FLAT TAXES AND EFFECTIVE TAX PLANNING - NTA ... TAXES AND EFFECTIVE TAX PLANNING 691 individual and business taxable income.8 The tax is administered at two levels. First, an individual

FLAT TAXES AND EFFECTIVE TAX PLANNING

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FLAT TAXES ANDEFFECTIVE TAXPLANNINGMICHAEL CALEGARI *

Abstract - Stiglitz (1985) shows thatincome deferral opportunities anddifferentially taxed economic activitiesprovide incentives for investors toengage in tax avoidance strategies. Inthis paper, I describe several tax avoid-ance strategies that can be used bytaxpayers in a Hall–Rabushka flat taxsystem to reduce or eliminate their taxliabilities. Effective tax planningcontinues to be viable in a flat taxregime because the idealized environ-ment envisioned by the proposal doesnot consider taxpayers’ strategicresponse to the new system. These taxplanning techniques can affect eco-nomic behavior, compliance andenforcement costs, and the distributionof the tax burden.

INTRODUCTION

Hall and Rabushka (1995) present asimple flat tax regime that eliminatesmany current sources of income anddeductions.1 Their proposal has beenembraced by many politicians and hasbeen introduced as legislation in the

U.S. Congress by Representative DickArmey and Senator Richard Shelby.2 Itsproponents claim that replacing thecurrent income tax system with the flattax will increase personal savings andbusiness investment, reduce interestrates and compliance costs, and curtailincentives and opportunities for taxevasion and tax avoidance (e.g., Armey,1996; National Commission on Eco-nomic Growth and Tax Reform, 1996).

In the current income tax system,taxpayers can successfully reduce theirtax liabilities by engaging in effective taxplanning. According to Stiglitz (1985),effective tax planning is based on threegeneral principles: postponing taxesfrom the current period into futureperiods, arbitraging across differentincome streams facing different taxtreatment (source-based arbitrage), andshifting income from high tax bracketsto low tax brackets (rate-based arbi-trage).3 By flattening tax rates, eliminat-ing double taxation, removing distinc-tions between ordinary and capital gainincome, and denying any offsets tocompensation or retirement income, theflat tax proposal removes severalpopular techniques that have tradition-ally been used to avoid income taxes.Hall and Rabushka claim that theirsystem is “airtight” in the sense that

*School of Accountancy, College of Business Administration,

Georgia State University, Atlanta, GA 30303.

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individuals and businesses would beunable to escape taxation by takingadvantage of exclusions, deductions, orcredits. Some supporters of the proposalsuggest that tax specialists such aslawyers and accountants will becomesuperfluous in a flat tax system (e.g.,Hoven, 1995; Sease and Herman,1996).

Notwithstanding the claim that the flattax system is airtight, however, the Hall–Rabushka proposal continues to providetaxpayers with opportunities to engagein effective tax planning.4 In this paper, Idescribe several simple tax avoidancestrategies that can be used by taxpayersto reduce or eliminate their tax liabilitiesin a flat tax regime.5 These strategiesexist because taxpayers can apply thethree principles of tax avoidance in theproposed flat tax system. Some of thesestrategies exist because the Hall–Rabushka flat tax removes barriers thatCongress has enacted over the years toforestall certain tax avoidance behavior.Other tax avoidance strategies takeadvantage of new opportunities that arenot available under the current taxregime.

The analysis in this article can affectinferences drawn from prior studies thatdo not consider the opportunities foreffective tax planning in a flat taxsystem. For example, studies thatexamine the distributional effects of aflat tax without regard to tax avoidancestrategies (e.g., Gravelle, 1995; U.S.Department of the Treasury, 1996; Gale,Hauser, and Scholz 1996; Dunbar andPogue, 1998) probably overstate the taxburden placed on high-income taxpay-ers who are best able to make effectiveuse of these strategies. It is also likelythat existing studies overstate thenegative effect of a flat tax on charitablecontributions because they do notincorporate taxpayers’ incentives to

engage in tax avoidance strategiesinvolving exempt organizations.6

In addition to analyzing and describingsome of the tax planning opportunitiesthat are available in the proposed Hall–Rabushka flat tax system, I also describeseveral possible modifications to theproposal that can reduce or eliminatethese tax avoidance opportunities.Unfortunately, many of these modifica-tions introduce more complexity into thesystem. For example, some of the taxstrategies that involve exempt organiza-tions and retirement plans can becontained by including limitations ontheir use and imposing taxes on certainactivities and transactions. Althoughthese modifications detract from thebeauty of the original proposal, theyare, I believe, a necessary step in theprocess of transforming the theoreticalflat tax model to a practical alternativeto the current income tax system.

The remainder of the paper is organizedinto eight sections. The first sectionsummarizes the Hall–Rabushka flat taxproposal.7 The second section definesthe analytical framework and identifiesassumptions that are used in analyzingthe tax avoidance strategies. The third,fourth, and fifth sections describe, inturn, tax postponement strategies,source-based arbitrage strategies, andrate-based arbitrage strategies, whichare available in the Hall–Rabushkaproposal. The sixth section discusses theeffect of these strategies on tax compli-ance. The seventh section presents somesuggestions for modifying the flat taxproposal to reduce tax planning oppor-tunities described in this paper. The finalsection offers some concluding remarks.

THE FLAT TAX PROPOSAL

The Hall–Rabushka flat tax proposalimposes a 19 percent tax rate on all


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individual and business taxable income.8

The tax is administered at two levels.First, an individual wage tax is imposedon individuals with compensation andretirement earnings in excess of apersonal allowance. The personalallowance is a standard deduction thatincreases with the number of depen-dents. Other types of personal expenses(e.g., alimony, medical, taxes, interest,donations, and employee businessexpenses) are not deductible.

The business tax is imposed on allbusinesses with positive taxable income.When business taxable income isnegative, the resulting negative tax iscarried forward as a credit againstfuture year taxes. The amount of thecarryover is augmented by an interestrate determined by the average dailyyield on three-month Treasury bills.

Each sole proprietorship, partnership,and corporation constitutes a business.A business may file any number ofbusiness tax returns for its varioussubsidiaries or other units, provided thatall business receipts are reported in theaggregate and that each expenditure forallowable business deductions isreported on no more than one return.9 Ifan individual operates as both anemployee and a business owner, thenthe taxpayer files two separate returns.Individual taxpayers who pay businesstaxes on their proprietorship income cantake advantage of the personal allow-ance by paying themselves a “wage,”which is deductible for business taxpurposes. For individual wage taxpurposes, however, compensatedindividuals cannot carry forward lossesfrom tax years with negative taxableincome.

Business taxable income is defined asbusiness receipts less allowable deduc-tions. Business receipts include sales

revenue, gross rents, royalties, and grossproceeds from the sale of property usedin a business. Business receipts alsoinclude the market value of propertyand services that the business providesto its owners or employees. Allowablebusiness deductions include compensa-tion paid to employees, the cost ofproperty used for business purposes,travel and entertainment expenses, andother expenditures incurred in carryingon a business. Businesses cannot deductthe cost of charitable donations,interest, dividends, payroll taxes, oremployee fringe benefits (other thanpension contributions).

Under the Armey–Shelby plan, busi-nesses must include as income themarket value of property or servicesreceived in connection with an ex-change of property or services.10 Thisprovision would require some businessesto recognize income upon the reorgani-zation or incorporation of an existingbusiness.11 For example, corporationswould be required to report as incomethe market value of business-useproperty transferred to a subsidiary inexchange for stock. In the Hall–Rabushka proposal, it is not clearwhether the transfer of business-useproperty to a corporation for corporatestock is a taxable event (Feld, 1995).

