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legislator than an alternative set of
plans with fewer preferences or
lower expenditures. The essence of
this over-expenditure argument is
this: each majority coalition, in aiming for passage of its own measure,
takes the taxes paid by citizens represented by non-coalition members
as given. In totaling the costs and
benefits of each project, the coalition
includes the costs to its members
but not the costs to nonmembers.
Because not all of the costs are considered, the coalition votes for more
of the public good than is needed
by society.
Transition Problems
Every tax system develops its own
inertia, in the sense that people who
make long-term decisions based on
the present system argue that it is
unfair to change the rules mid-game.
More than this, however, the economic system works to dissipate any
special benefits of the tax system by
adjusting relative prices. The result
is that individuals who gain little or
no special tax advantage from the
current tax system can nevertheless
be seriously hurt by tax reform. The
result is a wrenching problem for
tax reformers: how do we treat these
"innocent bystanders" who get
caught by the change?
For example, take the deductions
for mortgage interest and local property taxes, which are surely among
the most popular tax preferences in
the current system. When these
deductions were enacted, homeowners undoubtedly gained a direct
benefit in the form of lower taxes.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OR 44101

••

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

But these people will eventually sell
their homes, and at the time of the
sale the circumstances of the buyer
will be different than before. The
buyer can deduct mortgage interest
and property taxes, and this means
he will be willing to pay a higher
price for the house. The seller knows
this, and will accordingly raise the
price of the house to try to capture
some of this increased willingness to
pay. As a result, the new buyer will
give up some of this tax benefit to the
original owner in the form of higher
house prices; economists say that the
tax benefit has been capitalized into
the price of the house. In fact, under
certain market conditions, house
prices will rise to eliminate the entire
tax benefit; in other words, the present value of the stream of future
reductions in taxes will be just equal
to the increase in house prices.
Under more likely conditions, some
but not all of the tax benefit will
be capitalized away from the new
homebuyer.
Now, suppose that the government
institutes a pure flat tax that would
eliminate this tax preference. The
citizen who just bought a home sees
this as unfair to him, because he made
his plans based on the old system.
Although he may not receive large
benefits from the loopholes, the loss
of the loophole will cost him dearly.
Tax reformers cannot turn back the
clock; the tax reform would not be
raising the taxes of those who gained
from the old system-those are the
original homeowners who have
turned their tax benefits into cash.

Some tax reformers have suggested a gradualist approach in
which a new tax system would be
phased in gradually. While such an
approach would smooth the process
somewhat, it would not eliminate the
basic problem of dealing with individuals hurt by the reforms. Sooner
or later, the affected groups would
bear the burden of higher taxes. It
has also been suggested that these
individuals be "grandfathered" into
the tax system, so that, for example,
all homeowners at the time of the tax
reforms receive a special exemption
or deduction. But this approach could
significantly reduce the tax base
under the new tax system (thus raising marginal rates), and it would
cause horizontal inequity between
those who managed to receive the aid
and later home buyers who failed to
obtain tax relief.
Conclusion
Because of these political and economic forces, we ought to expect tax
reform to be incremental rather than
an abrupt adoption of bold, new
plans. It is not enough to introduce
new schemes, as tax reform requires
shifts in political opinions and alignments. Since these shifts in loyalties
come slowly and through much
negotiation and confrontation, it is
unlikely that a pure flat tax, or any
sort of sweeping tax reform, can be
adopted in unmodified form. To
formulate realistic alternatives, tax
reformers must understand the conflicts, and the compromises, inherent
in the current system.
BULK RATE
U.S. Postage Paid
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Permit No. 385

Federal Reserve Bank of Cleveland

Flat Taxes and the
Limits to Reform

ISSN 0428-1276
October 22, 1984

sured and the political realities of the
tax decision-making system.

