[Senate Hearing 109-785]
[From the U.S. Government Publishing Office]





                                                        S. Hrg. 109-785

   POTENTIAL EFFECTS OF A FLAT FEDERAL INCOME TAX IN THE DISTRICT OF 
                                COLUMBIA

=======================================================================

                                HEARINGS

                                before a

                          SUBCOMMITTEE OF THE

            COMMITTEE ON APPROPRIATIONS UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                            SPECIAL HEARINGS

                     MARCH 8, 2006--WASHINGTON, DC
                     MARCH 30, 2006--WASHINGTON, DC

                               __________

         Printed for the use of the Committee on Appropriations


  Available via the World Wide Web: http://www.gpoaccess.gov/congress/
                               index.html

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                      COMMITTEE ON APPROPRIATIONS

                  THAD COCHRAN, Mississippi, Chairman
TED STEVENS, Alaska                  ROBERT C. BYRD, West Virginia
ARLEN SPECTER, Pennsylvania          DANIEL K. INOUYE, Hawaii
PETE V. DOMENICI, New Mexico         PATRICK J. LEAHY, Vermont
CHRISTOPHER S. BOND, Missouri        TOM HARKIN, Iowa
MITCH McCONNELL, Kentucky            BARBARA A. MIKULSKI, Maryland
CONRAD BURNS, Montana                HARRY REID, Nevada
RICHARD C. SHELBY, Alabama           HERB KOHL, Wisconsin
JUDD GREGG, New Hampshire            PATTY MURRAY, Washington
ROBERT F. BENNETT, Utah              BYRON L. DORGAN, North Dakota
LARRY CRAIG, Idaho                   DIANNE FEINSTEIN, California
KAY BAILEY HUTCHISON, Texas          RICHARD J. DURBIN, Illinois
MIKE DeWINE, Ohio                    TIM JOHNSON, South Dakota
SAM BROWNBACK, Kansas                MARY L. LANDRIEU, Louisiana
WAYNE ALLARD, Colorado
                    J. Keith Kennedy, Staff Director
              Terrence E. Sauvain, Minority Staff Director
                                 ------                                

                Subcommittee on the District of Columbia

                    SAM BROWNBACK, Kansas, Chairman
MIKE DeWINE, Ohio                    MARY L. LANDRIEU, Louisiana
WAYNE ALLARD, Colorado               RICHARD J. DURBIN, Illinois
THAD COCHRAN, Mississippi (ex        ROBERT C. BYRD, West Virginia (ex 
    officio)                             officio)

                           Professional Staff
                             Mary Dietrich
                        Kate Eltrich (Minority)

                         Administrative Support
                            LaShawnda Smith

















                            C O N T E N T S

                              ----------                              

                        Wednesday, March 8, 2006

                                                                   Page

Opening Statement of Senator Sam Brownback.......................     1
Statement of Hon. Richard K. Armey, Chairman, FreedomWorks.......     4
    Prepared Statement of........................................     6
Statement of Daniel J. Mitchell, McKenna Senior Fellow in 
  Political Economy Domestic Policy Studies, The Heritage 
  Foundation.....................................................    10
    Prepared Statement of........................................    13
Statement of Chris Edwards, Director of Tax Policy, Cato 
  Institute......................................................    18
    Prepared Statement of........................................    20
Statement of Stephen J. Entin, President and Executive Director, 
  Institute for Research on the Economics of Taxation............    23
    Prepared Statement of........................................    26
Prepared Statement of Paul Strauss...............................    51

                        Thursday, March 30, 2006

Opening Statement of Senator Sam Brownback.......................    53
Statement of Hon. Natwar M. Gandhi, Chief Financial Officer, 
  Government of the District of Columbia.........................    55
Julia Friedman, Ph.D., Chief Economist, Government of the 
  District of Columbia...........................................    55
Prepared Statement of Natwar M. Gandhi...........................    61
Statement of Terence C. Golden, Chairman, Federal City Council...    71
John Hill, Chief Executive Officer, Federal City Council.........    71
Prepared Statement of Terence C. Golden..........................    73



















 
   POTENTIAL EFFECTS OF A FLAT FEDERAL INCOME TAX IN THE DISTRICT OF 
                                COLUMBIA

                              ----------                              


                        WEDNESDAY, MARCH 8, 2006

                               U.S. Senate,
          Subcommittee on the District of Columbia,
                               Committee on Appropriations,
                                                    Washington, DC.
    The subcommittee met at 2:05 p.m., in room SD-124, Dirksen 
Senate Office Building, Hon. Sam Brownback (chairman) 
presiding.
    Present: Senators Brownback and Allard.


               opening statement of senator sam brownback


    Senator Brownback. Good afternoon. I'm delighted to have 
you all here to discuss a very interesting topic, a very 
important topic that we're going to explore this afternoon.
    We're going to look at creating a fairer, simpler tax 
system in the District of Columbia. I believe that a voluntary 
flat Federal income tax for the District of Columbia residents 
would give us real-world valuable information about whether a 
flat tax is actually better than the current cumbersome system. 
I believe most taxpayers in the District of Columbia would 
welcome this opportunity. I believe most taxpayers in my State 
of Kansas would welcome this opportunity. But since I do not 
believe that we should merely impose a new system on D.C. 
taxpayers overnight, I would suggest that those who want to 
stay under the current tax system should feel free to do so. I 
think, however, that if people are given a chance, they'll 
abandon the current burdensome system.
    What we are discussing here is creating an optional flat 
tax in the District of Columbia. Every year, taxpayers in the 
District of Columbia suffer, like all Americans, from the 
burden of our complex and complicated Tax Code, confused by 
over 800 pages of IRS tax forms, perplexed by hundreds of pages 
of IRS instruction books, and nervous that they will make a 
mistake trying to calculate how much of their own money they 
have to hand over to the Federal Government.
    Now, I want to show you something here. We've got the 
Internal Revenue Code here. And here is just the Internal 
Revenue Code. I'm just holding it up for thickness. I did my 
weightlifting this morning so I could get this done. This is 
just the Internal Revenue Code itself. These are the words. I 
want to show you, if you're thinking this is the big-print 
edition of it, it's not; it's very fine print on all those 
pages.
    Now, that's not enough. I'm trained as a lawyer, I have to 
admit. You don't just go to the Code, you go to the regs to 
understand the Code. This is the Internal Revenue Code 
regulations that interpret these books. So, this is setting the 
guidance for what these laws are. And I want to just stack 
these all in front of you, so you can see the size of the 
Internal Revenue Code. And the laws and the books that 
interpret them is this size. This stack is the Internal Revenue 
Code and the regulations. It is unbelievably complex. It is 
unintelligible. You can have the most intelligent tax lawyer in 
the world, five of them, and they'll give you five answers to 
the same question. It is too burdensome. It is too complicated. 
As one tax expert told me, it needs to be taken out behind the 
barn and killed with a dull axe. It's too much. And I can 
barely lift it, on top of that.
    We need to create a different system. We need a system that 
people can understand, that's comprehensible.
    This confusion of the current Tax Code is one reason why 
almost two-thirds of all taxpayers have given up trying to 
figure out how to complete their own tax returns. Two-thirds 
now spend more of their hard-earned money just so someone else 
can try to sort it out. And I don't blame them. I do the same 
thing.
    I believe that our tax system should be fair, simple, and 
easy to understand. One way to make the system fair is to have 
taxpayers pay taxes based on a single flat rate that is applied 
to all taxpayers equally. Such a flat tax rate would only be 
applied to the amount of earned income above an exemption 
level, based on family size. Such an exemption level should be 
somewhere between $5,000 and $7,000 for each member of the 
household, so, at the higher exemption level, a couple with two 
children earning $28,000 would pay no Federal income tax at 
all.
    I do not think that the dollars that wage-earners have 
already paid taxes on should be taxed again when those dollars 
are saved or invested. This is a double taxation. It's a 
disincentive to savings and a disincentive to investing.
    As long as a flat tax rate is reasonable, it is a fairer 
tax than the current system, because it taxes all earned income 
at the same rate. Workers would not be punished for working 
harder and earning more money, because each dollar that they 
earned would be taxed at the exact same rate. This is fairer, 
it is simpler, and is a much easier to understand system, which 
would produce more economic activity and jobs.
    For years and years, policymakers and economists have 
debated how taxpayers would fare under a flat tax. I think we 
should stop speculating and debating and actually test the idea 
of a flat Federal income tax, and do it here in the District of 
Columbia, the Federal district. Some have questioned why we 
should give the District of Columbia this opportunity for 
fairer and simpler tax treatment while the rest of the Nation 
must continue to labor under the present nightmarish Tax Code. 
Believe me, I'd like to see a fairer tax system for all 
taxpayers in every American city, particularly for taxpayers in 
Kansas. And I would offer that we could do this as a model for 
the District of Columbia and Kansas, if you want to try two 
places. That would be fantastic.
    Now, while everyone talks about the need to simplify the 
Tax Code, real reform has been stymied by those who come up 
with all kinds of excuses to prevent us from fixing the broken 
system. The Federal Government has the authority to try a 
first-ever flat Federal income tax here in the Nation's 
Capital, because of the unique relationship it has with the 
District of Columbia, which our founding fathers set out in 
article I, section 8 of the Constitution. One result of 
Washington, DC being the seat of the Federal Government is that 
42 percent of all District property is not subject to local 
taxation. By Federal law, the District is precluded from taxing 
income at its source for those workers who are not residents of 
the District. The result is that 70 percent of income earned in 
the District cannot be taxed to support District municipal 
services. To some extent these Federal restrictions on the 
District's taxing authority have led city leaders to impose 
very high local income, property, and sales tax. In fact, for 
decades, residents of Washington, DC have endured one of the 
Nation's highest tax burdens. These high tax rates have been 
one reason that between 1970 and 2003, the District's 
population dropped by 26 percent, even though every neighboring 
county gained in population during this same time period.
    I believe that a flat Federal income tax would create more 
economic activity and jobs in the District, which would enhance 
the District's ability to raise revenues while actually 
lowering its own high local taxes.
    I look forward to hearing from our panel of distinguished 
experts about how a flat Federal income tax could work in the 
District of Columbia and what they think the effects of such a 
system would be.
    I'll introduce our panelists now, all together, and then we 
will have each of them present their testimony. And I'm looking 
forward to this.
    First would be the Honorable Dick Armey. He spent 18 years 
in the House of Representatives serving as majority leader from 
1994 until 2002. Since he's retired from the House, Mr. Armey 
has continued his fight for lower taxes, less government, more 
freedom as co-chairman of the grassroots nonprofit organization 
FreedomWorks.
    Daniel J. Mitchell is the McKenna senior fellow in 
political economics at The Heritage Foundation. His major 
research interests include tax reform, Social Security, and 
international tax competition. He's one the Nation's leading 
experts on the flat tax.
    Stephen J. Entin is president and executive director of the 
Institute for Research on the Economics of Taxation. He was 
Deputy Assistant Secretary for Economic Policy at the Treasury 
Department from 1981 to 1988, and developed the 1981 tax cuts 
in President Reagan's enterprise zone legislation.
    And our final witness is Chris Edwards, who's director of 
tax policy studies at the Cato Institute. He's an expert on 
Federal, State, and local tax and budget issues. Previously, he 
was a senior economist on the congressional Joint Economic 
Committee examining tax, Social Security, and entrepreneurial 
issues.
    I want to thank each of you for being here today. We will 
include your full statements into the record. I would ask, if 
you could, to make your presentations around the 7-minute mark, 
if you can, so that we can have a good discussion afterward. I 
do appreciate each of you coming to discuss this issue of a 
flat tax in the District of Columbia.
    Honorable Dick Armey, delighted to have you back in these 
halls, and the microphone and the floor is yours.
STATEMENT OF HON. RICHARD K. ARMEY, CHAIRMAN, 
            FREEDOMWORKS
    Mr. Armey. Thank you, Mr. Chairman. And let me say, it's a 
pleasure for me to be back, as well, and especially addressing 
this subject, which is near and dear to my heart.
    Let me--I think maybe I'll give you a little--talk a little 
bit about the intellectual history of the flat tax. We have my 
formal testimony available for the record.
    The flat tax was first conceived at the Hoover Institute by 
Professors Hall and Rabushka in 1984. In fact, I ran on the 
flat tax in my first race for Congress in 1984. And the--there 
was a fervor, as you know, for tax reform that went to 1986, 
and, at that point, since many people thought the 1986 bill 
either represented the fact that the job was done or that the 
job was hopeless--I'm not sure which conclusions were drawn--
tax reform, at least at that level of interest, seemed to wane. 
In 1994, I rehabilitated the original Hall-Rabushka idea and 
reintroduced it in Congress, along with Senator Shelby, and 
we've worked around that, as you know. Then it's become a 
matter of issue in Presidential races with Steve Forbes and 
others.
    It's--it was, in 1984, and remains today, a good idea that 
is proven out when it is applied. The idea of applying the 
notion to the District, as compared to the rest of the world--
and I won't go into all of the chapter-and-verse details of the 
burden of the taxes, all that is very--will be in the record. I 
think, though, it is an intriguing idea, about applying in the 
District of Columbia.
    Let me say that this would probably be the most 
comprehensive and effective enterprise zone legislation you 
could have for the District or for any other area. The fact 
that it is voluntary, I think, results in what could be the 
most difficult problem in its application for the District. And 
I should remind you that Delegate Eleanor Holmes Norton 
advanced this same idea about 10 years ago.
    Let me first take the enterprise zone. The fact of the 
matter is, if you take the flat tax in its application as an 
option available to people who live in the District, obviously 
most anybody with a complex, befuddling, and, I dare say, risky 
tax filing--and I say that seriously, because the fact of the 
matter is, for most of us, even though we do our dead level 
best, we ask and obtain good advice, and we do our--an earnest 
effort to comply with the law, as you have pointed out, nobody, 
even in the IRS, can be 100 percent certain they understand the 
law, so that, indeed, we all live with the risk that we may 
inadvertently, after the first best rigorous good-faith effort, 
have made what somebody construes to be a mistake that would 
get us before the auditors; and, frankly, for most Americans, 
this is not a happy experience--in any event, most people, when 
given the option, I believe, will opt for the simplified form, 
largely because it just makes life safer and simpler; second, 
because it will lower their taxes, in most instances. Also, if 
you are--if you apply it to the business enterprise, when you 
throw in the two big innovations in the code as it relates to 
business, which is expensing of capital and inventory, it 
becomes an enormous attraction for business.
    So, the upshot of its application here in the District, I 
would argue, would be to attract many people back from the 
suburbs into the city--who make their living in the city--and 
to attract a good bit of business enterprise, particularly 
small-business enterprise, back into the city, and do what we 
have seen done effectively with enterprise zone legislation in 
other areas, in a large and significant--to a large and 
significant degree.
    That argument, I think, is verified by watching the 
application of the tax in Eastern European nations after the 
fall of the Soviet empire. We have seen economic growth coming 
most quickly to those countries that most quickly went to the 
flat tax and set up their economy to be receptive for that. And 
other companies--countries now coming to the notion in order to 
catch up with the growth experiences they've seen. And very 
little is available to offer the different--an explanation for 
the different growth experiences of the different Eastern 
European countries, other than their tax structure. So, it 
seems to me there is a very good validation of the notion that 
the enterprise zone effect will work, and work well, for the 
District of Columbia.
    The fact that it's voluntary is, I think, very important. I 
like to think, because I'm such a fan of the big--of the flat 
tax, that I'd like to couch it in terms of those: those who are 
foolish may choose to stay with the old system. That's not 
altogether fair. Given the fact that so much of income 
maintenance is transferred to the American people through the 
Tax Code in such things as income tax credits of a variety of 
forms, it can appear that lower-income people, who are 
accustomed to taking their income transfer from the Federal 
Government in the form of the tax credits, might very well opt 
to stay with the old Tax Code. Unless there was an also 
attendant piece of legislation that alternatively provided for 
those same transfers to these people who are currently enjoying 
the tax credits, I believe that you would find that you would 
have less than a full participation in the flat tax, because 
the best, most rational reason for a person to stay with the 
old Tax Code would be to enjoy those income transfers not 
available under the flat tax. I would say, though, that that 
pretty well would define the population of people who would opt 
to stay with the old Code. I see no--as I've studied the code 
and the contrast of the two, I see no good reason.
    There are many myths about the existing Tax Code, that, for 
example, if you own a mortgage, you will lose. I promise you, 
most mortgage holders find they're better off with the flat tax 
than with a mortgage. We can talk about that later. One thing I 
do, again, want to say, it is voluntary. That's a good thing.
    My final observation, Mr. Chairman, would be that should 
you succeed in having this opportunity available to the 
citizens of the District of Columbia, you're going to have a 
tough time explaining to the citizens of Manhattan, Kansas, 
``Why them and not us?'' Because I think it will be observed, 
appreciated, and recognized as a great benefit to the citizens 
of this city.
    Senator Brownback. Well, that's why I've offered to have 
two pilots on this. We could do it in Washington, DC, and 
Kansas, just to pick a random State out that would be another 
one to provide this option to. But this is a particularly 
unique situation with the Federal District here. And so, I 
wanted to try and offer it here.
    Thanks, Congressman Armey, appreciate seeing you, 
appreciate you being back.
    [The statement follows:]
                 Prepared Statement of Richard K. Armey
    Good afternoon Mr. Chairman and Members of the committee. I am Dick 
Armey, former House Majority Leader, and currently Co-Chairman of 
FreedomWorks, a nonpartisan, nonprofit grassroots organization with 
more than 700,000 members that works for lower taxes, less government, 
and more freedom. Thank you for inviting me here today to discuss a 
flat federal income tax for the residents of Washington, DC.
    This is an opportunity to bring to the residents of Washington, DC, 
the benefits of fundamental tax reform that Eleanor Holmes Norton had 
hoped to bring to the District 10 years ago when she introduced a 
similar bill. She realized the economic growth such reform would offer 
the city. It is an opportunity to bring to the residents of Washington, 
DC, the benefits we should eventually bring to the whole country. 
Currently residents in nine countries around the world enjoy the 
benefits of a flat tax, and many other countries are considering this 
approach, from the United Kingdom, to Germany, to China.
    A flat income tax is fair, honest, simple, and pro-growth. That is 
what the American people want. They know that our current income tax 
system is broken. It is complex, it is unfair, it inhibits savings, 
investment and job creation, it imposes a heavy burden on families, and 
it undermines the integrity of the democratic process. It cannot be 
repaired by any tinkering or fine-tuning. It must be completely 
repealed and replaced with a flat income tax. While we should do this 
on a nation-wide basis, doing so for the District of Columbia is a good 
start.
    Under a flat tax, like in the Armey-Shelby flat tax bill introduced 
as recently as the 107th Congress, all income is taxed once and at one 
rate. Wage and pension income tax is collected from individuals. All 
other income tax, including investment income tax, is collected from 
businesses. Individuals fill out a tax return the size of a postcard. 
Business owners pay the same tax rate on profit (revenue minus 
expenses) and would file an equally straightforward tax form.
    To achieve the highest level of simplicity and fairness, all 
deductions and credits should be eliminated. The only exception in most 
proposals is for a generous personal exemption that every American 
would receive. For a family of four, for example, the first $40,000 in 
income could be exempt from tax. The personal deduction amount (which 
should be indexed to inflation) and the flat tax rate should be 
calculated to be revenue neutral, so as to not increase the deficit in 
the process of enacting this important reform.
    The flat tax is pro-family. It contains no marriage penalty and can 
be constructed to nearly double the deduction for dependent children. 
By ending the multiple taxation of saving, the flat tax provides all 
Americans with the tax equivalent of an unlimited IRA. This will make 
it easier for families to save for a home, a vacation, a college 
education, or retirement. The flat tax replaces the current income tax 
system, but does not affect the Social Security and Medicare payroll 
taxes.
    With a flat tax, there are no breaks for special interests. No 
loopholes for powerful lobbies. Just a simple tax system that treats 
every American the same. The flat tax would simplify the tax code, 
promote economic opportunity, and restore fairness and integrity to the 
tax system--all problems in the current system that need correcting, as 
I will detail in these next paragraphs.
Current Tax Code Problems and the Flat Tax Solution
            The Current Problem: Complexity
    The residents of Washington, DC, alone spend over 12 million hours 
completing their taxes. This is because the U.S. income tax code is 
unnecessarily complex; it is a monument to unnecessary waste. The IRS 
sends out eight billion pages of forms and instructions each year 
which, if laid end to end, would circle the earth 28 times. Nearly 
300,000 trees are cut down each year to produce the paper on which IRS 
forms and instructions are printed. The code exceeds 60,000 pages, and 
it takes Americans 6.6 billion hours to complete their taxes every 
year, which is more time than it takes to build every car, truck, and 
van produced in the United States. It now takes an average of over 26 
hours to file a standard 1040 and over 60 percent of Americans turn to 
professional help to file their taxes. Simply complying with the tax 
code imposes national costs as high as $194 billion annually. That 
comes to about $650 for every man, woman, and child in America, or a 
cost of about $360 million on the people of Washington, DC alone.
            The Flat Tax Solution: Simplicity
    The flat tax replaces the current income tax code and its maze of 
exemptions, loopholes, and targeted breaks with a system so simple 
Washingtonians could file their taxes on a postcard-size form. It has 
been estimated that a flat tax would reduce compliance costs by 94 
percent, saving Washington DC taxpayers as much as $334 million in 
compliance costs each year. That's money that could be saved, invested, 
or spent at businesses in Washington.
            The Current Problem: Unfair
    The main reason the tax code is so complex is the proliferation of 
deductions, credits, and other special preferences in the tax law. 
Because of these loopholes, taxpayers with similar incomes living next 
to each other, or in different parts of Washington can pay vastly 
different amounts in taxes. This uneven treatment of taxpayers is 
fundamentally unfair and is at odds with the American value of equality 
under the law.
            The Flat Tax Solution: Fairness
    The flat tax will restore fairness to the tax law by treating 
everyone the same. No matter how much money you make, what kind of 
business you are in, whether or not you have a lobbyist in Washington, 
you will be taxed at the same rate as every other taxpayer.
    However, by incorporating a large personal deduction, progressivity 
is maintained. This is what led D.C. Delegate Eleanor Holmes Norton to 
call her proposal a ``uniform tax'' rather than a ``flat tax'' which 
she felt incorrectly implied that is was not progressive. Under the 
flat tax, or uniform tax, the more you earn, the more you pay. In fact, 
because of the high family exemption, the more a taxpayer earns, the 
greater the share of his income he pays in tax. A family of four 
earning $25,000 would owe no tax under a proposal like the Armey-Shelby 
flat tax. A family of four earning $50,000 would pay only 6 percent of 
its income in income taxes while a family earning $200,000 would pay 14 
percent. But they would all have the same personal deduction, and the 
same rate on income above that deduction.
            The Current Problem: Hindering Economic Opportunity
    The tax code reduces incomes through punitive taxes on saving, 
work, and entrepreneurship. It places multiple layers of taxation on 
saving, thus reducing investments in new machines and technology that 
make Washington's workers more efficient and competitive. High marginal 
tax rates (that is, the tax rate on the last dollar earned) discourage 
work, saving, and entrepreneurial activity, which leads to a smaller 
and less productive economy. By favoring certain economic activities 
over others, the tax code distorts financial decisions and reduces 
economic efficiency. Dale Jorgenson, the chairman of the Economics 
Department at Harvard University, found that each extra dollar the 
government raises through the current system costs the economy $1.39.
            The Flat Tax Solution: Prosperity
    Because the flat tax treats all economic activity equally, it will 
promote greater economic efficiency and increased prosperity. When 
saving is no longer taxed twice, people will save and invest more, 
leading to higher productivity and greater take-home pay. When marginal 
tax rates are lower, people will work more, start more businesses, and 
devote fewer resources to tax avoidance and evasion. And because tax 
rules will be uniform, people will base their financial decisions on 
common-sense economics, not arcane tax law.
    The calculations that have been done to estimate the national 
benefits of a flat tax can be very roughly recalculated to figure out 
how much better off Washington, DC, would be. However, these numbers 
may be low since the barriers to capital and individual movement within 
the United States to a flat tax area like Washington, DC are so much 
less than the barriers to such movements from other nations to a flat 
tax United States, which is on what the initial estimates are based.
    According to one study by a former chief economist for Congress' 
Joint Committee on Taxation, under the flat tax the economy would be 
5.7 percent larger after five years than under the current system. That 
translates into over $500 billion in higher output--or roughly $927 
million for Washington, DC. That's more than $3,000 in higher income 
for the typical family of four. Michael Boskin, a former chairman of 
the Council of Economic Advisors, estimates that the flat tax would 
increase the size of the economy by 10 percent.
            The Problem: Undermining Good Governance
    The current tax code does more than complicate people's lives 
during tax season and reduce living standards. It pollutes Washington's 
political culture. As special-interest provisions have been added to 
the tax code, Washington's lobbying industry has flourished. The 
accompanying chart shows how the growth of the lobbying industry has 
coincided with the increased number of words (and special-interest 
provisions) in the tax code. 




    Washington's lobbying industry is the largest private employer in 
the nation's capital. If the lobbying industry were its own economy, it 
would be larger than the economies of about 60 countries. Since 1998, 
483 companies have lobbied the IRS alone, hiring 2,884 tax lobbyists, 
including 277 former federal government employees. While the thousands 
of lobbyists in Washington have prospered in an environment of tax 
favoritism, the typical taxpayer has not.
    While offering a flat tax to Washington DC alone would have little 
impact this problem, but it could be argued that a nation-wide flat tax 
would virtually eliminate Washington's tax lobbying industry, which 
would be a blow to Washington's economy, but a repercussion about which 
few Americans would complain.
            The Flat Tax Solution: Transparency
    By eliminating itemized deductions and special breaks, the flat tax 
would have a chilling effect on special-interest lobbying and transform 
the political culture in Washington. Under a simple, transparent system 
that taxes all income one time--and requires a supermajority vote to 
add a loophole--there will be far fewer lobbyists than under today's 
special-interest, free-for-all tax system.
Frequently Asked Questions
    Many D.C. residents find the flat tax to be a powerful and 
liberating idea. They like the fact that it is in line with the 
fundamental American understanding that everyone should be treated 
equally before the law. Of course, any major change leads even the 
strongest supports to ask questions like the following:
            Won't charities suffer as a result of the flat tax?
    No. As incomes rise under the flat tax, so, too, will donations to 
America's charities. As the nearby chart shows, over the past several 
decades, increases in giving have closely tracked increases in personal 
income. This trend continued even during the 1980s when the tax value 
of the deduction declined and fewer taxpayers were able to take the 
charitable deduction. Because incomes will increase significantly under 
the flat tax, giving will rise in the long run as well, even without 
the charitable deduction. 