Businesses are allowed to deduct thecost of all contributions to pension andretirement plans. Since discriminationrules and contribution limits are absent,businesses can target their retirementplans to fit the special needs of eachemployee. Similar to current law,employees are not required to recognizeincome from pension contributionsuntil they receive distributions fromthe retirement plan. However, individu-als are not allowed to deduct contribu-tions made to individual retirementplans.


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Income from investments and personalactivities is excluded from taxableincome. Likewise, gains and losses fromsales of investment and personal-useproperty are tax exempt. Estate and gifttax provisions are eliminated. Sincebusinesses are responsible for payingtheir own taxes, owners of partnerships,S corporations, and limited liabilitycompanies will no longer report theincome and losses of these entities ontheir separate returns. Instead, eachentity files a separate return.

Each employer is required to withholdflat taxes from the wages, salaries, andpensions of its employees and to remitthe withheld amounts to the InternalRevenue Service (IRS). The balance ofthe individual wage tax liability iscalculated and paid in the followingyear. On the other hand, businesses donot pay any estimated taxes during thetax year; instead, businesses pay theirentire flat tax liabilities in the yearfollowing the tax year. The due dates ofthe individual wage tax return and thebusiness tax return are not specified inthe proposal.

ANALYTICAL FRAMEWORK

The primary goal of effective taxplanning is to reduce the total tax bill ofthe taxpayer. Stiglitz (1985) identifiesthree basic principles of tax avoidancethat can be used by taxpayers in anincome tax system. These basic prin-ciples are (1) postponing taxes from thecurrent period into future periods (e.g.,deferring compensation income untilretirement or postponing realization ofcapital gains); (2) using source-basedarbitrage techniques to take advantageof differential treatment afforded todifferent types of income (e.g.,arbitraging between short-term andlong-term capital gains tax rates ordeducting interest on borrowed funds

used to finance tax-exempt invest-ments); and (3) taking advantage ofrate-based arbitrage opportunities thatoccur because tax rates change overtime or differ across taxpayers (e.g.,timing capital gain realizations tocoincide with periods of lower incomeor using intrafamily transfers to moveincome from high-tax-rate members tolow-tax-rate members).

According to Stiglitz (1985), opportuni-ties for tax avoidance depend on theextent to which a tax system allowstaxpayers to exploit these three prin-ciples. The availability of these taxavoidance principles also depends ondifferent aspects of the tax system. Thefirst principle, postponing taxes,depends on the method of accountingused in measuring the tax base and thetiming of the tax payment. Stiglitzobserves that tax postponementopportunities are a concomitant of cashbasis tax systems. In a cash basis flatrate consumption tax, which settlestaxes on a daily basis (e.g., a retail salestax), shifting income and deductions fora few days has little benefit. In the Hall–Rabushka flat tax system, however,businesses that defer cash receiptsacross tax years are able to postponetaxes for at least one year. Consistentuse of this strategy in a stable orgrowing business is the same as apermanent deferral of the tax.

The second principle, source-basedarbitrage, depends on legislatedexclusions or preferences. The flat taxsystem is especially vulnerable to source-based arbitrage strategies because itexcludes several sources of income fromtaxation. For example, sales of invest-ment property or personal-use propertydo not result in taxable income. Conse-quently, incentives exist for taxpayers toconvert business income to eitherinvestment or personal-use income.


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The third principle, rate-based arbitrage,depends on the availability of differingmarginal tax rates. In a flat tax system,individuals have two tax brackets: theflat rate and zero. Retirement plans andexempt organizations are also not taxedon their business or investment income.Therefore, individuals who are subject toa high marginal tax rate (i.e., withcompensation or retirement income inexcess of their personal allowance) havean incentive to move their income intoyears in which they are subject to lowtax rates (i.e., with compensation orretirement income below their personalallowance) or engage in transactionswith individuals or entities that aresubject to the zero tax rate.

However, effective tax planning and taxavoidance are not the same thing.Scholes and Wolfson (1988) show thatthe pursuit of a myopic tax avoidancestrategy can introduce significant nontaxcosts. For example, businesses thatattempt to postpone their tax liabilitiesin a flat tax system by borrowing topurchase equipment may inadvertentlylock themselves into suboptimalinvestments that are costly to reverse.Market frictions may also imposeadditional costs on a tax avoidancestrategy (Stiglitz, 1985; Scholes andWolfson, 1988). Stiglitz also points outthat the effect of a tax avoidancestrategy cannot be analyzed by lookingat its effects on a single taxpayer.Transactions that reduce one taxpayer’stax liability may increase the tax liabilityof others. For example, in a flat taxregime, the proceeds of the sale ofbusiness-use property must be recog-nized as income by the seller, whichoffsets the tax benefits of the deductiontaken by the buyer (Hall and Rabushka,1995). As long as the buyer and theseller are in the same marginal taxbracket and the seller recognizes incomein the same tax year that the buyer

deducts the payment, the governmentwould be indifferent to a tax strategythat defers taxes through postponingsales or accelerating purchases. In fact,buyers that engage in this form of taxavoidance may be merely replacingexplicit flat taxes with implicit taxes inthe form of higher asset prices.12

In contrast to the myopic goal of taxminimization, Scholes and Wolfson(1992) suggest that effective taxplanning requires taxpayers to consider(1) the tax implications of a proposedtransaction for all parties to the transac-tion; (2) explicit taxes, implicit taxes, andtax clienteles; and (3) the costs ofimplementing various tax-planningstrategies. For example, in pursuing atax avoidance strategy based onacquiring additional assets, the buyershould attempt to contract with a sellerwho is not subject to flat taxes (e.g., anexempt organization or a seller ofpersonal-use property). If the expectedcosts of identifying a tax-exempt sellerand negotiating a sales contract exceedthe tax benefits, however, the buyershould pursue a different strategy.

The tax avoidance strategies describedin this paper generally follow theseguidelines. For example, tax strategiesthat involve sales contracts considerboth parties to the transaction. Inorder to facilitate the analysis, how-ever, I make several simplifying assump-tions.

Assumption 1: Given a choice betweentwo different contracts for the purchaseof the same good, a consumer willchoose the contract with the lowestpresent value of cash payments.

Assumption 2: When determining theoptimal contract, business managersand consumers will consider the taxconsequences of the contract provisions.


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These first two assumptions concerntaxpayer behavior. The first assumptionindicates that the structure of thetransaction does not affect theconsumer’s decision. For example, inconsidering whether to lease or buyproperty, the consumer is not concernedwith intangible preferences such aspride of ownership. The first assumptionalso shows that the consumer is notaffected by framing effects or otherbehavioral anomalies. The secondassumption ensures that individualsand business managers correctlyunderstand the tax consequences oftheir behavior.

Assumption 3: There are no taxes otherthan the flat tax.

In the current economic environment,there exist several taxes other than thefederal income tax that can providepotential obstacles to the implementa-tion of effective tax planning in a flat taxregime. For example, transfer taxespresent an additional cost to flat taxminimizing strategies and state andlocal governments may continue to taxinvestment income and restrict theimmediate deduction of propertyacquisitions. On the other hand, the taxbenefits that result from using tax plan-ning strategies in a federal flat taxregime will be enhanced by state andlocal governments that convert theircurrent income tax system to a flat taxstructure. Social security taxes may alsoconfound or magnify the benefits of thetax strategies (Calegari, Key, and Smith,1996). The third assumption eliminatesthe confounding effects of theseadditional taxes.

Assumption 4: The form of the transac-tion determines the tax consequences ofthe transaction.