What's Wrong with the
Current System?
by Paul Gary Wyckoff
The current attack on the personal
income tax comes from both sides of
Although Congress and the adminthe ideological spectrum, but everyistration are always talking about tax
one agrees that the loopholes in the
reform, there is currently heightened
tax - the numerous credits, deducinterest in new, all-inclusive aptions, exclusions, and exemptionsproaches to the problem. According
are the crux of the problem.f
to Rudolph Penner, director of the
Although each side values both
Congressional Budget Office, "The
equity and efficiency, liberals tend
prospects for radical tax reform are
to stress equity objections to the
brighter than ever."! In his State of
loopholes, while conservatives tend
the Union message on January 25,
to stress efficiency considerations.
1984, President Reagan called for the Liberals argue that the current sysTreasury Department to make a
tem is inequitable on two counts.
comprehensive study of ways to
First, the system violates the prinmake the income tax more simple,
ciple of horizontal equity, which
more efficient, and more equitable.
demands that individuals in comparaTreasury Secretary Donald T. Regan
ble economic circumstances bear the
has indicated that the department
same tax." It has been argued, for
will probably recommend some sort
example, that through investment
of modified flat tax system in its
tax credits and accelerated depreciareport. The administration is not
tion, taxpayers earning their income
alone in its interest in flat taxes;
from investments may pay less tax
each major party has formulated a
than those who receive wage and
detailed and comprehensive modified salary income, even if both groups
flat tax proposal and has introduced
have the same total income and
it in Congress. This Economic Comhence the same command over ecomentary examines the nature of
nomic resources. Second, liberals
flat taxes, the inadequacies in the
argue that the current system also
present system that they would
fails the test of vertical equity, which
remedy, and the reasons why the allur- states that persons in different ciring goal of a pure flat tax is difficult
cumstances ought to pay different
to achieve. In the process, the article
amounts of tax based on their ability
illustrates the economic principles
to pay. This complaint crystallized
against which tax policy can be meaduring the 1984 presidential debate

-

Iuul Gary Wyckoff, an economist with the Federal
Reserve Bank of Cleveland, studies the public sector.
Michael Dvorak provided research assistance for this
article.
The views stated herein are those of the author and
not necessarily those of the Federal Reserve Bank of
Cleveland or the Board of Governors of the Federal
Reserve System.

••

1. See FOrtune, June 11,1984, p. 97.
2. A tax credit is a provision that allows the taxpayer to reduce his total tax bill after he has figured
his tax base (in this case, his income from various
sources) and has applied the appropriate tax rate
against that base. A tax deduction offsets (or
reduces) the citizen's tax base - for example, the
taxpayer might be allowed to reduce his taxable

over the proportion of Vice President
Bush's 1983 income paid in taxes;
Walter Mondale claimed that tax
loopholes allowed the relatively
wealthy Vice President to lower his
taxes to unreasonably low levels.
Conservatives contend that the
present tax system is inefficient.
They see the system as a leaky bucket
that draws resources from the well
of economic activity; every time the
bucket dips into the well and carries
off money for use by the government,
resources are lost through the leaks.s
This waste occurs because (1)individuals in the economy are encouraged to produce less than otherwise,
and (2) the economy ends up producing the wrong kinds of goods in the
wrong quantities.
As an example of the first type of
inefficiency, conservatives argue
that, because of all the special provisions in the tax code, tax rates are
higher than they need otherwise be.
Since they reduce the after-tax
rewards to economic activity, these
higher tax rates encourage people to
work and save less. The result is a
less productive economy than without the loopholes. By comparison,
the second source of inefficiency is
more subtle in its impact on economic welfare. Loopholes encourage
people to alter their behavior so as to
move them from heavily taxed to
lightly taxed activities. For example,
the exemption for employer-paid
fringe benefits, such as health and
life insurance, encourages people to
take more of their total "income" in
income by some portion of the amount he paid for
medical care. A tax exemption or exclusion is an
item that could, under a comprehensive tax plan,
be considered as part of the citizen's tax base but,
for one reason or another, is not counted in the base
for tax purposes. For example, income from state
and local government bonds is not counted as
income for purposes of the federal income tax.

the form of these benefits rather than
as wages. Similarly, the deductions
for mortgage interest and local property taxes give people an incentive to
move out of rental housing (for which
no such preferences are available)
into their own homes.
The economic losses from this second type of inefficiency are subtle
and can only be appreciated by comparing the present system with one
that does not alter individuals' behavior. Under the current system, the
tax becomes "attached" to certain
activities (such as living in rental
housing or taking wage income
rather than fringe benefits); in a
sense, individuals pay the tax out
of the money they allocate for that
activity. The taxpayer pays ':f.'; govthe
ernment by paying more for those
particular activities, even if they are
goods and services that he particularly desires. By contrast, under a
less distorting tax system in which all
activities are taxed equally, the individual has the flexibility to distribute
this tax burden in any way he wishes;
he can pay the tax by giving up the
goods and services that he values
least. Because the individual has the
freedom to distribute his tax burden
to minimize his loss of satisfaction,
economic theory teaches that a less
distorting tax system can generate
the same amount of revenue as
currently while making taxpayers
better off.
Flat Taxes - Pure
and Modified
A pure flat tax is attractive in its
simplicity. All of the taxpayer's
income, from whatever source, is
subject to tax (thus eliminating our
complex system of tax preferences),
and the tax is paid at a single, low
rate. In one stroke, the problems of
horizontal equity, disincentives for
saving and investment, and taxinduced changes in consumption are
solved. Since all income is taxed at
the same rate, taxpayers with the
same income are treated equally.