            But is the flat tax progressive?
    Sure it is, because of the generous family allowances--the only 
deduction that should be allowed. In the Armey-Shelby flat tax bill, 
the first $33,300 of income for a family of four was exempt--about 
$40,000 in today's dollars. As a result, middle-income people would pay 
a far lower share of their income in taxes than the rich, and the poor 
would pay nothing at all. Think about it. If a family of four makes 
$50,000 under the Armey-Shelby flat tax, the 17 percent flat-tax rate 
applies to less than a third of that family's income. But if a family 
of four makes $200,000, the 17 percent flat tax rate applies to 80 
percent of that family's income.
    But even if the flat tax didn't have this progressive feature, the 
rich would still pay a lot more in taxes than the middle class or the 
poor. With three times the net income (after taking out your personal 
exemption) you would pay three times the taxes. And so on. That seems 
pretty fair to me.
            Would the family allowance be indexed for inflation?
    If the proposal for D.C. is similar to the Armey-Shelby proposal, 
yes.
            Will the flat tax increase taxes on the middle class?
    No. Washingtonians at all income levels will have their taxes 
reduced. Not only will taxpayers keep more of their money, but their 
incomes will increase. Under the flat tax, the typical family will see 
its income rise by $5,000 to $7,000 within five years.
            I've heard the flat tax doesn't tax investors' income. Is 
                    this true?
    No, that is flat wrong. The flat tax taxes all income at the same 
rate, whether it comes from wages, stock dividends, or some other 
source.
            How will the flat tax affect pensions, 401(k)s, and other 
                    retirement plans?
    Because the flat tax ends the bias against saving, in effect, all 
income that is saved will be treated like an IRA or a pension. 
Currently, IRAs, 401(k)s, and pensions are unusual because they are 
taxed only once. Under the flat tax, all savings will be taxed only 
once. That will make it easier for Americans to save for their 
children's education, their own retirement, or anything else.
Conclusion
    The flat tax is so popular with the American people, and so many 
Washingtonians, because it embraces the core belief that all Americans 
should be treated equally. Rich or poor, black or white, we should all 
be viewed equal before the law. No more favoritism toward some citizens 
and harassment of others. No more loopholes. No tax breaks for 
corporations. No tax shelters. No depreciation schedules. No tables. 
Nothing.
    Instead of sending out pages and of pages of forms each year, the 
IRS would need to send out just one post card to every taxpayer. 
Washington's taxpayers would be spared more than 12 million hours of 
compliance time as they would be able to fill out their tax form post 
card in minutes. Everyone would make the same simple calculation: 
income, minus personal deduction, times tax rate. That's it.
    The simplicity and fairness would further the economic renaissance 
Washington, DC has seen over the past 10 years. The estimated $927 
million in higher economic output in Washington over the first five 
years of the flat tax would go a long way toward bringing the city's 
increased prosperity to every corner of the nation's capital.
    Thank you.
STATEMENT OF DANIEL J. MITCHELL, McKENNA SENIOR FELLOW 
            IN POLITICAL ECONOMY DOMESTIC POLICY 
            STUDIES, THE HERITAGE FOUNDATION
    Senator Brownback. Dr. Mitchell, good to have you here, and 
would appreciate your thoughts and suggestions and advice on 
this.
    Dr. Mitchell. Well, thank you, Mr. Chairman.
    With your permission, I'll just summarize a few of the 
points in my testimony and submit the rest for the record.
    I want to touch on a couple of, I guess, theoretical 
points, but then focus most of my remarks on some of the 
practical issues, some of the real-world evidence that 
surrounds tax reform.
    And probably the number one thing to start with is to keep 
in mind that we live in a globalized economy today. It is so 
much easier than it's ever been for jobs and capital to cross 
borders. This is one of the reasons why a District of Columbia 
flat tax would be such a great pilot program, because we would 
see so much faster growth, so many new jobs being created in 
the District of Columbia, that the rest of the country would 
put a lot of pressure on Congress, and I think we would break 
through the special-interest logjam and finally get fundamental 
tax reform if we had it in one jurisdiction. And the District 
of Columbia, of course, would be an ideal place to start it, 
because it truly is, as Congressman Armey mentioned, the 
enterprise zone of all enterprise zones.
    But, of course, this also applies internationally, not just 
inside the United States. We have seen--and I'll talk about 
this a little bit later--some of the countries that have put in 
place flat taxes, how revenues have gone up for government, how 
economic growth has boomed, how jobs have been created, how 
investment is flooding in. These are all positive things that 
maybe 20 years ago we didn't really have that much evidence to 
talk about. We had Hong Kong, but, for some reason, people 
wanted to say Hong Kong's a special case. I never understood 
why it was a special case. It showed that low taxes and a light 
burden of government frees up the entrepreneurial energy of 
people and leads to incredibly rapid economic growth.
    Let me just talk about some of the key principles of what 
you find in a flat tax.
    A low tax rate. Why a low tax rate? Because taxes are a 
price. Lawmakers across the country understand this when 
they're talking about tobacco taxes. ``We need to raise tobacco 
taxes to discourage people from smoking.'' Now, whether that's 
the right job of government to do, the economic analysis is 
correct. The higher the tax rate, the less you get of 
whatever's being taxed. Let's apply that same lesson to work, 
saving, investment, risk-taking, and entrepreneurship. We want 
a low tax rate on those things, because those are the things 
that create wealth, create jobs, and build a more competitive 
country. So, principle one is, you want the tax rate as low as 
possible.
    Second big principle: don't double tax savings and 
investment. If you earn money, pay tax on it, and you then 
decide to save and invest it, you shouldn't be hit with extra 
discriminatory layers of taxation simply because you save and 
invest. And, unfortunately, under our current tax system, 
between the capital gains tax, the corporate income tax, the 
personal income tax, and the death tax, you can have a single 
dollar of income taxed four different times. So, even if you 
get the rate low, but if you cycle the dollar through the Tax 
Code four times, the effect of marginal tax rate can be very 
high. And this is especially foolish. Every economic theory, 
even Marxism and socialism, they all agree that capital 
formation is really a prerequisite for a long-run economic 
growth and higher living standards. And yet, we reserve the 
very highest tax rates in our system for the people who are 
setting aside the seed corn of savings and investment for 
future economic growth.
    And then, of course, you want a simple system that gets rid 
of all the special preferences and penalties. We don't want 
industrial policy through the Tax Code--or at least we 
shouldn't want that--if we want people to make decisions on the 
basis of market factors, what's going to create the most 
wealth, as opposed to political factors. You can--with the Tax 
Code, you could encourage people to build factories that make 
candy bars that taste like onions. There's no doubt in my mind. 
You could do that through the tax system. But would it make 
sense? Wouldn't it be better to have that capital being 
invested in ways that actually generate long-run economic 
growth? And what a flat tax does is, by stripping out all the 
special-interest clutter in the tax system, we actually have a 
system that not only lowers compliance costs--you know, the 
$200 odd billion that people have to pay for tax lawyers, 
accountants, lobbyists, preparation, man hours--all that goes 
away. But perhaps an even bigger number, which is harder to 
calculate, I'll admit, is the notion that people are going to 
start making decisions solely on the basis of what's good for 
the economy, and that's going to generate much, much better 
economic performance.
    And probably the thing to focus on is, what have we 
actually seen in the countries that make those decisions? Ever 
since the collapse of the Soviet empire, we have seen now 10 
countries--because we just have Kyrgyzstan--I had to look it up 
on the map--Kyrgyzstan just joined the club a couple--less than 
1 month ago. But we have the three Baltic countries of 
Lithuania, Latvia, and Estonia, we have Slovakia, Ukraine, 
Russia, Georgia, Romania, Kyrgyzstan--I should probably cheat 
on the--look on the list there--Serbia--make sure I'm not 
missing one. If you look at the results in those countries, 
it's truly remarkable. The three Baltic countries are now known 
as the ``Baltic Tigers.'' They've already made all the 
requirements for joining the European Union, which means 
they're developed countries, a remarkable period of growth 
following the adoption of flat taxes, and, to be fair, lots of 
other market-oriented policies.
    The whole world--you know, notwithstanding my view on 
things, I realize the whole world doesn't revolve around taxes. 
But a good tax system is a precondition for rapid economic 
growth. And the countries that put in those flat taxes the 
longest period ago, back in the mid 1990s for the Baltics, have 
certainly grown the fastest. But even if you look more 
recently--Russia did a flat tax effective January 1, 2001. 
What's happened? They've got strong economic growth. Some of 
it's due to oil prices, of course, but it's especially 
interesting to see what's happened to personal income tax 
revenues. In less than--in just 4 years, personal income tax 
revenues, even after adjusting for inflation, have gone up by 
more than 100 percent. Why? Two factors. One, when your tax 
rate is very low, your incentive to evade the system falls 
dramatically. I mean, if you're paying 30 percent, your 
incentive to cheat is a lot higher than if you're paying 13 
percent. And I will note that former communists came up with a 
flat tax four points lower than the former House majority 
leader was able to propose, which----
    Senator Brownback. I always had questions about Dick 
Armey----
    Mr. Armey. The communists didn't have CBO scoring, or I'd 
have been there.
    Dr. Mitchell. Slovakia is another great example. They 
probably have one of the purest flat taxes out there, most 
closely related to the Hall-Rabushka proposal that was embedded 
in the proposal of Congressman Armey's. And Slovakia has just 
had an enormous increase in foreign direct investment, an 
enormous increase in jobs, and their economy is doing very 
well. Again, income tax revenues are above the projections.
    And we even have international bureaucracies, like the IMF 
and the World Bank, now writing papers and studies trumpeting 
the Slovakian flat tax. They weren't that sympathetic when it 
was being debated. But even they, who are normally more on the 
left of center, have recognized that this has been a great 
proposal, a great reform, to help create more jobs and lift 
people out of poverty.
    And then countries after countries--we're going to probably 
see Slovenia do a flat tax this year. We're probably going to 
see Kazakhstan do a flat tax this year.
    The question is--we now have a reverse Iron Curtain. We 
need the flat tax to come to the west. We need it to come to 
America. And I think the D.C. flat tax, building upon all this 
real-world evidence that we see--we know lower taxes work, and 
we know simpler tax systems work--I hope the D.C. flat tax 
could be the impetus for bringing this simple and fair system 
to America.
    Thank you.
    Senator Brownback. Thank you very much, Dr. Mitchell. 
Thanks for the thoughts.
    [The statement follows:]
                Prepared Statement of Daniel J. Mitchell
    My name is Daniel Mitchell. I am the McKenna Senior Fellow in 
Political Economy at The Heritage Foundation. The views I express in 
this testimony are my own, and should not be construed as representing 
any official position of The Heritage Foundation.
    There is widespread consensus that the current tax system is a 
complicated failure that hinders the nation's growth while allowing the 
politically well-connected to manipulate the system to get special 
breaks that are not available to average workers and businesses. This 
is stimulating a great deal of interest in shifting to a simple and 
fair flat tax.
    The United States should move quickly to reform its tax system. In 
a competitive global economy, jobs and capital flow to jurisdictions 
with better tax law. Traditionally, this process of ``tax competition'' 
has benefited the United States, but there is growing evidence that 
America is falling behind. Nations around the world are lowering tax 
rates and reforming their tax systems. Indeed, ten countries that were 
part of the former Soviet Bloc have adopted versions of the flat tax. 
These pro-growth reforms are yielding impressive results and are a road 
map for U.S. policymakers.
    Adopting a flat tax for the District of Columbia would be an added 
impetus for reform. Many policy makers want to dismiss Eastern European 
flat tax regimes. They also have ignored the Hong Kong flat tax, even 
though it has been a remarkable success for almost six decades.
    A flat tax in the District of Columbia would not be so easy to 
overlook. The economic renaissance would become a national case-study. 
Improved incentives for work, saving, and investment would create a 
laboratory for supply-side economics. There would be a significant 
influx of jobs and investment, and other states--especially neighboring 
jurisdictions--quickly would clamor for a similarly attractive tax 
code.
    Indeed, this is the reason why a flat tax for the District is 
desirable. Traditionally, economists do not like tax systems that 
create unequal treatment. And there is no question that a 
geographically restricted flat tax would discriminate against those in 
other parts of the country.
    But the perfect should not be the enemy of the good. The internal 
revenue code is riddled with discriminatory provisions. People are 
treated different based on the source of their income, the use of their 
income, and the level of their income. So if a geographically-based 
flat tax is the ``camel's nose under the tent'' for adoption of a flat 
tax for all Americans, then the short-run inequity would be more than 
offset by long-run prosperity and equality for the entire nation.
What Is a Flat Tax?
    Unlike the current system, a flat tax is simple, fair, and good for 
growth. Instead of the 893 forms required by the current system, a flat 
tax would use only two postcard-sized forms: one for labor income and 
the other for business and capital income. Unlike the current system, 
which discriminates based on the source, use, and level of income, a 
flat tax treats all taxpayers equally, fulfilling the ``equal justice 
under law'' principle etched above the main entrance to the U.S. 
Supreme Court building. And unlike the current system, which punishes 
people for contributing to the nation's wealth, a flat tax would lower 
marginal tax rates and eliminate the tax bias against saving and 
investment, thus ensuring better economic performance in a competitive 
global economy.
    There have been several flat tax proposals over the years, all of 
them based on the path-breaking proposal developed by two Hoover 
Institution economists. While no two plans are identical, they all 
share common features that fix the major flaws of the current Internal 
Revenue Code. Simplicity and fairness are also natural consequences of 
these component features of tax reform.
    These major features of a flat tax are:
    A Single Flat Rate.--All flat tax proposals have a single rate, 
usually less than 20 percent. The low, flat rate solves the problem of 
high marginal tax rates by reducing penalties against productive 
behavior, such as work, risk taking, and entrepreneurship.
    Elimination of Special Preferences.--Flat tax proposals would 
eliminate provisions of the tax code that bestow preferential tax 
treatment on certain behaviors and activities. Getting rid of 
deductions, credits, exemptions, and other loopholes also helps solve 
the problem of complexity, allowing taxpayers to file their tax returns 
on a postcard-sized form.
    No Double Taxation of Saving and Investment.--Flat tax proposals 
would eliminate the tax code's bias against capital formation by ending 
the double taxation of income that is saved and invested. This means no 
death tax, no capital gains tax, no double taxation of saving, and no 
double tax on dividends. By taxing income only one time, a flat tax is 
easier to enforce and more conducive to job creation and capital 
formation.
    Territorial Taxation.--Flat tax proposals are based on the 
commonsense notion of ``territorial taxation,'' meaning that 
governments should tax only income that is earned inside national 
borders. By getting rid of ``worldwide taxation,'' a flat tax enables 
U.S. taxpayers and companies to compete on a level playing field around 
the world.
    Family-Friendly.--All flat tax proposals have one ``loophole.'' 
Households receive a generous exemption based on family size. For 
instance, a family of four would not begin to pay tax until its annual 
income reached more than $30,000.
    Consumption-Based.--A tax code that does not discriminate against 
saving and investment is considered a consumption-based tax system, 
regardless of whether taxes are deducted from the paycheck or collected 
at the cash register. In this respect, a flat tax is a type of 
consumption tax. The difference between a flat tax and a national sales 
tax is where the tax is collected. A flat tax is levied on income--but 
only once and at one low rate--as it is earned. A sales tax is levied 
on income--but only once and at one low rate--as it is spent.
    Both the flat tax and the sales tax differ dramatically from the 
U.S. Internal Revenue Code. The current tax code has numerous forms of 
double taxation, such as its treatment of saving and corporate income. 
The current tax code also has several forms of wealth taxation or asset 
taxation, such as the capital gains tax and the death tax. (These also 
are forms of double taxation since the assets were acquired with after-
tax dollars.) The current tax code even has provisions that force 
taxpayers to overstate their income, such as forcing businesses to 
``depreciate'' the cost of new investment instead of allowing immediate 
and full deduction (a policy known as ``expensing'') when costs are 
incurred.
    None of these forms of double taxation, wealth taxation, or 
overtaxation exist in either a flat tax or a national sales tax, which 
is why public finance economists categorize both systems as 
consumption-based taxes.
How a Flat Tax Would Work for Individual Taxpayers
    Compared to the current system, a flat tax is extremely simple. 
Households pay tax on their labor income using a 10-line individual 
postcard. (See Form 1 in Figure 1.) They do not need to worry about 
reporting dividends, interest, and other forms of business/capital 
income. Those forms of income are taxed at the business level, thus 
obviating any need to tax them at the individual level since that would 
violate the principle of no double taxation.
    The individual postcard is so simple that a third-grader could file 
a family's tax return in about five minutes. Each household would 
report wage, salary, and pension income on Line 1, which should be 
easily available from W-2 forms. Using Lines 2-5, the household then 
would calculate its personal allowance, which is based on family size. 
The personal allowance on Line 5 is then subtracted from Line 1 to 
determine taxable income. This amount is reported on Line 6. The amount 
of tax is calculated on Line 7. This amount is then compared to the 
amount of tax withheld on Line 8, which then leaves either a tax 
payment (Line 9) or a refund (Line 10).
How a Flat Tax Would Work for Businesses
    Like the individual postcard form, the business postcard form is 
very simple. (See Form 2 in Figure 1.) All businesses, from Microsoft 
to a hot dog stand, would play by the same rules. There no longer would 
be separate tax rules for partnerships, sole proprietorships, S 
corporations and regular corporations. All business operations in 
America, whether owned by a U.S. company or owned by a foreign company, 
would pay tax on the income that they earn in the United States.




    All business taxpayers would put their total receipts on Line 1. 
They would then add together their labor costs, their input costs, and 
their investment costs on Lines 2 and 3. These costs are subtracted 
from gross receipts to determine taxable income on Line 4. Line 5 is 
the amount of tax that is due. Lines 6-10 exist in case a company 
either had losses from previous years and now has an opportunity to 
offset taxable income or has losses this year and needs to ``carry them 
forward'' to the next tax year.
How a D.C. Flat Tax Would Work
    Administering a geographically-targeted flat tax poses some 
challenges. In a modern economy, cross-border economic activity is very 
common. Would that activity be taxed under the D.C. flat tax, or in 
another state under the rules of the current internal revenue code? 
Would the flat tax only apply for those who reside in the District? 
Would the flat tax apply to businesses, or just to individuals? And if 
it applies just to individuals, would some of the policies outlined by 
Professors Hall and Rabushka--such as taxation of fringe benefits--be 
implemented?
    These are genuinely difficult issues. To minimize the obstacles, 
policy makers may want to focus on the easiest approach--which would be 
a flat tax for resident individuals. Such an approach would not be as 
beneficial as a comprehensive flat tax applying to all individuals and 
businesses, but such legislation would still achieve the goals of 
boosting economic growth in the District of Columbia and creating a 
successful example that would spur fundamental tax reform for the 
entire nation.
The Advantages of a Flat Tax
    There are two principal arguments for a flat tax--growth and 
fairness. Many economists are attracted to the idea because the current 
tax system, with its high rates and discriminatory taxation of saving 
and investment, reduces growth, destroys jobs, and lowers incomes. A 
flat tax would not eliminate the damaging impact of taxes altogether, 
but by dramatically lowering rates and ending the tax code's bias 
against saving and investment, it would boost the economy's performance 
when compared with the present tax code.
    However, the most persuasive feature of a flat tax for many 
Americans is its fairness. The complicated documents, instruction 
manuals, and numerous forms that taxpayers struggle to decipher every 
April would be replaced by a brief set of instructions and two simple 
postcards. This radical reform appeals to citizens who not only resent 
the time and expense consumed by filing their own tax forms, but also 
suspect that the existing maze of credits, deductions, and exemptions 
gives a special advantage to those who wield political power and can 
afford expert tax advisers.
    If enacted, a flat tax would yield major benefits to the nation, 
including:
    Faster Economic Growth.--A flat tax would spur increased work, 
saving, and investment. By increasing incentives to engage in 
productive economic behavior, it would also boost the economy's long-
term growth rate. Even if a flat tax boosted long-term growth by only 
0.5 percent, the income of the average family of four after 10 years 
would be as much as $5,000 higher than it would be under current tax 
laws.
    Instant Wealth Creation.--According to Harvard economist Dale 
Jorgenson, tax reform would boost national wealth by nearly $5 
trillion. It would do this in part because all income-producing assets 
would rise in value since the flat tax would increase the after-tax 
stream of income that they generate.
    Simplicity.--Complexity is a hidden tax amounting to more than $100 
billion. This is the cost of tax preparation, lawyers, accountants, and 
other resources used to comply with the Internal Revenue Code. The 
Internal Revenue Service even admits that the current tax code requires 
taxpayers to devote 6.6 billion hours each year to their tax returns. 
Yet even this commitment of time is no guarantee of accuracy. The code 
is so complex that even tax experts and the IRS often make mistakes. 
All taxpayers, from General Motors to a hamburger-flipping teenager, 
would be able to fill out their tax return on a postcard-sized form, 
and compliance costs would drop by tens of billions of dollars.
    Fairness.--A flat tax would treat people equally. A wealthy 
taxpayer with 1,000 times the taxable income of another taxpayer would 
pay 1,000 times more in taxes. No longer would the tax code penalize 
success and discriminate against citizens on the basis of income. Tax 
burdens would no longer depend on the number of lawyers, lobbyists, and 
accountants on the payroll.
    An End to Micromanaging and Political Favoritism.--A flat tax gets 
rid of all deductions, loopholes, credits, and exemptions. Politicians 
would lose all ability to pick winners and losers, reward friends and 
punish enemies, and use the tax code to impose their values on the 
economy. Not only does this end a major source of political corruption, 
but it is also pro-growth since companies would no longer squander 
resources lobbying politicians or making foolish investments just to 
obtain favorable tax treatment.
    Increased Civil Liberties.--Under current law, people charged with 
murder are presumed innocent and thus have more rights than taxpayers 
dealing with the Internal Revenue Service. By contrast, a flat tax 
would eliminate almost all sources of conflict between taxpayers and 
the government. Moreover, infringements on freedom and privacy would 
fall dramatically since the government would no longer need to know the 
intimate details of each taxpayer's financial assets.
    Economic Migration.--In addition to the aforementioned benefits, 
the District of Columbia would enjoy a substantial inflow of jobs and 
capital from the rest of the country. Indeed, economic migration might 
be the dominant effect when looking at the economics of a 
geographically-targeted flat tax. Similar migration (albeit from other 
nations) would occur with a nationwide flat tax, of course, but the 
impact of economic migration would be particularly pronounced in the 
case of a D.C. flat tax since it is much easier to move across state 
borders than it is to move across national borders.
Real World Evidence
    In a remarkable development, former communist nations are leading a 
global tax reform revolution. Estonia was the first to adopt a flat 
tax, implementing a 26 percent rate in 1994, just a few years after the 
collapse of the Soviet Union. The other two Baltic republics of the 
former Soviet Union enacted flat taxes in the mid-1990s, with Latvia 
choosing a 25 percent rate and Lithuania picking 33 percent. Along with 
other free-market reforms, the flat tax significantly improved economic 
growth, and the ``Baltic Tigers'' became role models for the region. 
Learning from its neighbors, Russia stunned the world by adopting a 13 
percent flat tax, which went into effect in 2001.
    The Russian flat tax quickly yielded positive results: The economy 
prospered, and revenues poured into government coffers since tax 
evasion and avoidance became much less profitable. The flat tax then 
spread to Serbia, which in 2003 chose a 14 percent rate. Slovakia 
hopped on the bandwagon the following year with a 19 percent flat tax, 
as did Ukraine, which chose a 13 percent tax rate. Earlier this year, 
Romania joined the flat tax revolution with a 16 percent tax rate, and 
Georgia adopted a 12 percent flat tax rate, which has the honor, at 
least temporarily, of being the lowest rate in the world.
    The flat tax revolution has been so successful that Estonia is 
lowering its rate to keep pace with other nations. The Estonian flat 
tax is now down to 24 percent and will drop to 20 percent by 2007, and 
Lithuania is in the process of lowering its 33 percent flat tax to a 
more reasonable 24 percent. Poland's government just announced that it 
will implement an 18 percent flat tax, and lawmakers in Croatia, 
Bulgaria, and Hungary are also considering tax reform. Last but not 
least, the opposition parties in the Czech Republic have promised to 
implement 15 percent flat tax regimes if they win the upcoming 
elections.
    In a global economy, it is increasingly easy for jobs and capital 
to escape high-tax nations and migrate to low-tax nations. This means 
that the reward for good tax policy is greater than ever before, but it 
also means that the penalties for bad policy are greater than ever 
before. This is why so many nations are lowering tax rates and 
reforming their tax systems. A flat tax will make America a magnet for 
investment and job creation.
Conclusion
    The current income tax system punishes the economy, imposes heavy 
compliance costs on taxpayers, rewards special interests, and makes 
America less competitive. A flat tax would dramatically reduce these 
ill effects. Perhaps more important, it would reduce the federal 
government's power over the lives of taxpayers and get the government 
out of the business of trying to micromanage the economy.
    There will never be a tax that is good for the economy, but the 
flat tax moves the system much closer to where it should be--raising 
the revenues that government demands, but in the least destructive and 
least intrusive way possible.
    A D.C. flat tax should be seen as a means to an end. In the short 
run, some will accurately grouse that it creates an additional inequity 
in the tax code. They will complain that it will cause tax-motivated 
migration. They will fret that taxpayers will engage in arbitrage to 
benefit from better tax law in a specific part of the country.
    These are all legitimate complaints, but they pay attention to the 
trees and forget about the forest. Fundamental tax reform has a great 
capacity to make America a freer and more prosperous nation. A D.C. 
flat could be the necessary prerequisite for the nationwide adoption of 
a simple and fair tax code.

    Senator Brownback. Mr. Edwards.
STATEMENT OF CHRIS EDWARDS, DIRECTOR OF TAX POLICY, 
            CATO INSTITUTE
    Mr. Edwards. Thank you very much, Mr. Chairman, for having 
me, and for these interesting and important hearings regarding 
a possible flat tax in the District of Columbia.
    Last November, President Bush's bipartisan Advisory Panel 
on Federal Tax Reform sounded the alarm regarding the need for 
major reforms. The panel proposed two different reform plans 
that would simplify the Tax Code, cut marginal rates, and 
reduce taxes on savings and investment. What we're talking 
about here today, the flat tax that's long been championed by 
Mr. Armey and others, would create even far greater 
simplification than the President's Advisory Panel proposed. A 
flat tax would have one low rate, and treat savings and 
investment in a neutral and efficient manner.
    On simplification, I must say that the problem is even more 
complex than you touched on with your stack of the Code and 
Federal regulations. There is, in addition to the Code and 
Federal regulations, thousands of pages of IRS rulings to guide 
taxpayers. There's thousands--tens of thousands, hundreds of 
thousands of pages of tax court cases. The Joint Committee on 
Taxation's report on Enron tax shelters was about 4 or 5 inches 
thick, just by itself. I believe the flat tax would eliminate a 
lot of that complexity, and it is one of the most important 
reasons for moving to a flat tax.
    Despite recent tax cuts, the Federal income tax system is 
remarkably complex and efficient still. The top Federal income 
individual and corporate tax rates are, today, higher than they 
were following reforms in 1986 championed by Ronald Reagan, yet 
competition in the global economy is even more intense than it 
was a couple of decades ago, after 1986. The corporate tax 
rates, in particular, have been cut radically around the world 
since our leading reforms in 1986. We used to have one of the 
lowest corporate tax rates in the world. Now we've got one of 
the highest.
    So, what sort of reforms should we pursue? Well, as Dan 
touched on, the countries of Eastern Europe have shown the way 
here. People have wondered about flat taxes--I mean, they've 
long been sort of an economist's dream, but we now know that 
they're a practical reality, as Dan touched on, in places like 
Russia and Slovakia.
    In addition to the countries that Dan touched on, I mean, 
there's, you know--Estonia is--was the first to install a flat 
tax in--back in 1994, with a 26 percent rate. Hong Kong has 
long had a--what you can call a voluntary flat tax system. 
They've got a regular graduated rate system, but individuals, 
as an alternative, can chose to play--pay a 15 to 16 percent 
flat tax in Hong Kong. So, that would--is sort of a model for 
what we're talking about for the District of Columbia. Hong 
Kong, by the way, doesn't tax individuals on dividends and 
capital gains at all, as under the flat tax.
    It's not just fairly small Eastern European economies that 
have radically cut their tax rates. The United States now has a 
much higher tax rate than the industrial countries of Western 
Europe, who are our main trading partners. And the average 
corporate tax rate across 25 European countries is now just 27 
percent. We've got a 35 percent Federal tax rate. The average 
State tax rate's 5 to 6 percent. But some places, like New York 
City, have a 17 percent corporate tax rate on top of the 
Federal corporate tax rate, enormously inefficient. I would see 
little reason for major corporations to shift, you know, any of 
their activity to New York City, when you've got places like 
London, and even Paris, these days, with more lower corporate 
tax rates.
    I think the countries around the world are going to 
continue to cut their corporate tax rates, because of the 
compelling benefits of attracting greater inflows of foreign 
investment. There's as much as $1 trillion a year in foreign 
direct investment that now crosses international borders. The 
United States is competing against many, many other countries 
these days for that investment, and it makes little sense to me 
that we have a tax system that repels investment rather than 
attracts it.
    So, should we start reforms in our Federal tax system with 
a flat tax for the District of Columbia? Well, the first thing 
I would note is that the District of Columbia has a lot of 
reforms it could do on its own. It's got a 9 percent top tax 
rate for individuals, much higher than the 50-State average of 
5\1/2\ percent. The District of Columbia has got a corporate 
tax rate of 10 percent, much higher than the 50-State corporate 
tax rate average of 6.9 percent. So, it makes sense, for me, if 
we were to go to a flat tax--a Federal flat tax in the District 
of Columbia, that any--the economic growth benefits, I think, 
would help fill the D.C. coffers, and the District of Columbia 
should use any extra economic--revenue from economic growth to 
lower its own corporate tax rates so that the Federal tax cuts 
don't just become a place for the District of Columbia to spend 
more taxpayer money.
    I think a District of Columbia--a flat--a voluntary flat 
tax in the District of Columbia is a great idea. It would mean 
that no one would have to pay higher taxes under an alternative 
flat tax system. I must say that one possible issue are--at 
least on a static basis, are possible Federal revenue losses. I 
would argue that--it would be unpopular in the District of 
Columbia, but one way to deal with that problem is to cut 
Federal spending in the District, either their special District 
appropriations or just general Federal spending in the 
District, to create a revenue-neutral plan with lower taxes and 
lower spending in the District.
    It seems to me if the District of Columbia--if you went to 
a tax system with a large revenue loss for the District of 
Columbia, neighboring States could complain. But, again, I 
think the solution would be to cut Federal spending in the 
District at the same time.
    And it seems to me there's a parallel idea being proposed 
for Federal highway spending. Some bills have been introduced 
in Congress that would allow States who opt out of the Federal 
highway system--States could pay lower Federal gas taxes, but 
they wouldn't get Federal highway spending. So, in that sort of 
parallel, States could opt out and pay lower Federal taxes, but 
get lower Federal spending. And I think that there's a parallel 
argument that could be made for the District of Columbia.
    A flat tax for the District of Columbia could include 
reforms to both individual and corporate taxes. I would say 
that, in general, corporate tax cuts have larger beneficial 
effects on the economy than individual tax cuts, although, in 
this case, both would be very favorable. The Joint Committee on 
Taxation, last year, modeled the effects of a similar-sized 
corporate and individual income tax cut. They found that the 
long-run growth benefits of corporate tax cuts were much larger 
than individual tax cuts. So, I think the upshot for the 
District of Columbia is that a corporate tax cut would be 
highly beneficial, would give the biggest bang for the buck, 
would help create jobs and stronger growth in the District.
    So, to conclude, the goal of Federal taxpayers should to, 
as the other panelists have said, replace the income tax, on a 
national basis, with a flat tax for the whole country. 
Certainly, the District could become a great model for broader 
national reforms. People want to know whether a flat tax is a 
realistic practical idea. As Dan said, the experience in other 
countries that have adopted flat taxes show that flat taxes--
the effect of flat taxes has been very positive in the real 
world. And it seems to me, in today's global economy we need to 
get moving on tax reforms. And so, I applaud you and this 
committee for looking at the idea of a flat tax in the District 
of Columbia.
    Thank you.
    Senator Brownback. Thank you, Mr. Edwards.
    [The statement follows:]
                  Prepared Statement of Chris Edwards
    Mr. Chairman and members of the Committee, thank you for inviting 
me to testify today regarding a possible flat tax for the District of 
Columbia.
    Last November President Bush's bipartisan Advisory Panel on Federal 
Tax Reform sounded the alarm regarding the need for major tax 
reform.\1\ The Panel proposed two reform plans that would simplify the 
tax code, cut marginal tax rates, and reduce taxes on savings and 
investment. Replacing the income tax with a flat tax would create even 
greater simplification and economic gains than the Panel's plans. A 
flat tax would have one low rate and would treat savings and investment 
in a neutral and efficient manner.
---------------------------------------------------------------------------
    \1\ President's Advisory Panel on Federal Tax Reform, ``Simple, 
Fair, and Pro-Growth: Proposals to Fix America's Tax System,'' November 
2005, www.taxreformpanel.gov.
---------------------------------------------------------------------------
    This testimony discusses why it is crucial to move ahead with 
federal tax reform along the lines of a flat tax. It also discusses 
some aspects to consider regarding a possible flat tax for D.C.
The United States Should be a Tax Reform Leader, Not a Laggard
    Despite recent tax cuts, the federal income tax system remains 
terribly complex and inefficient. The system is biased against savings 
and investment, and top income tax rates are higher today than after 
the last major reform in 1986.
    Yet competition in the global economy has intensified and most 
countries have slashed their income tax rates in order to attract 
foreign investment and promote growth. After the 1986 tax reform, the 
U.S. corporate tax rate was lower than in most countries, but today the 
rate is one of the highest in the world. While U.S. companies face non-
tax challenges such as high pension costs, it makes no sense to also 
burden them with an anti-competitive tax regime as they struggle to 
expand in domestic and foreign markets.
    What tax reforms should the United States pursue? The countries of 
Eastern Europe have shown the way ahead with sharp cuts to individual 
and corporate income tax rates. These countries have shown that low-
rate flat taxes are not just an economist's dream, but a practical 
reality that can boost growth, reduce tax avoidance, and increase 
fairness.
    Here is a summary of some of the tax reforms abroad:
  --Hong Kong.--Hong Kong has long had one of the world's most 
        efficient tax systems. The corporate income tax has a low 17.5 
        percent rate. The individual income tax has graduated rates 
        from 2 to 20 percent and various deductions, but individuals 
        can instead pay a 16 percent flat tax on a broader base. 
        Individuals are not taxed on dividends or capital gains.
  --Ireland.--Ireland has the second-highest income per capita and the 
        lowest overall tax burden in Europe. Its economy has grown 
        rapidly as a result of pro-market reforms including tax cuts. 
        The corporate tax rate is just 12.5 percent.
  --Estonia.--Prime Minister Mart Laar launched the European flat tax 
        revolution in 1994 by instituting a 26 percent flat tax for 
        individuals and corporations. Estonia is phasing down its rate 
        to 20 percent. Another pro-growth change, adopted in 2000, was 
        to exempt corporate retained earnings from tax. Estonia has 
        become a magnet for foreign investment and has enjoyed strong 
        economic growth.
  --Lithuania.--In 1994 Lithuania cut its corporate tax rate to 29 
        percent and its top individual rate to 33 percent. In 2002 the 
        corporate rate was cut to 15 percent. In 2005 Lithuania passed 
        a phased-in cut to its top individual rate to 24 percent. The 
        tax rate on dividends is 15 percent.
  --Latvia.--In 1995 Latvia cut its top individual tax rate to 25 
        percent. The corporate tax rate was reduced from 35 percent in 
        2001 to 15 percent in 2004. Domestic dividends are exempt from 
        tax.
  --Hungary.--Hungary cut its corporate tax rate to 18 percent in 1995 
        and reduced it further to 16 percent in 2004. Hungary has a top 
        individual income tax rate of 38 percent, but dividends are 
        taxed at a lower rate.
  --Russia.--In 2001 Russia replaced its individual income tax, which 
        had rates up to 30 percent, with a 13 percent flat tax. In 2002 
        it cut its corporate tax rate from 35 to 24 percent. Russia's 
        system is not a pure flat tax, as it retains some deductions 
        and narrow provisions. Domestic dividends are taxed at just 9 
        percent. Russia's tax reforms have been a big success. In 
        recent years, the nation's economy has grown strongly, tax 
        revenues have risen, and tax evasion has fallen.
  --Serbia.--In 2003 Serbia enacted a flat income tax with a 14 percent 
        rate on individuals and corporations.
  --Ukraine.--In 2004 Ukraine replaced its individual income tax, which 
        had a top rate of 40 percent, with a 13 percent flat tax. It 
        also cut its corporate tax rate from 30 to 25 percent.
  --Slovakia.--Slovakia adopted a flat rate tax of 19 percent on 
        individuals and corporations in 2004. The top tax rates had 
        been 38 percent and 25 percent, respectively. For individuals, 
        the flat tax has a large basic exemption and few special 
        preferences. Dividends are exempt from tax. Slovakia is 
        attracting large investment inflows and its economy is growing 
        strongly.
  --Poland.--In 2004 Poland cut its corporate tax rate from 27 to 19 
        percent. The top individual rate is a high 40 percent, but 
        reforms may be on the way. One party in the new coalition 
        government favors a low-rate flat tax, while the other favors a 
        cut in the top rate to 32 percent.
  --Georgia.--In 2005 Georgia adopted an individual flat tax with a 12 
        percent rate. The top individual rate had been 20 percent. The 
        corporate tax rate is 20 percent.
  --Romania.--Soon after coming into office, Romania's new president 
        issued an edict to replace the nation's income tax with a 16 
        percent flat tax on individuals and corporations, effective for 
        2005. The top tax rates had been 40 and 25 percent, 
        respectively.
    The table below shows that the United States has much higher income 
tax rates than do these flat tax countries. Indeed, the United States 
has a higher corporate tax rate than virtually all our trading 
partners. The average top corporate tax rate in the European Union is 
26.6 percent, which compares to the U.S. federal and average state rate 
of 39.5 percent.\2\
---------------------------------------------------------------------------
    \2\ Chris Edwards, ``Catching Up to Global Tax Reforms,'' Cato 
Institute Tax & Budget Bulletin no. 28, November 2005.

