Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Would a Flat Tax Affect Small Businesses?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Would a Flat Tax Affect Small Businesses?

Article excerpt

The U.S. Congress is considering several strategies to reform the federal income tax system. The most widely discussed strategy, a flat tax, would tax income received by businesses and individuals at the same low, flat rate. Flat tax proposals would eliminate most tax deductions and tax credits but would increase the personal exemption for individual taxpayers. While the debate continues over whether a flat tax would be fair to individual taxpayers, assessing the effect of a flat tax on economic growth and business activity is also important.

Most economists who analyze tax incentives conclude that a flat tax would encourage economic growth, which would have a positive effect on businesses in general. The effects on businesses would not be uniform, however, and many small businesses would be affected differently than large businesses. Small businesses are an important component in the U.S. economy, producing about half of private sector output and employing over half of the work force, so tax reformers need to understand how a flat tax would affect the small business sector of the economy.

This article examines the effects of a flat tax on businesses in general and on small businesses in particular. The first section of the article describes the goals and features of a flat tax and how a flat tax would affect businesses overall. The second section describes how a flat tax would affect small businesses differently from large businesses.

The article concludes that businesses in general are likely to benefit from a flat tax and that small businesses are likely to benefit more than large businesses. Most businesses would benefit from higher economic activity associated with a flat tax. Small businesses would benefit even more than large businesses, due in part to reduced compliance costs. In addition, a flat tax would eliminate tax deductions and tax credits less widely available to small businesses, thereby leveling the playing field between large and small businesses. Moreover, lower interest rates under a flat tax would offset more of the loss of interest deductibility for small businesses than for large businesses.

OVERVIEW OF FLAT TAX AND BUSINESS EFFECTS

Proponents of a flat tax have two primary goals. The first goal is to simplify the tax system to reduce the costs of keeping records and filling out tax forms. The second goal is to encourage economic activity by reducing the disincentives to work, savings, and investment in the current tax system.1

This section begins with an overview of the flat tax and then discusses how a flat tax would simplify compliance and encourage economic activity. The section concludes that businesses generally would benefit from lower compliance costs and increased economic activity. Although the tax bill on business income would tend to increase, the increase would be mitigated by eliminating the second layer of taxes owners pay on capital income. Many, but not all, businesses would benefit on net.

What is a flat tax?

Flat tax proposals are so named because they would tax all business and individual income at a single flat rate. To compensate for the loss of revenue from reducing tax rates, the proposals would broaden the tax base by eliminating many tax deductions and tax credits. The proposals would also increase the personal exemption and allow businesses to deduct the cost of new investments in the same year they incur the expense.

Economists agree that lower tax rates would encourage economic activity, but uncertainties remain about the minimum rate needed to generate the same revenue as the current system. The "revenue-neutral" rate depends, of course, on the size of the personal exemption for individuals and on how many deductions and credits remain. Proposed rates vary between 17 and 20 percent. The Treasury Department estimates these rates would be too low and that a 20.8 percent rate would be required for revenue neutrality in a flat tax as proposed by House Majority Leader Armey and Senator Shelby. …

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