Page 258 - The Principle of Economics

262 PART FOUR
THE ECONOMICS OF THE PUBLIC SECTOR
N In computing income for tax purposes, businesses would be allowed to deduct all legitimate business expenses, including expenses on new investment goods. This deduction for investment makes the flat tax more like a consumption tax than an income tax. As a result, a change to a flat tax would increase the incentive to save (or, more precisely, would eliminate the current tax system’s disincentive to save).
In short, advocates of the flat tax claim that there is a strong efficiency argument for this dramatic tax reform.
Critics of the flat tax are sympathetic with the goal of a simpler and more ef- ficient tax system, but they oppose the flat tax because they believe that it gives too little weight to the goal of vertical equity. They claim that a flat tax would be less progressive than the current tax system and, in particular, would shift some of the tax burden from the wealthy to the middle class. This concern may well be justified, but no one knows for sure. Our study of tax incidence shows that the burden of a tax is not necessarily borne by the person who sends the check to the government. If the flat tax did encourage greater saving, as advocates claim, it would lead to more rapid economic growth, which would benefit all taxpayers. No one can be certain, however, about how large the impact on eco- nomic growth would be.
QUICK QUIZ: Explain the benefits principle and the ability-to-pay principle. N What are vertical equity and horizontal equity? N Why is studying tax incidence important for determining the equity of a tax system?
CONCLUSION: THE TRADEOFF BETWEEN EQUITY AND EFFICIENCY
Almost everyone agrees that equity and efficiency are the two most important goals of the tax system. But often these two goals conflict. Many proposed changes in the tax laws increase efficiency while reducing equity, or increase equity while reducing efficiency. People disagree about tax policy often because they attach dif- ferent weights to these two goals.
The recent history of tax policy shows how political leaders differ in their views on equity and efficiency. When Ronald Reagan was elected president in 1980, the marginal tax rate on the earnings of the richest Americans was 50 per- cent. On interest income, the marginal tax rate was 70 percent. Reagan argued that such high tax rates greatly distorted economic incentives to work and save. In other words, he claimed that these high tax rates cost too much in terms of eco- nomic efficiency. Tax reform was, therefore, a high priority of his administration. Reagan signed into law large cuts in tax rates in 1981 and then again in 1986. When Reagan left office in 1989, the richest Americans faced a marginal tax rate of only 28 percent. During the four years of the Bush presidency, the top tax rate increased slightly to 31 percent.
When Bill Clinton ran for president in 1992, he argued that the rich were not paying their fair share of taxes. In other words, the low tax rates on the rich