                  TOP STATUTORY INCOME TAX RATES, 2005
                              [In percent]
------------------------------------------------------------------------
                    Country                      Individual   Corporate
------------------------------------------------------------------------
     COUNTIRES WITH INDIVIDUAL FLAT TAXES
 
Estonia.......................................         24.0         24.0
Georgia.......................................         12.0         20.0
Latvia........................................         25.0         15.0
Lithuania.....................................         33.0         15.0
Romania.......................................         16.0         16.0
Russia........................................         13.0         24.0
Serbia........................................         14.0         14.0
Slovakia......................................         19.0         19.0
Ukraine.......................................         13.0         25.0
                                               -------------------------
      Flat tax countries......................         18.8         19.1
 
          OTHER COUNTRIES AND REGIONS
 
Czech Republic................................         32.0         26.0
Hong Kong.....................................         16.0         17.5
Hungary.......................................         38.0         16.0
Ireland.......................................         42.0         12.5
Poland........................................         40.0         19.0
Singapore.....................................         22.0         20.0
Europe: 25 countries..........................         40.6         26.6
United States.................................         38.6         39.5
------------------------------------------------------------------------
Source: Chris Edwards, Cato Institute, based on KPMG data and various
  news reports. Rates include the national and average subnational tax
  rate.

    I suspect that countries around the world will continue to cut 
corporate tax rates, partly because of the large benefits that can be 
gained by attracting greater inflows of foreign investment. As much as 
$1 trillion of direct investment crosses international borders each 
year, and research shows that these flows are increasingly sensitive to 
taxes.\3\ Our tax system, particularly the corporate income tax, will 
have an increasingly negative effect on U.S. growth unless reformed. 
Also note that high tax rates and excessive tax complexity create an 
ideal breeding ground for Enron-style tax scandals.
---------------------------------------------------------------------------
    \3\ Chris Edwards and Veronique de Rugy, ``International Tax 
Competition: A 21st-Century Restraint on Government,'' Cato Institute 
Policy Analysis no. 431, April 12, 2002.
---------------------------------------------------------------------------
    The solution is to sharply cut the top corporate and individual 
income tax rates, either within a full flat tax reform package or under 
more limited reforms.\4\ U.S. policymakers need to wake up to the new 
global tax realities and put marginal tax rate cuts front and center in 
federal policy discussions. Replacing the high-rate income tax with a 
flat tax would be a great way to accomplish that.
---------------------------------------------------------------------------
    \4\ For a discussion of federal tax reform options, see Chris 
Edwards, ``Options for Tax Reform,'' Cato Institute Policy Analysis no. 
536, February 24, 2005.
---------------------------------------------------------------------------
A Flat Tax for D.C?
    The first thing to note about taxation in D.C. is the high marginal 
tax rates on individuals and businesses. The top D.C. individual tax 
rate is 9.0 percent, which compares to a 50-state average of 5.5 
percent.\5\ The top D.C. corporate rate is 10.0 percent, which compares 
to a 50-state average of 6.9 percent.
---------------------------------------------------------------------------
    \5\ Chris Edwards, ``State Revenue Boom Paves Way for Tax Cuts,'' 
Cato Institute Tax & Budget Bulletin no. 30, January 2006.
---------------------------------------------------------------------------
    Thus, regardless of possible federal tax changes in D.C., it would 
make sense for the city to reduce its high local tax rates to at least 
national average levels. I have argued that states should kill their 
corporate income taxes altogether, as these taxes have very high 
compliance costs compared to the little revenue collected.\6\ If a 
federal tax reform such as a flat tax were introduced in D.C., extra 
local revenue that is generated from higher economic growth should be 
used to cut high local income tax rates.
---------------------------------------------------------------------------
    \6\ Chris Edwards, ``State Corporate Income Taxes Should Be 
Repealed,'' Cato Institute Tax & Budget Bulletin no. 19, April 2004.
---------------------------------------------------------------------------
    A D.C. flat tax that is voluntary is an interesting idea for 
policymakers to consider. One model for a flat tax is the Hong Kong tax 
system. That city's individual income tax has a graduated rate 
structure, but it provides taxpayers with an alternative of a 16 
percent flat tax applied to a broader tax base.
    A voluntary flat tax would presumably result in a (static) federal 
revenue loss because no taxpayers would pay more than under the current 
system, while some would pay less. Because that may create a political 
hurdle, I'd suggest that the revenue loss be at least partly offset 
with cuts to federal spending in the District. Cuts could be made both 
to D.C. appropriations as well as spending under regular federal 
programs. For example, economic development funding could be cut, 
including programs such as Community Development Block Grants. Such 
spending is dubious to begin with, but certainly would not be needed 
with all the new investment pouring into the District to take advantage 
of the low federal tax rates.
    Another aspect to consider is that if a D.C. flat tax created a 
federal revenue loss, neighboring states might complain that D.C. 
residents were getting an unfair benefit. Again, the solution would be 
to cut federal spending in D.C. We could have a revenue neutral policy 
change that resulted from less federal taxes and less federal spending 
in the city, which would be combined with a more vibrant private sector 
economy.
    There is a parallel idea being proposed for federal highway 
spending. Bills have been introduced in Congress that would allow a 
state to opt-out of the federal highway system by ending both the 
federal gas tax and federal highway spending in a state. Thus, a state 
would pay less to the federal government but also get less back, in a 
roughly revenue neutral fashion.
    A flat tax for the District would (or could) include reforms to 
both individual and corporate taxes. Note that, in general, corporate 
tax cuts have larger beneficial effects on the economy than individual 
tax cuts. Last year the Joint Committee on Taxation modeled the effects 
of equal-sized hypothetical cuts to the federal corporate and 
individual income taxes.\7\ They found that in the long run a corporate 
rate cut caused a much larger increase in gross domestic product than 
an individual tax cut. The upshot for D.C. is that cutting the 
corporate tax rate (either the federal rate in the city or the local 
rate) would probably give the biggest bang for the buck to boost the 
city's economy.
---------------------------------------------------------------------------
    \7\ Joint Committee on Taxation, ``Macroeconomic Analysis of 
Various Proposals to Provide $500 Billion in Tax Relief,'' JCX-04-05, 
March 1, 2005.
---------------------------------------------------------------------------
Conclusion
    The goal of federal policymakers should be to replace the current 
income tax with a low-rate consumption-based system--such as the flat 
tax--for the whole country. A flat tax for D.C. is an interesting idea 
that could be the model for broader national reforms.
    Many people are interested in the flat tax, but want to know 
whether it would work as well as proponents expect it to. Certainly, 
the experience in countries that have adopted flat taxes has been very 
positive. In today's competitive global economy, we need to get moving 
on major tax reforms, and so I applaud the committee for exploring 
these issues.
    Thank you for holding these important hearings. I look forward to 
working with the Committee on its flat tax agenda.

    Senator Brownback. Mr. Entin, glad to have you here.
STATEMENT OF STEPHEN J. ENTIN, PRESIDENT AND EXECUTIVE 
            DIRECTOR, INSTITUTE FOR RESEARCH ON THE 
            ECONOMICS OF TAXATION
    Mr. Entin. Thank you, Mr. Chairman. Thank you for the 
opportunity to testify. I commend you and the subcommittee for 
wanting to demonstrate the gains that real tax reform could 
bring to workers and savers at all income levels.
    If I have any cautionary points to make, they stem from my 
concern that you haven't gone far enough. So, I am friend of 
the effort.
    Fundamental tax reform is about creating a tax system that 
is simpler and more conducive to economic growth than the 
current income tax. Simplicity alone is not enough. For 
example, ``Line 1, put down your income; Line 2, send it in,'' 
is as simple a tax system as you can get, but it is not 
conducive to growth. Economic growth means defining income 
correctly to get the tax base right, and taxing it in a 
uniform, nondistorting manner.
    The key question is, What is the tax base? Today's income 
tax falls more heavily on income used for saving and investment 
than consumption, and imposes further burdens with an add-on 
corporate tax and transfer--that is, estate and gift taxes. 
Long depreciation periods further discourage investment. These 
taxes reduce productivity, wages, employment, and incomes 
across the board.
    Neutral taxes, of which the flat tax is one, by contrast, 
treat all economic activity alike. They do not discourage those 
who produce the most with steeply graduated tax rates, and they 
are not biased against saving and investment in favor of 
consumption. Neutral tax systems, sometimes called 
``consumption-based taxes,'' include the saving-deferred tax, 
the national retail sales tax, the value-added tax, returns-
exempt flat tax, or some combination.
    Neutral taxes give saving the sort of treatment we give to 
limited amounts of pensions and IRAs. They don't double tax the 
corporation or the estate. They allow expensing, rather than 
depreciation. I go into these reasons in the addendum to the 
testimony, but I won't dwell on that here.
    Just let me say that if the United States replaced its 
personal and corporate income taxes with a saving/consumption-
neutral tax and eliminated the estate and gift taxes, capital 
investment, productivity, wages, and employment would increase, 
national output and national income would rise by 10 percent 
within about 7 to 10 years. A middle-income family of four 
earning about $50,000 would see roughly $5,000 in additional 
annual income. That's before tax, or about $3,500 after tax. 
Allowing for income growth over time, that 10 percent 
differential would be enough to allow the family to live in a 
$350,000 house instead of a $200,000 house, or to pay to send a 
child to a good college, or to retire with greater security. 
These are real benefits that we are simply throwing away by 
having a tax system that depresses saving and investment.
    Now, we hear a lot about the ``flat tax.'' What do we mean 
by the term? Several Eastern European countries, as Dan has 
described have adopted so-called ``flat'' income taxes. They 
apply a single tax rate--hence, ``flat tax''--to personal 
income, corporate income, and payroll or sales. These taxes are 
flat, only in the sense that they have one tax rate imposed 
several times. Saving is taxed twice, compared to consumption, 
and corporate income is taxed a third time. These systems are 
not fundamental tax reform. They improve simplicity and reduce 
compliance costs, but do not maximize growth and income. Now, I 
will say they are much better than the systems they replace, 
but they don't go far enough.
    By contrast, the Hall-Rabushka and Armey-Shelby flat taxes 
impose a single tax rate on nearly neutral consumed income 
base. They eliminate most tax biases against saving and 
investment in the corporate form. They tax capital income at 
the source, with many deductions eliminated for simplicity. I 
would say that some deductions needed to measure income 
accurately are eliminated, which can place some income on the 
wrong person's tax form, as by ignoring transfers, or may 
misstate income by ignoring certain business and education 
costs, including payments for State and local government 
services and education.
    The other neutral taxes similarly have flat rates in 
expensing and eliminate the antisaving biases. They differ in 
that they also exempt tuition and training, deduct or exclude 
State and local taxes or outlays for education, transfers to 
the poor, and services to business. And they correctly handle 
transfers such as charitable contributions, gifts, or alimony 
as income of the recipient.
    That aside, the various consumed income or HR-style, Hall-
Rabushka style, neutral taxes combine simplification with big 
spurs to economic growth. They are fundamental tax reforms 
worthy of the name. The economic benefits are well known, and 
it is long past time that one of them was adopted.
    The question here today is, what benefits might be had from 
enacting a voluntary saving, consumption-neutral tax--
specifically, a variation of Hall-Rabushka--for the District of 
Columbia? Individuals could volunteer to give up certain 
deductions in exchange for lower marginal tax rates and less 
onerous tax treatment of saving and investment. Such a 
demonstration would be feasible if some modifications are made 
to allow the tax to apply only to residents of the District or 
to any State or region, rather than to the Nation as a whole.
    These tax reforms, if enacted for the District, would lower 
the cost of capital for firms investing here. It would reduce, 
in some manner, the tax imposed on savers living in, or lending 
to, the District. Investment and employment would increase, and 
some of the increase would be investment attracted from over 
the borders from Maryland and Virginia, some would represent a 
rise in national economic output.
    The District has few manufacturing businesses, perhaps due 
to its limited geographical area, and it is likely to remain a 
place where human capital and labor-intensive service jobs 
dominate. Much of the investment might take the form of 
residential rental units. Some savers would find the District 
more attractive than their current States of residents for tax 
purposes, and might move here. Property values would be bid up. 
Additional residential construction should lower rents 
regionally, although the impact on specific neighborhoods 
within and about the District would vary. District income and 
property tax revenues would rise.
    Be warned, in scoring the budget cost of a flat tax 
proposal, the Treasury and the Joint Committee on Taxation of 
the Congress will not assume any gains in national economic 
output, because they are wedded to a static scoring method. 
They will not show gains in wages for District residents, which 
will distort the apparent income distribution of the tax 
changes.
    The proposal would make the tax voluntary. This is 
possible, to some degree, but there would have to be 
coordination between borrowers and lenders so that they were 
treating the same asset at--the same way on both ends. You 
would perhaps have to look at what would happen to fringe 
benefits if employers, versus employees, opted for different 
treatments.
    There would be some regional problems in implementation. 
You would have to very clearly define the payments to the 
savers that would be eligible for the alternative treatments. 
You would have to decide what would happen to that tax 
treatment if they moved out of the District. You would have to 
look at what would happen if businesses were lending 
nationally, not just within the District, and perhaps imposed 
some of these same sorts of rules governing international 
allocation of interest and income between the District and the 
rest of the country, as we now impose between countries--
companies operating here and operating globally. However, these 
things could be worked out. I'm not saying they would be easy, 
but they could be done.
    In conclusion, the benefits of shifting to a saving/
consumption-neutral tax system would be large, and would be 
distributed across most of the population. It's long past time 
for adopting such a system. I prefer to see it be done quickly 
and nationwide, but that may not be possible.
    I would hope that, at the very least, we can extend the 
2003 tax reductions on capital gains, dividends, marginal tax 
rates, and on the elimination of the estate tax. These are all 
steps toward fundamental tax reform. They go part of the way 
there, and I describe the benefits of that in the addendum to 
the report.
    Thank you very much.
    [The statement follows:]
                 Prepared Statement of Stephen J. Entin
    Mr. Chairman and Members of the Subcommittee: Thank you for the 
opportunity to testify on the economic advantages of fundamental tax 
reform. The Subcommittee is to be commended for exploring the gains 
that reform could bring to workers and savers at all income levels, and 
in all corners of the nation.
    Fundamental tax reform is about creating a tax system that is 
simpler and more conducive to economic growth than the current income 
tax. Simplicity alone is not enough. For example--``Line one: Put down 
your income. Line two: Send it in.''--is as simple a system as one can 
get, but it is not conducive to economic growth. Economic growth means 
defining income correctly to get the tax base right, and taxing it in a 
uniform, non-distorting manner.
What is the tax base?
    The broad-based income tax. The comprehensive or broad-based income 
tax in use today taxes most income as it is received, including income 
used for saving, and taxes the returns on saving as soon as they accrue 
(except for capital gains, which can be deferred until realized). Such 
taxes fall more heavily on income used for saving than for 
consumption.\1\ The tax bias against saving is made worse by imposing 
an add-on corporate tax and transfer (estate and gift) taxes. Long 
write-off periods for depreciable assets further discourage 
investment.\2\ These taxes impose high economic costs, including 
reduced productivity, wages, and incomes across the board.
---------------------------------------------------------------------------
    \1\ Income is ordinarily taxed when earned. If the income is used 
for consumption, there is generally no further federal tax (except for 
a few selective excises). One can buy a loaf of bread and eat it, or 
buy a television and watch a stream of programming, and there is no 
further federal tax. If it is used for saving, however, the returns on 
the saving (the streams of interest, dividends, capital gains, or 
profits of non-corporate businesses) are taxed. This is the basic 
income tax bias against saving. If used to buy corporate stock, the 
returns are also subject to the corporate tax before being paid as a 
dividend or reinvested to raise the value of the company (leading to a 
capital gain). This is a third layer of tax on saving. The estate tax 
is a fourth layer of tax on income that is saved. Even if the inherited 
saving was done in a tax deferred pension (offsetting the basic bias), 
it will be subject to the heirs' income tax, so the transfer taxes are 
always an extra layer of tax on saving.
    \2\ Depreciation forces businesses to delay claiming the costs of 
their investments in depreciable assets. The long write-off periods 
reduce the value of the capital consumption allowances by ignoring 
inflation and the time value of money. The allowances fall short of the 
real cost of the assets, overstating real profits and raising effective 
tax rates. Capital formation is discouraged, and productivity and wages 
are reduced. The correct tax treatment would be ``expensing'', that is, 
writing off the cost of investment assets immediately, in the year they 
are made. Expensing would correctly account for the real cost of 
investment, reducing the excess tax burden on capital and expanding 
investment and wages.
---------------------------------------------------------------------------
    Neutral taxes. Neutral taxes are those that treat all economic 
activity alike. In particular, they do not discourage those who produce 
the most with steeply graduated tax rates, and they are not biased 
against saving and investment in favor of consumption. Neutral tax 
systems (sometime called consumption-based taxes) include the saving-
deferred tax \3\, the national retail sales tax, the value added tax 
(VAT) \4\, the returns-exempt Flat Tax \5\, or some combination. To put 
saving and consumption on an equal footing, a tax system must impose 
the same tax, in present value, on income used for immediate 
consumption and on income saved for future consumption. To do so, 
neutral taxes either defer taxes on income saved (as with a pension or 
regular IRA) and tax the subsequent withdrawals of principal and 
earnings, or tax the income up front but eliminate taxes on the returns 
(as with a Roth IRA). Neutral systems do not have add-on layers of tax 
at the corporate level, either taxing the returns on corporate assets 
at the business level or the shareholder level, but not both. There is 
no estate or gift tax. Capital outlays are expensed immediately, rather 
than depreciated over time.
---------------------------------------------------------------------------
    \3\ A tax on income less net saving, in which all saving is tax 
deferred in the manner that current law allows for limited amounts of 
saving in an ordinary IRA, 401(k), or pension. This type of tax is also 
called an inflow-outflow tax, a consumed income tax, an individual cash 
flow tax, or an expenditure tax.
    \4\ Value added tax, including European style credit invoice method 
VATs, goods and services taxes or GSTs (as in Canada and Australia), or 
subtraction method VATs (also called business transfer taxes in the 
United States, such as is proposed in the USA Tax).
    \5\ A returns exempt tax does not allow a deduction for or deferral 
of current saving, which must be done on an after-tax basis, but it 
does not subsequently tax the returns on that after-tax saving. It is 
the method used for Roth IRAs, and is how individual savers are treated 
in the Hall-Rabushka or Armey-Shelby Flat Tax.
---------------------------------------------------------------------------
Benefits of neutral taxes
    A saving-consumption neutral tax with a flat rate would serve every 
type of economic actor better than the current income tax system, which 
includes the graduated comprehensive personal income tax, the corporate 
income tax, and the estate and gift taxes. If the United States were to 
replace its personal and corporate income taxes with a savings-
consumption neutral tax, and eliminate the estate and gift taxes, the 
country would experience a sharp reduction in the service price of 
capital, and a major increase in capital investment. Productivity, 
wages, and employment would increase. If the basic tax rate were kept 
low, there would be a further labor force response. All told, there 
would be something over a ten percent increase in national output and 
national income within about seven to ten years.
    For a middle income family of four earning about $50,000, that 
would mean a roughly $5,000 increase in annual income, before tax (and 
about $3,500 after tax). Allowing for a percent a year in real income 
growth over a working lifetime due to technological change, that 
initial 10 income percent differential would be enough to allow the 
family to live in a $350,000 house instead of a $200,000 house, or to 
pay to send a child to a good college, or to retire with greater 
security. With a ``static'' revenue neutral tax restructuring, there 
would be a significant positive revenue feedback for federal, state, 
and local tax authorities, reducing budget pressures. Alternatively, 
the revenue feedback could be used to further lower tax rates on labor 
and capital income. These are non-negligible real benefits that we are 
simply throwing away by having a tax system that is unnecessarily harsh 
on saving and investment.
What is meant by a ``flat tax?''
    The European ``flat taxes'' on an income base. Several Eastern 
European countries have adopted so-called ``flat'' income taxes. They 
apply a single tax rate (hence ``flat'' tax) to personal income, 
corporate income, and payroll or sales. These taxes are non-neutral, 
and are ``flat'' only in the sense that they have one tax rate, imposed 
several times. Saving is taxed twice compared to consumption, and 
corporate income is taxed a third time. These systems are partial, but 
not fundamental, tax reform. They improve simplicity and reduce 
compliance costs, but do not maximize growth and income.
    The Hall-Rabushka-Armey-Shelby Flat Tax on a consumed-income base. 
The Hall-Rabushka and Armey-Shelby ``Flat Taxes'' impose a single tax 
rate on a nearly neutral consumed-income base. They eliminate most tax 
biases against saving and investment and the corporate form. They are 
largely saving-consumption neutral because capital investment is 
expensed and corporate income is taxed only once at the business level 
and not again at the shareholder level. They tax capital income at the 
source, with many deductions eliminated for simplicity. However, some 
deductions needed to measure income accurately are eliminated for 
simplicity. Some call this part of the tax's ``flatness'', but this 
feature can place some income on the wrong person's tax form, as by 
ignoring transfers, or may misstate income by ignoring certain business 
and education costs, including payments for state and local government 
services and education.
    Other neutral consumed-income or cash-flow taxes. A consumed-income 
or consumption-based tax retains only those deductions needed to define 
income correctly (as revenue less the cost of earning revenue), and 
allocates the income for tax purposes to those who get to spend it by 
means of appropriate treatment of transfer payments. These systems 
include the consumed-income tax (revenue less saving = consumption 
spending), national retail sales tax (consumption spending), or VAT 
(consumption spending). All include expensing of investment outlays; 
exempt tuition and training; deduct (or exclude) state and local taxes 
(or outlays) for education, transfers to the poor, and services to 
businesses; and correctly handle transfers such as charitable 
contributions, gifts, or alimony as income of the recipient.
    The various consumed-income or H-R style neutral taxes combine 
simplification with the biggest potential for income growth. These are 
fundamental tax reforms worthy of the name. The economic benefits are 
well-known, and it is long past time that one of them was adopted. In 
recent years, each time we have moved in the direction of a neutral, 
pro-growth tax system, the economy has responded with more jobs and 
rising output. The tax reductions of 2001, as amended in 2003, with 
lower marginal tax rates, reduced double taxation of corporate income 
via the 15 percent rate caps on dividends and capital gains, and repeal 
of the estate and gift taxes, are steps in the right direction. We 
could achieve fundamental reform nationwide in stages, making these 
rate reductions permanent, enlarging the amounts of saving eligible for 
neutral treatment in IRAs and pensions, and shortening asset lives. 
Later, we could more completely integrate the individual and corporate 
taxes.
A Flat Tax for the District of Columbia?
    The question here today is what benefits might be had from enacting 
a voluntary saving-consumption neutral tax, specifically, a variant of 
the Hall-Rabushka ``Flat Tax'', for the District of Columbia, as an 
example for the nation. Individuals could volunteer to give up certain 
deductions in exchange for lower marginal tax rates and less onerous 
tax treatment of saving and investment. Such a demonstration would be 
feasible if some modifications are made to allow the tax to apply only 
to residents of the District (or to any state or region), rather than 
to the nation as a whole.
    Benefits for the District and the cost to the Treasury. A Flat Tax, 
or some variant, if enacted for the District, would lower the cost of 
capital for firms investing here. It would reduce, in some manner, the 
tax imposed on savers living in or lending to the District. Investment 
and employment would increase. Some of the increase would be investment 
attracted from over the borders from Maryland and Virginia. Some would 
represent a rise in national economic activity.
    The District has relatively few large manufacturing businesses, in 
part due to its limited geographical area. It is likely to remain a 
place where human capital and labor intensive service jobs dominate 
(law firms, hospitals, schools, restaurants). Much of the investment 
might take the form of residential rental units. Some savers would find 
the District more attractive than their current states of residence for 
tax purposes, and might move here. Property values would be bid up. 
Additional residential construction should lower rents regionally, 
although the impact on specific neighborhoods within and without the 
District could vary. District income tax and property tax revenues 
would rise.
    In scoring the budget cost of a Flat Tax proposal, the Treasury and 
the Joint Tax Committee of the Congress will not assume any gains in 
national economic output, because they are wedded to a static scoring 
method. The revenue estimators will not show the gains in wages for 
District residents, which will distort the distribution of the tax 
reductions across income classes. If they are being truly static, they 
would calculate the revenue change by looking only at the proposal's 
effect on current residents, without assuming many more people will 
move into the District to take advantage of the tax change. If the 
estimators wish to be antagonistic to the idea, they will omit the 
economic gains but assume a large influx of people into the District in 
search of lower tax rates on their capital and salary income.
    A voluntary application. The proposal would make the Flat Tax 
voluntary. That is possible to some degree, but there would have to be 
some areas of coordination between employers and employees, and between 
borrowers and lenders.
    For example, under the Flat Tax (and VAT), borrowers are not 
allowed to deduct interest, but lenders do not have to pay tax on 
interest received. Mortgages would carry the current after-tax interest 
rate, instead of the higher pre-tax rate we see today, and borrowers 
and lenders would be in the same net position, after-tax, as they are 
now. But if a homeowner or business borrower opted out of the Flat Tax, 
but its lender opted in, the interest income might escape tax entirely. 
There would have to be a requirement for each loan to be treated alike 
by the borrower and the lender. For example, financial firms might be 
allowed to offer homeowners either a taxable or a non-taxable mortgage, 
with both sides treating the interest on that particular loan alike.
    Also under the Flat Tax, businesses are not allowed to deduct 
fringe benefits, including health insurance premiums. In return, these 
are not taxable on the workers' tax forms, and they get a lower tax 
rate on their cash wages. If workers participate, but businesses opt 
not to participate, some fringe benefits might continue to escape tax 
entirely. Workers might get reduced tax rates without the ``base 
broadening'' that is meant to offset the revenue loss and make the tax 
system more neutral and efficient. If this aspect of the Flat Tax is 
retained, it would affect the revenue estimate. Workers and their 
bosses might have to opt in or opt out jointly to make the system work 
smoothly.
Regional considerations in designing the proposal
    Even with adjustments to the voluntary feature of the proposal, 
imposing a Flat Tax on a region within the country raises a number of 
administrative, enforcement, and compliance issues.
    All the major neutral tax systems are internally consistent applied 
nationwide. All specify consistent choices and definitions for income 
that crosses the national border. Similar care would be needed to 
preserve consistency if such taxes were to be implemented on a regional 
or state basis.
    The Hall Rabushka and other saving-consumption ``neutral'' taxes 
are really quite similar, falling on roughly the same amount of 
consumed income each year, with the main difference among them being 
the point of collection. Because of this difference, two of the systems 
would not be suitable for use in a sub-region of the country, such as 
the District of Columbia. The retail sales tax could be avoided by 
driving to Maryland or Virginia to shop. A ``destination'' type VAT 
(imposed on imports, rebated on exports) would require customs sheds at 
the bridges and border-crossing roads. An ``origin-type'' VAT (imposed 
on wages and capital income of residents) could be adapted to regional 
use. So could the Hall-Rabushka ``Flat Tax'' or the consumed income 
tax, with appropriate modifications.
    Residency requirements. It would be necessary to make rules 
relating to part time residents. The federal tax system would need to 
include the same sort of rules as states impose when people move in or 
out of their jurisdiction during the year. Presumably, the part-time 
District residents would be under one system for part of the year, and 
another for the remainder.
    The IRS would have to determine the validity of claims to residency 
status. If state practice is a guide, there would need to be 
requirements for people to be physically present for a number of days 
to qualify for the favored tax status. As a Federal tax example, under 
changes enacted in 2004, the IRS is currently adding a modest days-per-
year residency requirement to narrow eligibility for the federal income 
tax relief granted to residents of the U.S. Virgin Islands under 
section 936. Some sort of residency requirement would be needed for the 
District tax.
    Treatment of capital income. Saving-consumption neutral taxes 
either defer tax on income that is put into saving (as in a regular IRA 
or pension) and tax withdrawals from saving, or they tax income up 
front and exempt the returns (interest, dividends, or capital gains, as 
with a Roth IRA or municipal bond). Businesses expense outlays instead 
of depreciating them. If these features were retained in the District 
tax, then rules would be needed to define their application to 
individuals and businesses.
    Individuals under a regional tax. Individuals willing to give up 
some of their existing deductions could be offered a lower tax rate. 
High income, high saving individuals who have otherwise maxed out on 
their pension IRA and 401(k) contributions would find the District an 
attractive place to live, at least for tax purposes, because they would 
receive some form of pension treatment on more of their saving. The 
legislation setting up the District tax would have to define that 
treatment clearly.
    For example, under the returns-exempt method of the Hall-Rabushka 
tax, what would happen if people have lived and saved in the District, 
and later move out? Would they lose the exemption on the returns on the 
saving they did while living in the District? Some people would not 
save as much as the Flat Tax would ordinarily encourage them to do if 
this string were attached.
    If, alternatively, the deferral of saving method applied, then 
people would get universal IRA treatment of saving contributions for 
years in which they live in the District, but not for years they live 
outside. If they move out of the District, would they have to pay tax 
immediately on such accounts, or only when they withdraw the money? 
Would the inside build-up continue to be tax-deferred until withdrawal, 
or become taxable annually? Saving would be higher if the accounts were 
to retain their saving-deferred treatment until withdrawal. Either 
approach is administrable, but the legislation would have to set the 
rule.
    Businesses under a regional tax. A small business owner living and 
working in the District would presumably get to expense his District 
business outlays, and would pay tax on all returns. For a corporate or 
non-corporate business that operates in many states and the District, 
presumably only its investments placed in service in the District would 
be expensed.
    In the Hall-Rabushka Flat Tax, corporate income is taxed at the 
business level, and is not taxed again at the shareholders' level. The 
legislation would have to specify whether the District income of 
corporations paid as a dividend is to be exempt only for District 
residents or for shareholders nationwide. To realize the full economic 
effect, it should be nationwide. To determine how much of a capital 
gain stemming from reinvested after-tax District business income should 
be tax free, a ``deemed dividend'' (a notice allowing shareholders to 
raise the tax basis of their shares by the reinvested District income) 
could be adopted. Again, the legislation would have to specify if that 
were to apply only to shareholders who live in the District, or to all 
shareholders.
    Under the Hall-Rabushka tax plan, financial transactions are not 
taxed. Interest is non-deductible by the borrower, and not taxable to 
the lender.\6\ If the tax system is only applied in the District, there 
would have to be rules governing the treatment of interest paid and 
received by a business with multi-state operations. Presumably, a 
multi-state business could deduct interest on loans taken to invest in 
Kansas but not on loans taken to invest in the District. Presumably, 
interest earned by a District-based lender on loans made to out-of-
District borrowers would be taxable. Money is fungible. We have 
international interest allocation rules now to deal with firms that 
borrow and invest globally. Similar rules would be needed within the 
country to handle the different tax system for the District.
---------------------------------------------------------------------------
    \6\ Under Hall-Rabushka, special rules were suggested for taxing 
financial firms whose income is earned from the spread between interest 
earned and interest paid. Such rules appear to be difficult to design 
and implement. Consequently, under the Armey Flat Tax, banks and other 
financial institutions would be taxed as under current law, but with 
expensing.
---------------------------------------------------------------------------
    In a consumed-income tax, there is no corporate tax. Instead, 
corporate income is taxed when shareholders receive dividends or sell 
assets without reinvesting. If this method were chosen, each company 
would have to break its income into two parts, that which is District 
income, free of the federal corporate income tax, and that which is 
non-District income, taxable under the federal corporate tax. Dividends 
paid would then be taxable to the shareholders (wherever they reside). 
Non-corporate business income would appear on the owners' tax forms. 
Interest payments would be deductible, and interest received would be 
taxable, as under current law, for small business owners.
Conclusion
    The benefits of shifting to a saving-consumption neutral tax system 
would be large and would be distributed across most of the population. 
It is long past the time for adopting such a system.
    The country could move to such a system on a nationwide basis, step 
by step. Alternatively, it could proceed region by region. The latter 
is doable, but more difficult. Having one federal tax system for most 
of the country and another federal tax system for a single state or 
region would potentially create administrative and enforcement issues 
for the government and compliance problems for individual and business 
taxpayers that would have to be carefully addressed in writing the 
legislation and the regulations.
    Ideally, Congress would work toward a reformed tax for the whole 
country step by step as budget conditions allow. If a region by region 
approach is adopted, it might be administratively easier to use the 
saving-deferred method rather than the returns-exempt method of neutral 
taxation. If the Hall-Rabushka approach is adopted, it would be best to 
modify it so as not to eliminate deductions for charitable 
contributions and state and local taxes.
 Appendix--Economic Benefits of Extending the Fifteen Percent Tax Rate 
on Dividends and Capital Gains and the Other Pro-Growth Elements of the 
        2001 and 2003 Tax Acts, and of Enacting Further Reforms
    Several provisions of the Economic Growth and Tax Relief 
Reconciliation Act of 2001, as amended by the Jobs and Growth Tax 
Relief Reconciliation Act of 2003, helped to end the recession by 
turning around a severe slump in investment. Three key provisions 
either have expired, or soon will expire, if not extended by the 
Congress. The 15 percent top tax rates on dividends and capital gains, 
enacted in 2003, will expire at the end of 2008. The marginal income 
tax rate cuts enacted in 2001, and accelerated to full effect in 2003, 
will expire at the end of 2010. The 50 percent expensing provision in 
the 2003 Act was billed as a temporary jump start for investment and 
the recovery, and was allowed to expire at the end of 2004.
    The expected future tax treatment of saving and investment affects 
saving and investment being done today. Allowing the remaining 
investment-related provisions to expire would jeopardize the economic 
recovery. Extending them now, rather than waiting until the last 
minute, would reduce uncertainty as to whether the more favorable tax 
treatment will be available for investments whose lives extend beyond 
the sunset dates of the tax provisions. Immediate extension would boost 
investment spending, employment, and wages starting now, not three to 
five years down the road.
    All of these provisions are consistent with proposals for a 
fundamental reform of the tax system. Full reform would go even further 
in reducing tax biases against saving and investment, and the economic 
gains from a fundamental reform would be correspondingly larger.
Recent swings in the economy have mirrored swings in investment
    The main cause of the 2001 recession was a sharp drop in 
investment. The decline in spending on equipment and software, and in 
non-residential structures, is shown in Chart 1. The chart also shows 
the response of investment to subsequent tax changes.




