Republican candidates' tax plans may fall flat

WASHINGTON Fri Oct 21, 2011 4:36am EDT

Republican presidential candidates (L-R)  former Pennsylvania Senator Rick Santorum, Rep. Ron Paul (R-TX), businessman Herman Cain, former Massachusetts Governor Mitt Romney, Texas Governor Rick Perry, former House of Representatives Speaker Newt Gingrich and Rep. Michele Bachmann (R-MN) stand on stage before the start of the CNN Western Republican Presidential Debate in Las Vegas, Nevada, October 18, 2011. REUTERS/Steve Marcus

Republican presidential candidates (L-R) former Pennsylvania Senator Rick Santorum, Rep. Ron Paul (R-TX), businessman Herman Cain, former Massachusetts Governor Mitt Romney, Texas Governor Rick Perry, former House of Representatives Speaker Newt Gingrich and Rep. Michele Bachmann (R-MN) stand on stage before the start of the CNN Western Republican Presidential Debate in Las Vegas, Nevada, October 18, 2011.

Credit: Reuters/Steve Marcus

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WASHINGTON (Reuters) - A proposed overhaul of the tax system is catching fire among some Republican presidential candidates who see its potential to win over voters with its sheer simplicity, but there is skepticism among experts that a flat tax will prove a winning strategy.

Texas Governor Rick Perry, running in third place for the Republican nomination for president, plans to unveil a flat tax proposal next week.

He has not released details on how it would be structured but he is advised by magazine magnate Steve Forbes, who ran for the White House in 1996 on a platform calling for a 17 percent flat tax rate for those earning over $36,000 per year and had a similar plan when he ran in 2000.

Herman Cain attracts raucous cheers at Republican debates for his 9-9-9 plan, a flat-tax variation with a 9 percent income tax, 9 percent business tax and 9 percent national sales tax. He has surged to the front ranks in the Republican race with former Massachusetts Governor Mitt Romney.

Cain was a central target at a lively debate on Tuesday where candidates criticized his 9-9-9 tax reform plan.

He insisted his plan to reduce personal income and corporate taxes to 9 percent and create a 9 percent national sales tax would not raise taxes on middle-income Americans despite expert analysis that it would.

There is popular appeal in the idea of replacing thousands of pages of U.S. tax code, which multiply in number each year to add new tax treatments or exemptions for special interests and require armies of lawyers and accountants to interpret.

Billionaire businessman Warren Buffet has criticized as unfair a tax code that allows him to pay a lower tax rate than his secretary and President Barack Obama has fired up his liberal base by calling for raising taxes on the rich.

Momentum is building for some type of U.S. tax reform.

But the flat tax proposal, embraced widely by eastern European countries and Russia after the collapse of communism, faces significant hurdles in the United States.

The U.S. tax system is highly progressive. About 47 percent of American households do not earn enough to pay federal income taxes and the burden falls on middle- to upper-income groups, said Roberton Williams, senior fellow at the Tax Policy Center.

Low earners still must pay state and local taxes, along with the federal payroll tax to fund Social Security.

Change the mix and either the poor start paying taxes or an even higher burden is shifted to upper income groups, who traditionally are Republican supporters.

President Ronald Reagan, a Republican, considered a flat tax. His efforts and those of Forbes faltered, partly because of the challenge of finding other ways to raise revenues.

Special interest groups also lobby hard in support of tax breaks like the mortgage interest deduction, critical to the real estate, homebuilding and mortgage banking industries.

In 2008, Republican candidates Mike Huckabee and Tom Tancredo endorsed a flat tax before eventually dropping out of the primary race.

What impact it would have on U.S. economic growth in the short term is unclear. Fairness is a crucial issue and, in the past, once voters realize they would sacrifice popular tax deductions on mortgage interest, charitable donations and for children, support has withered.

RICH VS POOR

The fervor with which the flat tax ideas are being embraced in some Republican circles appears to reflect a deep hunger for simple answers and a quick fix to complex economic problems.

"Everybody is looking for a silver bullet, wipe the slate clean and start over again. Unfortunately that is just dreaming," said Bruce Bartlett, a former senior policy analyst at the Bush White House who also worked on tax policy in the Reagan years.

"I don't think the nature of the problems in the economy today are amenable to tax solutions."

For a flat tax to gain further traction, political economists and tax experts said it probably would need to exempt earnings up to a certain level.

Cain's plan provides no such exemption. As a result, the Tax Policy Center estimates the poorest 20 percent of Americans would see their after-tax incomes decline by one fifth, while the richest 0.1 percent who earn $2.5 million and above would get a $1.4 million tax break.

But the more earnings that are exempted, the higher the flat tax levy would be. And if mortgage interest or family deductions were also allowed, the rate could easily rise to 25 percent or more by some estimates -- a higher level than the average middle class family currently pays.

The attraction of a simple plan can quickly lose support once people realize the impact on their household finances, said Howard Gleckman, a tax expert at the Urban Institute.

A flat tax can shift economic incentives. If capital gains are not taxed, it favors capital over consumption, no bad thing in the longer term for an economy that needs to save more.

But raising taxes on consumption to compensate for lower income tax revenues again hits the lowest-income groups who spend about 98 percent of their income and have little left over for savings. For an economy suffering from lack of demand, this could hurt growth in the short term.

Alvin Rabushka, an economist at the Stanford University's Hoover Institution who along with Robert Hall is known as the godfather of flat tax, has heard all these criticisms before.

He has tirelessly promoted the flat tax since the 1980s and says eastern European countries that have adopted it have benefited from less tax evasion and corruption and enjoyed one percentage point higher growth than their neighbors.

"There is study after study after study, and all the estimates for job creation and for growth have a positive co-efficient over the long term," he said.

While a flat tax might not solve the lack of demand plaguing the U.S. economy today, he said it would do no harm.

"Why not do it when it would make some things better and wouldn't make things worse?"

(Editing by Bill Schomberg and Todd Eastham)

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