Business Taxes and the Flat Tax

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

March 7, 1996

Discussion of the flat tax to date has focused on the household-level tax, overlooking the business tax, overlooking the business tax. That, however, is the source of many of the flat tax’s largest potential gains and costs.

The flat tax would repeal the existing individual and corporate income taxes. A new, single tax rate would apply to taxable income for businesses and households.

At the household level, wages and pension benefits would be taxes above an exemption adjusted for family size. No other income would be taxed, and no other deductions would be allowed.

At the business level, the tax would apply to the difference between sales of goods and services on the one hand and the sum of wages, pension contributions, material costs and capital investments on the other.

The business tax would apply to incorporated as well as unincorporated businesses. The corporate income tax now raises about 20% of total income tax revenues. The Treasury Department estimates that the business tax would raise 42% of revenues under a flat tax.

The business tax has much to offer. It would be much simpler than existing taxes. By letting firms deduct all capital purchases in the year they are made, it would encourage greater investment. It would also let firms make choices for economic reasons rather than for tax considerations.

Some attention has been paid to one issue: The distribution of payments across firms would change. For example, firms with high levels of new investment and low borrowing levels would see reduced tax payments.

These changes may be misleading. Businesses remit tax payments to the government. But in the end, the burden of such taxes is borne by consumers, workers or shareholders via higher prices, lower wages or smaller return on equity.

At least two other issues merit comment. First is a potentially important loophole.

The business tax is not a cash flow tax. Receipts from sales of goods and services are taxable, bur receipt of interest income is not taxable. Outflows that are labeled purchases of goods and services or capital investments are deductible, while outflows that are labeled interest payments are not deductible.

This creates obvious incentives in transactions between businesses and entities not subject to the business tax (households, governments, nonprofits and foreigners).

To avoid paying taxes, businesses would seek to label the maximum amount of cash inflows as “interest income,” and as many cash outflows as possible as “purchases.” The other party (not subject to the business tax) would be indifferent to such labeling.

These incentives, and the resulting “creative bookkeeping,” could seriously erode the tax base and tax revenues.

These concerns have led tax experts Charles McLure of the Hoover Institution and George Zodrow of Rice University to conclude that the business tax “contains unacceptable opportunities for abuse.”

It may be possible to fix some of these problems by moving to a cash flow tax at the business level that includes financial flows. But a cash flow tax is a very different tax system, raising a host of additional questions.

The second issues is that the business tax may exacerbate recessions. Under the current system, tax payments drop during recessions, thus freeing cash for private spending. And they rise during booms, thus moderating the boom. This “automatic stabilizer” feature is almost universally deemed a virtue of the income tax.

Under the flat tax, however, the business tax may work as an automatic destabilizer.

The business tax base is sales less investments and less other items. Investment tends to be highly volatile over the business cycle. Thus in a recession, if investment drops more than sales, tax payments will rise, rather than falling as they would under the income tax.

The difference, of course, is that under the income tax, depreciation deductions are essentially a weighted average of previous year’s investments and so are more stable over the business cycle than investment is.

The flat tax is a simple, elegant proposal that addresses several large flaws in the tax system. Final judgment should depend on a host of factors. But the business tax, a central part of all plans, cannot be left out of any serious calculation.