The fourth assumption is necessary toavoid the lengthy and tediousboilerplate that tax planners use toachieve a favorable interpretation of thestatutes. In the interest of brevity, thestrategies described in this paper arenecessarily simple and crude. Experi-enced tax planners will surely be able torecast the proposed strategies in termsthat are likely to pass inspection.However, this assumption does notauthorize taxpayers to engage inunrestrained tax evasion. For example,an effective tax plan does not allow ataxpayer to claim that the amountrealized from the sale of property isexempt from income unless the taxpayercan defend this claim against an IRSchallenge. Although Congressionallysponsored flat tax proposals typicallyreduce or eliminate the role of the IRS(e.g., Armey, 1996), this analysispresumes that the IRS may observe thefinal structure of the transaction.

Assumption 5: A flat tax system requiresall taxpayers to use the same tax year.

The final assumption provides additionalstructure to the proposed flat taxregime. Previous studies have shownthat the Hall–Rabushka flat tax proposaldoes not provide any guidance onallowed tax accounting periods (e.g.,Feld, 1995; Calegari, Key, and Smith,1996). In the absence of any restrictionson the use of different tax years,taxpayers can use a plethora of differentschemes to avoid taxes. For example, inthe absence of any restrictions, cashbasis businesses could postpone theirtax liability by paying deductible fees torelated taxpayers with different taxyears. Since the tax minimizationstrategies that are associated withaccounting periods are well-known, Iassume that all taxpayers in a flat taxsystem use the same tax year.


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EFFECTIVE TAX POSTPONEMENTSTRATEGIES

Tax avoidance strategies are based onone or more of the three principlesiterated in Stiglitz (1985). As shown inthe prior section, effective use of a taxavoidance strategy also considers thethree constraints described in Scholes andWolfson (1992). In this section, I describesome simple tax planning techniques thatcan be used to postpone tax liabilities inthe Hall–Rabushka flat tax system.

Postponing Recognition of Sales orService Income

Cash basis taxpayers can postpone theirtax liabilities by delaying the receipt ofpayments for sales or services renderedduring the current tax year to a future taxyear. For businesses that are stable orgrowing, consistent use of this strategyover a long period of time is economi-cally equivalent to a reduction in the ag-gregate income reported. The current taxsystem places limits on the effective useof this strategy by restricting the availabil-ity of the cash method of accounting. Inthe proposed flat tax regime, all restric-tions on the use of the cash method areremoved. Consequently, this tax strategycan be used by virtually all businesses.

Effective tax planning requires businessesto use this strategy with discretion. Forexample, indiscriminate use of thisstrategy may create cash flow problemsfor the firm. In order to reduce thisnontax cost, it is common for businessesto sell their goods or services underinstallment contracts that imposeperiodic interest payments on the out-standing balance. The current tax systemplaces restrictions on the use of install-ment sales to defer income.13 In the flattax proposal, all businesses will be ableto defer income through installment

sales as long as the installment contractis not considered to be a cash equivalent.

The viability of postponing taxes bydelaying the receipt of payments orusing installment contracts dependscritically on the acquiescence of thecustomer. Consumers of personal-useitems or investment property may bewilling to participate in a deferredpayment contract because they are notadversely affected by the timing of thepayment. However, most businesscustomers would be unwilling to delaypayments because they cannot deductan item until they render payment. Inthis case, the tax savings to the sellerwould be offset by the tax liabilityincurred by the buyer. While businesscustomers with current-period tax lossesmay be willing to defer payment until asubsequent tax year, the proposedinterest adjustment to loss carryforwardsand the presence of transaction costscreate obstacles to the successfulimplementation of this strategy.

Accelerating Purchases or PrepayingExpenses

In the current system, cash basis taxpay-ers are able to postpone their taxpayments by accelerating the payment ofdeductible business expenses. To reducethe potential revenue loss from this taxavoidance strategy, the current taxsystem places restrictions on the currentdeductibility of many items. For example,the cost of inventory items is notdeductible until they are sold and thecost of capital expenditures and certainprepaid expenses must be depreciated oramortized over their estimated usefullives. Some items that are particularlysubject to abuse (e.g., passengerautomobiles and artwork) have addi-tional limitations. In the Hall–Rabushkaproposal, many of the restrictions placed


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on this basic tax avoidance strategy areeliminated. Since the cost of business-use property and services is immediatelydeductible, businesses have a strongincentive to accelerate their purchasesand prepay their business expenses.

The flat tax imposes a barrier to this“acceleration” strategy by requiring sellersto recognize income upon receipt. Whenbuyers and sellers have the same tax yearand the seller has positive taxable income,a buyer’s acceleration strategy is diametri-cally opposed to the seller’s deferralstrategy. It is not unlikely that sellers willoffer discounts for delaying paymentsuntil the beginning of the following taxyear. When this occurs, buyers that ac-celerate their year-end payments willprobably pay higher prices for purchasesthan those that are willing to defer pay-ments until a subsequent year. Implicittaxes in the form of higher prices willremove any benefits to this strategy. Ifbusinesses are able to immediatelydeduct the cost of assets purchasedunder an installment contract, however,an acceleration strategy will be effectivebecause buyers can obtain a deductionin a tax year before sellers recognize therelated income. While the Hall–Rabushka proposal does not directlyaddress this issue, Doernberg (1985)suggests that the flat tax system allowsbuyers to deduct the entire cost ofproperty purchased using an installmentcontract in the year of purchase.14

On the other hand, the flat tax providesan incentive for businesses to purchasebusiness property from nonbusinesssources. For example, a business may beable to deduct the cost of land previouslyused for investment or personal purposeswithout the seller recognizing anyincome. An acceleration strategy wouldalso be effective if the seller is an exemptorganization or a retirement plan. Feld(1995) points out that many types of

purchases can serve a dual purpose asbusiness inputs and as a store of valuefor the owners of the business. Deduct-ible business investments that serve thisdual purpose enable entrepreneurs toshelter income with investments by theirbusinesses in order to store value untilthe individuals need them.

EFFECTIVE SOURCE-BASED ARBITRAGESTRATEGIES

The flat tax system is susceptible tosource-based arbitrage strategiesbecause it has several categories ofexempt income. This section describestax avoidance strategies that attempt toconvert taxable business or compensa-tion income into tax-exempt income.

Converting Sales Revenue into InterestIncome

In the current system, there is littleadvantage to converting sales incomeinto interest income because both itemsare subject to the same tax rate. Sinceinterest income is not subject to taxationin a Hall–Rabushka flat tax system,business taxpayers have an incentive toconvert sales revenue into interestincome. One method that can be usedto accomplish this conversion is for aseller to offer a buyer a reduced salesprice in return for a higher interest rate.

For example, assume that a businessearns net income before interest andtaxes (Xb) on gross sales (S) each yearand that the tax rate is τ. Then, theafter–flat tax earnings of the businessare Xa = Xb(1 – τ). If Xb = $100,000, S =$900,000, and τ = 20 percent, the after-flat tax earnings of the taxpayer are$100,000 (1 – 0.2) = $80,000.

