The New Voodoo

Since the day he bade a tearful farewell to outgoing President George Bush, many in the Republican party have looked to Senator Bob Dole to lead the GOP back to the White House in 1996. Yet in recent weeks, M. Steve Forbes, millionaire owner of Forbes magazine, has pulled away from the pack of Republican presidential hopefuls and narrowed Dole's once insurmountable lead in the polls. Forbes, using a combination of negative advertisements financed by his millions and an optimistic, supply-side economic message, has now pulled ahead of Dole in New Hampshire and threatens Dole's lock on the Republican nomination.

At the heart of Forbes' message and his success is a proposal for the creation of a single income tax rate that he claims will increase the efficiency of the economy and lead to higher growth without increasing the tax burden on the middle class. Sadly, the facts do not support such optimistic conclusions. In reality, Forbes' flat tax would either substantially increase the budget deficit and thereby fail to spur economic growth or increase the tax burden on most Americans. Yet Forbes has consistently failed to point out these facts to the American people, a failure that we must not excuse.

In particular, Forbes' flat tax proposal would replace the existing, progressive system of taxation with a single tax rate of 17 percent on all income earned above $36,000. At the same time, his proposal would eliminate most deductions, like the home mortgage and charitable deduction, and exempt from all taxation unearned income derived from savings and investment. These changes, Forbes claims, would greatly simplify the tax code and spur economic growth through supply-side forces. This growth, moreover, would ensure that the federal budget deficit would not increase since the additional revenue derived from a larger economy would more than compensate for the loss in revenue that would result from a flat tax of only 17 percent.

In reality the consequences of Forbes' flat tax do not quite conform to his supply-side rhetoric. Admittedly the flat tax would spur economic growth. By reducing the income tax rate to 17 percent and eliminating the progressive nature of the tax, Forbes' proposal would increase the returns to labor and thereby increase the incentives to work. In other words, the average person would keep more of any additional earned income than he would previously and, as a result, would supply more labor. At the same time, the elimination of all taxes on investment income would encourage people to save and invest which would raise the supply of capital. Since long-run economic growth depends primarily upon the supply of capital and labor, the flat tax would increase growth and economic prosperity.

Like all economic models, however, the beneficial effects of the flat tax rest upon the ceteris paribus assumption, i.e., that all other things held constant. Yet under Forbes' proposal, ceteris paribus does not hold. This is because his flat tax, which amounts to a massive tax cut especially for the wealthy, would substantially increase the federal budget deficit and overheat the economy. Both of these consequences of the flat tax would serve to undermine and even undo the beneficial effects of having a single tax rate that exempts investment income.

Despite Forbes' claims to the contrary, his flat tax proposal would increase the budget deficit. Even he admits that his proposal could cost the government as much as $200 billion a year in revenues. Given such a sum and prior experience with the Reagan era tax cuts, Forbes' claim that economic growth would more than compensate for the lost revenue cannot be taken seriously. The Reagan-era tax cuts generated only enough additional revenue through the supply-side to offset a third of the lost revenues. Forbes' proposal is unlikely to do three times as well.

As a result, the budget deficit would no doubt balloon under his flat tax. This would then drive up interest rates since the government would need to borrow more money to finance the deficit and to do this would have to offer higher interest rates to lenders. These higher interest rates would then lower investment, which depends primarily upon the interest rate, and undermine the supply-side effects of the flat tax. The end result, of course, would depend on the size of the deficit, but in all likelihood investment would decrease and economic growth actually fall.

This problematic outcome would be further compounded by the demand-side consequences of Forbes' flat tax. Historically, supply-side tax cuts that produce budget deficits, like the Reagan tax cuts, tend to have a far greater effect on the demand-side of the economy than on the supply-side. In other words, Forbes' massive tax cut would substantially increase aggregate demand while only marginally increasing aggregate supply. The result, of course, is inflation. This higher inflation would then require the Federal Reserve to contract the money supply by raising interest rates which would also lower investment and hence long-term economic growth.

The only way out of this conundrum is the implementation of a flat tax that would not produce a budget deficit. Yet such a flat tax would require a rate of around 25 percent. Once the various deductions currently allowed are taken into account, such a flat tax would result in higher taxes for the middle class and lower ones for the wealthy. This flat tax would admittedly increase long-run economic growth, but it would also engender even greater economic inequality by undermining the middle class. This would return us to the familiar world of the efficiency-equity trade-off. More of one requires less of the other.

Given this, the question of whether the flat tax makes sense really comes down to how highly the American people value equity relative to efficiency. If they prefer greater efficiency and therefore higher economic growth to increased economic equality, then the government should implement the flat tax. On the other hand, if they prefer equity to efficiency, then the flat tax is not worth enacting. With this type of question, there are no easy or clear-cut answers.

The American people must decide for themselves what they value more: efficiency or equity. But for the American people to make such a decision, their leaders must not conceal from them the harsh economic realities of this world. There is no such thing as a free lunch. In this respect, Steve Forbes has manifestly failed to do his duty and tell the American people the truth about his flat tax. Instead, he has tried to fool the American people into believing that they can get something for nothing: higher economic growth without greater economic inequality. Hopefully, after four years of President Clinton, the American people will not place another liar in the White House.