••

3. It has been argued that some of these preferences account for economic differences between
taxpayers that are not reflected in their incomes.
For example, the deductions for medical expenses
can be rationalized as recognizing differences in
the need for income. It is difficult, however, to
justify most tax preferences in this way, since they

Since marginal tax rates are reduced
to one, low level, the reductions in
saving and investment are minimized.
And since all income is treated
equally and the tax is independent of
the taxpayer's consumption decisions
(i.e., no deduction for mortgage interest or charitable contributions), the
incentives to change the consumer's
behavior are also minimized. In addition, under a flat tax there is no need
to worry about indexation of tax
brackets (because tax-bracket creep
is impossible), income averaging
(because all income is subject to the
same rate of tax), or a marriage
penalty (because individuals pay the
same rate of tax regardless of their
spouse's income). A recent study
estimated that 1984 tax collections
averaged 12 percent of total income,
when income was measured comprehensively (i.e., including all items
that are exempted or excluded under
the current system).5 Hence, even
if lower marginal tax rates had no
effect on economic activity, a pure
flat tax of just 12 percent would raise
the same amount of revenue as the
current system.
The tax plans now under consideration in Congress, however, stray
considerably from this simple ideal. 6
The best-known plan, introduced
by Senator Bill Bradley (D-N.].) and
Congressman Richard Gephardt
(D-Mo.), is a case in point. The
Bradley-Gephardt Fair Tax proposal
broadens the tax base to eliminate
most existing exemptions, deductions,
and credits except the deductions for
mortgage interest, charitable contributions, state and local income and
property taxes, payments to IRAs
and Keogh plans, and employee business expenses. In addition, the
exclusions of veterans' benefits,
Social Security payments for lowand moderate-income taxpayers, and
interest on state and local government general obligation bonds are
retained, and the personal exemption
and standard deduction are increased. In terms of tax rates, too,

the Bradley-Gephardt proposal falls
short of the ideal; it is really a "giant
step" tax with three very wide tax
brackets of 14, 26, and 30 percent.
The sponsors claim, however, that
three-quarters of all taxpayers would
end up in the 14 percent bracket, and
for those people the plan would have
most of the benefits of a pure flat tax.
Also, although many deductions
would still be allowed under the proposal, most of them count only against
the 14 percent rate, regardless of the
citizen's tax bracket. The BradleyGephardt plan actually consists of
two taxes-a basic tax of 14 percent
and a progressive surtax with rates of
12 percent and 16 percent. This surtax would be applied only against
that portion of the taxpayer's income
that exceeds $25,000 (for a single
return, with a cutoff of $40,000 for a
joint return). The unique feature of
the Fair tax is that the exemptions
listed above can be used to reduce
taxable income for the basic tax, but
not for the surtax. In effect, the tax
reduction resulting from the deductions would be limited to 14 percent,
regardless of the taxpayer's income.
Bradley and Gephardt maintain that
their proposal would mean roughly
the same tax burden across income
classes as the current system.
A Republican alternative to the
pure flat tax has been introduced by
Congressman Jack Kemp (R-N.Y.)
and Senator Robert Kasten (R-Wis.).
The Kemp-Kasten FAST (Fair and
Simple Tax) plan would broaden the
tax base by eliminating most special
provisions of the tax code, except
deductions for charitable contributions, interest on loans for residential
property and education, medical
expenses above 10 percent of income,
ordinary business expenses, payments to IRAs and Keogh plans, and
real property taxes. Also, the exemptions for Social Security and military
and veterans' benefits would be
retained. On this somewhat broadened tax base, a single 25 percent
tax rate would be levied, and in this

do not target relief to the truly needy (i.e., the
deductions for local property taxes, mortgage
interest, and state and local bond interest).

4. The leaky bucket paradigm, however, was
conceived by a liberal economist, the late Arthur
Okun. See Arthur M. Okun, Equality and Efficiency:
The Big Tradeoff, Washington, DC: Brookings
Institution, 1975, pp. 91-100.

