Citizens for Tax Justice

FOR RELEASE ON Tuesday, March 5, 1995

Most New Yorkers Would Be Hit Hard by "Flat Tax"

Most New Yorkers would pay considerably higher federal taxes under "flat tax" legislation introduced by Rep. Richard Armey (R-Tex.) and Sen. Richard Shelby (R-Ala.), and endorsed by presidential candidate Malcolm S. "Steve" Forbes, Jr. These tax increases would be compounded by either a huge increase in the federal budget deficit or sharp reductions in federal programs.

A computer microsimulation analysis of the effects of the Armey-Shelby-Forbes flat tax plan on New Yorkers by Citizens for Tax Justice finds that under the plan at its eventual 17% tax rate (the proposed rate is 20% for the first two years):

Federal revenues would plummet by at least $156 billion a year--an amount that would double the current federal budget deficit.
Despite these huge revenue losses, the vast majority of New Yorkers--all income groups but the top 11% of New York families--would pay higher federal taxes.
In contrast, the very best-off New Yorkers--the 1.7% making more than $200,000 a year--would see their federal taxes cut by more than half.
If the flat tax rate is increased to avoid revenue losses, federal taxes would increase on all New York income groups except the best off 1.7%. Typical tax increases on New Yorkers in the $30,000 to $75,000 income ranges would be $1,300 to $2,500 annually.

"Because the flat tax cuts taxes so drastically on super-rich people like Steve Forbes, it inevitably means much higher burdens on everyone else," noted CTJ director Robert S. McIntyre. "Our new analysis quantifies the size of those increased burdens on residents of New York."

Repeal of itemized deductions especially hurts New Yorkers

The projected tax increases on middle-income New Yorkers under the flat tax are generally 20% to 40% larger than the estimated nation-wide average tax hikes for non-New York families with similar incomes. This reflects in large part the relatively heavy reliance by New Yorkers on itemized deductions, which the flat tax would repeal. New York's total use of itemized deductions is almost 50% above the national average. On average, about 31% of all New York families itemize deductions, compared to 26% nationwide. In addition, for those who do itemize, New Yorkers' average deductions are 23% higher than the national average.

Description of the Armey-Shelby-Forbes Flat Tax Proposal

Armey, Shelby and Forbes have proposed to repeal the federal personal income tax, the corporate income tax and the estate tax, and replace them with a 20% flat tax (scheduled to drop to 17% after two years) on wages, pensions and self-employment income. (Forbes typically talks only about the 17% eventual rate, but a spokesman for his campaign told Fortune, Feb. 5, that his flat tax plan "would duplicate" the Armey-Shelby plan.)

The new flat tax would also be imposed on employer-paid fringe benefits, including benefits paid by state and local governments and non-profit organizations. Individuals would no longer be taxed on their interest, dividends, capital gains and other "unearned" income. All itemized deductions, for state and local taxes, mortgage interest, charitable donations and so forth would be repealed, as would all federal tax credits.

Although the flat tax offers large exemptions against the wage portion of its tax--$10,700 per taxpayer and $5,000 per dependent in 1996 dollars--it taxes fringe benefits such as health insurance and employer-paid social security taxes with no exemptions. As a result, lower-income working families that now owe no federal income tax will pay substantial taxes under the flat tax. Businesses would file tax returns similar to those currently filed, except that: interest and dividends income would be exempt from taxation; capital expenditures would be deducted immediately rather than depreciated over time; interest paid would no longer be deductible; and 100% of meals and entertainment outlays (rather than only 50% under current law) could be deducted.

In the aggregate, these changes in corporate taxation would eventually appear to wipe out most taxes on corporations. Flat tax proponents, however, claim their plan would raise large amounts from business. That claim is based on the absurd notion that companies that have invested heavily in recent years would be subject to huge tax penalties on their past investments (due to loss of depreciation deductions).

The Armey-Shelby-Forbes flat tax plan's cavalier attitude about business taxation has been sharply criticized as unfair and irrational. Indeed, the almost random effects on different businesses from the lack of "transition rules" could cause huge economic dislocations and a sharp downturn in the economy. That is why even the otherwise pro-flat tax Kemp Commission report called for "generous" transition rules as part of any tax overhaul.

Plan as proposed promises huge deficits, economic dislocations

As proposed, the flat tax would add an estimated $49 billion to the annual federal budget deficit at its proposed 20% tax rate, with the loss ballooning to $156 billion a year at the eventual 17% tax rate. These "static" estimates almost certainly vastly understate the likely revenue losses, however. Any practical flat-tax plan would undoubtably provide substantial transition rules, and there would also be a wave of corporate merging and leasing activities to avoid the new flat tax.

Huge increases in the budget deficit would drive up interest rates, and throw the economy into recession. Alternatively, were the federal government to try to offset these huge deficit increases through program reductions, that would require cuts in federal programs even larger than those contemplated in last year's congressional budget plan. Under that legislation, not only were Medicare and Medicaid under assault, but New York state and local government were expected to lose $40 billion in aid over seven years.

Alternative Scenarios Show Similar Results

Besides comparing the revenue-losing Armey-Shelby-Forbes flat tax plan as proposed to current law, CTJ also looked at alternative "revenue-neutral" flat tax scenarios, including ones that assume either explicit transition rules to avoid driving large numbers of companies out of business or substantial corporate merger and leasing transactions that achieve the same result. Under these more likely scenarios, CTJ found that the flat tax could potentially break even at a 24.6% tax rate with the wage-tax exemptions proposed in the Armey-Shelby bill. CTJ also found that if the wage-tax exemptions were reduced to $5,100 per taxpayer and $2,400 per dependent, the plan could potentially break even at a 19.3% rate.

No matter which alternative scenario is chosen, most New Yorkers would pay much higher taxes under the flat tax, with average tax increases in the $30,000 to $100,000 income groups ranging from $1,000 a year to almost $4,000 annually.

"There's no free lunch here," noted McIntyre. "If the flat tax is designed to cut taxes by $150 billion or more, that will mean doubling the deficit or huge reductions in federal services, coupled with higher taxes on most families, higher interest rates and, most likely, a deep recession. If the flat tax rate is increased or its exemptions are lowered to try to break even, then almost everyone's taxes except the very rich's must go up even more."

State Revenues in Jeopardy, Too

CTJ also pointed out that were the federal government to repeal its income taxes in favor of a flat tax, then states would find it difficult or impossible to administer their own income taxes. "This would be a particular problem for states like New York that rely heavily on income taxes to pay for state services," McIntyre noted.

Source:

CTJ's analysis of the Armey-Shelby-Forbes flat tax was computed using the Institute on Taxation and Economic Policy's Microsimulation Tax Model, a tax simulation model similar in design and data sources to those used by the Treasury Department and the congressional Joint Committee on Taxation, but also equipped to analyze the effects of tax changes on a state-by-state basis.

Detailed Tables on the Effects of the Flat Tax on New Yorkers.

Citizens for Tax Justice is a non-partisan Washington, D.C. tax policy group.

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