As a society, we have decided-though not in any conscious way-to take more of our pay in forms other than money. We have gotten more medical care, cleaner air and water and easier recourse to law for everything from divorce to product liability. There’s nothing inherently wrong with this. Higher health spending has improved millions of lives. Our air and water have become cleaner. But along with the benefits, we need to be more aware of the costs. They affect our debates of everything from health care to legal reform, and yet their magnitude is not widely recognized. Let’s see why.
Productivity (the economy’s efficiency) is the wellspring of higher living standards. As we produce more, there’s more to buy, and living standards rise. Indeed, productivity and family income increased more or less in lock step for the first 25 years after World War II. Since then, the relationship has come unstuck. Even with slower productivity growth, we should have achieved sizable income gains. Between 1972 and 1990, productivity rose 18 percent, about twice the growth of median income.
What happened? America has hordes of economists (116,000 in 1991), and yet this question-the breakdown between productivity and income growth-has been virtually ignored. But a big part of the answer is bound to be the surge of nonwage spending. The table on the right shows how health care, environmental spending and legal costs have expanded as a share of the economy’s output (gross domestic product, or GDP) since 1972.
There’s been a massive spending shift of nearly 7 percent of GDP. In a $6 trillion economy, that means we now spend about $420 billion more annually on these activities than vie would have. For all the benefits, this sort of spending erodes take-home pay in two ways.
First, companies channel more of workers’ compensation into health insurance, not into paychecks. And second, companies recover higher environmental, regulatory and legal costs by raising prices. Either way, workers’ incomes suffer. (A good example of the price effect is the requirement of the Clean Air Act amendments of 1990, which will force oil companies to produce a less-polluting gasoline. The added costs may raise pump prices by 5 to 10 cents a gallon in 1995.)
Suppose that none of these changes had occurred and that, as a result, family incomes had risen another 7 percent between 1972 and 1990. Then, the gain would have been 15 percent (the actual income gain of 8 percent plus 7 percent more), close to the 18 percent productivity increase. From this, I conclude that rising health, environmental and legal costs cut income gains by roughly half.
Now let me hedge a bit. This is a crude estimate. It may not be precisely right. Growing income inequality may explain some of the slow rise of median family income (half of all families are above the median, half below); highincome families have done better than average. I have also made a lot of simplifying assumptions. Some exaggerate the impact of health, legal and regulatory spending; others understate it. Finally, I ignore the effect of the growth of two-earner couples on family incomes.
But my hunch is that, if some diligent economist made all the proper adjustments, the basic conclusion wouldn’t change. Maybe the wage loss would be as small as one quarter or as large as two thirds. (The Congressional Budget Office estimates that rising health-insurance costs alone have cut real wage gains by half since 1973.) Whatever the details, the loss of money income is a big one.
We need to acknowledge it. Instead, we deny and compartmentalize. We complain that our incomes aren’t rising fast enough. Meanwhile, we want extensive health-care benefits, a cleaner environment and more legal “rights” of all sorts. There’s only a loose understanding that these matters are ultimately connected. There’s a tendency to snicker at businesses that say they can’t afford a new fringe benefit, or that they’re being overregulated and swamped with paperwork. The assumption is that companies are just whining, that they can absorb the extra costs.
But in the end, the companies don’t absorb the costs. We all absorb the costs, which are passed along in one way or another. The cost of any single benefit or regulation isn’t typically large. But lots of small costs ultimately become big costs, and they grow over time. The lesson is especially apt now, because we’re on the threshold of a major debate about health care. We need to find ways to restrain rising costs. Likewise, we need to avoid the temptation of simply imposing expansive mandates on business-whether for health care or other employee benefits.
The same lesson applies to all regulatory and legal activities. We ought to search for opportunities to make our laws work with more speed and less expense. Reform of product-liability laws (a bill has just been introduced in Congress) is long overdue. In general, we need to more cost-conscious. The expense of perfection can be exorbitant: for example, eliminating the final ounce of pollution. “However desirable the goal, the question has to be asked: is the last step toward achieving it worth what you’re giving up?” says economist Milton Russell, director of the Joint Institute for Energy & Environment. We can disguise or ignore the costs; but we can’t eliminate them. That old and cliched axiom still applies: there’s no free lunch.
PERCENT OF GDP 1972 1990 Health care 7.6% 12.2% Environment 0.9% 2.1% Legal fees 0.9% 1.7% TOTAL 9.4% 16.0%
title: “There S Still No Free Lunch” ShowToc: true date: “2022-12-30” author: “Derek Gates”
And riding to the rescue is this year’s political outsider, Malcolm S. Forbes Jr., the centimillionaire magazine magnate, bearing his miracle for the millennium: the flat tax. To hear him and fellow travelers like the Kemp commission tell it, a flat tax would nuke the IRS and make taxes so simple that average people could do their returns during half time while watching the Super Bowl. Everyone’s taxes will go down, interest rates will plummet and the U.S. economy will boom forever.