••

sense the Kemp-Kasten plan is truly
a flat tax. To appeal to lower-income
citizens, however, the plan also calls
for increases in the personal exemption and standard deduction, and for
a special exclusion of 20 percent of
all wage and salary income up to
$39,300, an exclusion that would
gradually be phased out in higherincome brackets so that it would
equal zero above $100,000.
Why do these two congressional
plans fall short of the flat-tax standard of simplicity? The answer is
compelling, because public opinion
polls show that Americans would
prefer a simple flat tax to our current
system, and yet these proposals are
more like a compromise between
these alternatives rather than a flat
tax. Rooted in the institutions of the
market and Congress (and in the
interactions between them) are three
reasons why tax reform is a gradual,
incremental process.
Conflict between Vertical
Equity and Efficiency
Americans value not only the efficiency of their economic system but
also equity between income groups.
Because it is impossible for one tax
system to serve both goals fully,
there is inevitably some compromise
of efficiency for equity.
Historically, citizens' desire for
vertical equity has resulted in a progressive tax system-one in which the
proportion of one's income paid in
taxes rises with income. The flat tax,
however, would result in a proportional system in which the ratio of
taxes paid to income would be constant across income groups, resulting
in a massive redistribution of the
tax burden from the rich to the
poor. Because this is politically
unacceptable, both plans build some
progressivity into their tax schedules. The Bradley-Gephardt plan
does this by having three marginal
tax rates that increase with income;
the Kemp-Kasten plan accomplishes
this by excluding from tax a large

••

5. See Joseph A. Pechman and John Karl Scholz,
"Comprehensive Income Taxation and Rate Reduction," Tax Notes, vol. 17, no. 2 (October 11,1982),
pp. 83-93. Reprinted in Brookings General Series
Reprint 390, Washington, DC: Brookings Institution, 1983.

portion of the citizen's first several
thousand dollars of income, through
a large personal exemption and standard deduction and the special 20
percent wage and salary exclusion.
There is a price to be paid, however, for this deviation from the pure
flat tax. When progressivity is built
into a tax system, the inevitable
result is high marginal rates at the
top end and a reduction of incentives
to work and save for high-income
taxpayers. Moreover, the saving disincentive is particularly important at
the top, because a disproportionate
amount of aggregate saving comes
from well-to-do taxpayers. The
Kemp-Kasten and Bradley-Gephardt
plans attempt to reconcile the competing demands of equity and efficiency
-they do not escape the dilemma.
To continue with the leaky bucket
paradigm, we can visualize a progressive tax system as using the
bucket to transfer wealth from the
rich to the poor. That the bucket
leaks does not obviate the fact that
society wishes to make this transfer;
it does, however, make this redistribution more expensive. The task
faced by policymakers, therefore, is
to decide how much water is worth
transferring given these leaks.
Logrolling
While our system of congressional
representation is meant to weight all
citizens' preferences equally, individuals are likely to have different
intensities of feeling about a particular issue. The practice of logrolling
helps explain the historical pattern
in the United States of relatively
high marginal tax rates with lots of
tax preferences.
Individuals who receive a particular tax preference (e.g., the
residential energy tax credit) care a
lot more about that issue than individuals who are ineligible for that
preference; the benefits are concentrated among relatively few
individuals, while the costs of the
loophole are spread among all tax-

-

6. The discussion in this section is meant to be a
summary of these plans, not a complete description. Many minor features of these proposals have
been omitted. For further details, one should contact the congressional offices of the sponsors.

payers. If a person is eligible for an
energy tax credit, it could mean hundreds of dollars in tax savings; if he is
ineligible, the cost of bearing the additional tax burden from this loophole
is probably only a few pennies.
When preference intensities vary
in this fashion, representative systems tend to fall into vote trading, or
logrolling. Each representative trades
his vote on issues that are not important to him in exchange for his colleagues' votes on issues that are vital
to him. As a result, issues (or tax
preferences) that might not pass if
they were considered in isolation
(because only a small minority of
voters favor them) can be approved.
There is also a more subtle form of
vote trading, called implicit logrolling, in which a party or candidate
forms its platform by incorporating
the positions of many groups, favoring the position of each group on the
issue of most intense interest to it.
In this way, the party or candidate
ratifies in its platform the logrolling
outcome that would have occurred
had these groups participated in
some sort of direct democracy.
Scholars disagree on whether this
logrolling process results in an inefficient allocation of resources. On one
hand, it can be argued that logrolling
allows the representative process to
recognize the intensity of voters'
preferences." In this sense, logrolling
can be a check on the tyranny of the
majority." Otherwise, if the majority
favored some measure, even if the
members of the majority coalition
were only marginally interested in
the issue, they would prevail over
the wishes of a vitally interested
minority.
On the other hand, it has been
argued that logrolling results in a
public sector that is too large, that
completes projects for which the
costs exceed the benefits." Under
certain circumstances, logrolling can
result in the passage of a group of tax
preferences or spending measures
that give less satisfaction to each

••

7. See Dennis C. Mueller, "Public Choice: A
Survey," Journal of Economic Literature, vol. 14,
no. 2 (June 1976), p. 406.

8. See Mueller, "Public Choice: A Survey," p. 406.
9. See Gordon Tullock, "A Simple Algebraic
Logrolling Model," American Economic Review,
vol. 60, no. 3 (June 1970), pp. 419-26.

