Boosting Savings and Growth through a Flat Tax

As a primary source of investment capital, savings are the "seed corn" of the economy. When individuals and businesses save (instead of spending all their earnings on current consumption), they have capital available to invest themselves, or to lend to others. Economists have long understood that savings are critical to long-term economic growth, and policies which penalize savings make us poorer in the future than we would otherwise be.

That’s one of many reasons why Congress ought to scrap the current federal income tax code and replace it with a flat-rate income tax that has few or no deductions. Though today’s tax code is incomprehensible in many respects, no one doubts that it is partly responsible for America’s plummeting savings rate. In recent years, the savings rate has fallen below five percent, which means people today are saving perhaps a third as much of their incomes as their grandparents did.

Under the most prominent flat tax plan before the Congress—the so-called "Armey-Shelby" plan—the code would be scrapped in favor of a single, 17 percent rate, with personal allowances worth $33,300 for a family of four. Using data from the Internal Revenue Service, a Heritage Foundation study found that the average Michigan family would see a drop of $1,373 in their federal tax bill under Armey-Shelby—from $4,996 to $3,623.

A flat tax would improve the savings rate not just because it would leave citizens with more of their own money to either spend or save. More importantly, it would end the bias of the current tax code against savings by drawing a clear line between business and personal income, and it would tax each source of income a single time. This contrasts with the present system in which one source of income is often taxed two, and even three times.

For example, suppose that Ms. Jones of Bad Axe, Michigan, receives $1,000 in job bonuses. She has two options: She can spend the money, or she can save it. If she spends it, the current income tax would only tax this income a single time. If she’s in the 28 percent income tax bracket, she would owe $280 in income tax and have $720 left to spend.

Unfortunately, if Ms. Jones saves this money, she would not only owe $280 in taxes on the original income, but she would also pay taxes on the interest earned on the savings. If she saved the remaining $720 at a 6 percent rate, she would earn $43.20 in interest for the year. She would then have to declare her earned interest as income and pay an additional $12.10, cutting the return on her savings from 6 percent to just 4.3 percent.

In contrast, the flat tax would tax income only once, when it was earned, and not again later when it was saved. By eliminating this multiple taxation of income, the reward for saving would rise—thereby producing more savings and more capital available for productive investment.

By increasing the pool of capital, the flat tax would help push down interest rates. John Golob, an economist at the Federal Reserve Bank of Kansas City, has estimated that interest rates would drop by at least 25 percent under a flat tax. This would save families 25 cents on every dollar now spent on interest payments.

Lower interest rates would benefit families with mortgages, car loans and credit card payments. The less money spent on interest would mean the more money available to save. So rather than paying interest, families could be earning it.

The savings-friendly nature of a flat tax would help the people of Michigan improve the standard of living for themselves and future generations. Higher savings would help families put their children through college, reduce the worries of retirement, and even pay for that long-delayed vacation.

The overall effect on savings by a flat tax was best summed up in a recent study conducted by economists Barry Seldon, at the University of Texas at Dallas, and Roy Boyd, at Ohio University. In their view, "The area of greatest growth by far as the result of enactment of a flat tax would be savings. Savings would grow by more than 7 percent—more than twice as much as any other sector of the economy."

The flat tax idea is gaining ground around the country as more people understand what a heavy anchor the current system is on economic growth. What a flat tax would do to increase the "seed corn" of savings is, by itself, a powerful argument for its adoption.