    The 2001 Tax Act cut passed the Congress on May 26, 2001, but 
investment spending continued to slip for the rest of the year. That 
tax reduction did very little to encourage additional investment 
spending in the short run, giving out money mainly for social policies 
that are not related to economic growth. The bill's marginal tax rate 
reductions on small business owners, corporate shareholders, and other 
savers, which would have reduced the service price of capital and 
encouraged investment, were largely deferred until later years, with 
only half a percentage point effective in 2001. There was nothing else 
in the bill that directly lowered the cost of business investment.
    The early stages of the economic recovery in 2002 were weak because 
investment remained weak. The Jobs Creation and Worker Assistance Act 
of 2002 was signed into law on March 9, 2002. It contained a special 30 
percent ``bonus expensing'' provision for investment in equipment and 
software (but not for most structures). Also, the second half-point 
step in the phased income tax rate reduction became effective in 2002. 
Investment in equipment and software (but not structures) began to 
recover, modestly, over the next four quarters.
    The 2003 Tax Act was signed into law on May 28, 2003. It upped the 
special expensing provision to 50 percent, directly cutting the cost of 
equipment and software (but not most structures) for corporate and non-
corporate businesses. More importantly, it also brought forward to 2003 
the remaining 2 to 3.6 percentage points marginal income tax rate 
reductions on small business owners, shareholders, and savers scheduled 
for 2004 and 2006. Most importantly, for taxpayers in the top four 
brackets, it cut the top tax rates on dividends and capital gains from 
20 percent to 15 percent through 2008. For taxpayers in the 10 percent 
and 15 percent brackets, the rates were set at 5 percent through 2007, 
and zero in 2008.
    Investment in equipment and software shot up almost at once. 
Investment in non-residential structures, which was helped by the 
capital gains, dividend, and marginal tax rate cuts, but got no direct 
depreciation relief, abruptly stopped its decline and rose by a slight 
amount. Investment and growth remained strong throughout 2004. 
Employment and wage growth advanced. The expensing provision expired at 
the end of 2004. Investment growth seems to have slowed a bit since.
The tax cuts lowered the service price of capital. Failure to extend 
        them would raise the service price and reduce GDP
    The size of the capital stock and the level of investment depend on 
the service price of capital. The service price is the rate of return 
that an investment must earn to pay the taxes owed, cover its cost 
(depreciation), and yield a normal after-tax return to its owner. A tax 
increase on capital income raises the service price, and renders 
impractical any investment projects that cannot meet the higher service 
price. A tax reduction on capital income lowers the service price, and 
makes additional investment projects possible.
    Chart 2 and Table 1 show the service prices of various types of 
capital (equipment and software, structures, inventory, land) in the 
corporate and non-corporate sectors under 2004 law, with all three 
investment-related tax provisions in place. They also show the higher 
service prices that would result from their expirations, first of the 
expensing provision, then the 15 percent tax cap (corporate sector 
only), and then the marginal rate reductions. The numbers are for the 
private business sector, which is about 80 percent of GDP. The 
corporate sector is about 56 percent, and the non-corporate private 
sector about 24 percent of GDP.




                               TABLE 1.--SERVICE PRICE OF PRIVATE BUSINESS CAPITAL
----------------------------------------------------------------------------------------------------------------
                                                                                         Without 15
                                                                                          percent      Without
                                                                            Without 50    rate on       lower
                                                                2004 law     percent     dividends     marginal
                                                                            expensing   and capital      tax
                                                                                           gains       brackets
----------------------------------------------------------------------------------------------------------------
Private Businesses..........................................        0.132        0.134        0.148        0.157
Corporate Businesses........................................         .165         .168         .191         .202
    Equipment and software..................................         .301         .308         .352         .373
    Nonresidential structures...............................         .096         .097         .110         .116
    Residential structures..................................         .102         .102         .115         .122
    Inventories.............................................         .083         .083         .094         .099
    Nonfarm land............................................         .083         .083         .094         .099
    Farm land...............................................         .083         .083         .094         .099
Noncorporate Businesses.....................................         .082            .083                   .087
    Equipment and structures................................         .237            .243                   .246
    Nonresidential structures...............................         .064            .066                   .069
    Residential structures..................................         .082            .082                   .086
    Inventories.............................................         .065            .065                   .071
    Nonfarm land............................................         .065            .065                   .071
    Farm land...............................................         .065            .065                   .071
----------------------------------------------------------------------------------------------------------------
Date Source: Gary Robbins, Heritage Center for Data Analysis.

    The tax changes of 2003 boosted investment and GDP by lowering the 
service prices of various types of capital to the 2004 levels shown. 
For the whole private sector, the reduction was 2.5 percentage points, 
from 15.7 percent to 13.2 percent. The biggest reduction was in the 
corporate sector (a drop of 3.7 points, from 20.2 percent to 16.5 
percent), where the largest cut was on equipment and software (7.2 
points, from 37.3 percent to 30.1 percent). All three of the 
investment-related tax provisions, including the 15 percent tax rate on 
dividends, applied to the corporate sector. The non-corporate sector 
benefitted mainly from the individual marginal income tax rate 
reductions and the expensing provision. The service price in the non-
corporate sector, which fell from 8.7 percent to 8.2 percent, is far 
lower than in the double-taxed corporate sector.
    The biggest reduction in the corporate service price on equipment 
and software (over 4 points) was due to the 15 percent rate cap on 
dividends and capital gains, which reduced the double taxation of 
corporate income. Next in size was the marginal tax rate reductions on 
shareholders (about 2 points), then the expensing provision (under 1 
point). In the non-corporate sector, on all assets together, the 
marginal tax rate reductions had the bigger impact, with expensing 
larger for equipment and software.
    Allowing the expensing provision to expire eliminated about 8 
percent of the cut in the service price available in 2004. Allowing the 
15 percent rate cap on dividends and capital gains to lapse would 
eliminate about 56 percent of the cut in the service price. Allowing 
the marginal tax rate reductions to expire would end the remaining 36 
percent.
    Each percentage point reduction in the service price of capital 
increases the capital stock over time by about 1.5 percent. The 
resulting increase in the productivity of labor increases the demand 
for labor, and raises the total wage bill by a roughly similar percent. 
Private sector GDP rises by about 1.5 percent, with about two-thirds 
going to labor income and about one-third going to capital income, pre-
tax. Various layers of government take a bit over 30 percent of the 
increase in income as taxes, a revenue gain of about $40 billion to $50 
billion a year. Increases in the service price have the opposite effect 
on incomes and tax revenues. Failure to account for the changes in GDP 
and incomes, particularly labor incomes, seriously distorts the 
estimated revenue consequence of changes in taxation of capital.
    Every tax bill relating to capital income and cost recovery that 
Congress considers should be examined for its effect on the service 
price of capital. The Joint Committee on Taxation, in conjunction with 
the Congressional Budget Office, should develop or borrow the software 
to conduct that calculation, and report the result to the Finance and 
Ways and Means Committees along with the (static) revenue estimate. If 
the bill increases the service price, it will reduce investment and 
GDP, which will reduce or eliminate the expected revenue from the 
provision. If the bill lowers the service price, it will raise GDP, 
which will provide some revenue reflow. If you are comparing two tax 
provisions, and one raises the service price more than the other 
relative to the amount of revenue expected to be raised, then that bill 
will do more economic damage, per dollar of revenue raised, than the 
other.
Current tax system is biased against saving and investment
    The 15 percent top tax rate on capital gains and dividends is a 
step toward fundamental tax reform. It may be thought of as mitigating 
the double taxation of corporate income. Alternatively, it may be 
viewed as offsetting some of the basic income tax bias against saving, 
in effect extending to more saving about half of the tax relief given 
under Roth IRAs.
    Federal and state tax systems hit income that is saved harder than 
income used for consumption. At the federal level there are at least 
four layers of possible tax on income that is saved.
    (1) Income is taxed when first earned (the initial layer of tax). 
If one uses the after-tax income to buy food, clothing, or a 
television, one can generally eat, stay warm, and enjoy the 
entertainment with no additional federal tax (except for a few federal 
excise taxes).
    (2) But if one buys a bond or stock or invests in a small business 
with that after-tax income there is another layer of personal income 
tax on the stream of interest, dividends, profits or capital gains 
received on the saving (which is a tax on the ``enjoyment'' that one 
``buys'' when one saves). The added layer of tax on these purchased 
income streams is the basic income tax bias against saving.
    (3) If the saving is in corporate stock, there is also the 
corporate tax to be paid before any distribution to the shareholder, or 
any reinvestment of retained after-tax earnings to increase the value 
of the business. (Whether the after-tax corporate income is paid as a 
dividend, or reinvested to raise the value of the business, which 
creates a capital gain, corporate income is taxed twice--the double 
taxation of corporate income.)
    (4) If a modest amount is left at death (beyond an exempt amount 
that is barely enough to keep a couple in an assisted living facility 
for a decade), it is taxed again by the estate and gift tax.
    Eliminating the estate and gift tax and the corporate tax would 
remove two layers of bias. Granting all saving the treatment given to 
pensions or IRAs, either by deferring tax on saving until the money is 
withdrawn for consumption (as in a regular IRA), or by taxing income 
before it is saved and not taxing the returns (as in a Roth IRA), would 
remove the basic bias. Saving-deferred taxes, the Flat Tax, VATs, and 
retail sales taxes are examples of saving-consumption neutral taxes.
    The tax on capital gains is a double tax even for the non-corporate 
sector. The current value of a share of stock or a non-corporate 
business is the present (discounted) value of its future after-tax 
earnings. If for any reason (reinvested earnings, discovery of a better 
mousetrap, etc.) future earnings are expected to rise, the current 
value of the business or price of the stock will rise. If the future 
income does rise, that added income will be taxed when earned. To also 
tax the associated increase in the present value of the business is to 
double tax the future income.
Effects of marginal income tax rates on labor and capital
    Taxes on labor and capital income force up the cost of labor and 
capital, and reduce the quantity offered and employed. The supply of 
labor is not very elastic. Consequently, much of any tax imposed on 
labor is borne by the workers. [Chart 3.] Most people must work to have 
a satisfactory income, and many must conform their hours of work to the 
requirements of their employers. Moving across national borders is less 
of an option for labor than for capital. (Workers have some choices--to 
take or reject overtime, to contribute a second family earner to the 
labor force, how long to vacation, and when to retire.)




    The quantity of capital is more sensitive to taxes than is the 
quantity of labor. When a tax is imposed on capital, the quantity of 
capital employed falls until the rate of return rises to cover the tax, 
leaving the after-tax return about where it was before the tax. The tax 
is largely shifted to users of capital and those who work with it. 
[Chart 4.] Capital is easily reproduced (elastic supply) and it takes a 
large change in the quantity to make a large change in its rate of 
return. As for people's willingness to finance capital formation, 
people can always consume instead of save, or invest abroad instead of 
in the United States, if the rate of return on saving and investment is 
driven down by rising taxes.




    The differences in the elasticities of supply and demand for labor 
and capital suggest that there is an economic advantage to moving away 
from the so-called broad-based income tax, which taxes income used for 
saving and capital formation more heavily than income used for 
consumption, to various taxes that are saving-consumption neutral.\7\
---------------------------------------------------------------------------
    \7\ For a further explanation of the biases against saving in the 
current income tax, see Stephen J. Entin, ``Fixing the Saving Problem: 
How the Tax System Depresses Saving and What To Do About It,'' IRET 
Policy Bulletin, No. 85, August 6, 2001, p. 15 ff., Institute for 
Research on the Economics of Taxation, available at www.iret.org. Also 
see David F. Bradford and the U.S. Treasury Tax Policy Staff, 
Blueprints for Basic Tax Reform, second edition, revised (Arlington, 
VA: Tax Analysts, 1985).
---------------------------------------------------------------------------
The tax treatment of capital hurts labor
    The more there is of any one type of factor, the higher will be the 
productivity and incomes of the other factors that work with it and 
gain from its presence. A tax that reduces the quantity of capital 
lowers the wages of labor. Labor thus bears much of the burden of the 
tax on capital. (See Chart 5.) Because capital is more sensitive to 
taxation than labor, a tax on capital will have a relatively large 
adverse impact on the quantity of capital, which will then cause a 
relatively large drop in the marginal product and compensation of 
labor.




    Consider a small trucking company with five vehicles. Suppose that 
the rules for depreciating trucks for tax purposes change, with the 
government demanding that the trucks be written off over five years 
instead of three. The owner has had enough business to run four trucks 
flat out, and a fifth part time. He is barely breaking even on the 
fifth truck under old law. It is now time to replace one of the trucks. 
Under the new tax regime, it does not quite pay to maintain the fifth 
truck. The owner decides not to replace it, and his income is only 
slightly affected. But what happens to the wages of the fifth truck 
driver? If he is laid off, who bears the burden of the tax increase on 
the capital?
    Several studies in the economic literature illustrate that a zero 
tax rate on capital income would raise the after-tax income of labor, 
in present value terms, even if labor must pick up the tab for the lost 
tax revenue.\8\ Productivity and wages would be higher (Chart 4 in 
reverse), leaving workers with higher gross wages and more after-tax 
income.
---------------------------------------------------------------------------
    \8\ Martin Feldstein, ``Incidence of a Capital Income Tax in a 
Growing Economy with Variable Savings Rates,'' The Review of Economic 
Studies, 41(4), 1974, pp. 505-513. Christophe Chamley, ``Optimal 
Taxation of Capital Income in General Equilibrium with Infinite 
Lives,'' Econometrica, 54, May 1986, pp. 607-22. Kenneth L. Judd, 
``Redistributive Taxation in a Simple Perfect Foresight Model,'' 
Journal of Public Economics, 28, October 1985, pp. 59-83. Also, see 
Kenneth L. Judd, ``A Dynamic Theory of Factor Taxation,'' American 
Economic Review, 77, May 1987, pp. 42-48; H. Greg Mankiw, ``The Savers-
Spenders Theory of Fiscal Policy,'' American Economic Review, 90(2), 
2000, pp. 120-125; and Casey B. Mulligan, ``Capital Tax Incidence: 
First Impressions from the Time Series,'' NBER Working Paper 9374, 
National Bureau of Economic Research, Cambridge, MA, December 2002. 
Andrew Atkeson, V.V. Chari, and Patrick J. Kehoe, ``Taxing Capital 
Income: A Bad Idea,'' Federal Reserve Bank of Minneapolis Quarterly 
Review, Vol. 23, No. 3, Summer 1999, pp. 3-17.
---------------------------------------------------------------------------
Budget impact
    The faster economic recovery since the 2003 Tax Act has improved 
the budget outlook. For fiscal year 2005, federal revenues ran 14.5 
percent, or $274 billion, ahead of 2004 levels. The deficit for fiscal 
2005 ran 22.9 percent, or $94 billion, below that of fiscal 2004. There 
have been large gains in taxes not withheld. These revenues are from 
non-corporate business income, bonuses and options, and capital gains 
and dividends. A large part of the improvement in fiscal year 2005 
receipts is due to higher capital gains realizations and higher 
dividend payments.
    Dividend payments have risen sharply since the 2003 Act.\9\ They 
would rise further if the 15 percent tax rate were made permanent. More 
companies are paying dividends. Many are raising dividends. More would 
do so if the rate reductions on their shareholders were made permanent. 
Added dividend payouts reduce the revenue loss from lowering the rate 
on dividends already being paid. Under their revenue estimating rules, 
the JCT and Treasury try to gauge the increase in dividends due to a 
tax rate cut. This will be new territory for them, however. 
Furthermore, they do not go on to calculate the reduction in the 
service price of capital and the resulting increases in investment, 
employment, and wages, and so they miss the higher tax revenues 
resulting from the higher incomes.
---------------------------------------------------------------------------
    \9\ See Daniel Clifton and Elizabeth Karas, ``Two Years Later: Tax 
Cut Still Paying Dividends for American Shareholders'', American 
Shareholders Association, Washington, DC, June 2005, pages 11-12, 
analyzing Standard and Poors 500 historical dividend data. Also Stephen 
Moore and Phil Kerpen, ``Show Me the Money! Dividend Payouts after the 
Bush Tax Cut'', CATO Institute Briefing Papers No. 88, Washington DC, 
October 11, 2004.
---------------------------------------------------------------------------
    Treasury estimates for extending the 15 percent tax rate cap on 
dividends beyond 2008 include revenue gains of about half a billion a 
year from higher dividend payments in 2005-2008. Treasury is 
acknowledging that some firms have hesitated to raise dividends, or 
have limited the increases, due to uncertainty about how long the lower 
rate will last. Extension would boost payouts starting now, adding to 
short term revenue. Treasury shows losses in the out years from 
lowering the rates on dividends they assume would have been paid in 
their baseline. This loss is exaggerated by failure to take account of 
the economic impact on investment, employment, and wages.
    The Treasury, the Congressional Budget Office, and the Joint 
Committee on Taxation underestimate swings in revenue from tax rate 
changes on capital gains. A tax rate reduction has three effects: an 
``unlocking'' effect as people choose to realize (``take'') more gains 
at low tax rates; a valuation effect, as the lower tax rate increases 
the market value of stocks and increases the quantity of gains 
available to be taken; and an economic effect, as the lower tax rate on 
capital reduces the service price of capital, and raises the desired 
capital stock, investment, employment, output, and taxable incomes.
    Federal revenue estimators try to account for the unlocking effect 
under their revenue scoring rules, but they ignore the market effect 
(stock markets have risen since the 15 percent capital gains rate was 
enacted) and, most importantly, they ignore the economic effect of the 
reduction in the service price of capital. In addition, the unlocking 
effects have generally been larger than the estimators anticipated. 
Studies in the mid-1980s at Treasury suggested that the reductions in 
the capital gains tax rate from nearly 40 percent to 28 percent in 1979 
and from 28 percent to 20 percent in 1981 have raised revenue.\10\ By 
contrast, the capital gains rate hike, from 20 percent to 28 percent, 
enacted in 1986, was followed by a collapse in realizations. Long term 
gains as a share of GDP did not recover to 1985 levels for twelve 
years. [Chart 6.]
---------------------------------------------------------------------------
    \10\ See the following Treasury Department Papers: the panel study 
in ``Report to Congress on the Capital Gains Tax Reduction of 1978'', 
Office of Tax Analysis, September, 1985; Michael R. Darby, Robert 
Gillingham, and John S. Greenlees, ``The Direct Revenue Effects of 
Capital Gains Taxation: A Reconsideration of the Time Series 
Evidence'', Research Paper 8801, Office of the Assistant Secretary for 
Economic Policy, May 24, 1988; Gillingham, Greenlees, and Kimberly D. 
Zieschang, ``New Estimates of Capital Gains Realization Behavior: 
Evidence from Pooled Cross-Section Data'', OTA Paper 66, May 1989, and 
Gerald E. Auten, Leonard E. Burman, and William C. Randolph, 
``Estimation and Interpretation of Capital Gains Realization Behavior: 
Evidence from Panel Data'', OTA Paper 67, May 1989, both from the 
Assistant Secretary for Tax Policy, Office of Tax Analysis; Gillingham 
and Greenlees, ``Evaluating Recent Evidence on Capital Gains 
Realization Behavior'', August 4, 1989; and ``The Effect of Marginal 
Tax Rates on Capital Gains Revenue, Another Look at the Evidence'', 
Research Paper 9003, Dec. 1, 1990, both from the Office of Economic 
Policy. Also see Gillingham, Greenlees, and Zieschang, ``An Econometric 
Model of Capital Gains Realization Behavior'', presented at the 65th 
Annual Conference of the Western Economic Association, July 1, 1990.