the form of these benefits rather than
as wages. Similarly, the deductions
for mortgage interest and local property taxes give people an incentive to
move out of rental housing (for which
no such preferences are available)
into their own homes.
The economic losses from this second type of inefficiency are subtle
and can only be appreciated by comparing the present system with one
that does not alter individuals' behavior. Under the current system, the
tax becomes "attached" to certain
activities (such as living in rental
housing or taking wage income
rather than fringe benefits); in a
sense, individuals pay the tax out
of the money they allocate for that
activity. The taxpayer pays ':f.'; govthe
ernment by paying more for those
particular activities, even if they are
goods and services that he particularly desires. By contrast, under a
less distorting tax system in which all
activities are taxed equally, the individual has the flexibility to distribute
this tax burden in any way he wishes;
he can pay the tax by giving up the
goods and services that he values
least. Because the individual has the
freedom to distribute his tax burden
to minimize his loss of satisfaction,
economic theory teaches that a less
distorting tax system can generate
the same amount of revenue as
currently while making taxpayers
better off.
Flat Taxes - Pure
and Modified
A pure flat tax is attractive in its
simplicity. All of the taxpayer's
income, from whatever source, is
subject to tax (thus eliminating our
complex system of tax preferences),
and the tax is paid at a single, low
rate. In one stroke, the problems of
horizontal equity, disincentives for
saving and investment, and taxinduced changes in consumption are
solved. Since all income is taxed at
the same rate, taxpayers with the
same income are treated equally.

••

3. It has been argued that some of these preferences account for economic differences between
taxpayers that are not reflected in their incomes.
For example, the deductions for medical expenses
can be rationalized as recognizing differences in
the need for income. It is difficult, however, to
justify most tax preferences in this way, since they

Since marginal tax rates are reduced
to one, low level, the reductions in
saving and investment are minimized.
And since all income is treated
equally and the tax is independent of
the taxpayer's consumption decisions
(i.e., no deduction for mortgage interest or charitable contributions), the
incentives to change the consumer's
behavior are also minimized. In addition, under a flat tax there is no need
to worry about indexation of tax
brackets (because tax-bracket creep
is impossible), income averaging
(because all income is subject to the
same rate of tax), or a marriage
penalty (because individuals pay the
same rate of tax regardless of their
spouse's income). A recent study
estimated that 1984 tax collections
averaged 12 percent of total income,
when income was measured comprehensively (i.e., including all items
that are exempted or excluded under
the current system).5 Hence, even
if lower marginal tax rates had no
effect on economic activity, a pure
flat tax of just 12 percent would raise
the same amount of revenue as the
current system.
The tax plans now under consideration in Congress, however, stray
considerably from this simple ideal. 6
The best-known plan, introduced
by Senator Bill Bradley (D-N.].) and
Congressman Richard Gephardt
(D-Mo.), is a case in point. The
Bradley-Gephardt Fair Tax proposal
broadens the tax base to eliminate
most existing exemptions, deductions,
and credits except the deductions for
mortgage interest, charitable contributions, state and local income and
property taxes, payments to IRAs
and Keogh plans, and employee business expenses. In addition, the
exclusions of veterans' benefits,
Social Security payments for lowand moderate-income taxpayers, and
interest on state and local government general obligation bonds are
retained, and the personal exemption
and standard deduction are increased. In terms of tax rates, too,

the Bradley-Gephardt proposal falls
short of the ideal; it is really a "giant
step" tax with three very wide tax
brackets of 14, 26, and 30 percent.
The sponsors claim, however, that
three-quarters of all taxpayers would
end up in the 14 percent bracket, and
for those people the plan would have
most of the benefits of a pure flat tax.
Also, although many deductions
would still be allowed under the proposal, most of them count only against
the 14 percent rate, regardless of the
citizen's tax bracket. The BradleyGephardt plan actually consists of
two taxes-a basic tax of 14 percent
and a progressive surtax with rates of
12 percent and 16 percent. This surtax would be applied only against
that portion of the taxpayer's income
that exceeds $25,000 (for a single
return, with a cutoff of $40,000 for a
joint return). The unique feature of
the Fair tax is that the exemptions
listed above can be used to reduce
taxable income for the basic tax, but
not for the surtax. In effect, the tax
reduction resulting from the deductions would be limited to 14 percent,
regardless of the taxpayer's income.
Bradley and Gephardt maintain that
their proposal would mean roughly
the same tax burden across income
classes as the current system.
A Republican alternative to the
pure flat tax has been introduced by
Congressman Jack Kemp (R-N.Y.)
and Senator Robert Kasten (R-Wis.).
The Kemp-Kasten FAST (Fair and
Simple Tax) plan would broaden the
tax base by eliminating most special
provisions of the tax code, except
deductions for charitable contributions, interest on loans for residential
property and education, medical
expenses above 10 percent of income,
ordinary business expenses, payments to IRAs and Keogh plans, and
real property taxes. Also, the exemptions for Social Security and military
and veterans' benefits would be
retained. On this somewhat broadened tax base, a single 25 percent
tax rate would be levied, and in this

do not target relief to the truly needy (i.e., the
deductions for local property taxes, mortgage
interest, and state and local bond interest).

