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

Last November President Bush’s bipartisan Advisory Panel on Federal Tax Reform¹ sounded the alarm regarding the need for major tax reform. The Panel proposed two reform plans that would simplify the tax code, cut marginal tax rates, and reduce taxes on savings and investment. Replacing the income tax with a flat tax would create even greater simplification and economic gains than the Panel’s plans. A flat tax would have one low rate and would treat savings and investment in a neutral and efficient manner.

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

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

Despite recent tax cuts, the federal income tax system remains terribly complex and inefficient. The system is biased against savings and investment, and top income tax rates are higher today than after the last major reform in 1986.

Yet competition in the global economy has intensified and most countries have slashed their income tax rates in order to attract foreign investment and promote growth. After the 1986 tax reform, the U.S. corporate tax rate was lower than in most countries, but today the rate is one of the highest in the world. While U.S. companies face non‐​tax challenges such as high pension costs, it makes no sense to also burden them with an anti‐​competitive tax regime as they struggle to expand in domestic and foreign markets.

What tax reforms should the United States pursue? The countries of Eastern Europe have shown the way ahead with sharp cuts to individual and corporate income tax rates. These countries have shown that low‐​rate flat taxes are not just an economist’s dream, but a practical reality that can boost growth, reduce tax avoidance, and increase fairness.

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

• Hong Kong. Hong Kong has long had one of the world’s most efficient tax systems. The corporate income tax has a low 17.5 percent rate. The individual income tax has graduated rates from 2 to 20 percent and various deductions, but individuals can instead pay a 16 percent flat tax on a broader base. Individuals are not taxed on dividends or capital gains.
• Ireland. Ireland has the second‐​highest income per capita and the lowest overall tax burden in Europe. Its economy has grown rapidly as a result of pro‐​market reforms including tax cuts. The corporate tax rate is just 12.5 percent.
• Estonia. Prime Minister Mart Laar launched the European flat tax revolution in 1994 by instituting a 26 percent flat tax for individuals and corporations. Estonia is phasing down its rate to 20 percent. Another pro‐​growth change, adopted in 2000, was to exempt corporate retained earnings from tax. Estonia has become a magnet for foreign investment and has enjoyed strong economic growth.
• Lithuania. In 1994 Lithuania cut its corporate tax rate to 29 percent and its top individual rate to 33 percent. In 2002 the corporate rate was cut to 15 percent. In 2005 Lithuania passed a phased‐​in cut to its top individual rate to 24 percent. The tax rate on dividends is 15 percent.
• Latvia. In 1995 Latvia cut its top individual tax rate to 25 percent. The corporate tax rate was reduced from 35 percent in 2001 to 15 percent in 2004. Domestic dividends are exempt from tax.
• Hungary. Hungary cut its corporate tax rate to 18 percent in 1995 and reduced it further to 16 percent in 2004. Hungary has a top individual income tax rate of 38 percent, but dividends are taxed at a lower rate.
• Russia. In 2001 Russia replaced its individual income tax, which had rates up to 30 percent, with a 13 percent flat tax. In 2002 it cut its corporate tax rate from 35 to 24 percent. Russia’s system is not a pure flat tax, as it retains some deductions and narrow provisions. Domestic dividends are taxed at just 9 percent. Russia’s tax reforms have been a big success. In recent years, the nation’s economy has grown strongly, tax revenues have risen, and tax evasion has fallen.
• Serbia. In 2003 Serbia enacted a flat income tax with a 14 percent rate on individuals and corporations.
• Ukraine. In 2004 Ukraine replaced its individual income tax, which had a top rate of 40 percent, with a 13 percent flat tax. It also cut its corporate tax rate from 30 to 25 percent.
• Slovakia. Slovakia adopted a flat rate tax of 19 percent on individuals and corporations in 2004. The top tax rates had been 38 percent and 25 percent, respectively. For individuals, the flat tax has a large basic exemption and few special preferences. Dividends are exempt from tax. Slovakia is attracting large investment inflows and its economy is growing strongly.
• Poland. In 2004 Poland cut its corporate tax rate from 27 to 19 percent. The top individual rate is a high 40 percent, but reforms may be on the way. One party in the new coalition government favors a low‐​rate flat tax, while the other favors a cut in the top rate to 32 percent.
• Georgia. In 2005 Georgia adopted an individual flat tax with a 12 percent rate. The top individual rate had been 20 percent. The corporate tax rate is 20 percent.
• Romania. Soon after coming into office, Romania’s new president issued an edict to replace the nation’s income tax with a 16 percent flat tax on individuals and corporations, effective for 2005. The top tax rates had been 40 and 25 percent, respectively.