    Extending the 15 percent top tax rate on dividends and capital 
gains now would be excellent insurance against renewed weakness in 
investment. It would lower the projected service price of capital, and 
would improve the economic outlook. The revenue consequences would be 
positive in the short run, and less negative than the static revenue 
projections from Treasury and the JCT in the long run. More 
importantly, the effect on the economy, wages, and employment would be 
---------------------------------------------------------------------------
sharply positive.

    Senator Brownback. Thank you very much, Mr. Entin.
    Gentlemen, I appreciate all the testimony. I've got some 
questions I want to ask each of you.
    Congressman Armey, let me start off with you on this. 
You've been around this topic for a long period of time. There 
has been widespread support for it. There is enormous 
frustration about the current Tax Code, across the Nation. I've 
held town hall meetings on this, years ago, and people are more 
frustrated with the complexity than with the rates. And then, 
you note, as well, something that I haven't heard other people 
testify, just a fear factor here that, ``Somehow I'm going to 
get it wrong, and then somebody's going to come after me for 
it.''
    Why have we not been able to get fundamental tax reform, 
then, with all of that going forward?
    Mr. Armey. Well, I--of course, I study and worry about this 
all the time. And I appreciate the question. I think there are 
a variety of reasons. One, there is confusion in the country 
about which way to go. There is a large share of our 
population, a large active and vocal group of people in the 
country, that believe we ought to have a national sales tax. 
This dissipates a lot of energy that could be devoted and 
funneled on this--on the tax reform. And I can just say I've 
studied on this for years, and I remain even more convinced 
today than ever before that a national sales tax would be a 
disaster--an economic disaster, administrative disaster, and a 
disaster which, among other things, would result in an enormous 
growth in the underground economy in this country.
    Every good thing that is predicted for a national sales 
tax, when, in fact, it has been enacted in the world, has 
failed to materialize. Just the opposite. Every good thing 
that's been predicted for the flat tax has, indeed, 
materialized into greater degrees than hoped for.
    So, it strikes me one of the things we're going to have to 
do is finally get ourselves settled on one option, as opposed 
to flirting with what I, frankly, have to characterize in no 
other words than patent foolishness, a national sales tax. But 
that does make it difficult to get a nation focused.
    The other is, quite frankly, this Nation is behind the 
eight ball relative to the relatively new governments in the--
and enterprises--in the liberated Eastern Europe, in that we 
have a very large, effective, and well-focused, and highly 
well-funded tax complexity system of professionals in the 
country. And my favorite is, for example--and there's a lot of 
mythology that they attend to. I always like pointing out that 
the great myth of the realtors is that the American dream is to 
own your own home, when, in fact, it is to get your kids out of 
it.
    But we have a group of people whose profession is how to 
maximize revenues or returns, or whatever, under this existing 
Tax Code. If the Code goes away, their job goes away, the 
professionals, who are very skillful and able people in 
universities, that are responsible for helping people, 
nurturing them through the process of giving to universities.
    And, quite frankly, as Milton Friedman--I'm going to resort 
to Milton Friedman on this one--as Milton Friedman points out, 
the two tax-writing committees themselves. I mean, I can 
honestly say--I've been in Congress for 18 years--I have not 
yet once heard somebody say, ``I would like to be on the Ways 
and Means Committee, because I'm fascinated with the subject 
area.'' The fact of the matter is, the first best reason people 
want to be on the Ways and Means Committee is, it's the best 
way, and easiest way, to fund their campaigns, because there is 
that professional trading of this and that consideration. Now, 
I don't mean to say their work's not legitimate. Within the 
context of this Tax Code, it is a legitimate committee that's--
that operates, I think, by and large, with legitimate 
governance. But, two observations: One, it has this aberrant 
side effect of being--making campaigns easier--more easily 
funded; and, two, Armey's axiom is that, ``Even a sane man will 
act crazy in crazy institutions.'' And our Tax Code is a crazy 
institution.
    So, I don't want to be too critical of the committees, but 
do understand the committees would, themselves, resist this 
kind of a change, because it would, in fact, put them out of 
business. And that--so, you've got--you have that system of tax 
professionals.
    Then, the--finally, from a more ideological point of view, 
there are people in the country who still believe that it is a 
legitimate and necessary function of the Tax Code, as over and 
against my belief that it is a corruption of the Tax Code, to 
use the Code for income redistribution and social engineering. 
And, again, these poor, misguided souls, in my estimation, 
simply don't understand, there's only one legitimate reason to 
have a Tax Code, and that is to raise money. And, as Adam Smith 
said, in 1776, that ought to be done in such a manner as to 
strip the down off the goose with the least amount of squawks. 
And our Code doesn't do that.
    Senator Brownback. Mr. Edwards, I want to focus in on Hong 
Kong, because they have this optional flat tax system, and I 
want to ask you about that. First, what's the rate in Hong 
Kong?
    Mr. Edwards. Yeah, they have a graduate individual system, 
with rates that go from 2 to 20 percent. So, their top rate, 
under their regular system, is not that high. And if your--
effectively, your effective tax rate rises above their flat 16 
percent rate, you pay, at most, 16 percent on a broader income 
tax base.
    Senator Brownback. So, they basically have an alternative 
maximum flat tax?
    Mr. Edwards. Basically, that's how it works, yeah.
    Senator Brownback. Because I've heard other people say 
that's what we ought to do with the AMT, make it into an 
alternative maximum tax and just----
    Mr. Edwards. Yeah, the AMT certainly has lower rates in the 
regular system, and a broader base.
    Senator Brownback. What about people opting in and opting 
out of the Hong Kong system? Do you know the numbers, or have 
you studied that? And do people bounce back and forth in that 
system, then?
    Mr. Edwards. I think that's allowed. In fact, I think 
it's--my understanding, from Allen Reynolds, my colleague, 
who's more of an expert on the system than me, is that it's 
essentially--the tax authorities do the calculation for you. If 
your return goes in, and you pay--and you've got higher than 16 
percent effective rate, essentially you're--you know, that's 
the cap, that's the most that you can pay. So, it's--they've 
essentially enshrined the principle that no one should pay more 
than 16 percent of their income in taxes.
    Senator Brownback. Dan, what should the flat tax rate be 
here in the District of Columbia? I notice you poked your 
colleague, Congressman Armey, as asking for too high of a rate. 
What should it be in the District of Columbia, other than, 
obviously, as low as possible?
    Dr. Mitchell. Well, you took away my obvious answer right 
there. Frankly, you have a tradeoff. The lower the rate you 
have in the District, the better the economic growth results, 
the more this will be a pilot program that'll get the rest of 
the country excited. But, I think Steve Entin correctly warned 
you that the Joint Committee on Taxation is going to get all 
nervous about that, because what they will do is make 
assumptions about huge amounts of people moving into the 
District, and, therefore, Federal tax revenue collections from, 
say, Maryland and Virginia, going down. So, they're not just 
going to look at the existing tax base in the District and not 
give you a very friendly score on that, and not count the 
economic growth effects, as Steve mentioned. But they're going 
to say, ``If it's so much more attractive, because the rate is 
so low in the District, it's going to--you're going to bounce 
into some very difficult issues with the revenue scoring, 
simply because we've never fixed that process.''
    Senator Brownback. Do we have an example of anywhere in the 
world that's gone to a flat tax that has not produced positive 
economic growth numbers?
    Dr. Mitchell. Well, I can best--for instance, Serbia--I've 
never studied that system. I have no idea how well it works. 
You know, the countries that are in, you know, closer to the 
west, and the bigger countries, are the ones that have gotten 
the most attention. And, of those, unquestionably, big revenue 
increases in Russia; Slovakia, same thing. Romania has only 
been in effect just a little bit over a year; they've had very 
good results. The three Baltic countries, very, very positive 
results over time.
    Senator Brownback. So, a flat tax creates positive economic 
growth and tax receipt growth.
    Dr. Mitchell. Both economic growth--the key relationship is 
faster economic growth means a bigger tax base. There's just 
more income out there to tax, so, even though it's at a lower 
rate than it might have been under the old system, because 
people are doing two things, the government can come out 
without a loss of revenue. Number one, they're not evading and 
avoiding the tax system as much. And, number two, they actually 
have better incentives to work, save, and invest. And the 
combination of those two factors have resulted, especially if 
you look at the better, more purer flat tax systems--you know, 
not all these systems, as Steve said, are Hall-Rabushka-style 
systems--but, say, Estonia, Slovakia, Hong Kong would probably 
be the three best systems that are the most pure. And we've 
unambiguously had superb results from those jurisdictions.
    Senator Brownback. Both substantial economic growth and 
substantial increase in tax revenues.
    Dr. Mitchell. Uh-huh.
    Senator Brownback. Even though this, here will be scored by 
the Joint Committee on Taxation, static, and so, will probably 
be scored as a net revenue loser to the Government.
    Dr. Mitchell. Yeah. I mean, it depends on your definition 
of ``substantial revenue.'' Slovakia, I think you're talking 
about a half a percent of GDP income tax collections being 
above the static forecast. In Russia, it's been much more 
dramatic, but they start it with a bigger problem of tax 
evasion. You know, so it just depends on what your base is, 
what you're factoring in. But certainly we have not seen 
anything that could be characterized as a loss of revenue. The 
revenues come in over forecast in all the situations I'm aware 
of. Again, I don't want to pretend that I know the intricacies 
of Ukraine and Serbia, other than knowing that they have one 
rate. I have no idea how well the systems work. They obviously 
have a lot of other issues and challenges in those countries. 
And so, there's just not good data coming out.
    Senator Brownback. Let me turn to my colleague. We're 
joined by Senator Allard of Colorado.
    Senator Allard. Well, thank you, Mr. Chairman.
    And I want to welcome the panel. I want to apologize that I 
wasn't here at the start of your hearing. It wasn't that I 
wasn't interested. It was that I had a budget hearing going on 
at the same time, and I wanted to get there and get my two bits 
in before I had an opportunity to come here.
    And I want to also compliment you on working hard to 
simplify the Tax Code, particularly as it applies to 
Washington, DC. I have always been one who has felt that we 
needed to have tax reform in this country. I have felt that, in 
addition to that, we need to be sure that we reduce the tax 
rate. In other words, we not have tax reform, then end up 
increasing the tax rate.
    The State of Colorado, from which I represent, has a 
modified flat tax that they use. It's built off of the Federal 
income tax. It does simplify filling out the tax form for many 
citizens in the State of Colorado. The disadvantage, of course, 
is that they tie their tax policy somewhat to the Federal 
level. And that tax policy is not always wise, in my view.
    I do think that to apply a flat tax to Washington, DC--and 
I think of--we can think of it in terms of a State--I think 
it's less problematic than it is for the State of Colorado, 
because they're so closely tied in with the Federal budget 
anyhow, and they are--basically have to answer to the Congress. 
So, I think it's a wonderful idea. And I hope that we can get 
this to sell here in the Congress.
    There's been other tax reform measures, as was alluded to 
by Mr. Armey here, in his comments, the sales tax reform. Most 
of that idea was actually promoted in the House of 
Representatives, when both Mr. Armey and I served over in the 
House, from my good friend from Colorado, Congressman Schaefer. 
And he was a strong advocate of the sales tax. And I've--I took 
the position that we probably shouldn't be advocating or going 
with a sales tax, unless we can assure ourselves that we don't 
end up with a double-tax system. And that required a 
constitutional amendment to eliminate the income tax 
provisions. Otherwise, I felt like we could temporarily 
eliminate the income tax, put in place a sales tax at the 
national level, and then, a decade or two later, we'd 
inevitably be back with an income tax again. We'd have a two-
tax system. And I think we'd be much worse off than we are 
today if that should happen.
    So, I've always had some reservations about the sales tax. 
And the argument was always, ``Well, you could get rid of the 
IRS.'' But if you have a sales tax, you'd have to have an 
auditing function. And that means--I looked at it from a 
perspective of a small business man. I already have--if I have 
a sales tax, I already have the State auditors coming in, and 
the city auditors coming in. Now I've got to have the Federal 
auditors come into my small business and look at it? I didn't--
I wasn't--I didn't shine on that too well.
    I think the most practical and the--approach to tax reform 
has to be the flat tax. And--now, the proposal that we have 
over on the House side was a flat tax--it was a modified flat 
tax. We had a couple of exceptions. Number one was the 
mortgage--the interest on mortgages of homes, and also 
charitable giving. And I don't know whether you're talking 
about those exceptions or not here on the District of Columbia 
bill.
    Senator Brownback. Well, this would be a straight flat 
tax----
    Senator Allard. Flat tax.
    Senator Brownback [continuing]. Option, so that you keep 
the current Code, but you also create the option, but the 
option doesn't have any--it doesn't include mortgage 
deductions, charitable deductions, it is a flat rate, period.
    Senator Allard. Flat tax, yeah. And that might----
    Mr. Armey. Let me just----
    Senator Allard [continuing]. Work a little better, 
because----
    Mr. Armey [continuing]. Interject that the retention of the 
mortgage deduction and the charitable deduction may end up 
being a political reality.
    Senator Allard. Right.
    Mr. Armey. But it is dumb tax policy.
    Senator Allard. Yeah. Well, I mean----
    Mr. Armey. And there is, in fact, no justification for 
doing so, in terms of your desire to see more charitable 
contributions or to see more people own their homes. But the 
fact of the matter is, these are two very, very strong, 
powerful lobbies, and they sell their--as we say in Texas, 
their BS very well.
    Senator Allard. Well, and I'm assuming that your flat tax 
is going to be somewhat like Colorado's, you're going to tie it 
into the Federal. And if you do that, it's not a problem.
    Mr. Armey. Right.
    Senator Allard. It's already there. So, I appreciate it.
    I--do you--let me just ask this, sort of, generic question 
to the panel. Well, let me--before I do that, let me--I think 
the President has us on the right approach on tax policy, 
particularly on two of the taxes. Number one, I think reduction 
of capital gains worked again, as it did for the Kennedy 
administration, when John Kennedy implemented it, and when it 
happened with the Reagan administration, when President Reagan 
implemented it. And I think we saw it work again. And we saw it 
work, even when we had some adverse economic events happening. 
We had high energy costs. I remember, in 1970, with high energy 
costs, we ended up with a misery index--double-digit 
unemployment, double-digit inflation, double-digit interest 
rates. And, you know, his tax policy worked, and created 
growth, even in the face, not only of high energy costs, but 
also paying for a terrorist war out here. And I think that 
speaks to the strength of his policy. And I think one of the 
strongest aspects of it was the aspect where we allowed 
expensing for small business, up to $100,000. To me, that was a 
real income driver. It was a driver for small business, a 
driver for our economy, and, I mean, the Federal revenues went 
up. And so, I just wanted to make that--get that two bits in.
    But let me ask you, Do you--ask this panel--do you see any 
down sides for having a flat tax here in Washington, DC?
    Senator Brownback. If I could, Senator--and I want the 
panel to answer this--I've got a markup, upstairs, in 
Immigration, I've got to slip up to, to get them a quorum. So, 
I'm going to turn the gavel over to Wayne to do that. And I 
appreciate very much the panelists being here. I may be able to 
come back down. But I think it's been excellent discussion.
    I do hope, as well, that you talk with them about the issue 
of charitable giving, because people raise the issue of, 
``Isn't this going to make a hit on your charitable giving?'' 
So, I hope we can address that, some, as well--if you don't 
mind taking over----
    Senator Allard. Sure.
    Senator Brownback [continuing]. To charity.
    Senator Allard. I'll be glad to. Is there any other 
questions you want me to cover?
    Senator Brownback. Just on the charitable giving, because I 
think it's important to get that out in the record.
    Senator Allard. Yeah.
    Mr. Armey. Let me----
    Senator Allard. If we run out of----
    Mr. Armey. Let me respond to both points. The first quick 
short answer to yours, on the downside question, is, the answer 
is no. I see nothing but good things for the city. I can see 
that some of the areas around the city might not be real happy, 
but the city--I don't--I can't conceive of a down side for the 
city, especially when you recognize the voluntary subscription 
aspect.
    Now, let me just talk about the charitable giving thing, 
because it's been kind of a pet peeve of mine for some time. 
When we did the Reagan tax cuts, we cut the tax benefit of 
charitable gift to one-third of what it had been prior to the 
Reagan tax cuts. And charitable giving went up. The reason 
charitable giving went up was, people's incomes went up. 
Revenue to the country doubled in the decade of the 1980s in 
the aftermath of the tax--Reagan tax cuts.
    The fact of the matter is, what happens with charitable 
giving is that, once again, as with investment activity, you 
get--you will get more charitable giving, and it will be 
given--the decisions, the choice criteria, where and how much 
to give will be made on charitable criteria, rather than tax 
criteria. And I just have to tell you, anytime you have a 
decision made on economic criteria, criteria of the heart, 
criteria of the mind, you're going to have better choices and 
better results than when you have decisions that are made on 
political criteria. This, I say to you, pursuant to Armey's 
axion number none, ``The market's rational, the Government's 
dumb.'' And people, when they're guided by the need to maximize 
my well-offness in terms of Government policies, are not going 
to make the same rational, and, I would say, equally free, 
decision.
    My--for example, I might find--I find this interesting--if 
I had a--under American tax law today, if I--it would make more 
sense for me to give $12,000 to the Society for the Prevention 
of Cruelty of Animals than to a relative that's not well off, 
because the animals will not be, then, in turn, required to pay 
taxes to the Government under $12,000, and my relatives would. 
Now, I mean, you've got a tax law that says, now Dick Armey 
wants to make a decision of the heart, he'll put people before 
animals; if he wants to make a decision compliant with the Tax 
Code, he puts animals before people. This is why--now, I know 
it sounds harsh for me to say the word ``dumb,'' but I just, 
frankly, can't find much of another word to use.
    Senator Allard [presiding]. Other members of the panel who 
would like to respond to the question?
    Mr. Entin. Yeah.
    Senator Allard. Mr. Entin, and then Dr. Mitchell.
    Mr. Entin. I don't want to sound ``dumb''--but there are 
some other principles of sound tax theory that I think we need 
to consider. My late boss, Norm Ture, who was a tax expert here 
in the city for many years, was a strong advocate of these 
neutral taxes, but he also wanted to put the principle forward 
that income should be taxed as close to the level at which 
people get to spend it as possible. So, that if, for example, 
someone is paying alimony to an ex-spouse, the alimony comes 
off one's tax return and goes onto the tax return of the 
recipient. Similarly, with charity, if I'm giving money to 
someone else, it should come off my tax return and go onto 
theirs.
    Now, under the flat tax, and most of the variations of it, 
including that which Senator Brownback has described, there 
would be an exempt amount for the poor--in fact, quite a 
generous one--so that if people receiving income are too poor 
to owe tax on it, they shouldn't have to pay tax on it, nor 
should it be taxed before they get it.
    So, the point is that you really--for the maximum amount of 
visibility and transparency in the tax system, you should 
probably tax them on a--at the point where the people who are 
spending it can see that there's a tax imposed. So, I would 
differ, on that basis.
    I would agree that the fuss that the special interests made 
over the mortgage interest deduction was just a bunch of a 
hullabaloo. If mortgages are at 8 percent, and the borrower and 
the lender are in the 25 percent tax bracket, they're both 
paying and getting 6 percent, after tax. And if you have the 
flat tax, they simply go to a 6 percent rate to start with. It 
seems to me that was very much a slander against the flat tax 
on the part of the retailer--the realtors.
    I would be more concerned with the loss of the deduction of 
the property tax. If you're a business, it's clearly an 
expense. And taxable income should be revenues minus the cost 
of earning revenues.
    But there's another consideration. Most of the neutral 
taxes would regard tuition as a cost of earning future income. 
It's an educational outlay. It's an investment in human 
capital. You're expensing physical capital. You should expense 
the tuition. To a large degree, the property tax deduction does 
that for primary schools. And the State tax deduction does 
that, to a considerable degree, for State universities. And 
much of the rest of those taxes goes to transfer payments to 
the poor.
    So, I think those are reasonable, on other principled 
grounds. I don't agree that we would have a collapse of 
charitable giving if we denied the deduction. I think that most 
of the ordinary arguments made against the Armey plan on those 
bases are phony. I just have this other kind of tax 
consideration that leads me to conclude that those should be 
kept.
    Chris made a statement about the alternative minimum tax, 
in response to Senator Brownback's question about an 
alternative maximum tax. I have some serious reservations about 
the AMT. Again, it disallows some legitimate business 
deductions, so it's overstating the business's real income, and 
that of individuals, in many cases. So, you're taxing 
something, but it's not income. I don't know what it is, but 
it's not income, after costs. And, yes they do lower the rate 
in the statute, but they have a large chunk of exempt amount 
under the AMT, which they phase out between two levels of 
income. If you're in the phase-out range, you're not paying the 
26 and 28 percent tax rate, you're paying 32\1/2\ and 35. And 
in that range, your rates are as high, or higher, than under 
the ordinary income tax, at the margin. It is really not a good 
alternative tax system. If you're going to do an alternative 
tax system, do the Hall-Rabushka or do the consumed income tax, 
but don't do the AMT. That's not a good way to go.
    Now, there are two other neutral tax systems, the VAT and 
the national retail sales tax. I don't think you could adapt 
either one of them, as they are normally put forward, to be a 
test case for the District of Columbia. If you tried to put a 
major sales tax, at the Federal level, on the District of 
Columbia, people would drive to Maryland to get their 
groceries. You'd have to have Customs sheds and checkpoints at 
all the roads between the District and Maryland, and on the 
bridges to Virginia. I don't know what you'd do at the 
airports. They're crowded enough.
    If you tried to do the value-added tax on the normal basis 
where you exempt exports and tax imports, you'd have the same 
customs shed problem. And you could perhaps do it on an origin 
basis, which is the opposite of the way VATs are treated all 
around the world. So, I think there are administrative problems 
with those other approaches.
    And there are some administrative problems in translating 
the flat tax into a regional tax, or a consumed income tax into 
a regional tax, that you would have to address carefully in the 
legislation.
    I do think that the effort to get this discussion going as 
to why the tax systems are too complicated and antigrowth is 
very important. And if you can come up with demonstration 
legislation that takes care of these administrative details 
that would otherwise drive the Treasury nuts, you know, more 
power to you. I do commend you for being interested in the 
issue and trying to get something done to blast it off dead 
center.
    Thank you.
    Senator Allard. Well, it is a more simplified tax, when you 
go to a flat tax. Like, in Colorado, you just take the bottom 
line off your Federal income tax form. I think the rate's 6 
percent or 6\1/2\, something like that. Just multiply that out, 
and you've got what you pay in the State. You can do it on a 
postcard, if you don't have a complicated tax form. If you have 
a complicated tax form, you're not going to get it done on a 
postcard.
    Dr. Mitchell.
    Dr. Mitchell. I was just going to add a couple of quick 
points. Only about 30 percent of people in the country itemize, 
as it is. So, 70 percent of the people who are homeowners, 
people who give to charity, they're not doing it for the tax 
benefit, clearly, at all. And to echo what Congressman Armey 
said, we had an actual experiment in the 1980s. If itemized 
deductions really were critical, then we should have seen 
terrible results for housing and for charity in the 1980s, 
because marginal tax rates, and, therefore, the value of the 
deduction, fell so dramatically. Instead, we saw just the 
opposite. Why? What matters for charity, what matters for 
housing, what matters for just about everything in the country, 
other than maybe bankruptcy law, is strong economic growth. If 
you have people earning more income and people generating more 
wealth, they're going to give more money to charity, they're 
going to buy bigger homes, more homes, and that should be the 
key thing about tax policy.
    Raise revenue in the least destructive way possible so you 
can have the maximum economic output, big tax base, low tax 
rates. That's the fundamental principle of taxation, that--I'm 
just afraid that we're forgetting about, while the rest of the 
world is catching up. And sooner or later, a country like 
China's going to adopt a flat tax. I mean, we can look at 
Slovakia, be impressed by their results, but that's not going 
to have a big echo effect on our competitiveness. It's going to 
spread. It's going to keep spreading, because of globalization, 
and I just worry that we're going to fall behind while other 
countries are doing this.
    Senator Allard. Mr. Edwards.
    Mr. Edwards. Yeah, to build on that a little, I mean, 
Senator Brownback's first question to Mr. Armey was, you know, 
why has there been these big hurdles to tax reform? And why 
haven't we got it done yet? And it does seem to me, looking 
ahead--and I agree with Dan entirely--that, you know, in some 
ways, it should get easier to do a big tax reform in the 
future, because the gap between the most efficient tax systems, 
the highest-growth countries in the world, and us will get 
larger and larger. Global capital flows will keep going up and 
up and up and up, and that means that the cost of not having an 
efficient tax system will rise. And as more--right now, for 
small- and medium-sized countries, like in Eastern Europe, 
there's a compelling economic interest in radically cutting 
your tax rates, because you're a small country within a 
gigantic global pool of capital. So, the United States has been 
somewhat resistant to tax reform, because we have such a big 
economy and because investors want to put money here for nontax 
reasons. But as other countries catch up and keep cutting, like 
China, the pressure on us will rise and rise. And that's why I 
think, you know, sometime in the future we will get a flat tax. 
You know, maybe not in this year or next year, but I think the 
pressure will keep rising.
    Mr. Entin. Chris has made an important point about the 
international capital flows and the global economy. I'd like to 
bring that down to a specific problem you may face here, and 
that the President may face. The President's proposed that the 
Treasury begin doing dynamic analysis and get away from the 
static estimates. Chairman Thomas, in Ways and Means, has been 
trying to get the Joint Committee on Taxation to do that for 
some years. The people doing these analyses from the old guard 
in the tax theoretic community tend to look at a closed 
economy. They tend to neglect the international capital flows. 
They tend to assume that domestic saving isn't responsive to 
these incentives, and that, therefore, if you did get 
investment incentives, there would no money to pay for it, 
unless the Government ran huge budget surpluses, which we're 
not going to do.
    The smaller countries adopting these proposals are 
attracting capital from abroad, and they can get the use of 
other people's saving. If the French are not investing very 
much in France, they can invest in Slovakia. If the taxes in 
France aren't doing a good job for their local investment, the 
savers in France can just invest somewhere else. The United 
States sends a lot of money abroad into global mutual funds. If 
we improved our tax climate here, that money might stay home. 
Wouldn't be any additional savings in the world, but we'd be 
getting to use it more than the others. Foreign saving could 
flow in.
    When you do these changes that make investment in the 
United States look more attractive, the saving materializes. 
And those on the static revenue side who don't want to bother 
thinking about that, and some of those who are supposedly doing 
dynamic analysis, but still think about closed models where 
they don't have these savings flows, are going to come up with 
the wrong answers.
    So, if Treasury doesn't do it right, this effort won't work 
well. And if the Joint Committee on Taxation continues to do it 
wrong, they may claim they're doing dynamic analysis, but 
they're not doing it correctly. And they will still give you 
bad outcomes on the bills that you put forward to make the 
country grow, which will make it look like it's too expensive 
to do them. It's really too expensive not to do them.
    I really think that the Congress needs to take the Joint 
Committee on Taxation in hand, and I hope the administration 
will take the Treasury in hand, when it tries this experiment, 
so that it gets done right.
    Senator Allard. Well, I agree with you, in your comment. 
Again, one of the frustrations I had in coming to the Congress 
is the static scoring that they did. And it disadvantaged--
basically, it disadvantaged any of those who were proposing a 
tax reduction. In Colorado, we have dynamic scoring. And I 
think we did as good a job as they do here at the Federal level 
in coming up with what--they actually did a better job than 
they actually were coming up here at the Federal level, as far 
as projecting what the incomes would be from the policy changes 
that we were making.
    The--and what we did in Colorado is that we followed the--
you know, when we projected income and expenses, we followed 
those. And if we saw them moving in a way that was going to 
create--we have an amendment that says that we can't run the 
deficit in our budget. So, then, if we saw that, at some point 
in time during the fiscal year, where when it extrapolated out 
to the end of the year, showed that we're going to end up with 
a deficit, we would begin--institute a policy change in the 
middle of the year, even if it required a special session of 
the legislature, so that we could change it before we got to 
that point where we had a deficit at the end of the year.
    So, I thought--and--but, you know, I can only think of once 
where we had to come in and change that just before we 
adjourned. Actually, we didn't even have to call a special 
session; just before. But other--the 8 years I was in the State 
Senate there, I thought it worked extremely well for us. And I 
think once you get people familiar with the process and 
familiar with the dynamic scoring methods that work, then the 
tradition can carry on. And I think it will work for us. And I 
like the idea of dynamic scoring, because I think you remove 
the prejudices out of the system. And I think when you go with 
a static scoring, you build in some prejudices that 
disadvantage those of us.
    And on flat--on the AMT and the telephone tax, there's two 
examples of where you're going to tax the rich. And we ended up 
taxing everybody, because everybody grew their revenues up to 
the point where they reached into those parameters. We've seen 
that happen time and time again. And that's the argument that 
we have on the flat tax. I can see it coming. ``All you're 
doing is, you're going to help the wealth, and the poor are 
going to continue to pay their taxes.'' And that's the 
argument, as Mr. Armey knows, that we're going to be facing 
here. And if you have a good--you know, I--my response to it, 
obviously, is that, you know, when the tide rises, everybody 
benefits. If you have a better argument on that, I would 
certainly like to hear what that might be, when we get that 
argument that all we're doing is benefiting the wealthy. 
They'll use that argument in any tax cut that we do, by the 
way. But if you have any suggestions, I'd like to hear what you 
have.
    Yes, Mr.----
    Mr. Armey. Why don't I just say, you know, there's a 
great--fascinating mythology of American tax discourse--and, of 
course, a great lie, and it probably has some truth to it--most 
wealthy people have many avenues by which they can shelter or 
otherwise disguise, and, therefore, abridge their tax 
liabilities. And the flat tax eliminates everything that can be 
described as a ``loophole.'' So, I mean, I laugh at the 
people--my good friend Charlie Rangel being the most colorful 
of these--and I do say this sincerely; I love Charlie Rangel 
like a brother, but he is funny--in that, on one hand, ``All my 
rich friends''--he's talking to me--``all my rich friends got 
them loopholes that you guys put in, you Republicans, put in 
for them.'' And then we want to talk about passing a flat tax, 
where there are no loopholes, ``Well, that's just another thing 
you're doing for your rich friends.'' So, Charlie, he's going 
to have it that way, either way.
    But one little thing we picked up during one of the 
Presidential campaigns when we had a lot of colorful 
campaigning going on, was, somebody took the time to figure out 
Ross Perot's tax liability. During that year, his tax rate was 
11 percent. And had Ross Perot filed under the flat tax in that 
year, he would have paid 17 percent. So, I know that's only one 
instance, but I have to say it was quite fun for me to traffic 
that one around during that period of time.
    Senator Allard. Mr. Entin.
    Mr. Entin. In addition to analyzing things dynamically to 
estimate revenues, you really need to--well, if you did that, 
you would need to know what would happen to the economy and to 
people's incomes as a result of the tax change. When you cut 
taxes on capital, more capital is formed. Old capital has more 
competition from the new capital. They don't gain very much.
    Senator Allard. Yeah.
    Mr. Entin. But with the new capital in place, labor's more 
productive, and the wages are bid up, and so is the number of 
jobs. Most of the gain from reducing taxes on capital goes to 
labor. There's quite an economic literature building on this 
now. So, all of those distribution tables and burden tables, 
that the Joint Tax people give you, that don't assume any 
change in wages when you cut the taxes on capital, and just 
show the initial impact of the tax change on who sends the 
check in to the Government, are not burden tables at all; 
they're initial incidence tables. If you did the burden table 
correctly, which you have to do, to do dynamic scoring, you'd 
show labor getting the bulk of the gain from moving to 
something like the flat tax. You need to reform the Joint 
Committee on Taxation in more than one way, is what I'm trying 
to say. And if you did that, you'd get the very result that you 
described earlier.
    Senator Allard. Thank you.
    Mr. Edwards. To put that in a quick principle to sort of 
remember here, is that the more mobile the tax base, the less 
likely that the burden actually ends up being paid by that tax 
base. The classic example is the corporate income tax in the 
global economy. Probably much of the burden of the U.S. 
corporate income tax falls on U.S. labor, not on U.S. capital 
holders. High-income individuals generally have much more 
mobile tax bases than low-income taxpayers. If you try to--the 
more you try to tax the rich, they've got many more options to 
try to avoid taxes--by changing their type of income, by moving 
income abroad. So, you know, folks may think they're--some 
folks may think you're going to gain a lot by taxing the 
wealthy and taxing corporations, but you don't, because they've 
got a lot more options than average taxpayers.
    Senator Allard. Yeah, corporations, too. In fact, that's 
one of the challenges, whether it's the State or Federal. If 
you look at how much corporations pay from year to year, 
there's a big oscillation back and forth, and they have the 
capability of moving around their income more than individuals 
would have.
    Dr. Mitchell, were you going to--did you have a--were you 
going to respond?
    Dr. Mitchell. I think my panelists----
    Senator Allard. Okay.
    Dr. Mitchell [continuing]. Did an excellent job.
    Mr. Armey. Well, I just--I did want to make the point that 
all this was known to us in the works of Bastiat and Mills, in 
the last 18th century. So, we keep working at it, we might 
understand as much as they did in 1776.
    Senator Allard. Yeah. Very good.
    Well, let me just draw this to a conclusion. I know you're 
all busy people, and I want to thank you for taking the time 
from your busy lives to come here and help inform us about the 
proper tax policy that we ought to be pursuing. And I, for one, 
will be working with the chairman of the committee to see if we 
can come up with a good flat tax policy here for Washington, 
DC. Thank you for your testimony, and have a safe trip home.