4. The leaky bucket paradigm, however, was
conceived by a liberal economist, the late Arthur
Okun. See Arthur M. Okun, Equality and Efficiency:
The Big Tradeoff, Washington, DC: Brookings
Institution, 1975, pp. 91-100.

••

sense the Kemp-Kasten plan is truly
a flat tax. To appeal to lower-income
citizens, however, the plan also calls
for increases in the personal exemption and standard deduction, and for
a special exclusion of 20 percent of
all wage and salary income up to
$39,300, an exclusion that would
gradually be phased out in higherincome brackets so that it would
equal zero above $100,000.
Why do these two congressional
plans fall short of the flat-tax standard of simplicity? The answer is
compelling, because public opinion
polls show that Americans would
prefer a simple flat tax to our current
system, and yet these proposals are
more like a compromise between
these alternatives rather than a flat
tax. Rooted in the institutions of the
market and Congress (and in the
interactions between them) are three
reasons why tax reform is a gradual,
incremental process.
Conflict between Vertical
Equity and Efficiency
Americans value not only the efficiency of their economic system but
also equity between income groups.
Because it is impossible for one tax
system to serve both goals fully,
there is inevitably some compromise
of efficiency for equity.
Historically, citizens' desire for
vertical equity has resulted in a progressive tax system-one in which the
proportion of one's income paid in
taxes rises with income. The flat tax,
however, would result in a proportional system in which the ratio of
taxes paid to income would be constant across income groups, resulting
in a massive redistribution of the
tax burden from the rich to the
poor. Because this is politically
unacceptable, both plans build some
progressivity into their tax schedules. The Bradley-Gephardt plan
does this by having three marginal
tax rates that increase with income;
the Kemp-Kasten plan accomplishes
this by excluding from tax a large

••

5. See Joseph A. Pechman and John Karl Scholz,
"Comprehensive Income Taxation and Rate Reduction," Tax Notes, vol. 17, no. 2 (October 11,1982),
pp. 83-93. Reprinted in Brookings General Series
Reprint 390, Washington, DC: Brookings Institution, 1983.

portion of the citizen's first several
thousand dollars of income, through
a large personal exemption and standard deduction and the special 20
percent wage and salary exclusion.
There is a price to be paid, however, for this deviation from the pure
flat tax. When progressivity is built
into a tax system, the inevitable
result is high marginal rates at the
top end and a reduction of incentives
to work and save for high-income
taxpayers. Moreover, the saving disincentive is particularly important at
the top, because a disproportionate
amount of aggregate saving comes
from well-to-do taxpayers. The
Kemp-Kasten and Bradley-Gephardt
plans attempt to reconcile the competing demands of equity and efficiency
-they do not escape the dilemma.
To continue with the leaky bucket
paradigm, we can visualize a progressive tax system as using the
bucket to transfer wealth from the
rich to the poor. That the bucket
leaks does not obviate the fact that
society wishes to make this transfer;
it does, however, make this redistribution more expensive. The task
faced by policymakers, therefore, is
to decide how much water is worth
transferring given these leaks.
Logrolling
While our system of congressional
representation is meant to weight all
citizens' preferences equally, individuals are likely to have different
intensities of feeling about a particular issue. The practice of logrolling
helps explain the historical pattern
in the United States of relatively
high marginal tax rates with lots of
tax preferences.
Individuals who receive a particular tax preference (e.g., the
residential energy tax credit) care a
lot more about that issue than individuals who are ineligible for that
preference; the benefits are concentrated among relatively few
individuals, while the costs of the
loophole are spread among all tax-

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6. The discussion in this section is meant to be a
summary of these plans, not a complete description. Many minor features of these proposals have
been omitted. For further details, one should contact the congressional offices of the sponsors.

