Flat Tax Impact on Saving and the Economy

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

February 19, 1996

The notion of a “flat tax” has attracted increased attention and support in recent months. As pushed by Steve Forbes, Richard Armey, the Kemp Commission and others, the flat tax would give each family a large exemption, tax all wage income above that level at a single, low rate and would exempt interest, dividends and capital gains from all household-level taxes. Proponents claim the flat tax would be simpler than the current tax system, and would generate dramatic increases in saving and economic growth. Alas, while the new system would certainly be simpler (if it lasted), proponents of the flat tax are likely to be disappointed by the impact on saving.

Concern about saving and growth is well-founded. After averaging 8% of gross domestic product from 1950 to 1980, U.S. private saving—that is, saving by businesses and families—has averaged 4.9% since 1990. Low saving has both personal and national economic consequences. Some households save very little and will be ill-prepared to retire. A nation with a low saving rate will have few resources available for productive private investment, or will have to borrow from abroad to finance investment. Higher saving could help support people in retirement, strengthen economic growth and raise living standards for all.

Income tax’s drag on saving

Critics charge the income tax has been a drag on saving. Some forms of personal saving are taxed twice, once when earned and again when the saving produces investment income. Corporate income is taxed at the corporate level and again when it is received by shareholders. The income tax does not adjust capital gains and interest income for inflation. Under the flat tax, these issues simply would not arise, because all capital income is exempted from the household-level tax.

The flat tax could boost saving by raising the after-tax return on saving and by shifting income toward high-saving households. Estimates suggest shifting from a pure income tax to a pure flat tax would raise long-term saving by between 10% and 20%, thus raising the saving rate by a half percent to 1% of GDP. But the actual increase would be smaller, for four reasons.

Flat tax issues

First, our current system is not a pure income tax, but a hybrid between a consumption and income tax. Funds placed in pensions, 401(k) plans, Keoghs and most IRAs, or individual retirement accounts—which together account for about half of private saving—are not taxed until they are withdrawn, just as they would be treated under a flat tax. This means these investments now earn the full pre-tax rate of return. But even advocates acknowledge shifting to a flat tax should reduce pre-tax interest rates. This will reduce the return on pensions and related plans. Voluntary contributions to such accounts may fall as well.

Second, pension coverage may fall. The pension system has been fueled by its sizable tax advantages. But why should workers and employers continue to accept the high regulatory and administrative costs of pensions if under a flat tax they can get the same favorable tax treatment on saving in any form? If employers scrap their pension plans, workers will have to set aside the equivalent amounts in their personal saving accounts just to maintain the level of saving. To the extent that workers fail to do so, saving will fall.

Third, if the mortgage interest deduction is retained, households will be able to deduct interest payments, even though they would not have to pay taxes on interest income. This would create incentives for households to borrow, which would reduce the saving rate further.

Fourth, special transitional rules governing the conversion to a flat tax could severely reduce the effect on saving. Why might such rules arise? People have purchased homes expecting to receive mortgage interest deductions; businesses have borrowed money and made investments expecting to take write-offs for interest payments and depreciation. A flat tax immediately would end these deductions on old investments. This would reduce the value of existing homes and businesses relative to new ones.

Making the transition

The Catch-22 is this. A “cold turkey” switch to a flat tax—with no transitional relief—would penalize people for having done things (like saving, buying a house, or borrowing and investing) that are not only perfectly legal but also in many cases encouraged by the tax system. But the flat tax would produce significant gains in efficiency and saving only if transitional rules are not allowed. This occurs because allowing transitional relief reduces one source of tax revenue and hence requires higher rates in the rest of the system—for example, on wage income—to raise the same amount of revenue.

Hence, transitional relief, which may seem completely reasonable and in any case may be a politically necessity, could dramatically reduce the impact of reform on saving and growth—by as much as 70% to 100% according to different studies—and likely would result in a less efficient tax system.

Thus, the flat tax might have little long-term impact on saving. Of course, there are other reasons to consider reform. Growth could occur through better allocation of investment or smaller costs of tax compliance. Fairness and simplicity are valuable in themselves. But more modest reforms of the income tax could achieve some of these goals. And without significant increases in saving and growth, it is hard to see how uprooting the entire tax system is worth the risks, redistributions and adjustment costs it would impose.