A very simple and appealing idea–which explains why Steve Forbes has catapulted from obscurity to a solid second place among Republican presidential contenders. The current tax code is an incredible mess. Some income, like interest from municipal bonds, is tax-exempt. Some, like corporate dividends, is in effect taxed twice. Some, like social-security payments, may or may not be partly taxable, depending on your income. The IRS has hundreds of different forms, and even tax professionals disagree about what some of them mean.
So Forbes’s tax plan is enormously appealing. No muss, no fuss, a simple form. But things start to fall apart when you look at how Forbes’s plan would actually work. Especially when you compare his plan with the book from which it sprang: “The Flat Tax,” by Robert Hall and Alvin Rabushka of Stanford University’s Hoover Institution. This book is known as “the bible” in flat-tax circles. Steve Forbes has transmuted the bible, a quite candid book, into a political document by massaging its numbers until they came out right, and ignoring some unpleasant facts. I’m not yet another Forbes-basher; I worked at Forbes magazine for seven years and got to know and like Steve Forbes. He’s absolutely right that the tax code is a disaster and should be drastically changed. My major problems with Forbes’s plan are that its numbers don’t add up and that it would greatly enlarge the gulf between haves and have-nots.
Before we proceed, a flat-tax primer. Under Forbes’s plan, you would take your salary and self-employment income, subtract $26,200 for a couple filing jointly, subtract an additional $5,800 per dependent, and pay 17 percent of what’s left. The tax rate is flat: one bracket fits all. Investment income–interest, dividends and capital gains–would be wholly free from taxes. Social-security payments would be tax-free, too. There would be no inheritance tax. There would be no itemized deductions, such as those now allowed for mortgage interest, state and local taxes and charitable contributions. Corporations would no longer be able to deduct interest expense, their half of social-security payments or the cost of fringe benefits other than pensions. The corporate-tax rate would drop to 17 percent from the current 85 percent. By contrast to the corporate rate, the current personal income tax is progressive, with five brackets ranging from 15 to $9.6 percent. It’s riddled with loopholes, deductions and credits.
Back to the main event. When I asked for nitty-gritty details of how Forbes’s plan works, his staff referred me to the bible, which is quite a good book. Its authors have spent more than a decade refining their work and promoting a flat tax. But the book contradicts Forbes in some important areas. That’s doubtless because authors Hall and Rabushka are academics whose work has to withstand critical scrutiny, while Forbes, for all his outsider affectations, has become a politician.
The bible says that under its plan, which calls for a 19 percent tax after deducting$25,500 for a family of four, “the flat tax is a little higher than the current income tax in the range from $$0,000 to $90,000.” Oops. That would raise taxes on most of the middle class. Hardly the way to get elected. So Forbes massaged the numbers: he boosted deductions to $36,800 for a family of four and used a 17 percent rate. Look, Ma, no middle-class tax increase. Hall and Rabushka say their plan is revenue neutral: it would produce the same amount the government collects now. When I asked Forbes at a NEWSWEEK lunch last week how his lower tax rate and bigger exemptions square with the bible, his answer was “who says it has to be revenue neutral?” He says his plan is a tax cut; how big he doesn’t say. How will we fill the gap? With economic growth and government spending cuts (page 27). Details? Forbes isn’t saying.
The Clinton Treasury Department, hardly an unbiased source, says it would take a 20.8 percent tax rate for Forbes’s plan to be revenue neutral; it assumes no growth generated by the flat tax. Forbes says massive growth will wipe away all problems, the same type of thinking that gave us the $5 trillion national debt that’s eating us alive. You may recall that Ronald Reagan, on whom Forbes models himself, said his tax cuts would balance the budget. Instead, they helped add trillions to the national debt.
Forbes’s plan would eliminate the Earned Income Tax Credit, which benefits low-paid people. The Treasury says preserving the credit would add a half-percent or so to Forbes’s tax rate. Preserving the credit seems only fair, considering how much Forbes’s plan would benefit the well-off. We won’t even discuss the impact of social-security and Medicare taxes, which fall most heavily on the lowest-salaried people. That’s because you and your employer each pay 7.65 percent tax on the first $62,700 you make this year, but only 1.45 percent each on anything above that.