payers. If a person is eligible for an
energy tax credit, it could mean hundreds of dollars in tax savings; if he is
ineligible, the cost of bearing the additional tax burden from this loophole
is probably only a few pennies.
When preference intensities vary
in this fashion, representative systems tend to fall into vote trading, or
logrolling. Each representative trades
his vote on issues that are not important to him in exchange for his colleagues' votes on issues that are vital
to him. As a result, issues (or tax
preferences) that might not pass if
they were considered in isolation
(because only a small minority of
voters favor them) can be approved.
There is also a more subtle form of
vote trading, called implicit logrolling, in which a party or candidate
forms its platform by incorporating
the positions of many groups, favoring the position of each group on the
issue of most intense interest to it.
In this way, the party or candidate
ratifies in its platform the logrolling
outcome that would have occurred
had these groups participated in
some sort of direct democracy.
Scholars disagree on whether this
logrolling process results in an inefficient allocation of resources. On one
hand, it can be argued that logrolling
allows the representative process to
recognize the intensity of voters'
preferences." In this sense, logrolling
can be a check on the tyranny of the
majority." Otherwise, if the majority
favored some measure, even if the
members of the majority coalition
were only marginally interested in
the issue, they would prevail over
the wishes of a vitally interested
minority.
On the other hand, it has been
argued that logrolling results in a
public sector that is too large, that
completes projects for which the
costs exceed the benefits." Under
certain circumstances, logrolling can
result in the passage of a group of tax
preferences or spending measures
that give less satisfaction to each

••

7. See Dennis C. Mueller, "Public Choice: A
Survey," Journal of Economic Literature, vol. 14,
no. 2 (June 1976), p. 406.

8. See Mueller, "Public Choice: A Survey," p. 406.
9. See Gordon Tullock, "A Simple Algebraic
Logrolling Model," American Economic Review,
vol. 60, no. 3 (June 1970), pp. 419-26.

legislator than an alternative set of
plans with fewer preferences or
lower expenditures. The essence of
this over-expenditure argument is
this: each majority coalition, in aiming for passage of its own measure,
takes the taxes paid by citizens represented by non-coalition members
as given. In totaling the costs and
benefits of each project, the coalition
includes the costs to its members
but not the costs to nonmembers.
Because not all of the costs are considered, the coalition votes for more
of the public good than is needed
by society.
Transition Problems
Every tax system develops its own
inertia, in the sense that people who
make long-term decisions based on
the present system argue that it is
unfair to change the rules mid-game.
More than this, however, the economic system works to dissipate any
special benefits of the tax system by
adjusting relative prices. The result
is that individuals who gain little or
no special tax advantage from the
current tax system can nevertheless
be seriously hurt by tax reform. The
result is a wrenching problem for
tax reformers: how do we treat these
"innocent bystanders" who get
caught by the change?
For example, take the deductions
for mortgage interest and local property taxes, which are surely among
the most popular tax preferences in
the current system. When these
deductions were enacted, homeowners undoubtedly gained a direct
benefit in the form of lower taxes.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OR 44101

••

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But these people will eventually sell
their homes, and at the time of the
sale the circumstances of the buyer
will be different than before. The
buyer can deduct mortgage interest
and property taxes, and this means
he will be willing to pay a higher
price for the house. The seller knows
this, and will accordingly raise the
price of the house to try to capture
some of this increased willingness to
pay. As a result, the new buyer will
give up some of this tax benefit to the
original owner in the form of higher
house prices; economists say that the
tax benefit has been capitalized into
the price of the house. In fact, under
certain market conditions, house
prices will rise to eliminate the entire
tax benefit; in other words, the present value of the stream of future
reductions in taxes will be just equal
to the increase in house prices.
Under more likely conditions, some
but not all of the tax benefit will
be capitalized away from the new
homebuyer.
Now, suppose that the government
institutes a pure flat tax that would
eliminate this tax preference. The
citizen who just bought a home sees
this as unfair to him, because he made
his plans based on the old system.
Although he may not receive large
benefits from the loopholes, the loss
of the loophole will cost him dearly.
Tax reformers cannot turn back the
clock; the tax reform would not be
raising the taxes of those who gained
from the old system-those are the
original homeowners who have
turned their tax benefits into cash.

Some tax reformers have suggested a gradualist approach in
which a new tax system would be
phased in gradually. While such an
approach would smooth the process
somewhat, it would not eliminate the
basic problem of dealing with individuals hurt by the reforms. Sooner
or later, the affected groups would
bear the burden of higher taxes. It
has also been suggested that these
individuals be "grandfathered" into
the tax system, so that, for example,
all homeowners at the time of the tax
reforms receive a special exemption
or deduction. But this approach could
significantly reduce the tax base
under the new tax system (thus raising marginal rates), and it would
cause horizontal inequity between
those who managed to receive the aid
and later home buyers who failed to
obtain tax relief.
Conclusion
Because of these political and economic forces, we ought to expect tax
reform to be incremental rather than
an abrupt adoption of bold, new
plans. It is not enough to introduce
new schemes, as tax reform requires
shifts in political opinions and alignments. Since these shifts in loyalties
come slowly and through much
negotiation and confrontation, it is
unlikely that a pure flat tax, or any
sort of sweeping tax reform, can be
adopted in unmodified form. To
formulate realistic alternatives, tax
reformers must understand the conflicts, and the compromises, inherent
in the current system.
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Federal Reserve Bank of Cleveland

Flat Taxes and the
Limits to Reform

ISSN 0428-1276
October 22, 1984

sured and the political realities of the
tax decision-making system.

