The Need for Tax Reform and the Possibility of a Flat Tax for the District of Columbia

Share

Mr. Chairman and members of the Committee, thank you forinviting me to testify today regarding a possible flat tax for theDistrict of Columbia.

Last November President Bush's bipartisan Advisory Panel onFederal Tax Reform1 soundedthe alarm regarding the need for major tax reform. The Panelproposed two reform plans that would simplify the tax code, cutmarginal tax rates, and reduce taxes on savings and investment.Replacing the income tax with a flat tax would create even greatersimplification and economic gains than the Panel's plans. A flattax would have one low rate and would treat savings and investmentin a neutral and efficient manner.

This testimony discusses why it is crucial to move ahead withfederal tax reform along the lines of a flat tax. It also discussessome aspects to consider regarding a possible flat tax for D.C.

The U.S. Should be a Tax Reform Leader, Not aLaggard

Despite recent tax cuts, the federal income tax system remainsterribly complex and inefficient. The system is biased againstsavings and investment, and top income tax rates are higher todaythan after the last major reform in 1986.

Yet competition in the global economy has intensified and mostcountries have slashed their income tax rates in order to attractforeign investment and promote growth. After the 1986 tax reform,the U.S. corporate tax rate was lower than in most countries, buttoday the rate is one of the highest in the world. While U.S.companies face non-tax challenges such as high pension costs, itmakes no sense to also burden them with an anti-competitive taxregime as they struggle to expand in domestic and foreignmarkets.

What tax reforms should the United States pursue? The countriesof Eastern Europe have shown the way ahead with sharp cuts toindividual and corporate income tax rates. These countries haveshown that low-rate flat taxes are not just an economist's dream,but a practical reality that can boost growth, reduce taxavoidance, and increase fairness.

Here is a summary of some of the tax reforms abroad:

  • Hong Kong. Hong Kong has long had oneof the world's most efficient tax systems. The corporate income taxhas a low 17.5 percent rate. The individual income tax hasgraduated rates from 2 to 20 percent and various deductions, butindividuals can instead pay a 16 percent flat tax on a broaderbase. Individuals are not taxed on dividends or capital gains.
  • Ireland. Ireland has thesecond-highest income per capita and the lowest overall tax burdenin Europe. Its economy has grown rapidly as a result of pro-marketreforms including tax cuts. The corporate tax rate is just 12.5percent.
  • Estonia. Prime Minister Mart Laarlaunched the European flat tax revolution in 1994 by instituting a26 percent flat tax for individuals and corporations. Estonia isphasing down its rate to 20 percent. Another pro-growth change,adopted in 2000, was to exempt corporate retained earnings fromtax. Estonia has become a magnet for foreign investment and hasenjoyed strong economic growth.
  • Lithuania. In 1994 Lithuania cut itscorporate tax rate to 29 percent and its top individual rate to 33percent. In 2002 the corporate rate was cut to 15 percent. In 2005Lithuania passed a phased-in cut to its top individual rate to 24percent. The tax rate on dividends is 15 percent.
  • Latvia. In 1995 Latvia cut its topindividual tax rate to 25 percent. The corporate tax rate wasreduced from 35 percent in 2001 to 15 percent in 2004. Domesticdividends are exempt from tax.
  • Hungary. Hungary cut its corporatetax rate to 18 percent in 1995 and reduced it further to 16 percentin 2004. Hungary has a top individual income tax rate of 38percent, but dividends are taxed at a lower rate.
  • Russia. In 2001 Russia replaced itsindividual income tax, which had rates up to 30 percent, with a 13percent flat tax. In 2002 it cut its corporate tax rate from 35 to24 percent. Russia's system is not a pure flat tax, as it retainssome deductions and narrow provisions. Domestic dividends are taxedat just 9 percent. Russia's tax reforms have been a big success. Inrecent years, the nation's economy has grown strongly, tax revenueshave risen, and tax evasion has fallen.
  • Serbia. In 2003 Serbia enacted a flatincome tax with a 14 percent rate on individuals andcorporations.
  • Ukraine. In 2004 Ukraine replaced itsindividual income tax, which had a top rate of 40 percent, with a13 percent flat tax. It also cut its corporate tax rate from 30 to25 percent.
  • Slovakia. Slovakia adopted a flatrate tax of 19 percent on individuals and corporations in 2004. Thetop tax rates had been 38 percent and 25 percent, respectively. Forindividuals, the flat tax has a large basic exemption and fewspecial preferences. Dividends are exempt from tax. Slovakia isattracting large investment inflows and its economy is growingstrongly.
  • Poland. In 2004 Poland cut itscorporate tax rate from 27 to 19 percent. The top individual rateis a high 40 percent, but reforms may be on the way. One party inthe new coalition government favors a low-rate flat tax, while theother favors a cut in the top rate to 32 percent.
  • Georgia. In 2005 Georgia adopted anindividual flat tax with a 12 percent rate. The top individual ratehad been 20 percent. The corporate tax rate is 20 percent.
  • Romania. Soon after coming intooffice, Romania's new president issued an edict to replace thenation's income tax with a 16 percent flat tax on individuals andcorporations, effective for 2005. The top tax rates had been 40 and25 percent, respectively.