                     ADDITIONAL SUBMITTED STATEMENT

    The subcommittee has received a statement from Paul Strauss 
which will be inserted in the record at this pont.
    [The statement follows:]
                   Prepared Statement of Paul Strauss
    Chairman Brownback, members of the Subcommittee: I thank you for 
the opportunity to present this statement for the record on the subject 
of the proposed D.C. flat tax. I am disappointed that the committee 
will not be hearing testimony from any individuals or officials who 
represent the District of Columbia. Given that the flat tax, if 
adopted, would apparently affect only the citizens of D.C., I would 
hope that you would consider their needs and concerns above the 
theories of ideologues. The Honorable Dick Armey may know about the 
Great State of Texas, but he's no expert in D.C.'s taxes.
    It is worth noting that the 16th amendment provides that there 
shall be a uniform system of federal income taxation. Imposing a flat 
tax on D.C., and only on D.C., is not only in violation of the spirit 
of that amendment but also smacks of elitism, by imposing an unfair 
system on those citizens who do not have a vote to change it. Whether 
Congress' plenary power over the District would trump our 
constitutional rights under this amendment is a question that would 
likely need to be resolved by our courts.
    While national tax policy is, of course, within the purview of the 
national legislature, it would be unconscionable to impose an unwanted 
flat tax system on the people of D.C. The proposed flat tax could 
destroy the economic stability of the District of Columbia by taking 
from those who already have too little and giving to those who live in 
the richest parts of the city. D.C. is in an even worse position to 
deal with a flat tax than other places would be because of our unique 
situation. Unlike a large state, in which there is not only a sizable 
middle class but a diverse economy with industries that would not be so 
harmed by switching to a flat tax, D.C. has an economy centered on real 
estate, government, and nonprofit work.
    Flat tax systems typically remove deductions such as charitable 
contributions, the Earned Income Tax Credit, and deductibility of 
mortgage interest. D.C. has a dynamic economy; the leading source of 
revenue is real property taxes. Additionally, we have an unusually 
large number of people employed in the non-profit sector. If the flat 
tax eliminates these exemptions, the D.C. economy could suffer 
tremendously. Consequently, there would also be less tax revenue 
flowing into local coffers as well as the national treasury than under 
the current system.
    It is morally wrong for Congress to use D.C. as an ``experiment.'' 
However, that point aside, D.C. is not even a good subject for 
experimentation because of the unique economy of the city. It is also 
wrong to pick on D.C. to experiment simply because we don't have a 
voting representative in this body. I also find it alarming that this 
Congress, which has all but bankrupted the federal government, now 
wants to change the system in D.C., which has a budget surplus. Perhaps 
instead of national tax experts testifying on how to change D.C.'s 
federal tax systems, Congress would do well to have the District of 
Columbia's financial management team give suggestions about how to 
improve our national economy.
    Thank you again for the opportunity to offer testimony in 
opposition to this proposal. In closing, let me thank Kasey Dunton of 
my legislative staff for her help in preparing this statement.

                          SUBCOMMITTEE RECESS

    And I'll go ahead and call the subcommittee--in recess--
recess the subcommittee. Thank you.
    [Whereupon, at 3:25 p.m., Wednesday, March 8, the hearing 
was recessed, to reconvene subject to the call of the Chair.]


   POTENTIAL EFFECTS OF A FLAT FEDERAL INCOME TAX IN THE DISTRICT OF 
                                COLUMBIA

                              ----------                              


                        THURSDAY, MARCH 30, 2006

                               U.S. Senate,
          Subcommittee on the District of Columbia,
                               Committee on Appropriations,
                                                    Washington, DC.
    The subcommittee met at 1:34 p.m., in room SD-138, Dirksen 
Senate Office Building, Hon. Sam Brownback (chairman) 
presiding.
    Present: Senator Brownback.

               OPENING STATEMENT OF SENATOR SAM BROWNBACK

    Senator Brownback. Good afternoon. The hearing will come to 
order. Thank you all for joining us today. Today we are going 
to continue to explore how the Federal Government might test a 
fairer, simpler flat system in the District of Columbia. I 
might also mention at the outset I have offered numerous times 
if people in the District are concerned about being a test 
case, I would offer my State of Kansas to be also in that pool 
of people to be tested for this prospect.
    We are going to dig into more of the specifics today. A few 
weeks ago the subcommittee heard testimony about how a 
voluntary flat Federal income tax for District of Columbia 
residents could give us some valuable real world information 
about whether a flat tax is actually better than the current 
cumbersome system and I believe also helpful to the District of 
Columbia.
    I believe most taxpayers in the District of Columbia would 
greatly welcome this opportunity. But since we do not believe 
that the Federal Government should merely impose a new system 
on D.C. taxpayers overnight, I would suggest that this be 
voluntary, that those who want to stay under the current system 
should feel free to do so.
    April 15 is right around the corner and taxpayers across 
the country are spending their evenings and weekends racing to 
complete their tax returns. This is no small task, given our 
complex and complicated and many times unreconcilable Tax Code. 
Most taxpayers are confused by the 800 different IRS tax forms 
and the hundreds of pages of IRS instruction books. Adding to 
this burden is the real fear that taxpayers suffer wondering if 
they will make a mistake trying to calculate how much of their 
own money they have to hand over to the Federal Government. 
They also become suspicious that the existing maze of credits, 
and exemptions is unfair and gives some special advantage to 
those who wield political power or can afford an expert tax 
adviser.
    There are two principal arguments for a flat tax, economic 
growth and fairness. Earlier this month economists testified 
before this subcommittee that the current tax system, with its 
high rates and discriminatory taxation of saving and 
investment, stymies economic growth, destroys jobs, and lowers 
incomes. By lowering tax rates and ending the Tax Code's bias 
against savings and investment, witnesses said that a flat tax 
would boost the economy's performance.
    Of course, I would like to see a fairer tax system for all 
taxpayers in every American city, particularly for my taxpayers 
in Kansas. But while everyone talks about the need to simplify 
the Tax Code, real reform has been blocked by those who come up 
with every kind of excuse to prevent us from fixing the broken 
system or even testing a new one.
    I believe that the Federal Government can pilot a first-
ever flat Federal income tax here in the Nation's Capital 
because of the unique constitutional relationship it has with 
the District of Columbia. One result of Washington, DC, being 
the seat of the Federal Government is that over 40 percent of 
all District property is not subject to local taxation. I 
repeat that again: 40 percent. By Federal law, the District is 
precluded from taxing income at source for those workers who 
are not residents of the District. The result is that 70 
percent of income earned in the District cannot be taxed to 
support District municipal services. Let me repeat that number: 
70 percent cannot be taxed.
    So to some extent these Federal restrictions on the 
District's taxing authority have led city leaders to impose 
very high local income tax, property, and sales taxes. In fact, 
for decades residents of Washington, DC, have endured one of 
the Nation's highest tax burdens. As the District's population 
has steady declined, the tax burden on those who have chosen to 
stay has become heavier and heavier.
    I believe that a voluntary flat Federal income tax would 
create more economic activity and jobs in the District, which 
would enhance the District's ability to raise revenue while 
actually lowering its own high local taxes.
    I look forward to hearing from our panel of local District 
of Columbia experts about how a flat Federal income tax would 
affect the District of Columbia, and that is what the focus of 
the hearing today is about. First to testify will be Dr. Natwar 
Gandhi. He is Chief Financial Officer (CFO) for the District of 
Columbia, a very well known individual that has worked quite 
hard and well in getting the city's financial structure back in 
shape. He is responsible for the city's finances, including its 
approximately $7 billion in annual operating and capital funds.
    As the independent CFO, Dr. Gandhi manages the District's 
financial operations, which include tax and revenue 
administration, the treasury, comptroller, and budget offices, 
economic and fiscal analysis, and revenue estimation functions, 
and agency fiscal operations.
    We also have Mr. Terence Golden and Mr. John Hill, 
President and CEO respectively of the Federal City Council. It 
is a nonprofit, nonpartisan organization dedicated to the 
improvement of our Nation's Capital. Federal City Council is 
composed of and financed by 200 business, civic, professional, 
and education leaders. Mr. Golden is also Chairman of Bailey 
Capital Corporation of Washington, DC. It is a private 
investment company. Mr. Hill served as Executive Director for 
the District of Columbia Control Board from May 1995 to June 
1999.
    I want to thank you all for being here and testifying 
today. I think we will run the clock at about 6 minutes. I do 
want to be able to get to some series of questions, but the 
focus of today's hearing--we talked about the theory at the 
last hearing. I would like to see the practical impacts in 
Washington, DC, of such an effort and that is what our primary 
focus will be today.
    Dr. Gandhi, delighted to have you here and the floor is 
yours.
STATEMENT OF HON. NATWAR M. GANDHI, CHIEF FINANCIAL 
            OFFICER, GOVERNMENT OF THE DISTRICT OF 
            COLUMBIA
ACCOMPANIED BY JULIA FRIEDMAN, Ph.D., CHIEF ECONOMIST, GOVERNMENT OF 
            THE DISTRICT OF COLUMBIA

    Dr. Gandhi. Thank you, Mr. Chairman. Mr. Chairman, good 
afternoon. I am Natwar M. Gandhi, Chief Financial Officer of 
the District of Columbia. I am here to testify on the matter of 
the fiscal relationship between the Federal Government and the 
District of Columbia and to discuss your idea for a voluntary 
Federal flat tax for District businesses and households. I am 
joined on my left by Dr. Julia Friedman, our Chief Economist.
    A voluntary Federal flat tax may add to the desirability of 
the District as a place to live and work. However, it will also 
give rise to additional challenges within the District as more 
activities compete for the limited amount of available space. 
In this testimony, I will speak in general terms about the 
concept of a voluntary Federal flat tax in the District. If a 
legislative plan is presented by the Congress for implementing 
a flat tax in the District, I will work with the Congress to 
provide analysis of the plan.
    Consistent with my role as the District's independent Chief 
Financial Officer, my testimony will only address the fiscal 
and economic impact of the flat tax. I will not discuss the 
political or social policy aspects of the flat tax since that 
role is reserved for the elected officials of the District.
    As the Nation's Capital, we enjoy national galleries, 
monuments, and parks that are the envy of the world and that 
attract millions of tourists and business travelers. These 
travelers and the government that draws them create the 
economic and fiscal basis of the city. The Federal-city 
relationship is complex and not without problems, particularly 
in the fiscal arena. The rules are well known, that the 
District has the jurisdictional responsibility of a city, 
county, State, and school district while it has only the tax 
base of a core city.
    There is a mutually beneficial relationship between the 
District and the Federal Government stemming from the 
District's position as the home of the Federal Government. At 
the same time, D.C.'s complex jurisdictional responsibility and 
limitations result from the special relationship with the 
Federal Government. The end result is that the District has an 
artificially constricted tax base, as you mentioned, sir, and 
the overwhelming needs of an inner city.
    Excuse me. I get choked up when I talk about taxes.
    Senator Brownback. Well, take a sip of water then.
    Dr. Gandhi. For the District the juxtaposition of a limited 
tax base against the responsibilities of multiple jurisdictions 
produces chronic budgetary distress, ranging annually from $470 
million to about $1.1 billion according to the Government 
Accountability Office (GAO) report in May 2003. Even in the 
wake of D.C.'s phenomenal fiscal recovery of the past decade--
and may I brag a little, Mr. Chairman; it has indeed been a 
phenomenal recovery. In the mid-1990s when John Hill was our 
Executive Director of the Control Board, we had roughly $500 
plus million in deficits. Today we enjoy about $1.6 billion in 
surplus in our fund balance, about a $2.1 billion turnaround 
which is unmatched, unparalleled anywhere in the municipal 
annals of the history in this country. So this is a truly 
remarkable achievement on the part of the Control Board, the 
Congress, of our elected leaders, Mayor and the Council.
    Even in the wake of D.C.'s phenomenal fiscal recovery of 
the past decades, it faces pervasive infrastructure problems, 
high tax and debt burdens, and the needs of a large number of 
urban poor, like that found in every city.
    The District's economic recovery in the late 1990s was 
hastened by the Federal wisdom and action, for example the 
fiscal improvements brought about by the 1997 Revitalization 
Act. Still, the District now struggles and will continue to 
struggle with the multi-jurisdictional requirements and a 
limited urban tax base. There are additional Federal 
constraints on use of significant parts of the tax base that is 
there. You just mentioned about how we cannot tax the income 
tax base here and also the real property base.
    Two consequences of this structural imbalance between the 
District's revenue base and its spending requirements are: one, 
a high per capital tax burden, with some of the highest tax 
burdens in the region and the country; and the highest per 
capita borrowing. D.C.'s tax burden on households is in the 
upper one-third when compared to the largest cities in the 
United States. The burden is greater on the business. D.C.'s 
tax rate on net business income is 9.975 percent. The gross 
receipts tax on public utilities used by businesses is around 
11 percent and the real property tax on commercial property is 
around $1.85 per $100 value, as compared to a range of 92 cents 
to about $1.16 in the neighboring suburbs.
    The GAO ranks D.C.'s tax burden among the very highest in 
the country. Indeed, sir, there are only two States in the 
country that would have a higher tax rate than we do. About 42 
States have lower tax rates than we do.
    Further, the District's very high per capita borrowing 
reflects the city's efforts to sustain infrastructure generally 
provided by multiple jurisdictions. The District's per capita 
tax-supported debt burden exceeds $8,000, the highest per 
capita of any major city in the Nation. For a long time, sir, 
our tax policy has been once we find a taxpayer we never let 
him go. We keep piling on. And at the same time, either we tax 
or we borrow to meet our needs.
    Challenges may arise, however, adding to D.C.'s structural 
imbalance in coming years. First, all State and local revenue 
systems are stressed by the changing nature of the economy as 
it evolves more into a service-oriented economy.
    Turning another page, page 5, sir, the District of Columbia 
has a large urban population that needs help. Census data for 
2004 estimate D.C.'s poverty rate at around 19 percent, the 
fourth highest in the Nation after Mississippi, Louisiana, and 
New Mexico. Of D.C.'s 248,000 plus households, 18 percent have 
incomes less than $15,000. Median household income is about 
$46,000 in a metropolitan area where median household income is 
around $71,000. Only about one-third of the District's 
households are at or above the metropolitan median. Like other 
cities, the District is accountable for greater efforts to help 
the less advantaged in the city's population.
    Income discrepancy among D.C.'s residents is reflected in 
the distribution of D.C.'s adjusted gross income, as shown in 
table 1. The concentration of both income tax burden on a small 
number of filers is evident. Those filers with adjusted gross 
income of $75,000 and more take up 17 percent of the filers, 
have 57 percent of the income, and pay 71 percent of the 
District's individual income tax. That is quite a remarkable 
number, Mr. Chairman, if you were to look at the table, that 
roughly 4 percent of our taxpayers pay 44 percent of our income 
taxes, 17 percent pay 71 percent of income taxes, and roughly 
50 percent pay 93 percent of our income taxes. So roughly the 
other half simply does not pay.
    Filers with more than $200,000 income comprise just 4 
percent of all filers, 30 percent of income, and 44 percent of 
local income tax collections. At the lower income level, about 
one-half of all filers have $30,000 or less in the adjusted 
gross income (AGI) income and 16 percent have even $10,000 or 
less.
    Turning to page 7, Mr. Chairman, as you have suggested a 
Federal flat tax in the District of Columbia, the tax would 
apply both to individuals on their earned income and to 
businesses on their gross income net of costs, wages, and 
investment in plant and equipment. Individuals would be taxed 
only on personal earnings. Businesses would not be taxed on 
tangible investment. The flat tax thereby eliminates any 
potential double taxation of rents, profits and interest and 
eliminates tax disincentives to investment.
    The tax would be calculated at a constant tax rate on 
taxable income and the rate could be applied either on all 
income or income above some threshold amount that is tax 
exempt. There would be no other exemptions or deductions.
    Depending on how it is formulated, a Federal flat tax could 
benefit few, some, or most individual taxpayers living in the 
District. Under the chairman's proposal, District taxpayers 
will have the choice of either the flat tax or the current tax 
depending on which method gives them a more favorable tax 
liability.
    Table 2 illustrates the Federal tax liabilities on current 
District residents. The table also identifies the District's 
relatively unusual distribution of taxpayers types. Fifty-five 
percent of D.C.'s income tax payers are single filers with no 
dependents, another 22 percent are single individuals with 
dependents, and 3 percent are dependents with taxable income. 
This leaves only 20 percent who are filing as married 
households. This is quite a remarkable number, sir, that only 
20 percent of our tax filers are married.
    Turning to page 9, single filers have D.C. AGI of about 
$45,745 and for those with wage and salary income average 
earned income is around $44,934.
    With the first alternative of the flat tax, about $4,000 of 
personal exemption and 18 percent tax on the remainder, the 
calculated tax is around $7,368. This amount exceeds current 
tax both for the itemizers and for those taking standard 
deductions. The average single person is not most likely to 
choose this flat tax. The only filer type that most likely 
prefers this tax is the married two-earner type that has much 
higher average income at $201,000 and plus. This filer 
currently pays $35,326 to about $40,000 depending on 
deductions. The liability drops to about $25,000 with the flat 
tax at $4,000 per exemption and 18 percent tax rate.
    The second alternative flat tax is much less restrictive 
and would likely be chosen by many filers, including singles 
with standard deductions and married people with standard 
deductions as well. This alternative has a more generous $8,000 
personal exemption and a lower, 16 percent tax rate. Even with 
this form, approximately 50,000 D.C. filers who take the 
Federal earned income tax credit, so-called EITC, are likely to 
prefer the current tax. This Federal credit can actually refund 
more than the total tax owed by a working class or low income 
filer. Under the current tax treatment for the average head of 
the household, for example, the refund adds about $1,350 for a 
filer with standard deduction and about $2,170 for a filer with 
itemized deductions.
    The third alternative is a simple compromise of the two 
previous ones, with a more generous personal exemption at 
$8,000 and more restrictive tax rate at 18 percent. In this 
format there is likely to be a greater mixture of those 
choosing the flat and those choosing the current tax forms.
    The final column in table 3 confirms that a filer with no 
earned income will benefit significantly from a flat tax on 
individual income. As compared to the current tax, an average 
single filer taking the standard deduction saves about $6,000 
and a married filer with one income about $15,000.
    I turn to page 12, sir, in the middle of the page. The 
first alternative, with $4,000 personal exemption and 18 
percent tax rate on earned income, would be selected by 
approximately 15 percent of D.C.'s current individual income 
tax filers with earned income, based on our very rough 
calculations. The second alternative, $8,000 personal exemption 
and 16 percent tax rate, would be chosen by about 75 percent of 
current filers with earned income. And the third alternative, 
with an $8,000 exemption and 18 percent tax rate, would be 
chosen by roughly 60 percent of current filers with earned 
incomes. We assume that filers with incomes only from other 
sources will choose the flat tax alternatives. These 
approximate ratios are based on our individual income tax 
filers for 2003 D.C. taxes.
    In providing the choice between the flat and the current 
tax methods, you offer, sir, a significant benefit to the 
residents of the District. The Federal Government would lose 
revenue from D.C. taxpayers, at least in the startup years. The 
amount could be as large as $1 billion in the first year, as 
roughly approximated by our data. The billion dollar 
calculation is made by us and is based on the District's own 
tax base and Tax Code. It is not to be considered an 
authoritative number because Federal revenue depends on the 
Federal code and Federal base and actual first year losses 
depend on the alternative flat tax that is selected. Scoring of 
actual losses must come from the Federal sources.
    In the later years, the amount of the Federal revenue loss 
will depend on how much economic activity is stimulated by the 
voluntary flat tax. Individuals moving to the District in order 
to take advantage of the flat tax would increase the Federal 
losses because their total Federal tax liabilities would fall. 
True economic growth, however, could offset these losses. Some 
economists argue that businesses will want to locate in the 
District for tax purposes because their tangible investments 
would be fully expensed by the flat tax and therefore not 
subject to Federal taxation. This incentive to invest could 
then produce economic growth.
    I turn to page 14. The District's own tax base could grow 
under a voluntary Federal tax due to two influences: one, 
businesses and households that move to the District to get 
preferred Federal tax status; and two, expansion of the current 
economic base. Both income and real property tax revenues would 
grow. This assumes that D.C.'s own tax treatment of households 
and businesses does not change and the optional Federal flat 
tax is enacted as a permanent change to the Federal tax law. 
The District would continue to base tax calculation on the 
equivalent of current Federal adjusted gross income and would 
continue to tax all income received by the household and not 
just earned income.
    Turning to the next page, in general we would not expect 
that franchise tax revenue to the District government would 
grow at a rate comparable to the growth of local business 
income. We would expect growth in real property tax revenue, as 
competition for limited space becomes more fierce. The property 
values, assessments, and costs inevitably will rise with demand 
because the District is a small, highly developed jurisdiction 
with federally mandated height limitations.
    I pass over some of the compliance issues and turn to page 
16. More important, what impact there would be on our 
households. A small group of very high income taxpayers, 
especially with no wage income, fewer than about 1,000 current 
households, would be major beneficiaries of the flat tax. These 
taxpayers rely on income from interest earnings, rental 
activity, and profits and capital gains.
    Further, we expect that others with similar sources of 
income would want to move into the District for the Federal tax 
benefit. For example, a married two-income filer living 
elsewhere with $650,000 of gross income currently pays about 
$185,000 in Federal tax and may pay up to about $40,000 in a 
local non-D.C. tax jurisdiction. If all the income is from non-
wage and salary sources, the filer can save about $185,000 in 
Federal tax annually by moving to the District. The filer would 
pay about $60,000 in D.C. income tax, about $20,000 more than 
previously, thus netting about $165,000 annual tax savings from 
the move.
    If all the filer's income is due to wage earnings and the 
couple moves to the District, Federal tax could drop to 
$150,000 under the most restrictive of the flat tax options. 
D.C. local tax adds back about $20,000, leaving the taxpayer 
with a net tax reduction of at least $50,000 annually. Even 
with the higher cost, some households are likely to find the 
District a beneficial new location.
    Once they move to the District, these new residents would 
owe the District local income tax. If for example the District 
adds about 500 households, just about 5 percent, to the number 
with incomes above $200,000, then individual income tax revenue 
would increase roughly $30 million annually. Similarly, an 
addition of about 1,000 more such households might generate $60 
million in additional D.C. government revenue.
    Of course, it is very difficult to estimate how many may 
move in or out without analyzing a concrete flat tax proposal. 
More new residents would mean more revenue and fewer new 
residents means less increase in revenue. While the District 
could not close the structural imbalance with these new 
residents alone, the net fiscal contribution to the District 
would be beneficial.
    Non-wage income is not limited to the very wealthy. Other 
middle class to upper income households might want to move here 
to shelter retirement savings and other investment income from 
Federal tax. Much as Florida is a haven from State income taxes 
in retirement, the District would be a partial haven from the 
Federal income taxes for retirees. Households attracted in this 
way are likely to have a net fiscal benefit for the District's 
budget.
    Because of this tax incentive, a voluntary Federal flat tax 
could add to housing price pressures in the District. While 
positive occurrences for budgetary purposes, this is a serious 
problem for other reasons related to the loss of urban middle 
class. For more than 50 years, the population of the District 
has been falling. Within the smaller total population, the 
District has more people at the lower end of the income 
distribution, far fewer in the middle class, and a declining 
upper income population. In recent years the number of 
households in the District is growing again, but not the 
population. Many of these new households are high income, a 
nearly necessary condition in a city where housing prices grew 
an average 15 percent annually over the last 5 years and 
roughly doubled in that period. With only 2 percent increase in 
the households overall, the number of households with at least 
$100,000 or more in income grew by 27 percent in the time 
period of 2000-2004. Population has not grown because, as a 
generalization, the filers moving in are single or sometimes 
couples, while the filers moving out are more likely to have 
children.
    We do not know how much the voluntary tax would add to 
price pressure for the housing. Because a flat tax neutralizes 
the favorable tax treatment of itemizers--most of these are 
home buyers--additional housing price pressure can be dampened. 
Compared to the current tax system, a person electing to use 
the flat tax would not be able to deduct either mortgage 
interest or real property taxes from taxable income, thereby 
limiting the boost of a potential offer price for housing.
    However, if theorists are right and if business demand 
rises for the D.C. location under a flat tax, then commercial 
users will bid up the prices, shifting the property markets 
somewhere or somewhat away from residential land uses and 
further increasing housing prices.
    However, the similarity between our estimated $1 billion 
possible initial revenue loss at the Federal level and the 
magnitude of the District's structural imbalance of about $1 
billion is striking. Clearly, the benefits of reduced Federal 
taxation will accrue to the citizen and business taxpayers 
while the structural imbalance is a problem of local 
government.
    Still, thoughtful policy management could find a way to 
narrow the local budgetary problem as a result of this 
windfall. It is, after all, much like a negotiated middle 
between the current Federal tax policy for the District and the 
current Federal treatment allowed Puerto Rico, where there is 
no Federal tax on local earnings. In Puerto Rico the state 
government receives the revenue from taxation to the local 
earnings.
    Mr. Chairman, I thank you for holding this hearing and 
providing this forum. The possibility of a new, deeper and 
better Federal-city relationship is very exciting. I look 
forward to any questions you may have. This concludes my oral 
comments. I would appreciate kindly putting my full testimony 
in the record. Thank you, sir.
    Senator Brownback. Your full testimony will be put into the 
record.
    [The statement follows:]
                 Prepared Statement of Natwar M. Gandhi
    Good afternoon Mr. Chairman and members of the Senate 
Appropriations Committee on the District of Columbia. I am Natwar M. 
Gandhi, Chief Financial Officer of the District of Columbia. I am here 
to testify on the matter of the fiscal relationship between the Federal 
government and the District of Columbia and, to discuss your idea for a 
voluntary Federal flat tax for the District's businesses and 
households.
    A voluntary Federal flat tax may add to the desirability of D.C. as 
a place to live and to work. However, it will also give rise to 
additional challenges within the District as more activities compete 
for the limited amount of available space.
    In this testimony I will speak in general terms about the concept 
of a voluntary Federal flat-tax in the District. If a legislative plan 
is presented by the Congress for implementing a flat tax in the 
District, I will work with the Congress to provide analysis of the 
plan. Consistent with my role as the District's independent Chief 
Financial Officer, my testimony will only address the fiscal and 
economic impact of the flat tax. My testimony does not discuss the 
political or social policy aspects of a flat tax, since that role is 
reserved for the elected officials of the District.
Unique relationship
    The District of Columbia is home to the Government of the United 
States of America. D.C. enjoys national galleries, monuments and parks 
that are the envy of the world and that attract tourists and business 
travelers. These travelers and the government that draws them create 
the economic and fiscal bases of the city.
    The Federal-city relationship is complex and not without problems, 
particularly fiscal problems. The words are well-worn--D.C. has the 
jurisdictional responsibilities of a city, county, state, and school 
district while it has only the tax base of a core city. There is a 
mutually beneficial relationship between the District and the Federal 
government stemming from the District's position as the home of the 
Federal government. At the same time D.C.'s complex jurisdictional 
responsibilities and limitations result from this special relationship 
with the Federal government. The end result is that the District has an 
artificially constricted tax base and the overwhelming needs of an 
inner city.
    For D.C., the juxtaposition of a limited tax base against the 
responsibilities of multiple jurisdictions produces chronic budgetary 
distress--ranging from $470 million to $1.1 billion, according to the 
GAO in their May 2003 report. Even in the wake of D.C.'s phenomenal 
economic and fiscal recovery of the past decade, the District faces 
pervasive infrastructure problems, high tax burdens, and the needs of a 
large number of urban poor (like that found in every city).
    The District's economic recovery in the late 1990s was hastened by 
Federal wisdom and action--for example in the fiscal improvements 
brought by the 1997 Revitalization Act. Still, the District now 
struggles, and will continue to struggle, with multi-jurisdictional 
requirements on a limited urban tax base. And, there are additional 
Federal constraints on use of significant parts of the base that is 
there. For example, approximately two-thirds of the income tax-base and 
more than one-quarter of the real property tax-base are exempt from 
local tax due to Federal restrictions.
    Two consequences of this structural imbalance between the 
District's revenue base and its spending requirements are: (1) a high 
per capita tax burden with some of the highest tax burdens in the 
region and the country; and (2) the highest per capita borrowing. 
D.C.'s tax burden on households ranks in the upper one-third when 
compared to the largest city in each state (for total state and local 
burden of sales, income, property, and automobiles).
    The burden is greater on businesses. D.C.'s tax rate on net 
business income is 9.975 percent; the gross receipts tax on public 
utilities used by businesses is 11 percent; purchases of intermediate 
products used by D.C. businesses are subject to the general retail tax; 
and the real property tax on commercial property is $1.85 per $100 of 
value as compared to a range of $0.92 to $1.16 in neighboring suburbs.
    The GAO ranks D.C.'s tax burden among the very highest in the 
country. ``The District's tax burden (actual revenue collected from 
local resources relative to their own-source revenue capacity) is among 
the highest of all fiscal systems, . . .  The District's actual tax 
burden exceeded that of the average state fiscal system by 33 percent, 
based on our lower estimate of its own-source revenue capacity, and by 
18 percent, based on our higher estimate of that capacity.'' \1\
---------------------------------------------------------------------------
    \1\ GAO-03-666, District of Columbia, Structural Imbalance and 
Management Issues, May 2003, page 41.
---------------------------------------------------------------------------
    The District's very high per capita borrowing reflects the city's 
effort to sustain infrastructure generally provided by multiple 
jurisdictions. At $6,598 per capita, the D.C. debt burden exceeds the 
combined state and local burden in New York City by $813--or 14 
percent. The District burden exceeds that of other cities by even 
larger margins.
    Challenges may arise, however, adding to D.C.'s structural 
imbalance in coming years. First, all state and local revenue systems 
are stressed by the changing nature of the economy, as it evolves more 
into a service oriented economy. Because state and local tax systems 
were developed around the manufacturing and sale of goods, the old ways 
of gathering tax revenue are increasingly inadequate to the newer 
economy. The revenue challenge is made even greater in the District by 
the Federal prohibitions against taxing incomes earned by non-residents 
workers and incomes earned by certain professional services.
    Second, the District has a large urban population that needs help. 
Census data for 2004 estimate the D.C. poverty rate at about 19 
percent, the fourth highest in the nation when compared to states, 
after Mississippi, Louisiana, and New Mexico. Of D.C.'s 248,563 
households, 18 percent have income of less than $15,000.\2\ Median 
household income is about $46,600--in a metropolitan area where median 
household income of $70,900. Only about a third of D.C.'s households 
are at or above the metropolitan median. Like other cities, D.C. is 
accountable for greater efforts to help the less advantaged in the 
city's population. The fiscal year 2007 budget, recently submitted by 
the Mayor to the Council, works hard to manage the expenditure needs 
and fiscal requirements of D.C.'s lower income population.
---------------------------------------------------------------------------
    \2\ American Community Survey, 2004.
---------------------------------------------------------------------------
    Income discrepancy among D.C. residents is reflected in the 
distribution of D.C. Adjusted Gross Income as shown in Table 1. The 
concentration of both income and tax burden on a small number of filers 
is evident--those filers with adjusted gross income of $75,000 and more 
make up 17 percent of filers, have 57 percent of the income, and pay 71 
percent of the District's individual income tax. Filers with more than 
$200,000 in gross income comprise just 4 percent of all filers, 30 
percent of income, and 44 percent of local income tax collections. At 
the lower income levels, about one-half of all filers have $30,000 or 
less DCAGI--16 percent have $10,000 or below.

