The Hall–Rabushka flat tax proposal

1. This morning, Francis in the comments asked: "Mark, what do you think of the Hall–Rabushka flat tax proposal? Basically a flat-rate tax on income but not applying to savings/investments?" Having now read up on H-R's actual proposals and the handy Q&A, I can report that this is not what they said at all.

2. The gimmick is that interest would not count as taxable income in the recipient's hands for the simple reason that it will no longer be counted as an allowable expense to the payer. Clearly, there is no need for a tax on dividend income as such, as these are paid out of post-corporation tax profits, and the flat corporation tax rate would be the same as the flat income tax rate. So what they propose for interest is exactly the same - the interest is not an allowable deduction, so it is paid out of post-corporation tax profits and there is clearly no need to levy income tax on the recipient.

3. More importantly, under US tax rules as they stood (they might have changed since), homeowners could claim mortgage interest as a deduction from income (see page 163). Under H-R, there would be no such deduction - this is very sensible indeed, because having such a deduction merely pushes up house prices and hence land prices, and by disallowing the expense, they broaden the tax base and hence allow a lower overall flat income tax rate.

4. H-R also say that they would allow businesses to deduct the full cost of plant and machinery in the first year, instead of only allowing depreciation (or capital allowances, as in the UK). That also seems fair enough, because by and large the manufacturer of plant and machinery has to pay tax on the profits made from the sale in the year of sale, so this would be tax neutral. Actually this is not particularly radical, because once a business has got going, its cash outlay on new plant and machinery each year is +/- equal to its annual depreciation charge (or capital allowance entitlement), and they also suggest that businesses would no longer be allowed to claim depreciation for existing plant and machinery.

5. Skimming through, they also say there is no need for taxing fringe benefits (company car etc) because the expenses would be disallowed at employer level (page 179); there is no need for capital gains tax on shares, as these are claims on post-tax income (page 165); they would get rid of capital gains tax on owner-occupied housing as a quid pro quo for losing the mortgage interest deduction (page 165); get rid of the deduction for charitable donations (page 157) and get rid of inheritance tax (page 190) and so on and so forth.
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6. All this seems very sensible, but then they misapply their own principles to come up with a truly insane proposal (page 179):

Q: How are individuals taxed on their rental activities? Is rental income part of wages or business income? Would individuals have to file both business and individual tax forms if they had both kinds of income?

A: Renting is definitely a business activity and would require a business tax form. Rental receipts are taxed as business income, but purchase of rental property qualifies for a first-year write-off.

7. Owner-occupiers would not be entitled to the first-year write-off of course (and no capital gains tax on a sale), so there is a complete mismatch which could be merrily abused as follows:

a) Instead of buying a house for $200,000 (with a rental value of say $10,000 a year), the cunning owner-occupier would invest $200,000 into an existing (profitable) company, buy the house and the company would claim a $38,000 tax rebate (sticking with their rate of 19%). If he already owns the house, then he can sell it to his own company for $200,000+ instead of paying himself a salary (thus banking the $200,000 tax free).

b) Sure, the future rental income would also be taxable at 19%, but who's to say what the rental value really is? If the owner-occupier pays rent of only $5,000, this is like an "interest free loan from the government" (to quote Tom Cruise's character in The Firm) of $38,000, which is repayable in instalments of $950 a year ($5,000 x 19%).

c) The value of the $38,000 up-front rebate is clearly $38,000 and the net present value of the annual tax payments of ¢950 is (say) $19,000 (discounted to infinity at 5%, with nothing payable at all if the house is left empty). The net balance of $19,000 would merely push up house prices i.e. land prices accordingly (thus undoing everything they just achieved by disallowing mortgage interest as a tax deduction).

d) If and when you came to sell the house, you would simply sell the whole company (so no capital gains tax) or the company would sell the house to a company owned by the next occupier who pulls the same scam (i.e. the interest-free loan gets rolled over).

8. H-R completely overlook the possibility or impact of such shenanigans with their own Q&A (page 166)

Q: Doesn’t the flat tax encourage speculation in land by granting first-year write-off for land purchases?

A: The sellers of land have to count their proceeds as taxable income; this offsets the deduction granted to the purchaser. Prices of undeveloped residential land may rise a little, but with a 19 percent tax rate, the effect should be small. Land transactions are included in the flat tax because it is difficult to separate the value of land from the value of the buildings on it.

Difficult to separate the value? Haven't we heard this somewhere before?

Firstly it isn't difficult, and secondly there is absolutely no need to extend the favourable tax treatment for purchases of plant and machinery (which depreciates fairly quickly and has to be replaced; and where the seller of the machinery is liable to tax on the amount received) to bricks and mortar (which depreciate so slowly as to be effectively permanent, and where the seller as like as not would be an owner-occupier and who sells his house tax free).

9. If the aim is to disallow private expenditure (in the same way as the employer can't claim the cost of fringe benefits) and to broaden the overall tax base (thus requiring a lower overall flat tax rate to raise the same amount of revenue), then surely the only sane solution is to treat landlords and owner-occupiers exactly the same and to go for symmetry:

- no tax deduction for the purchase price or amortisation, and no capital gains tax on a sale;

- no deduction for mortgage interest or repair costs;

- the rental value of the house to be included in taxable income of the owner, whether rent is received or not (any cash rent received up to the official rental value would be tax-free), so it makes no difference if you are an owner-occupier, a landlord or you own a vacant building (or else people would be able to get the $38,000 tax deduction by buying a vacant home through a company and then realising the gains tax free by selling the shares in the company).

- if your employer provides you with accommodation, then either he owns it and is taxed on the rental value (but no tax on employee - there would be no tax on fringe benefits, see 5. above); or your employer rents it on your behalf, then either we allow the rental income as an expense (which goes against the general rule) or he can avoid a double charge by adding a corresponding amount to your cash salary and then paying the rent out of your new higher net salary and netting off the two.

10. Even better of course would be to tax the rental value of land at higher rates and all other income (i.e. all earned income) at lower rates or not at all, but hey. To be entirely fair to H-R, they do mention the topic on page 165: "We believe that taxing housing is properly ceded to local governments under our federal system. Local property taxes capture part of the value of the services of a house.".

That looks like a severe case of "chickening out" to me. If they are going to draw up a blue print for radical tax reform, why not at least suggest that the only tax which local governments can levy is a tax on rental values (and abolish state or city income or sales taxes)? For example, they do go as far as to say (page 168):

Q: What about such other taxes as state, county, excise, and sales taxes? What would happen to them under the flat tax?

A: Although we would prefer that other units of government besides the federal government switch to taxes based on the same principle as the flat tax, we have limited our proposal to federal action. The only important implication of our proposal for other federal taxes is the elimination of the deduction for state and local income taxes and property taxes under the federal income tax (the deduction for state and local sales taxes was eliminated in 1987).