The 0% Tax Rate Solution

According to "The 0% Tax Rate Solution," an editorial in the July 14, 2009 edition of the Wall Street Journal:

It's better policy, and politics, than the proliferation of tax credits.
By PETER FERRARA

The federal income tax code is now so mangled that we can probably increase federal revenues with a 0% income tax rate for a majority of Americans.

Long before President Barack Obama took office, the bottom 40% of income earners paid no federal income taxes. Because of refundable income tax credits like the Earned Income Tax Credit (EITC), in 2006 these bottom 40% as a group actually received net payments equal to 3.6% of total income tax revenues, according to the latest Congressional Budget Office data. The actual middle class, the middle 20% of income earners, pay only 4.4% of total federal income tax revenues. That means the bottom 60% together pay less than 1% of income tax revenues.

This actually resulted from Republican tax policy going all the way back to the EITC, which was first proposed by Ronald Reagan in his historic 1972 testimony before the Senate Finance Committee on the success of his welfare reforms as governor of California. Besides calling for workfare, Reagan proposed the EITC to offset the burden of Social Security payroll taxes on the poor. As president, Reagan cut and indexed income tax rates across the board and doubled the personal exemption. The Republican majority Congress, led by former House Speaker Newt Gingrich, adopted a child tax credit that President George W. Bush later expanded and made refundable, while also reducing the bottom tax rate by 33% to 10%.

President Bill Clinton expanded the EITC in 1993. But it was primarily Republicans who abolished federal income taxes for the working class and almost abolished them for the middle class. Now Mr. Obama has led enactment of a refundable $400 per worker income tax credit and other refundable credits, which probably leaves the bottom 60% paying nothing as a group on net.

Many conservatives are deeply troubled by this, arguing that everyone should be contributing something to the tax burden. They worry that, not paying for any of the tab, this majority will see no reason not to vote for limitless spending burdens. But are conservatives now going to campaign on increasing taxes on the bottom 60%, arguing that is good tax and social policy? Steve Lonegan recently demonstrated in the New Jersey gubernatorial primary that this is not a viable political position. He proposed a 3% state flat tax which, while very good tax policy, would increase taxes slightly for the bottom half of income earners. His victorious opponent Chris Christie pounded away in advertising on that point.

But what if Republicans proposed a federal tax reform with a 0% income tax rate for the bottom 60% of income earners? With that explicit 0% tax rate framing the issue, abolishing the refundable tax credits that actually ship money to lower income earners through the tax code would become politically viable. Trading an explicit 0% tax rate for the bottom 60% in return for eliminating the refundable tax credits would likely be at least revenue neutral, and probably result in a net increase in revenue.

Such tax reform can and should be combined with overall welfare reform based on work that would ensure an adequate safety net for the poor. Considering the success of the 1996 reform to the Aid to Families with Dependent Children (AFDC) program, further reform could result in huge overall savings. Besides AFDC, there are 85 more federally administered welfare programs that could benefit from reform.

Moreover, we should then be free to adopt sound tax policy for the top 40% of earners who make 75% of total income. Suppose we tax all of the income of those top 40% once with a 15% flat tax? That would be close to revenue neutral on a dynamic basis (i.e. counting work incentive effects).

The usual distribution arguments against such a flat rate would not apply because the bottom 60% would bear a 0% rate. All flat tax proposals effectively try to do the same through generous personal exemptions that are tax neutral for low- and moderate-income workers. But the explicit 0% rate would make the reform more easily understood.

This -- rather than adopting still more refundable tax credits as some conservatives are advocating -- is also the way to eliminate the distorting tax preference for employer-provided health insurance. For the bottom 60%, there would no longer be any health insurance tax preference, and for the rest the favoritism would be reduced to a minimal 15%. Or the tax exclusion for employer provided health benefits could be eliminated altogether, affecting only the top 40%. The economic distortions caused by every other tax preference in the code would be minimized or eliminated entirely in this same way.

Contrary to the fears of conservatives, this tax system would sharply limit the size of government. No politician would dare suggest imposing income taxes anew on the bottom 60%. While the last two Democratic presidents won by running on a tax cut for the middle class, that game would be over. Instead conservatives can argue for middle-income and working-class votes to protect the 0% tax rate from big government liberals. As the Obama administration will soon learn, higher income earners have flexibility in their taxable income and increasing revenues by raising taxes on them is not easy.

Mr. Ferrara is director of entitlement and budget policy for the Institute for Policy Innovation. He served in the White House Office of Policy Development under President Reagan.