Instead of selling its product for S,suppose that the business is able to sellits product to its customers at a dis-


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counted sales price equal to its normalexpenses (S – Xb) plus additionaltransaction costs (T) due in one year andbearing interest at the annual rate r.15

Since the sales price has been reducedto (S – Xb + T ), the taxpayer will not oweany flat taxes. Moreover, since the salesprice is not collected for one year, thetaxpayer will be forced to finance itsexpenses for the next year at its borrow-ing rate, k. If the business is able to sellits product using this type of transaction,then its after–flat tax earnings under thenew arrangement, Xa

N, will be

XaN = (S – Xb + T )(1 + r) – (S – Xb + T)(1 + k)

and the alternative sales arrangementwill be profitable as long as

XaN / (1 + dB) > Xb(1 – τ )

where dB = Xb(1 – τ ) / (S – Xb) is thebusiness’ discount rate calculated interms of the business’ opportunity cost.Solving equation 2 for r provides us withthe interest rates that are acceptable tothe business:

r > k + Xb(1 – τ)(1 + dB) / (S – Xb + T ).

Using the amounts in the example andassuming that k = 8 percent and T =$5,000, the business’ discount rate (dB)is $80,000 / $800,000 = 10 percent andthe minimum interest rate that must becharged by the business to earn at leastXb(1 – τ ) must exceed 8 percent +$80,000(1.10) / $805,000 = 18.93percent.

Once again, the success of this tax strategydepends on the type of customer thatpurchases the product or service. Bus-iness customers will be unlikely to enterinto the alternative contract because thetax benefit derived from substitutinginterest income for sales income (Xbτ ) isexactly offset by the business customer’sloss of the tax deduction on the price re-duction. By contrast, if the seller’sproduct is purchased by an individualconsumer, then the purchase price of theproduct does not contain any current orpotential tax consequences for thecustomer.16 The consumer will be willingto purchase a product under the newsales arrangement as long as the presentvalue of the total amount that will bepaid for the product does not exceed theoriginal purchase price of the product:

(S – Xb + T ) / (1 + dC) < S

where dC is the discount rate for theconsumer. Solving for r provides us withthe interest rates that are acceptable tothe consumer:

r < S(1 + dC ) / (S – Xb + T ) – 1.

Substituting equation 5 into equation 2and solving for dC provides us with theconsumer discount rates that arenecessary for the business taxpayer toearn positive profits using the alterna-tive sales arrangement:

dC > S –1[(S – Xb + T)(1 + k)

+ Xb(1 – τ)(1 + dB)] – 1.

1

2

3

4

5

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Continuing with our example, when Xb

= $100,000, S = $900,000, T = $5,000,τ = 20 percent, k = 8 percent, and dB =10 percent, equation 6 indicates thatthe business will be willing to sell theproduct and the consumer will bewilling to purchase the product underthe alternative arrangement as long asthe consumer’s discount rate (dC)exceeds [$805,000(1.08) +$80,000(1.10)] / $900,000 – 1 = 6.38percent. For example, if the consumer’sdiscount rate equals the business’sborrowing rate (i.e., dC = k = 8 percent),equation 5 shows that the business willbe able to charge an interest rate of$900,000(1.08) / $805,000 – 1 = 20.75percent and equation 2 shows that thebusiness will be able to earn profits of$805,000(1.2075–1.08) / 1.10 –$80,000 = $13,307 above the $80,000earned in the absence of the alternativesales arrangement.

This analysis assumes that the entire taxbenefit will accrue to the business. In acompetitive environment, competingbusinesses will attempt to increase theirsales by offering interest rates that allowcustomers to share in the tax savings.Consequently, it is possible that the longrun benefits of the new sales arrange-ment will be shared by both the sellerand the buyer.

Converting Sales of Business Propertyinto Sales of Personal-Use Property

In the current tax system, taxpayersdevote much time and energy in effortsto convert ordinary income into prefer-entially taxed capital gains. In a flat taxregime, taxpayers can no longer takeadvantage of these popular tax avoid-ance strategies because the distinctionbetween ordinary and capital income iserased. In its place, however, the Hall–Rabushka proposal creates new arbi-trage opportunities by eliminating the

taxation of income from nonbusinessproperty. Since taxpayers are taxed onsales of business-use property but arenot taxed on sales of personal-useproperty, individuals may be able toconvert taxable business income intonontaxable nonbusiness income.

In the current tax system, gains fromsales of personal-use items are generallysubject to taxation. One of the fewexceptions to this general rule involvessales of personal residences. In theTaxpayer Relief Act of 1997, Congressgranted a $250,000 exclusion for singleindividuals ($500,000 for marriedindividuals filing jointly) on gains frombiannual sales of personal residences.The financial press quickly recognizedthe arbitrage opportunities inherent inthis exclusion. For example, tax advisorsindicate that wealthy individuals withseveral residences and vacation homesare being advised to occupy each homefor two years before selling in order toreduce or eliminate their tax liability onthe sale (Asinof and Herman, 1997).Similar advice is being offered toindividuals who are able to buy run-down properties, fix them up, live inthem, and then turn them over for aprofit. This technique also makes sensefor contractors who can build their ownhomes, live in them for the requisitetime, and build a new home during thetwo-year residency requirement beforeselling the old home. Since the Hall–Rabushka system removes all restrictionson these tax avoidance strategies, it ispossible that this type of tax avoidancestrategy could become endemic in a flattax regime.

Since the proposed flat tax rules dependon the taxpayer to determine whetherincome is derived from businessactivities or personal activities, it is likelythat some taxpayers will attempt tostructure their lifestyles so that their


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income will appear to be derived fromnontaxable personal sources. Thecontractor who builds and resells herpersonal residence is one example ofthis type of tax avoidance behavior. Foranother example, consider an individualwho earns prize money and awardsfrom athletic tournaments or artisticcompetitions. Current law includes allprize money and awards in income. Theflat tax proposal will tax the income onlyif it is derived from either businessreceipts or from compensation. At whatpoint does a leisure activity or hobbybecome a business for flat tax pur-poses? The current hobby loss rulesdeny deductions for losses attributableto an activity that is not engaged in forprofit but require recognition of allhobby-generated income. As a result,taxpayers currently attempt to cast theirhobbies as businesses when the hobbyis projected to have continuous netoperating losses. In a flat tax regime,however, hobby income is not subject totaxation. Instead of trying to classifytheir activities as businesses in order todeduct activity-related expenses,individual taxpayers in a flat tax systemhave an incentive to structure theirprofitable business activities as hobbiesin order to avoid income recognition.

Converting Rental Agreements intoSales Agreements

In a typical lease arrangement, a lessee(the tenant) leases property from alessor (the landlord) for a fee based ontime. The landlord is usually responsiblefor paying the taxes, insurance, andmaintenance costs of the property,although this is not always the case.Since both rent and interest are func-tions of time, and since rental income isincludable while interest income isexcludable, landlords in a flat tax regimehave an incentive to convert rentalincome to interest income. Once again,

the basis of this tax avoidance opportu-nity is the differential tax treatmentimposed on different income streams.

The tenant’s amenability to this conver-sion depends on the tenant’s businessstatus. Tenants who lease business-useproperty are unlikely to participate in anattempt to convert rental income intointerest income because the tenant willno longer be able to deduct thepayment. Tenants who lease personal-use property are not exposed to thisproblem because they are unable todeduct the cost of either rent or interestexpenses. Therefore, landlords and non-business tenants have incentives tocreate a contract that transforms taxablerent income into nontaxable interestincome.

One way for a landlord to effect thisconversion is to sell the property to thetenant for a mortgage note due at theend of the lease term with interest-onlypayments due periodically.17 Consider abuilding lease in which the annual rentalpayments equal R, annual maintenanceexpenses equal m, the market value ofthe property is V, and the landlord’sborrowing rate is c. Then, the annualdebt service on the property is Vc andthe annual after–flat tax income of thelandlord is

XA = (R – m)(1 – τ) – Vc.