The bible says its flat tax would result in individuals’ paying less total income taxes than they do now, while “raising the amount of federal revenue collected from businesses.” Forbes denied that businesses’ tax payments would rise under his plan, but I couldn’t get him to give me an explanation I could understand. His campaign referred me to Daniel Mitchell, a senior fellow at the Heritage Foundation. Mitchell told me that corporations would definitely pay more income taxes than they do now, given the huge loopholes in current law. So how can Forbes say that corporations won’t pay higher taxes? Mitchell’s answer: when corporations can no longer deduct fringe benefits like health care, they will try to compensate by reducing wages or holding down future increases. See? It’s not really a tax on business, because business will pass it along to employees. And it’s not a tax on people, either. Mitchell, by the way, believes that employees would make out because the economy would grow and demand for labor would get so strong that corporations would have to raise wages.
FORBES HAS rightly drawn flak because under his plan, people living off interest, dividends and capital gains will pay no tax. Billionaires Bill Gates and Warren Buffett could sell stock, pocket their gains tax-free and live tax-free off interest and dividends forever, while striving salary earners will have to ante up to Uncle Sugar. In the hermetic universe in which theorists dwell, you have to do things this way, because you want to tax income only once. Corporations would pay income tax, so no one should have to pay tax on corporate dividends, because that money’s already been taxed. Similarly, people who have paid taxes on their salary income should be able to put their after-tax money to work without having to pay tax on what that money earns. Interest income shouldn’t be taxable because it wouldn’t be deductible to the payers. In a perfect world, all this is consistent, logical and fair.
But there are a few real-world problems. Investment income would be treated so much more favorably than salary income that it would put wealthy inheritors and other people with access to large amounts of capital even farther ahead of the game than they are now, compared with people who have to claw their way up the ladder. And why should the manager of a billion-dollar hedge fund get her 20 percent piece of the profits tax-free, while the people who deliver sandwiches to her have to pay tax on their salary and tips? Why would it make sense to let corporate chairmen pay minimal taxes on stock options when they receive them, as called for in the bible, and for them to keep all the capital gains the options generate, while optionless middle managers pay full freight?
The current tax code is a horror. It’s full of loopholes and provisions that favor certain investments. Then there’s the hideously complex alternative minimum tax, designed to catch taxpayers who use too many special provisions. I’m pretty good with numbers and my personal finances are very simple. But I can’t do my own taxes because the instructions make me crazy and the rules are always changing. People and corporations with really big bucks at stake can usually hire some high-priced talent to help them find some loophole to squeeze through, while salaried people pay through the nose.
The rationale for a flat tax is that you want to keep corporate and personal income taxes at the same level. That way, there’s no reason for people to prefer corporate income to personal income, or the other way around. In the real world, however, I think that the difference between a 17 percent rate on earned income and a zero rate on investment income would keep the tax-avoidance industry flourishing. I don’t know how they will do it, but you can bet that plenty of sharp cookies will make a living by showing people how to get their income as interest, capital gains and dividends rather than as salary.
IF YOU ELIMINATED most deductions, treated investment income like other income and tightened up corporate-tax rules, you might have a reasonably simple and fair system. You could have mildly graduated rates. Taxing investment income at both the corporate and personal levels, as it’s taxed now, may not be sound economics. But it’s reasonably sound social policy, considering that most investment income flows to upper-income people. The Forbes flat tax is simple, but not fair. In addition, there are some little-noted but very important corporate flat-tax provisions. These would make labor far more costly to companies than it is now, and would make machines far cheaper. Is this really what we want to do? I don’t think so.
In case you’re wondering, I’d make out like a bandit with the Forbes flat tax. Had it been in effect in 1994, my federal income tax would have been 36 percent lower. So his idea is great for me-but it’s a lousy deal for the country.
PHOTO (COLOR): No muss, no fuss: Kemp, Dole and Gingrich pitch the flat tax
A flat tax–and Forbes’s isn’t the only plan–would be simpler, but there are perils. A guide:
Instead of five income-tax brackets, there would be only one for individuals and corporations. Phil Gramm would tax at 16 percent, Forbes at 17.
Forbes would end write-offs for mortgage interest, state and local taxes and charitable giving. Gramm and others would keep the mortgage and charity deductions.
Without additional federal spending cuts, a flat-tax system– with the Forbes or Gramm rates–would increase the deficit.
Given the current code’s complexities, the idea of a simple flat tax is enormously attractive. But because Forbes’s 17 percent plan exempts interest, dividends and capital gains from Uncle Sam’s reach, it would help the rich more than the poor or the middle class. Here’s how married couples with two children would fare in three income brackets:
Gross income $20,000 $75,000 $300,000 Minus itemized deductions 6,350 15,417 45,164 Minus personal exemptions 9,800 9,800 0 Taxable income 3,850 49,783 254,836 Tax (after payroll-tax rebate) -355* 8,999 77,220
Gross income $20,000 $75,000 $300,000 Wages and salaries 19,227 73,593 282,197 Minus exemptions/ allowances 29,650 29,650 29,650 Taxable income 0 43,943 252,547 Tax (no payroll-tax rebate) 0 7,470 42,933 ..MR.-