The table below shows that the United States has much higherincome tax rates than do these flat tax countries. Indeed, theUnited States has a higher corporate tax rate than virtually allour trading partners. The average top corporate tax rate in theEuropean Union is 26.6 percent, which compares to the U.S. federaland average state rate of 39.5 percent.2

tax chart

I suspect that countries around the world will continue to cutcorporate tax rates, partly because of the large benefits that canbe gained by attracting greater inflows of foreign investment. Asmuch as $1 trillion of direct investment crosses internationalborders each year, and research shows that these flows areincreasingly sensitive to taxes.3 Our tax system, particularly the corporate incometax, will have an increasingly negative effect on U.S. growthunless reformed. Also note that high tax rates and excessive taxcomplexity create an ideal breeding ground for Enron-style taxscandals.

The solution is to sharply cut the top corporate and individualincome tax rates, either within a full flat tax reform package orunder more limited reforms.4U.S. policymakers need to wake up to the new global tax realitiesand put marginal tax rate cuts front and center in federal policydiscussions. Replacing the high-rate income tax with a flat taxwould be a great way to accomplish that.

A Flat Tax for D.C?

The first thing to note about taxation in D.C. is the highmarginal tax rates on individuals and businesses. The top D.C.individual tax rate is 9.0 percent, which compares to a 50-stateaverage of 5.5 percent.5 Thetop D.C. corporate rate is 10.0 percent, which compares to a50-state average of 6.9 percent.

Thus, regardless of possible federal tax changes in D.C., itwould make sense for the city to reduce its high local tax rates toat least national average levels. I have argued that states shouldkill their corporate income taxes altogether, as these taxes havevery high compliance costs compared to the little revenuecollected.6 If a federal taxreform such as a flat tax were introduced in D.C., extra localrevenue that is generated from higher economic growth should beused to cut high local income tax rates.

A D.C. flat tax that is voluntary is an interesting idea forpolicymakers to consider. One model for a flat tax is the Hong Kongtax system. That city's individual income tax has a graduated ratestructure, but it provides taxpayers with an alternative of a 16percent flat tax applied to a broader tax base.

A voluntary flat tax would presumably result in a (static)federal revenue loss because no taxpayers would pay more than underthe current system, while some would pay less. Because that maycreate a political hurdle, I'd suggest that the revenue loss be atleast partly offset with cuts to federal spending in the District.Cuts could be made both to D.C. appropriations as well as spendingunder regular federal programs. For example, economic developmentfunding could be cut, including programs such as CommunityDevelopment Block Grants. Such spending is dubious to begin with,but certainly would not be needed with all the new investmentpouring into the District to take advantage of the low federal taxrates.

Another aspect to consider is that if a D.C. flat tax created afederal revenue loss, neighboring states might complain that D.C.residents were getting an unfair benefit. Again, the solution wouldbe to cut federal spending in D.C. We could have a revenue neutralpolicy change that resulted from less federal taxes and lessfederal spending in the city, which would be combined with a morevibrant private sector economy.

There is a parallel idea being proposed for federal highwayspending. Bills have been introduced in Congress that would allow astate to opt-out of the federal highway system by ending both thefederal gas tax and federal highway spending in a state. Thus, astate would pay less to the federal government but also get lessback, in a roughly revenue neutral fashion.

A flat tax for the District would (or could) include reforms toboth individual and corporate taxes. Note that, in general,corporate tax cuts have larger beneficial effects on the economythan individual tax cuts. Last year the Joint Committee on Taxationmodeled the effects of equal-sized hypothetical cuts to the federalcorporate and individual income taxes.7 They found that in the long run a corporate ratecut caused a much larger increase in gross domestic product than anindividual tax cut. The upshot for D.C. is that cutting thecorporate tax rate (either the federal rate in the city or thelocal rate) would probably give the biggest bang for the buck toboost the city's economy.

Conclusion

The goal of federal policymakers should be to replace thecurrent income tax with a low-rate consumption-based system-such asthe flat tax-for the whole country. A flat tax for D.C. is aninteresting idea that could be the model for broader nationalreforms.

Many people are interested in the flat tax, but want to knowwhether it would work as well as proponents expect it to.Certainly, the experience in countries that have adopted flat taxeshas been very positive. In today's competitive global economy, weneed to get moving on major tax reforms, and so I applaud thecommittee for exploring these issues.

Thank you for holding these important hearings. I look forwardto working with the Committee on its flat tax agenda.


1President's AdvisoryPanel on Federal Tax Reform, "Simple, Fair, and Pro-Growth:Proposals to Fix America's Tax System," November 2005,www.taxreformpanel.gov.

2Chris Edwards, "CatchingUp to Global Tax Reforms," Cato Institute Tax & Budget Bulletinno. 28, November 2005.

3Chris Edwards andVeronique de Rugy, "International Tax Competition: A 21st-CenturyRestraint on Government," Cato Institute Policy Analysis no. 431,April 12, 2002.

4For a discussion offederal tax reform options, see Chris Edwards, "Options for TaxReform," Cato Institute Policy Analysis no. 536, February 24,2005.

5Chris Edwards, "StateRevenue Boom Paves Way for Tax Cuts," Cato Institute Tax &Budget Bulletin no. 30, January 2006.

6Chris Edwards, "StateCorporate Income Taxes Should Be Repealed," Cato Institute Tax& Budget Bulletin no. 19, April 2004.

7 Joint Committee onTaxation, "Macroeconomic Analysis of Various Proposals to Provide$500 Billion in Tax Relief," JCX-04-05, March 1, 2005.

Chris Edwards

Subcommittee on the District of Columbia
Committee on Appropriations
United States Senate