For example, assume that R = $12,000,m = $2,000, V = $100,000, τ = 20percent, and c = 8 percent. Then, thebusiness taxable income from theproperty (R – m) is $12,000 – $2,000 =$10,000 and the after–flat tax earningsof the landlord are

$10,000(1 – 0.2) – $100,000(0.08) = $0.

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Instead of renting the property for R,suppose the landlord sells the property tothe tenant for an interest-only non-recourse installment note equal toV(1 – τ ) –1 bearing an interest rate equalto r = (R – m)(1 – τ)/ V. The interest is duemonthly and the principal is due at theend of what would have been the end ofthe lease period. Since the tenant (as thenew owner) will now be responsible forthe maintenance of the property, thetenant is indifferent between payingannual rent of R and annual interestpayments of rV(1 – τ ) –1 because rV (1 –τ ) –1 = (R – m). On the maturity date ofthe note, the tenant-borrower will defaultbecause the tenant will not pay principalof V (1 – τ)–1 when the property is worthV. As a result of the default, the landlord-lender can either (1) extend the due dateof the note (after adjusting the principalportion of the note for changes in thevalue of the property) or (2) repossess theproperty through foreclosure.18 If thelandlord-lender decides to foreclose onthe note and repossess the property, thelandlord will not owe any flat taxesbecause she never receives the principalportion of the sales price. The landlord-lender and the tenant-borrower will agreeto this arrangement as long as the taxsavings exceed the transaction costs, T:

XA = rV/(1 – τ ) – cV = (R – m)τ > T.

Using the amounts in the example, thesales price of the property is $100,000/(0.8) = $125,000; the interest ratecharged by the landlord-lender is r =$10,000(1 – 0.2) / $100,000 = 8 per-cent; the annual rent paid by the tenantis $125,000(0.08) = $10,000; and thelandlord-lender’s after–flat tax earnings(excluding transaction costs) are

$10,000 – $100,000(0.08) = $2,000.

The additional earnings that result fromthis strategy can be allocated betweenthe landlord and the tenant in amutually beneficial arrangement.

As I stated earlier, effective tax planningrequires that consideration be given tothe nontax costs associated with theproposed tax minimization strategy. Inthis particular tax-minimizing arrange-ment, the landlord should be aware thatthe tenant-borrower may engage inactions that reduce the profitability (tothe landlord) of the strategy. Forexample, as the new (albeit temporary)owner, the tenant may ignore hisresponsibility to properly maintain theproperty or neglect to pay the propertytaxes and insurance on the property. Inorder to ensure that the tenant-borrower meets these obligations, thelandlord-lender may require the tenant-borrower to remit monthly payments forproperty taxes, insurance, and mainte-nance to escrow accounts supervised bythe landlord-lender.

Another nontax cost to the landlord canoccur if the value of the propertyappreciates during the installmentperiod. If the appreciated value of theproperty, VA exceeds V(1 – τ ) –1, thetenant-borrower has an incentive toexercise his option to pay off the note.The landlord-lender may be able toprotect herself from the consequencesof this action by (1) inserting a provisionin the sales contract that allows thelandlord-lender to demand immediatepayment before VA exceeds V(1 – τ ) –1,(2) making sure the duration of theinstallment note (i.e., the lease term) isshort enough to forestall excessiveappreciation, or (3) indexing theprincipal, V(1 – τ ) –1, to an appropriatemeasure of appreciation, such as thelocal rate of inflation or the localhousing index.

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Converting Nondeductible Personal-UseExpenditures into Deductible BusinessInputs

The current income tax system containsprovisions designed to restrict the abilityof individuals to deduct expenses orlosses relating to items used for personalpurposes. For example, the deductiblebasis of personal-use assets transferredto a business is limited to the lower ofcost or fair market value. Restrictions arealso placed on the deduction of capitalexpenditures and inventory. Because theHall–Rabushka proposal requires theimmediate write-off of all businessproperty, business owners have anincentive to direct their businesses topurchase assets that will later betransferred to the owners.

Under the proposal, it is easy toconceive that taxpayers will buy a“business” car or real property, take animmediate deduction for the purchaseprice, and then convert the item topersonal use for resale or enjoyment.19

The conversion could occur through adividend, a bargain purchase, or bymerely allowing the individual taxpayerto use the property for personalpurposes. The Hall–Rabushka proposalplaces restrictions on the use of thisstrategy by requiring businesses toreport as income the market value ofproperty and services that the businessprovides to its owners or employees.Thus, a corporation will probably berequired to recognize the market valueof previously deducted business-useproperty distributed as dividends to itsshareholders.20

Although the proposal requires busi-nesses to report as income the value ofproperty provided to their owners andemployees, there are a multitude of taxavoidance strategies that businesses andtheir owners can use to take advantageof the immediate write-off rule. For

example, when a company purchases“business” property and later convertsthe property to personal use, thebusiness is allowed to immediatelydeduct the entire cost of the propertybut is later required to include only themarket value in income. If the marketvalue is determined as the property’s netrealizable value, then the business willobtain a net deduction equal to thecosts of purchasing and selling theproperty. Consider an individual whodirects her business to purchase“business” real estate in December for$205,000, of which $5,000 is attribut-able to loan fees and other closingcosts. When the business transfers thereal estate to the individual in thefollowing year, the business will reportas income the net realizable value of theproperty, or $200,000 minus commis-sions and other costs of sales. Thus, byusing this strategy, the individual may beable to write off the costs of buying andselling personal-use property.

Another tax avoidance strategy in thisarea involves the re-conversion of thepersonal-use property into business-useproperty. In the Appendix, I show thatbusinesses can deduct the market valueof personal-use property converted tobusiness-use property. Consider anindividual who is interested in acquiringa vacation home. In year 1, the indi-vidual directs his business to purchasethe home as business property. In year2, the business converts the property topersonal use. However, before the endof the tax year, the individual re-converts the property to business use byrenting the property to unrelatedindividuals. The current tax law limitsdeductions on residences used primarilyfor personal purposes to the amount ofincome generated by the residence. Bycontrast, the Hall–Rabushka proposalappears to require the taxpayer to takea deduction in year 1, recognize gain on


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the conversion of the property topersonal use at the beginning of year 2,and then take a deduction on the re-conversion of the property to businessuse at the end of year 2. If this se-quence of events is repeated over anumber of years, it may be possible forthe business to defer income recogni-tion until the owner either ceases thesequence or sells the property. Thisdeferral strategy can also be effected bydirecting the business to sell theproperty to its owner for a claim that isnot due for a number of years. Periodicinterest payments payable to thebusiness are excluded from businessincome. This tax avoidance strategy usestwo principles: postponing taxes andarbitraging across different characteriza-tions of assets.

Contributing Noncash Business PropertyInstead of Cash to ExemptOrganizations

In most cases, the Hall-Rabushkaproposal denies deductions for non-business expenditures. Althoughdonations to tax-exempt charities canserve a business purpose, Hall andRabushka (1995) indicate that neitherbusinesses nor individuals will beallowed a deduction for charitablecontributions.21 Despite this apparentprohibition, it is possible for businessesto retain the benefit of their originaldeduction on purchases of businessproperty that are later contributed to acharitable organization. This de factodeduction for noncash contributions isavailable because the Hall–Rabushkaproposal does not require businesses torecapture the value of donations thatwere previously deducted as costs ofbusiness inputs.22

Suppose that a business purchasesproperty for an amount C and uses theproperty in its trade or business. After n

number of months, the businessdonates the property, now worth V, to acharitable organization. Since theproperty is originally used as a businessinput, the business is allowed to deductthe full cost of the property, C. Thebusiness is not required to recapture itspreviously deducted cost because theproperty is not provided to its owners oremployees. If the business had contrib-uted cash instead of property, it wouldhave to sell V(1 – τ)–1 of services orinventory to obtain V worth of cash. Bycontributing business property insteadof cash, the business avoids a flat taxliability of Vτ (1 – τ ) –1.

