures that you're going to have some symmetry between what you're doing with the top rate on the personal side and the top rate on the corporate side," he said. "So there can't be any gaming." (See Tax Notes, Feb. 20, 2006, p. 837, Doc 2006-3217, or 2006 TNT 34-5.)

Perhaps. But 35 percent is steep by today's global standards, steep rates encourage companies to shift profits to low-tax jurisdictions. As Sullivan observes, no one has been able to stop that trend, despite decades of legislative and regulatory effort. Wyden and Emanuel won't be able to stop it either.

Historically, many Democrats have used corporations as a foil in debates over tax fairness. While more than willing to provide legislative plums to lucky corporate constituents, they gave their rhetoric a populist, antibusiness edge. Demonizing predatory corporations can make for good politics. Or at least it used to.

But for the last few decades, a new sort of business-friendly Democrat has resisted that temptation. Eager to compete with Republicans for the favors of corporate America, they have softened the party's antibusiness bias. In the process, they have improved their political prospects and promoted better tax policy.

Wyden and Emanuel are two of those new Democrats, but the Fair Flat Tax retains a whiff of the Democrats' older rhetorical tradition. And that's a shame. Tax shelters have made corporations a popular whipping boy, but the gradual decline of the corporate income tax can't be explained by those shenanigans. It's a much larger, more tenacious, and ultimately inexorable process.

Democrats need to face that reality. In the 1920s, Andrew Mellon saved the personal income tax by reducing the steep rates enacted during World War I. In the process, he defanged the levy's bitterest opponents. He was an unlikely savior for the income tax, but an effective one. Eighty years later, Democrats have a chance to do something similar for the corporate income tax. Wyden and Emanuel should seize that opportunity.