The table below shows that the United States has much higher income tax rates than do these flat tax countries. Indeed, the United States has a higher corporate tax rate than virtually all our trading partners. The average top corporate tax rate in the European Union is 26.6 percent, which compares to the U.S. federal and average state rate of 39.5 percent.²

I suspect that countries around the world will continue to cut corporate tax rates, partly because of the large benefits that can be gained by attracting greater inflows of foreign investment. As much as $1 trillion of direct investment crosses international borders each year, and research shows that these flows are increasingly sensitive to taxes.³ Our tax system, particularly the corporate income tax, will have an increasingly negative effect on U.S. growth unless reformed. Also note that high tax rates and excessive tax complexity create an ideal breeding ground for Enron‐​style tax scandals.

The solution is to sharply cut the top corporate and individual income tax rates, either within a full flat tax reform package or under more limited reforms.⁴ U.S. policymakers need to wake up to the new global tax realities and put marginal tax rate cuts front and center in federal policy discussions. Replacing the high‐​rate income tax with a flat tax would 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 high marginal tax rates on individuals and businesses. The top D.C. individual tax rate is 9.0 percent, which compares to a 50‐​state average of 5.5 percent.⁵ The top D.C. corporate rate is 10.0 percent, which compares to a 50‐​state average of 6.9 percent.

Thus, regardless of possible federal tax changes in D.C., it would make sense for the city to reduce its high local tax rates to at least national average levels. I have argued that states should kill their corporate income taxes altogether, as these taxes have very high compliance costs compared to the little revenue collected.⁶ If a federal tax reform such as a flat tax were introduced in D.C., extra local revenue that is generated from higher economic growth should be used to cut high local income tax rates.

A D.C. flat tax that is voluntary is an interesting idea for policymakers to consider. One model for a flat tax is the Hong Kong tax system. That city’s individual income tax has a graduated rate structure, but it provides taxpayers with an alternative of a 16 percent 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 under the current system, while some would pay less. Because that may create a political hurdle, I’d suggest that the revenue loss be at least partly offset with cuts to federal spending in the District. Cuts could be made both to D.C. appropriations as well as spending under regular federal programs. For example, economic development funding could be cut, including programs such as Community Development Block Grants. Such spending is dubious to begin with, but certainly would not be needed with all the new investment pouring into the District to take advantage of the low federal tax rates.

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

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

A flat tax for the District would (or could) include reforms to both individual and corporate taxes. Note that, in general, corporate tax cuts have larger beneficial effects on the economy than individual tax cuts. Last year the Joint Committee on Taxation modeled the effects of equal‐​sized hypothetical cuts to the federal corporate and individual income taxes.⁷ They found that in the long run a corporate rate cut caused a much larger increase in gross domestic product than an individual tax cut. The upshot for D.C. is that cutting the corporate tax rate (either the federal rate in the city or the local rate) would probably give the biggest bang for the buck to boost the city’s economy.

Conclusion

The goal of federal policymakers should be to replace the current income tax with a low‐​rate consumption‐​based system‐​such as the flat tax‐​for the whole country. A flat tax for D.C. is an interesting idea that could be the model for broader national reforms.

Many people are interested in the flat tax, but want to know whether it would work as well as proponents expect it to. Certainly, the experience in countries that have adopted flat taxes has been very positive. In today’s competitive global economy, we need to get moving on major tax reforms, and so I applaud the committee for exploring these issues.

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

¹President’s Advisory Panel on Federal Tax Reform, “Simple, Fair, and Pro‐​Growth: Proposals to Fix America’s Tax System,” November 2005, www​.taxre​form​pan​el​.gov.

²Chris Edwards, “Catching Up to Global Tax Reforms,” Cato Institute Tax & Budget Bulletin no. 28, November 2005.

³Chris Edwards and Veronique de Rugy, “International Tax Competition: A 21st‐​Century Restraint on Government,” Cato Institute Policy Analysis no. 431, April 12, 2002.

⁴For a discussion of federal tax reform options, see Chris Edwards, “Options for Tax Reform,” Cato Institute Policy Analysis no. 536, February 24, 2005.

⁵Chris Edwards, “State Revenue Boom Paves Way for Tax Cuts,” Cato Institute Tax & Budget Bulletin no. 30, January 2006.

⁶Chris Edwards, “State Corporate Income Taxes Should Be Repealed,” Cato Institute Tax & Budget Bulletin no. 19, April 2004.

⁷ Joint Committee on Taxation, “Macroeconomic Analysis of Various Proposals to Provide $500 Billion in Tax Relief,” JCX-04–05, March 1, 2005.