For example, consider a computermanufacturer that desires to donate$500,000 to its favorite charity. Assumethat its inventory includes computersworth $625,000 (original cost of$400,000) and that the flat tax rate τequals 20 percent. If the manufacturersells the computers and donates theproceeds to the charity, it will pay$625,000(0.2) = $125,000 of tax.Instead, if the manufacturer donatescomputers worth $500,000 to thecharity and sells $125,000 worth of theinventory directly to customers, its taxbill will be $125,000(0.2) = $25,000. Ineffect, the manufacturer saves$100,000 in taxes by donating propertyinstead of cash. In both circumstances,the charity obtains the $500,000donation.

A variation on this theme allows anindividual taxpayer to obtain a chari-table deduction for contributions madein connection with the conversion ofpersonal-use property into business-useproperty. In the current flat tax proposal,it is uncertain whether taxpayers canobtain a deduction for the cost or fairmarket value of personal-use propertyconverted to business use. However, ifthe taxpayer contributes personal-use


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property to a charitable organization,which then resells the property to theindividual’s business, the business willbe allowed a business input deductionand the charity will receive the cashvalue of the property. For example,suppose that taxpayer wishes to convertpersonal-use property worth $500,000(original cost of $100,000) to business-use property and, at the same time,desires to make a donation to a charity.If the taxpayer donates the property tothe charity and later instructs herbusiness to repurchase the property atits fair market value, the taxpayer will, ineffect, obtain a business charitablededuction.

In both examples, the exempt organiza-tion does not recognize “unrelatedbusiness taxable income” on thetransaction because it is not in thebusiness of selling property. Current taxrules levy an unrelated business incometax (UBIT) on income from activities thatare not related to the exempt purposeof a charitable entity. In order to besubject to the UBIT, however, thebusiness activity must be regularlycarried on by the organization. More-over, the current rules specify that theUBIT is not imposed on sales of mer-chandise as long as substantially all ofthe merchandise has been received asgifts or contributions. The Hall–Rabushka proposal, which dispenseswith these rules, does not provide anyguidance on reporting requirements forexempt organizations.

Converting Employee Status to Self-Employment Status

In the current income tax system,provisions exist that encourage businesstaxpayers to classify workers as indepen-dent contractors instead of as employ-ees. These provisions include (1) theability of independent contractors to

fully deduct business-related expenses,23

(2) the ability of independent contrac-tors to deduct business-related interestexpenses (employees cannot deductbusiness-related interest expense), and(3) the ability of independent contrac-tors to calculate self-employment taxafter business deductions (employeescannot deduct the cost of employeebusiness expenses from gross wages indetermining the social security tax base).On the other hand, the current taxsystem also provides some important taxbenefits to employee status. Forexample, the cost of fringe benefits(e.g., medical and disability insurance)paid on behalf of employees is deduct-ible by businesses and excludable byemployees, while the cost of fringebenefits paid on behalf of an indepen-dent contractor is not excludable by theindependent contractor. In a flat taxsystem, however, the benefits toindependent contractor status areenhanced while the benefits to em-ployee status are reduced. Consider thefollowing points.24

(1) In a flat tax regime, self-employedindividuals can offset theiremployment-related income withlosses from other businessesowned by the taxpayer. Employ-ees, on the other hand, cannotoffset their compensation withlosses from other businessesowned by the taxpayer.

(2) In a flat tax regime, self-employedindividuals can deduct all of theirbusiness expenses. Employees, onthe other hand, cannot deduct anyemployment-related expenses.

(3) In a flat tax regime, self-employedindividuals can obtain charitablecontribution deductions fordonations of business-use prop-erty. Employees, on the otherhand, cannot deduct their prop-erty contributions.


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(4) In a flat tax regime, businessescannot deduct the cost of em-ployee benefits. In the current taxsystem, businesses can deduct thecost of employee benefits.

This analysis shows that there are fewflat tax reasons for an individual todesire to be classified as an employee,while there are many flat tax reasons foran individual to wish to be classified asan independent contractor. Since theindividual will pay less taxes as anindependent contractor than as anemployee, businesses can pay lessbefore-tax compensation to an indepen-dent contractor than to an employee.Consequently, an effective tax plannerwill encourage businesses and workersto organize their relationship as one inwhich the worker is treated as anindependent contractor for tax pur-poses.

EFFECTIVE RATE-BASED ARBITRAGESTRATEGIES

By reducing the current progressive taxrate system to two rate brackets,eliminating phaseouts, and excludinginvestment income from taxation, theflat tax removes many of the incentivesfor taxpayers to engage in rate-basedarbitrage strategies. By increasingpersonal exemptions and enhancing theability of exempt organizations toexclude business income, however, theflat tax proposal continues to provideopportunities for taxpayers to reduce oreliminate their tax liabilities using thesestrategies.

Shifting Income to Taxpayers with LowerMarginal Tax Rates

The Hall–Rabushka proposal provideseach taxpayer with a personal allowance(similar to a standard deduction) equalto $9,500 for unmarried taxpayers and

$16,500 for married taxpayers.25 Thepersonal allowance is increased by$4,500 for each dependent.26 Theproposal also allows taxpayers to usetheir full personal allowance even whenthey are reported as dependents onother returns.27

Since the personal allowance is availableto all taxpayers regardless of depen-dency status, taxpayers with income inexcess of their personal allowance havean incentive to shift income to thosewho have taxable income below theirpersonal allowance. For example, ataxpayer can direct her business to paydeductible compensation to her child upto the amount of the child’s personalexemption without incurring any flat taxliability. If the tax environment includeslabor taxes, however, the benefit of thisstrategy is reduced by the amount bywhich the social security tax, which isimposed on the child’s wages, exceedsthe present value of the child’s futuresocial security benefits. If the parent’searned income exceeds the socialsecurity income base, then an income-shifting strategy will increase the totalsocial security taxes paid by the twotaxpayers.

Organizing a Business as an ExemptOrganization

The Hall–Rabushka proposal continuesto exempt certain charitable organiza-tions from the flat tax.28 However, theproposal also removes most of theCodeís restrictions on using exemptorganizations to operate businesses.29

Consequently, under its current provi-sions, the flat tax allows individuals toorganize their sole proprietorships asexempt organizations as long as theresidual income of the organizationdoes not revert to individual or corpo-rate owners. By organizing as anexempt organization, individuals would


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be able to avoid taxes until cash iswithdrawn from the business in theform of compensation, rent, or otherservice income.

The business could also be structured sothat some of the business property isowned by an exempt private founda-tion. For example, the foundation couldown property that it leases to thebusiness or employ workers whoprovide services to the business. Thebusiness can then pay deductible fees tothe exempt foundation, which, in turn,contributes its net earnings to charitableorganizations designated by thebusiness owner. By excluding incometransferred to tax-exempt entities, thebusiness obtains the equivalent of adeduction for charitable contributions.The strategy is especially effective if theexempt organization is able to sell laborservices to the taxable business organi-zation because exempt organizationsare not penalized by the flat taxproposal’s restrictions on the deductionof employee fringe benefits.

Shifting Income Using Retirement Plans

Economists have long known that a taxdeductible investment in a retirementplan is economically equivalent to a tax-exempt investment as long as tax ratesare constant over time (e.g., Brown,1948; U.S. Department of the Treasury,1977). When tax rates increase (de-crease) over time, individuals are betteroff investing in the tax-exempt invest-ments (retirement plan).