   TABLE 1.--TY2004 INDIVIDUAL INCOME TAX FILERS, D.C., BY D.C. ADJUSTED GROSS INCOME CATEGORY, FROM FORM D-40
----------------------------------------------------------------------------------------------------------------
                                                                              DCAGI--
                                                  --------------------------------------------------------------
                                                                                                          Over
                                                    $0-$10K  $10-$20K  $20-$30K  $30K-$75K  $75K-$200K    $200K
----------------------------------------------------------------------------------------------------------------
Number Returns.........................   262,328    41,368    43,718    39,596     85,971     35,041      9,821
Returns (percent)......................       100        16        17        15         33         13          4
Income (percent).......................        99         3         5         7         28         27         30
Tax Amount (millions)..................    $1,037        $4       $22       $44       $229       $277       $459
Tax Percentage.........................       100  ........         2         4         22         27         44
EITC Returns (percent).................        99        33        33        28          5  ..........  ........
----------------------------------------------------------------------------------------------------------------
Note: 6,813 filers have DCAGI of less than or $0. These are not included here.



Voluntary Federal Flat Tax
    The Chairman has suggested a Federal flat tax in the District of 
Columbia. The tax would apply both to individuals--on their earned 
incomes--and to businesses on their gross income net of costs, wages, 
and investment in plant and equipment. Individuals would be taxed only 
on personal earnings. Businesses would not be taxed on tangible 
investment. The flat tax thereby eliminates any potential double 
taxation of rents, profits, and interest and eliminates tax 
disincentives to investment. (Because unearned incomes are partly held 
in tax exempt portfolios, not all are currently double-taxed.) The tax 
would be calculated at a constant tax rate on taxable income and the 
rate could be applied either on all income or on income above some 
threshold amount that is tax exempt. There would be no other exemptions 
or deductions.
    Taxation of Individuals.--Depending on how it is formulated, a 
Federal flat tax could benefit few, some, or most individual income 
taxpayers living in the District. Under the Chairman's proposal, 
District taxpayers will have the choice of either the flat tax or the 
current tax, depending on which method gives them a more favorable tax 
liability.
    Table 2 illustrates the Federal tax liabilities on current 
residents, based on filer groups and average income of the filer 
groups. The table also identifies the District's relatively unusual 
distribution of taxpayer-types. Fifty-five percent of D.C. income 
taxpayers are single filers with no dependents, another 22 percent are 
single individuals with dependents, and 3 percent are dependents with 
taxable income. This leaves 20 percent who are filing as part of a 
married household.\3\ The incomes reported in Table 2 are the average 
D.C. Adjusted Gross Income (DCAGI) for the filer group in TY2004.
---------------------------------------------------------------------------
    \3\ The corresponding Federal distribution of filers for TY2003 is 
45 percent married, 13 percent head of household, and 42 percent single 
(including dependents).

               TABLE 2.--CURRENT TAX ON FEDERAL INCOME TAX FILERS FILING FROM A D.C. ADDRESS, BY FILER TYPE AND BY AVERAGE INCOME, TY2004
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                             Est
                                                       Percent of                                          Average       Ave                   Current
                                            Number of     Total                Type of Filer             Income, by  Deduction,   Exemption  Federal Tax
                                             Filers      Filers                                             Filer     by Filer                Liability
                                                                                                            Group       Group
--------------------------------------------------------------------------------------------------------------------------------------------------------
TOTAL....................................     262,328         100  ....................................  ..........  ..........  ..........  ...........
SINGLE...................................     145,433          55  Standard deduction..................     $45,745      $3,370           1      $6,046
                                                                   Itemized deduction..................      45,745      12,920           1       4,079
HEAD OF HOUSEHOLD \1\....................      57,197          22  Standard deduction..................      30,891       7,300           3      (1,350)
                                                                   Itemized deduction..................      30,891      13,756           3      (2,171)
MARRIED FILING JOINT (1 INCOME)..........      27,829          11  Standard deduction..................     116,802      10,000           4      15,186
                                                                   Itemized deduction..................     116,802      27,975           4      10,686
MARRIED FILING JOINT (2 INCOMES).........      14,825           6  Standard deduction..................     201,060      10,000           3      40,540
                                                                   Itemized deduction..................     201,060      30,274           3      35,326
MARRIED FILING SEPARATELY................       8,003           3  Standard deduction..................      58,631       5,000           2       9,271
                                                                   Itemized deduction..................      58,631      17,039           2       6,259
DEPENDENT FILER..........................       7,799           3  Standard deduction..................       6,952       5,000  ..........         196
                                                                   Itemized deduction..................       6,952       5,000  ..........         196
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ The mean head-of-household filer is eligible for the Refundable Earned Income Tax Credit. Without EITC, the filer would pay $0 tax.
 
Data Source: Calculations based on DC Form D-40.

    Table 3 identifies the impact of various formats of a Federal flat 
tax on D.C. resident filers. To do this, the table first identifies how 
much wage and salary ``earned'' income a filer has--and also notes that 
some filers have no such income and, instead, rely on other types of 
income such as dividends, interest, and profit. This is critical 
because current taxpayers with no ``earned'' incomes pay no individual 
income tax under the flat tax. Overall, about 86 percent of D.C. filers 
have earned income; the other 14 percent (adjusted for those with 
earned income deferred from a prior year for current use) would have 
zero liability and most likely prefer a flat tax.
    Single filers have average DCAGI of $45,745 and, for those with 
wage and salary income, average earned income of $44,934. With the 
first alternative of the flat tax--a $4,000 personal exemption and 18 
percent tax on the remainder, the calculated tax is $7,368. This amount 
exceeds current tax both for itemizers (at $4,079) and for those taking 
the standard deduction (at $6,046). The average single person is not 
most likely to choose this flat tax. The only filer type that prefers 
this tax is the married, 2-earner type that has much higher average 
income at $201,060 and $155,537 from combined wages and salaries. This 
filer currently pays $35,326 or $40,540, depending on deductions; the 
liability drops to $25,837 with the flat tax at $4,000 per exemption 
and 18 percent tax rate.
    The second alternative flat tax is much less restrictive and would 
likely be chosen by many filers, including--at average incomes--singles 
with standard deductions and married people with standard deductions, 
as well as married two income filers with itemized deductions. This 
alternative has a more generous $8,000 personal exemption and a lower 
16 percent tax rate. Even with this form, the approximately 50,000 D.C. 
filers who take the Federal Earned Income Tax Credit (EITC) are likely 
to prefer the current tax. This Federal credit can actually refund more 
than the total tax owed by a working, low-income filer. Under current 
tax treatment for the average head of household, for example, the 
refund adds $1,350 for a filer with standard deductions and $2,171 for 
a filer with itemized deductions.
    The third alternative of a Federal flat tax in Table 3 is a simple 
compromise of the two previous, with the more generous personal 
exemption at $8,000 and the more restrictive tax rate at 18 percent. In 
this format there is likely to be a greater mixture of those choosing 
the flat and those choosing the current tax forms.
    The final column of Table 3 confirms that a filer with no earned 
incomes will benefit significantly from a flat tax on individual 
income. As compared to the current tax, an average single filer taking 
the standard deduction saves $6,046; a married filer with one income 
saves $15,186.

                                    TABLE 3.--CURRENT TAX AND FLAT TAX OPTIONS ON D.C. FEDERAL INCOME TAX FILERS, BY FILER TYPE AND BY AVERAGE INCOME, TY2004
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                       Flat Tax   Flat Tax   Flat Tax
                                                                                                                                                      Liability  Liability  Liability
                                                         Number                                            Est      Average                           at $4,000  at $8,000  at $8,000
                                               Number    Wage &    Percent                               Average      W&S                   Current      & 18       & 16       & 18     Any Flat
                                                 of      Salary   of Total         Type of Filer         Income,     Income   Exemptions    Federal    Percent    Percent    Percent   Tax Non-W
                                               Filers    Filers     Filers                               by Filer   for W&S                   Tax       Wage &     Wage &     Wage &    &S Filer
                                                                                                          Group      Filers                             Salary     Salary     Salary
                                                                                                                                                      Filer \1\  Filer \1\  Filer \1\
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
TOTAL.......................................   262,328   224,684        86  ..........................  .........  .........  ..........  ..........  .........  .........  .........  .........
SINGLE......................................   145,433   122,958        85  Standard..................    $45,745    $44,934           1     $6,046      $7,368     $5,909     $6,648  .........
                                                                            Itemized..................     45,745     44,934           1      4,079       7,368      5,909      6,648  .........
HEAD OF HOUSEHOLD \2\.......................    57,197    53,619        94  Standard..................     30,891     30,531           3     (1,350)      3,336      1,045      1,176  .........
                                                                            Itemized..................     30,891     30,531           3     (2,171)      3,336      1,045      1,176  .........
MARRIED FILING JOINT (1 INCOME).............    27,829    22,804        82  Standard..................    116,802    107,594           4     15,186      16,487     12,095     13,607  .........
                                                                            Itemized..................    116,802    107,594           4     10,686      16,487     12,095     13,607  .........
MARRIED FILING JOINT (2 INCOMES)............    14,825    12,589        85  Standard..................    201,060    155,537           3     40,540      25,837     21,046     23,677  .........
                                                                            Itemized..................    201,060    155,537           3     35,326      25,837     21,046     23,677  .........
MARRIED FILING SEPARATELY...................     8,003     6,478        81  Standard..................     58,631     59,600           2      9,271       9,288      6,976      7,848  .........
                                                                            Itemized..................     58,631     59,600           2      6,259       9,288      6,976      7,848  .........
DEPENDENT FILER.............................     7,799     6,232        80  Standard..................      6,952      7,245  ..........        196       1,304      1,159      1,304  .........
                                                                            Itemized..................      6,952      7,245  ..........        196       1,304      1,159      1,304  .........
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\1\ Shows preference for Flat Tax Option.
\2\ The average head-of-household filer is eligible for the refundable Earned Income Tax Credit. Without EITC, the filer would pay $0 tax.
 
Data Source: Calculations based on DC Form D-40.

    Filers who have no incomes from wages, salaries, or other earned 
income sources will pay no tax under a flat tax. This explains the 
blank column under ``no-wage filer'' for each flat tax option.
    Renters and those who choose standard deductions on the current tax 
are more likely to benefit from a flat tax than many homebuyers and 
others who itemize (because their Federal tax burden is not eased by 
deductible expenditure on mortgage interest, real property tax, and 
other itemized deductions). While itemizers also may benefit from flat 
taxation, the magnitude of the benefit is likely to be smaller simply 
because itemizers already benefit from some tax breaks.
    Individuals with incomes from rents, interest, capital gains, and 
other unearned sources will gain from a flat tax; these incomes will no 
longer be taxed under the individual income tax. They will be taxed 
only as part of the income of the business that generates them.
    Voluntary Flat Tax.--In providing the choice between flat and 
current tax methods, the Chairman offers a significant benefit to 
residents of the District. The Federal government will lose revenue 
from D.C. taxpayers at least in the start-up years--the amount could be 
$1 billion in the first year, as roughly approximated based on D.C.'s 
data.\4\
---------------------------------------------------------------------------
    \4\ The $1 billion is a calculation made by the OCFO of the 
District and based on the District's own tax base and tax code. It is 
not to be considered authoritative because the Federal revenue depends 
on the Federal code and Federal base. Determination of actual losses 
must come from Federal sources.
---------------------------------------------------------------------------
    In later years, the amount of Federal revenue loss will depend on 
how much economic activity is stimulated by the voluntary flat tax. 
Individuals moving to D.C. in order to take advantage of the flat tax 
would increase Federal losses--because their total Federal tax 
liabilities would fall. True economic growth, however, could offset 
these losses. Some economists argue that businesses will want to locate 
in D.C. for tax purposes because their tangible investments would be 
fully expensed by the flat tax and therefore not subject to Federal 
taxation. This incentive to invest could then produce economic growth.
    The incentive is partly offset by transition costs to businesses 
that would lose depreciation benefits under a flat tax. The voluntary 
aspect of the proposal is, effectively, a transition plan, allowing 
current assets to be depreciated before electing the flat tax. An 
explicit transition plan would directly address assets currently being 
depreciated. A critical component of the transition plan is to identify 
how often a taxpayer can choose between flat and current treatments: is 
it annually, only once for all time, or some intermediate number of 
choices? Taxpayer behavior will be affected by this component. Also, 
taxpayers generally prefer that tax policy be predictable, allowing 
them to plan in terms of it. Any flat tax proposal should be offered as 
permanent, not temporary or experimental, if taxpayers are going to 
adjust their basic behavior around the policy change.
Impact on the District's Revenues
    The District's own tax base could grow under a voluntary Federal 
flat tax, due to two influences: (1) businesses and households that 
move to District to get preferred Federal tax status and (2) expansion 
of the current economic base. Both income and real property tax 
revenues would grow. This assumes that D.C.'s own tax treatment of 
households and businesses does not change and that the optional federal 
flat tax is enacted as a permanent change to federal tax law (a 
perception that it is temporary would substantially reduce these 
effects). D.C. would continue to base tax calculations on the 
equivalent of current Federal Adjusted Gross Income and would continue 
to tax all incomes received by households, not just earned income.
    The fiscal impact on D.C. from the flat tax on business income is 
difficult to assess. For D.C., the revenue gains from adding more 
incorporated and unincorporated businesses would depend on the ability 
of new businesses to shelter income from local taxation. In D.C., about 
70 percent of business tax filers pay only the local minimum tax of 
$100 annually. Partnerships and proprietorships with 80 percent or more 
of their income due to services of the owners do not even file locally. 
The issues in taxing business income are known well across state and 
local jurisdictions and income tax sheltering is a complex art.
    In general, we would not expect that franchise tax revenue to the 
District government would grow at a rate comparable to the growth of 
local business income. This assumes that D.C.'s tax policy for business 
income does not change and that D.C. decouples from the Federal change 
in definition of taxable income. If instead D.C. were to adopt the 
proposed Federal treatment of expensing investment outlays, then local 
revenue would decline.
    We would expect growth in real property tax revenue as competition 
for limited space becomes more fierce. Property values, assessments, 
and costs inevitably will rise with demand because the District is a 
small, highly developed jurisdiction with federally mandated height 
limitations.
    Tax Administration and Compliance.--A voluntary flat tax will 
complicate tax compliance for District residents as well as tax 
administration at both the Federal and local level. With a voluntary 
flat tax, a District taxpayer will have to compute the tax both ways 
prior to deciding which option is best for his or her situation. 
Assuming that the District decouples from the Federal flat tax, a 
District taxpayer who chooses the flat tax will have to maintain 
separate records of information that currently is copied from Federal 
tax forms, in order to comply with the D.C. tax system. At the Federal 
level, the Internal Revenue Service (IRS) would have the added burden 
of auditing residency, as the voluntary flat tax will create new tax 
sheltering opportunities based on where a taxpayer lives. At the local 
level, the D.C. tax administration would lose the benefit from IRS 
audit and enforcement activities.
    Impact on Households.--A small group of very high-income taxpayers, 
especially those with no wage income (fewer than 1,000 current 
households), will be major beneficiaries of the flat tax.\5\ These 
taxpayers rely on income from interest earnings, rental activity, and 
profits and capital gains. Further we expect that others with similar 
sources of income would want to move into the District for the Federal 
tax benefit.
---------------------------------------------------------------------------
    \5\ In the District 86 percent of filers have wage or salary income 
and an unknown number of others take deferred earnings as part of 
current year income. This is subject to a flat tax. Of those filers 
with incomes of $500,000 or more, only two-thirds have wage or salary 
income.
---------------------------------------------------------------------------
    For example, a married, 2-income filer living elsewhere, with 
$650,000 gross income, currently pays about $185,000 in Federal tax and 
may pay $40,000 in local (non-D.C.) tax. If all of the income is from 
non-wage-and-salary sources, the filer can save $185,000 in Federal tax 
annually by moving to D.C. The filer would pay about $60,000 in D.C. 
income tax, about $20,000 more than previously, thus netting $165,000 
annual tax savings from the move. If all the filer's income is due to 
wage earnings and the couple moves to D.C., Federal tax could drop to 
$115,000 under the most restrictive of the flat tax options. D.C. local 
tax adds back $20,000--leaving the taxpayer with a net tax reduction of 
at least $50,000 annually. Even with higher costs in D.C., some 
households are likely to find D.C. a beneficial new location.
    Once they move to the District, these new residents would owe the 
District's local income tax. If, for example, D.C. added about 500 
households, or about 5 percent, to the number with incomes over 
$200,000, then individual income tax revenue would increase roughly $30 
million annually. Similarly, an addition of 1,000 more such households 
might generate $60 million of additional D.C. government revenue. Of 
course, it is very difficult to estimate how many may move in or out 
without analyzing a concrete flat tax proposal. More new residents 
would mean more revenue and fewer new residents mean less increase in 
revenue. While D.C. could not close the structural imbalance with these 
new residents alone, their net fiscal contribution to D.C. would be 
beneficial.
    Non-wage income is not limited to the very wealthy; other middle to 
upper-income households might want to move here to shelter retirement 
savings and other investment income from Federal tax. Much as Florida 
is a haven from state income taxes in retirement, D.C. could be a 
partial haven from Federal income taxes for retirees. (Pension income 
could continue to be taxed under the flat tax.) Households attracted in 
this way are likely to have net fiscal benefit for the District's 
budget.
    Because of this tax incentive, a voluntary Federal flat tax could 
add to housing price pressures in D.C. While a positive occurrence for 
budgetary purposes, this is a serious problem for other reasons related 
to the loss of the urban middle-class. For more than 50 years the 
population of the District has been falling. Within the smaller total 
population, D.C. has more people at the lower end of the income 
distribution, far fewer in the middle class, and a declining upper-
income population. A recent study by the Brookings Institution 
documents this change for the period 1979-1999. The data separate 
households into national quintiles (the top 20 percent, next 20 
percent, and so forth) and then locate households from 100 cities, 
including D.C., within those groups. When compared to 1979, the number 
of D.C. households in the middle quintile in 1999 is down by nearly 14 
percent and, in fact, declined in all but the lowest quintile group. 
The number of D.C. households in the lowest national quintile group 
increased 14 percent in the 20 year period.\6\
---------------------------------------------------------------------------
    \6\ A recent study of the 100 largest cities finds that ``in just a 
handful of divided cities (7), including Washington, D.C., does the 
number of households at the extremes of the (income) distribution 
exceed that in the middle.'' The study finds the following for D.C., 
based on the U.S. Census of 1979 and 1999. Income groups are determined 
based on national quintiles.
    # Households Low Income Lower-Middle Middle Upper-Middle High
    1979   57,837 53,611  50,019 40,141  53,897
    1999   66,094 51,759  43,157 38,505  49,076
    Change +14% -3%    -14% -4%    -9%
    Source: Alan Berube and Thacher Tiffany, ``The Shape of the Curve: 
Household Income Distributions in U.S. Cities, 1979-1999, The Brookings 
Institution, August 2004.
---------------------------------------------------------------------------
    D.C. has lost middle-class population in a very pronounced way. 
This decline is closely entwined with the loss of school-age population 
as families have moved out; the rise in property values as higher-
income singles and couples have moved in; and the decrease in upward 
mobility because poorer people have fewer housing options as they work 
and improve their earnings capacity. Indeed, much of the out-migration 
is known to be of middle-income families looking for better housing and 
schooling opportunities.
    In recent years, the number of households in D.C. is growing again, 
but not the population. Many of these new households are higher 
income--a nearly necessary condition in a city where housing prices 
grew an average of 15 percent percent annually over the last 5 years 
and roughly doubled in the period. With only a 2 percent increase in 
households overall, the number of households with at least $100,000 
income grew by 27 percent in 2000-2004.\7\ Population has not grown 
because, as a generalization, the filers moving-in are single, or 
sometimes couples, while the filers moving-out are more likely to have 
children.
---------------------------------------------------------------------------
    \7\ American Communities Survey, U.S. Census, 2000 and 2004.
---------------------------------------------------------------------------
    D.C. is a core city and, like other core cities, the home of a 
disproportionate share of the region's poor, both those permanently 
poor and those working upward out of poverty. Housing prices that 
``squeeze out'' the middle-class pose serious obstacles for lower-
income earners. Without access to potentially better housing, they also 
have less access to better transportation, perhaps to safer 
neighborhoods and higher performing schools. The whole promise of 
upward mobility is damaged--except for those who leave.
    We believe that the Federal flat tax for D.C. would add to housing 
price pressures in the District. Given the recent demand for housing, 
especially among higher-income homeowners, it is hard to describe how 
much more dramatic the impact might be.
    We do not know how much the voluntary flat tax would add to price 
pressure. Because a flat tax neutralizes the favorable tax treatment of 
itemizers--most of these are homebuyers--additional housing price 
pressure is dampened. Compared to the current tax system, a person 
electing to use the flat tax would not be able to deduct either 
mortgage interest or real property taxes from taxable income, thereby 
limiting the boost to a potential offer-price for housing. However, if 
theorists are right and business demand rises for D.C. locations under 
a flat tax, then commercial users will bid up prices, shifting the 
property market somewhat away from residential land uses and further 
increasing housing prices.
    A New-View of the Federal/city relationship.--The similarity 
between the $1 billion possible initial revenue loss at the Federal 
level and the magnitude of D.C.'s structural imbalance of about $1 
billion is striking. Clearly the benefits of reduced Federal taxation 
will accrue to citizen and business taxpayers while the structural 
imbalance is a problem of local government. Still, thoughtful policy 
management could find a way to narrow the local budgetary problem as a 
result of this windfall. It is, after all, much like a negotiated 
middle between current Federal tax policy for D.C. and current Federal 
treatment allowed Puerto Rico where there is no Federal tax on local 
earnings. In Puerto Rico the state government receives the revenue from 
taxation of local earnings.
    Mr. Chairman, I thank you for holding this hearing and providing 
this forum. The possibility of a new, deeper, and better Federal/city 
relationship is very exciting. I look forward to any questions.