What's Wrong with the
Current System?
by Paul Gary Wyckoff
The current attack on the personal
income tax comes from both sides of
Although Congress and the adminthe ideological spectrum, but everyistration are always talking about tax
one agrees that the loopholes in the
reform, there is currently heightened
tax - the numerous credits, deducinterest in new, all-inclusive aptions, exclusions, and exemptionsproaches to the problem. According
are the crux of the problem.f
to Rudolph Penner, director of the
Although each side values both
Congressional Budget Office, "The
equity and efficiency, liberals tend
prospects for radical tax reform are
to stress equity objections to the
brighter than ever."! In his State of
loopholes, while conservatives tend
the Union message on January 25,
to stress efficiency considerations.
1984, President Reagan called for the Liberals argue that the current sysTreasury Department to make a
tem is inequitable on two counts.
comprehensive study of ways to
First, the system violates the prinmake the income tax more simple,
ciple of horizontal equity, which
more efficient, and more equitable.
demands that individuals in comparaTreasury Secretary Donald T. Regan
ble economic circumstances bear the
has indicated that the department
same tax." It has been argued, for
will probably recommend some sort
example, that through investment
of modified flat tax system in its
tax credits and accelerated depreciareport. The administration is not
tion, taxpayers earning their income
alone in its interest in flat taxes;
from investments may pay less tax
each major party has formulated a
than those who receive wage and
detailed and comprehensive modified salary income, even if both groups
flat tax proposal and has introduced
have the same total income and
it in Congress. This Economic Comhence the same command over ecomentary examines the nature of
nomic resources. Second, liberals
flat taxes, the inadequacies in the
argue that the current system also
present system that they would
fails the test of vertical equity, which
remedy, and the reasons why the allur- states that persons in different ciring goal of a pure flat tax is difficult
cumstances ought to pay different
to achieve. In the process, the article
amounts of tax based on their ability
illustrates the economic principles
to pay. This complaint crystallized
against which tax policy can be meaduring the 1984 presidential debate

-

Iuul Gary Wyckoff, an economist with the Federal
Reserve Bank of Cleveland, studies the public sector.
Michael Dvorak provided research assistance for this
article.
The views stated herein are those of the author and
not necessarily those of the Federal Reserve Bank of
Cleveland or the Board of Governors of the Federal
Reserve System.

••

1. See FOrtune, June 11,1984, p. 97.
2. A tax credit is a provision that allows the taxpayer to reduce his total tax bill after he has figured
his tax base (in this case, his income from various
sources) and has applied the appropriate tax rate
against that base. A tax deduction offsets (or
reduces) the citizen's tax base - for example, the
taxpayer might be allowed to reduce his taxable

over the proportion of Vice President
Bush's 1983 income paid in taxes;
Walter Mondale claimed that tax
loopholes allowed the relatively
wealthy Vice President to lower his
taxes to unreasonably low levels.
Conservatives contend that the
present tax system is inefficient.
They see the system as a leaky bucket
that draws resources from the well
of economic activity; every time the
bucket dips into the well and carries
off money for use by the government,
resources are lost through the leaks.s
This waste occurs because (1)individuals in the economy are encouraged to produce less than otherwise,
and (2) the economy ends up producing the wrong kinds of goods in the
wrong quantities.
As an example of the first type of
inefficiency, conservatives argue
that, because of all the special provisions in the tax code, tax rates are
higher than they need otherwise be.
Since they reduce the after-tax
rewards to economic activity, these
higher tax rates encourage people to
work and save less. The result is a
less productive economy than without the loopholes. By comparison,
the second source of inefficiency is
more subtle in its impact on economic welfare. Loopholes encourage
people to alter their behavior so as to
move them from heavily taxed to
lightly taxed activities. For example,
the exemption for employer-paid
fringe benefits, such as health and
life insurance, encourages people to
take more of their total "income" in
income by some portion of the amount he paid for
medical care. A tax exemption or exclusion is an
item that could, under a comprehensive tax plan,
be considered as part of the citizen's tax base but,
for one reason or another, is not counted in the base
for tax purposes. For example, income from state
and local government bonds is not counted as
income for purposes of the federal income tax.