In a flat tax regime, low tax bracketindividuals should never invest in aretirement plan because the tax rate onthe withdrawal date can never be lessthan zero. When an individual’s currentmarginal taxable income exceeds thepersonal allowance, it may seem thatthe decision to invest in a retirement

plan depends on the taxpayer’s futuremarginal tax liability. Individuals whoexpect flat tax rates to decline or expectto earn taxable income below theirfuture inflation-adjusted personalallowances are likely to invest inretirement plans. In the simple flat taxsystem, however, individuals may wishto invest in a retirement plan even iffuture rates are expected to rise becausethe Hall–Rabushka proposal removes allbarriers to tax avoidance strategies.

Under the flat tax proposal, individualsare allowed to set up as many plans asthey wish. The proposal does not placeany restrictions on the amount that canbe invested in each plan, the investmentpolicy of the plan, or how long the planassets can accumulate without beingwithdrawn. It may be possible forindividuals to set up retirement accountsnaming future generations as beneficia-ries. The funds from these accounts canbe borrowed by any individual orpledged as collateral for loans. Scholesand Wolfson (1992) describe a simplescenario in which taxpayers borrowagainst their retirement plan to financetheir current consumption. If thetaxpayer’s borrowing rate equals therate of return on the plan assets, thenthe amount of the loan (includingaccumulated interest) on the date of thetaxpayer’s death would equal the planassets. The secured creditors would thenreceive the plan assets to pay off theloan, leaving no assets to pay the taxliability to the government. This scenariomay be feasible in a flat tax regimebecause all restrictions on this strategyhave been removed.

Business owners may also direct theirretirement plans to purchase, own, andoperate all or part of their individuallyowned businesses. If the retirement plandirectly owns the business assets, thenthe individual can postpone the tax


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liability on any income earned by thebusiness until funds are withdrawn fromthe plan. In the absence of any with-drawal restrictions, it is conceivable thata family business that is organized as aretirement plan (i.e., owned directly bythe plan) will never incur any flat taxes.

Individuals who are interested in makingcontributions to exempt organizationscan obtain a deduction equivalent bydirecting the employer to set up aseparate retirement plan naming theexempt entity as the beneficiary. Afterthe initial investment is made, thecharitable beneficiary can borrow fromlenders pledging the retirement plan ascollateral. When the individual dies, thebeneficiary can withdraw the plan assetswithout any tax liability.

These examples show that the absenceof restrictions on the use of retirementplans enables individuals in a flat taxregime to engage in a wide variety oftax avoidance strategies.

Tax Planning for Future Self-Employment Business Income

Since negative business taxes can becarried forward indefinitely, self-employed taxpayers have an incentive toorganize future business ventures at theearliest possible date. In a tax environ-ment without labor taxes, an individualwho expects to earn positive businessincome in future years can generate (oraugment) current year business losses bypaying himself a wage equal to thepersonal deduction. Since the wagedoes not exceed the personal deduc-tion, the individual does not owe anyindividual wage taxes. The wage createsa loss for business tax purposes, whichcan be carried forward and used tooffset future taxes. For example,consider a college student who isstudying to become a doctor and

establishes a business in year n. Forsimplicity, assume that the average dailyyield on three-month Treasury Billsduring the tax year (T) is constant acrossyears. By establishing a business duringthe first year of college that pays awage equal to the personal deduction,D, the student will generate a negativetax carryover equal to

τ D [(1 + T )n+1 – 1] / T – τ D.

If we assume that the student isunmarried and that n = 7 years, τ = 20percent, D = $10,000 per year, and T =6 percent each year, then, upongraduation, the amount of the negativetax that will be carried into the first yearof business is

$10,000(0.2)[(1.068 – 1)(0.06) –1 – 1]

= $17,795.

This tax strategy is available for alltaxpayers whose wages are less than thepersonal deduction. In the absence ofsocial security taxes, all taxpayers willreport wage income that equals orexceeds their personal deductions. If thetaxpayer’s current wage (Wc ) is less thanthe personal deduction, then thetaxpayer should establish a business thatpays a wage equal to Wc – D. If thetaxpayer does not use the negative taxcarryover in future tax years, thenegative tax can be sold to othertaxpayers who can use the credit.30

When the economic environment alsoincludes labor taxes, the self-employedindividual will not create the nontaxablewage when the social security taxpayment (SP) exceeds the present valueof the social security tax benefit (SB) plusthe future income tax benefit:

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SP > {SB + τD[(1 + T)n+1 – 1] / T – τD}

(1 + dI)–n

where dI is the individual’s discount rate.Since a compensated individual’s annualsocial security tax is limited to the wagebase (W), individuals who expect to earnannual income in excess of the wagebase are less likely to create a negativetax carryover that exceeds tW.

SOME IMPLICATIONS FOR TAXCOMPLIANCE

Hall and Rabushka (1995) describeseveral ways in which current taxcompliance costs will be reduced by aflat tax. Slemrod (1996) estimates thatthe flat tax will cut business compliancecosts by one-third and personal compli-ance costs by 70 percent.31 The declinein business compliance costs resultsmainly from the removal of deprecia-tion, uniform capitalization, alternativeminimum tax, and foreign tax provisionsfrom the tax system.32 This studysuggests that businesses will incursignificant tax avoidance costs inattempting to structure their organiza-tion and transactions to take advantageof exclusion provisions. However, theseadditional compliance costs will beoffset, to a large degree, by the removalof current tax avoidance strategies thatseek to convert ordinary income tocapital gains.

For wage earners and retirees (earningonly investment and pension income),the proposed flat tax system willcertainly reduce compliance costs. Thereduction in personal compliance costsis achieved mainly by excluding capitalgains on sales of investment andpersonal-use property, eliminatingitemized deductions, and taxingbusiness income from sole

proprietorships and conduit entities atthe business level. This study shows,however, that the flat tax stronglyencourages individuals to organize theirlabor as independent contractorsinstead of as employees. Blumenthaland Slemrod (1992) show that self-employed taxpayers spend significantlymore time and money on tax compli-ance than other individual taxpayers.Not only do self-employed individualsspend more time tracking their incomeand deductions, they must makedifficult decisions in determining theinclusion or deduction of business items.Feld (1995) and Graetz (1997) showthat the flat tax does not alleviate thisproblem. It is also well-documented thatindependent contractors are less likelyto file tax returns, and more likely to fileinaccurate tax returns, than wageearners (Mason, 1997). It is possible thatthe expected decline in personalcompliance costs for many wageearners will be negated as theseworkers arrange to classify themselvesas independent contractors.

The study shows that taxpayers in a flattax system can engage in tax avoidancestrategies that attempt to classifyprofitable business activities as eitherhobbies or investments. This type ofstrategy will be costly for the govern-ment to monitor because the IRS wouldbe required to show that the activitiesare both profitable and business related.By contrast, in the current system, it isusually sufficient for the IRS to showthat the activity is profitable. The IRSwill also need to expand their oversightof exempt organizations and retirementplans as businesses use these entitiesto facilitate their tax minimizationstrategies.