    Senator Brownback. Thank you very much, Dr. Gandhi. That 
was very interesting and very thorough. I want to ask some 
questions about that afterwards.
    Mr. Golden, Chairman of the Federal City Council, thank you 
for joining us.
STATEMENT OF TERENCE C. GOLDEN, CHAIRMAN, FEDERAL CITY 
            COUNCIL
ACCOMPANIED BY JOHN HILL, CHIEF EXECUTIVE OFFICER, FEDERAL CITY COUNCIL

    Mr. Golden. Thank you, Mr. Chairman, for allowing me to be 
here. I have to say I really appreciate the opportunity to 
speak to you and also to be on this board and panel that you 
are visiting with today. I think you have three of the 
strongest financial minds in our city to talk to you: 
obviously, Julia and Dr. Gandhi, who I think has been 
tremendous for our city over the long term; John Hill, who is 
now our Chief Executive Officer and was the head, the Executive 
Director of the Federal Financial Board that oversaw our 
improvement, really has a good grip on what's happening. So I 
am proud to be with them.
    Before I begin, I would like to first submit my record--my 
written statement for the record.
    Senator Brownback. It will be in the record.
    Mr. Golden. Thank you so much.
    I would like to begin by saying thank you to you, chairman, 
for all you have done for our city. The record of your 
committee in providing us with support through a lot of 
difficult challenges is greatly appreciated. I also want to 
thank you for your recognition of the challenges that are 
facing the District of Columbia. I cannot tell you how many 
times I have appeared and a number of us have appeared before 
groups similar to this without a real understanding of what 
pressures we face as the District of Columbia that are unique 
because we are the Nation's Capital.
    I also want to acknowledge the efforts that you have made 
on this flat tax. It represents a significant step forward and 
something that has the potential of making a real difference in 
the District of Columbia. So we really do appreciate what you 
have done and where you are headed overall.
    Dr. Gandhi talked about all the unique relationships of the 
District of Columbia and its special place in our country, and 
also the situation that occurs as a result of that. From my 
point of view, simply there are really two major issues that 
cause the business community and cause all of the taxpayers 
real concern. First of all, we do a lot of wonderful things for 
the Federal Government, for our leaders that come in and work 
here in the city, and for the 20 million individuals who visit 
our Nation's Capital. But clearly the bottom line is that the 
cost of doing this and running this city is very expensive. Our 
budget, both the Federal and District component, is $7.5 
billion a year. Imagine that for 570,000 residents, and when 
you begin to parse that out and look at who are actually paying 
taxes, as opposed to receiving benefits, it is an even greater 
struggle. So I think you are right on target in understanding 
some of the challenges that we face.
    I think all of us as businessmen are also very much 
concerned about the future outlook. Clearly we have had a great 
run in time, but we have also had some tremendous capital 
expenditures that we need to deal with in the future. 
Unfortunately, when the District became--responsibility for the 
District was transferred to its residents, what was also 
transferred to us was the burden of an infrastructure that was 
old, obsolete, and in tremendous need of repair.
    Today we start this year with a bond debt of about $4.4 
billion, which is roughly $7,000 per capita, which is the 
highest in the Nation. So we are already beginning with some 
tremendous challenges.
    When we look at the outlook of what we have got to deal 
with this infrastructure, things get even worse for us. The 
number one priority for us and I think for you and for the 
Congress and the Federal Government is we need to get a crime 
lab and a lab that deals with biohazards and all those things 
that are important. Clearly, we are the first responder in our 
city. We have an obligation to be prepared. The cost, however, 
for the residents of the District of Columbia for this crime 
lab is $200 million.
    We had--when the schools were transferred to the District, 
the average age of our schools I think was something like 63 
years old. Today we have looked and budgeted what the 
modernization of those schools is and it is over $2 billion.
    Our libraries also, which were in a state of disrepair, are 
going to cost us $250 million to improve. Our budget for roads 
and bridges is extraordinary. Just as a small indicator, we 
have over 300 bridges to maintain here in the District of 
Columbia.
    So what I am saying is our capital costs, we are already 
the highest per capita in the country in terms of capital 
obligations, and we have got the outlook of having another $4 
billion facing us over the next 10 to 12 years. So we are 
concerned. Clearly, as you have identified and as Dr. Gandhi 
has identified, we have severe limitations on our ability to 
tax and that has certainly had an impact overall.
    I think that when you look at this tax burden you cannot 
help but question the fact that over the last 3 years our 
population has gone from close to 800,000 down to some 570,000 
today. I would represent that the taxes and the tax burdens 
themselves have a direct impact on that. Most of the people 
that have left are middle class taxpayers and that is both 
African-American and white.
    So just to begin with let me say, do we need to do 
something? I think that we absolutely do. Senator Brownback, we 
believe that your flat tax does begin to address the District's 
financial needs. Until we have something, some specific 
legislation to look at, it is hard for us to respond in detail 
or make a final recommendation, and I think Dr. Gandhi's 
presentation of alternatives will take a week to go through and 
decipher exactly what begins to make sense and the like.
    But I would say, in the mean time we really can offer some 
general observations. First of all, let me say that we believe 
that anything that makes the District more attractive to live 
and work in and which increases its tax base is worthy of 
consideration. The fact that the proposed approach is optional 
is good. It allows low income taxpayers to continue to take 
advantage of the earned income tax credit and the other 
deductions that are available. So I think you have addressed 
some of the issues that a lot of people have raised.
    It is clear to all of us that under the flat tax the 
District would benefit financially. More people would move into 
the city, our District tax base would increase. The lower the 
flat tax is, the greater would be the impact overall. I think 
all of us are having a hard time with estimating exactly how 
many people would move in and we would have to do some careful 
analysis with that once the legislation got fleshed out. But we 
certainly see that the impact would be great.
    I think when we look at the legislation itself a host of 
issues need to be considered in evaluating the overall impact 
of the flat tax legislation. I think for existing and potential 
District taxpayers, I think they will be interested in knowing, 
one, the size of the personal exemption, whether mortgage 
interest payments are to be treated as deductions, the 
treatment of charitable deductions, and the level at which 
taxpayers begin to receive benefit from the flat tax.
    The real question is is the flat tax fair to all of our 
taxpayers. From the Federal Government's point of view, I think 
the issue is is the District-oriented flat tax good for the 
United States and good tax policy? Is the benefit to the 
District worth the Federal costs of the program or are there 
better alternatives for addressing the District's needs?
    I think from our point of view as the business community, 
we also want to take a careful look at this legislation for 
more than just its financial impact. Our relationship with the 
District and our attitudes have certainly changed over the last 
20, 30 years. The District community is committed to diversity 
within the District. We want to make sure that the new tax 
legislation does not have the unintended consequences of 
displacing the District's low and middle income residents. 
Clearly, the whole issue of gentrification is an issue in our 
city and I think, as with all major cities, the cost of living 
in the city and the cost of housing in the city is running the 
risk of displacing our low and moderate income residents.
    In conclusion, Senator Brownback, let me applaud you for 
your efforts to get District residents--to propose this 
legislation. We appreciate your desire to hear from us and 
other District residents. We also appreciate your desire to 
hear from our elected leadership. We would like to ask you as 
you prepare this legislation if we could not participate and if 
you could not work with the Mayor and our delegate and the 
District Council to see what we can do together.
    Most importantly, I guess in summation, I want to thank you 
again for your efforts on our behalf. We do have some major 
issues. We recognize that you understand them and we would like 
to work with you to see what we can do to make a better 
District and one that is worthy of being our Nation's Capital. 
Thank you very much.
    [The statement follows:]

                Prepared Statement of Terence C. Golden

    Good afternoon, Mr. Chairman, and members of the Committee. 
My name is Terry Golden and I am appearing before you today in 
my capacity as Chairman of the Federal City Council. With me is 
John Hill, who is the Council's Chief Executive Officer. As you 
may know, the Federal City Council is a nonprofit, non-
partisan, business supported civic organization dedicated to 
the improvement of the Nation's Capital. Founded in 1954, the 
Council's membership includes 200 of the top business, 
professional, educational, and civic leaders in the Washington 
metropolitan area.
    You have invited us to testify today on the possible 
effects of creating an optional flat Federal income tax for 
District of Columbia residents. We recognize that no specific 
legislation has been introduced and that a host of issues 
remain to be decided, such as the size of the personal 
exemption and whether deductions would be retained for 
charitable donations or mortgage interest payments. In view of 
the foregoing, we believe that it is difficult to say precisely 
what the effects of a flat tax in the District would be.
    However, in addressing the issue, we think a good place to 
begin is with a brief review of several key facts. First, as 
Senator Brownback has frequently acknowledged, the District of 
Columbia is unique in our country in that it has the 
governmental responsibilities of a city, a county, and a state. 
Among the costs that the District must bear with its own 
revenue are the costs of developing and maintaining a physical 
and human infrastructure (e.g. roads and bridges, mass transit, 
police, fire, and other first responders) that serves not only 
the City's 570,000 residents but the half million daily 
commuters who work in the District and the 20 million annual 
visitors to the Nation's Capital. While being the Nation's 
Capital confers many advantages on the District, one 
disadvantage of Washington, D.C. being the seat of the Federal 
government is that more than 40 percent of all District 
property is not subject to local property taxes because it is 
owned by the Federal government, foreign governments, or 
international organizations. Also, the District is uniquely 
disadvantaged in that Congress has explicitly prohibited it 
from taxing at the source the income of persons who work in the 
District but reside elsewhere. The net effect of this 
prohibition is that 70 percent of all income earned in the 
District cannot be taxed by the District to support District 
municipal services.
    Senator Brownback, as you pointed out in your opening 
statement at this Subcommittee's hearing on March 8th, the 
cumulative effect of these Federal restrictions on the 
District's tax base has led City leaders to impose on District 
residents and businesses a very high tax burden. As you also 
noted, this high tax burden undoubtedly is one reason why the 
City's population has declined over the past several decades 
while the neighboring jurisdictions have gained population.
    We believe that as a general proposition, anything that 
makes the District a more attractive place to live and work and 
that enables the District to grow its tax base is worthy of 
consideration.
    As we understand your thinking, your proposal would give 
District residents the option of continuing to pay their taxes 
under the current Federal tax system or they could opt for the 
flat tax. Permitting residents to choose is especially 
important in this City as many of our low income residents 
avail themselves of the Earned Income Tax Credit and we 
wouldn't want to see them barred from doing so.
    Under a flat tax, the District would benefit financially 
and more people, including a number of people of substantial 
net worth, would likely move into the City. We believe that the 
prospect of substantially lower Federal taxes unquestionably 
would be an incentive to move into the District. How many 
people would do so, however, is anybody's guess. It's worth 
noting that today, in the absence of a flat tax, the District 
is experiencing unprecedented growth in its housing stock and 
is attracting a substantial number of upper income households.
    One concern that has been expressed about a flat tax is 
that it could lead to more displacement as wealthier households 
displace lower income residents from established neighborhoods. 
The District's business community is committed to the strength 
of a diverse community and to the idea that the District should 
be a community in which all are welcome, irrespective of 
income, race, ethnicity, or household composition. We believe 
that the issue of displacement is complex and that there are a 
host of variables that influence where people choose to live. 
Should you decide to develop legislation, we would urge you to 
give this matter the serious attention it deserves and, more 
generally, we would urge you to work with the District's 
elected officials if you decide to put forward specific 
legislation.
    Finally, we believe that the aggregate loss in Federal tax 
revenue resulting from a D.C. flat tax could be considerable. 
While we agree that establishing a flat tax for the District 
undoubtedly would lead to more locally raised tax revenue for 
the District government, whether this is a tax efficient way to 
make additional resources available to the District is a matter 
that should be more fully explored.
    Whether--or how much--net new economic activity and jobs 
would be created in the District by a flat tax is unknowable 
but we certainly agree that enhancing the District's ability to 
raise revenue while enabling the City to lower its own local 
taxes is a goal we all share.
    We thank you for your commitment to strengthening the 
District's economy and for your interest in making the City an 
even better place to live, work, and visit.

    Senator Brownback. Thank you, Mr. Golden.
    I understand, Mr. Hill, you are just here for questions; is 
that correct? Or do you have a statement?
    Mr. Hill. No, I do not have a separate statement.
    Senator Brownback. Okay, good.
    Thank you for the comments and thoughts. I want to start 
off at the end and maybe work backwards here. Dr. Gandhi, one 
of the first meetings that you and I had when I took over this 
position was you were discussing with me the structural 
imbalance of the District and you were saying, look, we are $1 
billion short annually. There seemed to be two main proposals 
that you were bringing forward at that time. Now, maybe there 
are other options, but as I was seeing it one was discussion of 
a commuter tax, so that people that come in, work in the 
District, help pay the costs within the District. The second 
one was a Federal subsidy of some form or another to help make 
up for the Government taking 40 percent of the property.
    Are there other options, absent this option of a flat tax. 
But are there other options available for that disparity?
    Dr. Gandhi. I think basically from the Federal Government 
perspective those are the key proposals that should be 
considered. But I do not have any illusions about the commuter 
taxes, nor do I have any illusion where the Government, the 
Federal Government, would just give away $800 million or so or 
$1 billion or so. So the question then is how can we find a 
way, one, to provide incentives for people to move to the city.
    The heart of the matter is, as you pointed out, sir, that 
we have lost population. There were 100,000 more people living 
in the city. They are not living there today. My issue here is 
that if you live in the city you pay city's taxes. I do not 
care where you work, Virginia, Maryland, whatever. So how do we 
make city more attractive place to live, so that once you live 
in the city you pay city's taxes?
    Now, as we have pointed out in our testimony, there is some 
demographic shift in this, in our households. But our 
population is not increasing. So we have to find a way in which 
to bring more people in the city.
    Obviously, if there is a commuter tax here, that would be 
great. If we have a subsidy from the Federal Government, it 
would be even better. But I just do not have any illusions 
about that, sir.
    Senator Brownback. Neither do I have any illusions about 
that, because when I chaired the D.C. authorizing committee at 
the very outset people were bandying around a commuter tax. I 
heard clearly from one Virginia Senator quite quickly about 
that and I anticipated I would hear from the other and the 
Maryland Senators and some others possibly, too, on that pretty 
quickly. Then just the notion of a direct Federal subsidy in 
the quantities that would be needed is pretty hard to imagine 
in this budgetary environment.
    So part of the reason for putting this forward was to offer 
another alternative of how you can make up for some of that 
lost ground.
    You talked about, and maybe you hit it, about what would be 
the impact on businesses moving to the District. You go through 
a pretty good analysis, it seems like to me, from your office's 
perspective, about what happens to individual filers and what 
is likely to happen there. But I do not get as much of a feel 
from you on what you think would happen to businesses moving 
into the District. Do you have that or have I just missed it or 
is that just too hard?
    Dr. Gandhi. No, sir. I think it is very difficult to gauge 
as to how many businesses will move in unless we know a 
concrete proposal, a very defined proposal with some specific 
provisions. The fundamental point in the case of businesses is 
their ability to expense their investment in the year in which 
they would incur the cost. That will be the fundamental 
attraction for them. So to the extent that we can do that, that 
would be a great incentive on the part of the businesses to 
come in.
    But at the same time, the issue would be what about the 
businesses that already have a lot of inventory on their hands, 
a lot of equipment already on their hands? Generally, they 
claim the cost of goods sold, their depreciation, as tax 
deductions. So it depends upon what kind of transition rules 
you would provide, what kind of specific flat tax proposal you 
will provide for the businesses. All that will be a part of 
basic consideration for businesses to move into the city.
    Further, they also want some kind of certainty. If they 
were to view this merely as a pilot project or an experiment 
for, say, 5 years, then my sense here is that they would be 
hesitant to move into the city, primarily because what happens 
after 5 years? So all these considerations are critical.
    But the bottom line here is that businesses are looking at 
all times to reduce their costs. Tax is one of the most 
fundamental costs of doing business. So let us keep that in 
mind. Once you have a proposal that is far more defined, with 
specific rules, the transition requirements, then I think it 
would be better for us to be able to work with you and come up 
with numbers as to what our expectations are about businesses 
moving into the city or moving out of the city.
    Senator Brownback. Now, one of the people that testified at 
the last hearing said what an optional flat tax in the District 
would create a super-charged enterprise zone, in his 
terminology. What do you think of that as a descriptor for what 
this would do?
    Dr. Gandhi. Sir, it does provide basically a safe harbor 
for people to say, look, if I do not like flat tax I will take 
the current tax if I am better off doing it that way. Again, it 
depends upon taxpayers, either individual or business, as to 
how they are located in their tax situation. If I am a 
taxpayer, a business taxpayer, with a lot of inventory on my 
hands, a lot of investment already on my hands, then my 
preference will be to stay with the current system because it 
allows me to take depreciation and cost of goods sold as my 
expenditures.
    But if I were a new business coming into the city, then I 
can write off all my taxes as far as the investment and the 
purchases are concerned. So again, it depends upon what kind of 
specific provisions do we have for flat tax, what kind of 
transitional rules are we going to provide, and, given that you 
would give them a choice--hey, pick what you would like--it 
removes their initial concerns or fears about coming to the 
city.
    Senator Brownback. But overall you like the option of a 
flat tax for creating growth, economic growth and vitality in 
the District.
    Dr. Gandhi. I think there is a great promise. But let us 
keep in mind, sir, if you look at my table 1 that we have in 
the testimony, what you see in the table is a very uneven 
distribution, almost a bimodal distribution, of our taxpayers. 
So if you look at the taxpayers, say roughly 4 percent of them 
are paying 44 percent of the taxes, 17 percent of them paying 
71 percent of our taxes. So if you have a flat tax here, what 
will happen is that there will be a substantial redistribution 
of taxes moving toward lower income taxpayers.
    As you can see from the chart, roughly half of our 
taxpayers just do not pay taxes. So the question for us then is 
how are you going to make up for the lost revenue?
    The second issue that we want to keep in mind here is that 
it would have social implications. So I think it is better for 
our policymakers, the elected leaders, the Mayor and the 
Council, to grapple with these issues before coming to a 
conclusion that the flat tax is the right thing to do.
    Senator Brownback. You noted that and that is a proper 
thing to note, is the social impact of this. You do not address 
that here and that is a proper thing to note. But I am just 
trying to get your outlook from the fiscal position on this. 
Now, if it is that you do not think this is a good idea 
fiscally for the District, then please state so as well.
    Dr. Gandhi. As I pointed out, to the extent that it would 
bring in high income individuals or taxpayers, businesses, to 
the city, it is better off for the city in terms of it is going 
to raise our tax intake. As I just said, if you just add 500 
people, 500 taxpayers at $200,000 or above in that income you 
are generating $30 million, just 5 percent. Ten percent would 
roughly double that.
    So it would bring in people here that will pay more taxes. 
Two, it would also provide a lot of disposable income. Because 
these people are not paying taxes, they would have more to 
spend. So that could provide a lot of economic activity to the 
city.
    The question that we want to keep in mind, however, is that 
one cannot simply look at flat tax from fiscal perspective, as 
you know better than I, and that is where the concerns are.
    Senator Brownback. The District has been losing population 
for 50 years. The surrounding suburbs have been growing 
rapidly. Why? We note the tax differential, but it cannot be 
exclusively that.
    Dr. Gandhi. That is correct, sir. There are several 
considerations. Tax is one of them. As you have pointed out and 
we have pointed out in other testimony, we have a very high tax 
rate, even though the Council and the Mayor have engaged in a 
tax parity initiative whereby we are reducing our taxes. But 
for a long time our tax rates have been very high, higher than 
regional jurisdictions and, as I pointed out, higher than 
practically all States except two in the country. So that is 
one very important consideration.
    But at the same time, 10 years ago we had a major public 
safety issue here. Schools are a major problem even today, even 
though we have a very energetic superintendent and the city has 
committed to put a lot of money in our school infrastructure. 
But still, if you are a family with young children, schools are 
a very, very important consideration.
    The last of all is an affordable housing crisis. The city 
has a major problem in being able to provide housing at an 
affordable level. So when you put all these things together, we 
have lost a substantial number of people as you pointed out, 
sir.
    Senator Brownback. What is the city doing to encourage 
middle class families to move into the city?
    Dr. Gandhi. Well, as I pointed out, the city is engaged in 
lowering our tax rates. Now from something like 9.5 at one 
point in time, now our tax rate will be around 8.7 beginning 
this year. Further, we have substantially improved our public 
safety environment. As I pointed out, the schools are a major 
priority for the Mayor and the Council. I think all in all the 
city is also engaged in providing a lot of funding for 
affordable housing.
    But all this will take time, I would say close to 5 to 10 
years, before we could turn around the corner on that.
    Senator Brownback. I want to look at the number of married 
filers in the District.
    Dr. Gandhi. Yes, sir.
    Senator Brownback. You testified that it was at only 20 
percent compared to 45 percent nationally.
    Dr. Gandhi. Yes, sir.
    Senator Brownback. Now, has the number of married filers in 
the District declined over the decades and what is the reason 
for this?
    Dr. Gandhi. Well, again I think that has been the case. If 
you are married with children, schools are extremely important. 
And if we cannot provide adequate academic environment here, 
people with children would leave, and we have seen people 
leaving. The out migration that we have seen are basically with 
the families with children. The in migration that we have seen 
are the households which are basically single people or two-
income, no children families.
    The question at the end of the day is for any married 
couple, with or without children, are we going to be safe here? 
When we have children, will we have good schools to send our 
kids to, and can we afford to live in the city? Those are the 
key considerations, and the Mayor and the Council have been 
engaged very deliberately in a very considered effort to 
improve on those fronts. But as I pointed out, it will take 
some time.
    Senator Brownback. Mr. Golden and Mr. Hill, I talked at the 
outset with Dr. Gandhi about the other sourcing for 
infrastructure money. You noted the infrastructure needs that 
you have here, budgetary needs that you have, $2 billion needed 
for schools, $200 million for a crime lab. I thought you said 
$4 billion for roads and road needs. I do not know if you put a 
number on that.
    Mr. Golden. No, we did not.
    Senator Brownback. Okay. I know the number is large. But do 
you have another option for creating tax revenue for the 
District outside of the two, three we have talked about today, 
a Federal subsidy, a commuter tax, or a flat tax that creates 
more growth? Do you have another option?
    Mr. Golden. I really do not think there are----
    Senator Brownback. I do not think that mike is on.
    Mr. Golden. There we go. Is that better?
    Senator Brownback. Yes.
    Mr. Golden. I am not sure that there are a lot of great 
options there. Clearly, as far as our capital needs are 
concerned, as far as issuing further debt or something of that 
sort, we are getting very close to the overall limit. I think 
Dr. Gandhi has placed a cap on our city of about 11 percent of 
our total budget being used to pay debt service on our bond 
debt and so forth. When you look at we were already over $4 
billion in indebtedness and the number was a total of around $4 
billion, including education and a lot of other factors, we are 
at a limit there.
    I do not think we can necessarily tax our way out of that 
dilemma. So it is a major issue for us. I think clearly what 
you are pointing the direction in is the direction of getting 
more people inside the city, both businesses and individuals, 
to share the burden. And I think that that is clearly a good 
strategy.
    I also do think that the Federal Government continues to 
have an obligation. You know, the crime lab is there to serve 
our responsibilities as being a first responder, as an example. 
We were saddled when we became in charge of our own welfare 
here in the District, the residents had voting power, we were 
saddled with an overall burden from the Federal Government from 
years past of, as an example, the schools of $2 billion of 
facilities there.
    So it just seems to me to push that off on another group of 
taxpayers when in fact the Federal Government left the District 
in a very--when you left it to the District it was 570,000 
residents, but very few taxpayers. I do think there continues 
to be a Federal responsibility for addressing some of those 
issues.
    Dr. Gandhi. If I may comment on that, Mr. Chairman. I think 
the fundamental point that we want to remember here is that, 
even though we enjoy being the Nation's Capital and we are very 
proud of being host to the Nation's Capital, but basically the 
city is paying roughly $500 million annually for what I would 
call a state-like function, like how many States--how many 
cities run universities or Medicaid or mental health or a tax 
department?
    We have to carry all these expenditures on our shoulders 
and we cannot afford to do that. As Mr. Golden pointed out, you 
cannot tax any more. Indeed, we are going the other way. We are 
trying to reform our taxation and lower the tax rates. And also 
we cannot borrow any more. I have already pointed out to our 
Mayor and the Council that if we want to borrow any more it 
would have negative impact on our bond ratings and we do not 
want to go there.
    Senator Brownback. You noted at the end of your testimony 
that this is kind of a halfway step between what we do now and 
Puerto Rico.
    Dr. Gandhi. Yes, sir.
    Senator Brownback. Where we have no Federal tax, tax on 
local earnings.
    Dr. Gandhi. Yes, sir.
    Senator Brownback. Why do you make that analogy and 
example? You view this as a way of creating that type of half 
step, or just that that is a convenient shorthand way of 
looking at what this would do?
    Dr. Gandhi. I would like to do it full way. We would like 
to basically keep all the local taxation in the city. We pay 
roughly $2.5 billion every year from the District to the 
Federal Treasury in income taxes. That is a lot of money to be 
paid for a jurisdiction that is not a State. My sense here is 
that the Puerto Rican solution is an excellent one.
    But the question is, do I have illusions about that? I do 
not think so. The important point, however, is, how do we get 
some way to expand our tax base? Our Mayor had, oddly enough, 
said that his goal was to bring in 100,000 more people to the 
city. To repeat myself, if you live in the city you pay city's 
taxes. So how do we increase our population, taxpaying 
population? The more important thing here is that we have to 
improve our schools, our public safety environment, we have to 
make our housing affordable, and our taxes have to be far more 
competitive with our region's, because we are competing against 
world-class jurisdictions--Fairfax, Montgomery. One Metro stop 
and you are in Fairfax or in Montgomery County.
    Senator Brownback. But if you created zero Federal income 
tax in the District, say that if we are going to be here but 
not represented, taxation without representation, then how 
about pulling the taxation off. Would you not take your social 
issues that you have been very deeply concerned about and 
mentioned here, would you not exacerbate those even greater if 
you had zero Federal tax here?
    Dr. Gandhi. Well, I think the important thing is that we 
have to make sure that even if there is a flat tax here the 
District's taxes also have to be moderate, that we cannot be--
we cannot simply compensate, that whatever you were paying to 
the Federal Government now you pay to the District government. 
I do not think that would work. The question here is that we 
ought to provide an economic environment here whereby we can 
have more people come into the city and do business and leave 
peacefully.
    Senator Brownback. I agree with that. It is just it seems 
like that if you had a zero Federal tax place here in the 
District of Columbia, your charts that you were talking about 
skewing people that would be attracted here go off the charts 
at that point in time. Then you have got a lot of people with 
substantial income saying, all right, I have got a real place I 
want to live now.
    Are your concerns not magnified?
    Dr. Gandhi. That is where the political and the social 
policy issues come into play. That is the decision that the 
elected leaders and you, sir, would have to make as to what 
kind of Nation's Capital do we want, who do we want to live 
here. That is a very, very important question. I really do not 
have answers for those questions.
    Senator Brownback. I am just trying to kind of pin you down 
where you are on this and I am having difficulty really trying 
to ascertain that, Dr. Gandhi.
    Dr. Gandhi. These questions are beyond my----
    Senator Brownback. But I think I understand what you are 
saying.
    Dr. Gandhi [continuing]. Beyond my pay scale, sir.
    Senator Brownback. That economically this is a big plus, 
but you have got other considerations as well.
    Dr. Gandhi. That is correct, sir.
    Senator Brownback. But economically that is why I offer my 
State up. If you would let us do it, I would be very happy 
about that. I recognize there are other considerations to it 
and there always are in tax policy because those have social 
impact to them as well.
    Well, thank you. I am appreciative of your thorough 
analysis, particularly on the individual rates and impact and 
individual income tax options. I think we ought to be able to 
take those same sorts of options and put them in a business 
framework and be able to determine what would happen to 
business activity. But maybe that is too much to try to model. 
It would be interesting to see that, but that is something we 
can try to generate from Federal sources of that type of 
information, because my guess is there would be a substantial 
impact on business creation and formation in the District of 
Columbia if there was stability to that type of system, and we 
will have to see what that is.
    Dr. Gandhi. And we will work with you, Mr. Chairman, to 
refine the proposal and also come up with some scenarios as to 
how businesses can be expanded with a different kind of flat 
tax.
    Senator Brownback. Mr. Hill.
    Mr. Hill. In answer to your previous question about other 
ways that it might be possible to increase and expand the tax 
base for the District, there are a number of parcels of land in 
the District that are currently owned by the Federal Government 
and also ones that are being looked at in terms of 
redevelopment. The ability to take some of that property and 
put it into the tax base for the city could have significant 
benefits for the city.
    The Mayor in his plan to increase the number of taxpayers 
by 100,000 also included as part of that not just bringing new 
people into the city, but trying to address the literacy issue, 
which keeps a number of our citizens out of the workforce and 
therefore makes them not qualified to take some of the jobs 
that are even created here, so that people from outside the 
city have to come in because they are more qualified to take 
those jobs.
    So I think that a combination of those factors as well as 
the State functions issue that Dr. Gandhi made could have a 
significant impact on additional revenue for the city.
    Senator Brownback. Okay. Has the Federal City Council 
identified those parcels that you would like to see conveyed 
from the Federal Government to the District?
    Mr. Hill. Well, there certainly is one parcel now that is 
under discussion, Walter Reed Hospital, and what should happen 
with Walter Reed. It is clear that the District is very 
interested in the possibility of developing that in a way that 
it could bring in new residents and also bring in additional 
businesses to that area. Certainly the State Department is 
interested in it for the possibility of having additional 
Embassies, which would further exacerbate the problem of having 
this property in the tax base, as well as the General Services 
Administration (GSA) is interested in it in order to provide 
additional space for government facilities.
    So of those three competing uses, it is quite clear that 
some of the uses that the District would want for that property 
would help. And I know that the city has looked at other 
parcels of land as well that could potentially be transferred 
to the city.

                         CONCLUSION OF HEARINGS

    Senator Brownback. Good. Thank you all very much for your 
time and effort and your analysis on this. If you have 
additional statements you want to put into the record, please 
let us know.
    Julia, I want to thank you particularly as the economist. I 
know you did a lot of the work on this analysis and I 
appreciate all that effort and focus in your doing that.
    The hearing is recessed.
    [Whereupon, at 2:43 p.m., Thursday, March 30, the hearings 
were concluded, and the subcommittee was recessed, to reconvene 
subject to the call of the Chair.]

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