The study also indicates that taxpayerswill attempt to take advantage of flattax provisions that allow businesses to

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immediately deduct the cost of propertythat is later converted to personal use.These expanded write-off rules intro-duce new opportunities and incentivesfor tax evasion. Since current taxdepreciation rules attempt to mirroreconomic depreciation, the conversionof property held by individuals andpartnerships from business use topersonal use in the current tax system isnot usually treated as a taxable event. Ina flat tax system, however, the conver-sion of business-use property topersonal use is always a taxable event.This conversion requires businesses toself-report the fair market value of theconverted property as business income.This type of transaction is difficult forthe government to monitor as it doesnot involve an arms-length transfer. It isalso costly for the taxpayer to determinethe value of the converted property.Consequently, it is likely that a substan-tial percentage of business owners willeither fail to report the conversion orunderreport the value of the convertedproperty. Since the conversion does notinvolve unrelated parties, the IRS willprobably need to conduct additionalaudits to monitor this type of activity.

While the compliance and enforcementcosts associated with a flat tax regimewill certainly be lower than the costs ofthe current system, this brief analysisshows that it will probably be necessaryfor the IRS to conduct additional auditsin certain areas of business taxation.

SUGGESTIONS FOR LIMITING TAXAVOIDANCE OPPORTUNITIES

Some of the benefits of the tax strate-gies described in this study can bereduced by modifications to the Hall–Rabushka proposal. However, thesemodifications generally introduce morecomplexity into the system. For example,the benefits of using a tax postpone-

ment strategy, that involves delaying thereceipt of payments for sales or servicesacross tax years can be reduced byrequiring businesses to file business taxreturns on a quarterly or monthly basis(instead of on an annual basis). Requir-ing businesses to prepay their annualflat tax liabilities using monthly orquarterly estimated tax installmentswould also reduce the benefits of a taxpostponement strategy, althoughannual tax postponement strategies areeasier to accomplish than quarterly ormonthly postponement strategies.

The benefits of tax postponementstrategies that defer income recognitionthrough installment contracts can beeliminated by either requiring sellers touse the accrual method to reportinstallment sale income or by charginginterest on the deferred taxes. The useof the accrual method for installmentsales can be supported under the“matching” principle because busi-nesses would be allowed to immediatelydeduct the cost of the purchased item.In many cases, it would also be simplerfor businesses to recognize income atthe point of sale instead of recognizingincome over the life of the installmentnote. Charging interest on the post-poned tax liability, though arguablymore complex, would reach the sameresult while preserving the flat tax’spredilection for the cash method ofaccounting.

The benefits from tax postponementstrategies that accrue to businesses thatare able to deduct the cost of assetspurchased under installment contracts intax years before the seller recognizes therelated income can be mitigated byeither denying the deduction until theseller recognizes the income (i.e.,allowing a deduction only whenprincipal payments are made on theinstallment note) or requiring businesses


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to capitalize and amortize the cost ofinventory, capital expenditures, andprepaid expenses. Since both modifica-tions require additional annual book-keeping adjustments, it is not clearwhich method will be preferred in amodified flat-tax system. There areseveral ways, however, in which thecurrent income tax rules can be simpli-fied. For example, the elimination ofspecial depreciation rules for alternativeminimum tax, earnings and profits, andthe midquarter convention wouldcertainly reduce compliance costs. Thewidespread business practice ofimmediately deducting low-cost assetscould also be codified. Depreciation andinventory accounting could also besimplified by allowing businesses toelect to use the same methods for bothtax and financial reporting purposes.

Since the flat tax eliminates interestdeductions, it would also be easy toadjust depreciation for inflation in sucha system. For example, instead ofimmediately deducting the entire cost ofbusiness-use assets in the year they areplaced in service, the flat tax could allowbusinesses to immediately deduct thepresent value of all depreciationdeductions in the year of purchase(Auerbach and Jorgenson, 1980). Thismodification would simplify currentdepreciation bookkeeping withoutintroducing new arbitrage opportunities.Since the Hall–Rabushka proposalrequires businesses to recognize themarket value of business assets that areconverted to personal use, this modifieddepreciation system would reduce thebenefits of source-based arbitragestrategies that attempt to convertpersonal-use expenditures into deduct-ible business inputs.

To limit the benefits of convertingbusiness income into tax-exemptpersonal-use income, the flat tax

proposal could consider placing restric-tions on the amount of such activitiesallowed during a year. For example, thegeneral exclusion of personal-useincome could be limited to gains belowa certain threshold or restricted toactivities that involve little or nopersonal effort. The proposal could alsoconsider a simple rule that requiresindividuals to classify an activity as abusiness if sales or service income isearned in more than two of the previousfive years. In the absence of a compre-hensive set of restrictions, however, it islikely that tax practitioners will continu-ally conjure up new tax avoidancestrategies to exploit this arbitrageopportunity.

Source-based arbitrage strategiesinvolving the conversion of taxable salesor rent revenue into exempt interestincome can be curtailed by requiringbusinesses to recognize interest receivedfrom customers under installmentcontracts. An interest recognition rulemay be difficult to enforce, however,when financing is arranged throughaffiliated companies. It is also possiblethat an interest recognition requirementwithout offsetting interest deductionsmay have adverse effects on interestrates.

The current flat tax loophole that allowsbusinesses to contribute previouslydeducted capital items to exemptorganizations can be eliminated byrequiring businesses to recognize themarket value of contributed property orservice as income at the time of thecontribution. Section 102(6) of the Hall–Rabushka proposal currently requiresbusinesses to recognize as income themarket value of property and servicesprovided to their owners or employees.The flat tax proposal can easily expandthe list of prohibited transfers in Section102(6) for business contributions to


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charitable entities, political organiza-tions, government officials, etc. Ifcharitable contributions made bybusinesses are considered to be taxabletransfers to owners or employees,however, then businesses may be lesslikely to make charitable donations ofproperty (e.g., donations of computersto schools).

To limit tax avoidance strategiesinvolving exempt organizations andretirement plans, the flat tax proposalshould be augmented by rules similar tothose now used in the current taxsystem. In the case of retirement plans,many of the current rules can bereplaced by simply requiring all individu-als (and exempt organizations) to pay anexcise tax equal to the flat tax on anywithdrawals from retirement plans.Before removing any of the current taxrules in these areas, however, a detailedanalysis should be made to determinewhether the proposed flat tax system isable to enjoin the tax avoidancebehavior that originally precipitated theenactment of the current tax rules.

Conclusions

Some proponents of the Hall–Rabushkaflat tax proposal state that the flat taxsystem will render tax lawyers andaccountants irrelevant.33 This studyshows that the early reports of theirdemise are greatly exaggerated. Theidealized flat tax environment envi-sioned by the flat tax proposal does notconsider taxpayers’ strategic response.In this paper, I describe several tax-planning techniques that can be used bytaxpayers in a Hall–Rabushka flat taxsystem to postpone, reduce, or elimi-nate their flat tax liabilities. These tax-planning techniques are based on thethree general principles of tax avoidanceenunciated in Stiglitz (1985). Theproposed flat tax system provides

taxpayers with opportunities for taxavoidance because (1) the cash methodof accounting proscribed by the proposalallows taxpayers to defer income oraccelerate deductions; (2) the exclusionof nonbusiness income allows taxpayersto take advantage of arbitrage opportu-nities across different types of income;and (3) the progressive features of theindividual wage tax and the removal ofvirtually all restrictions on retirementplan contributions and exempt organiza-tion business activities creates opportuni-ties for taxpayers to arbitrage acrossdifferent tax rates. These tax avoidancestrategies can be exploited in theproposed system because the flat taxproposal places few restrictions on taxavoidance opportunities.

A significant proportion of the complex-ity in the current tax system wasdeveloped in reaction to tax avoidancestrategies. The incentives to engage intax avoidance behavior will not disap-pear in a flat tax regime. The Hall–Rabushka proposal provides an intrigu-ing plan for reducing the complexity andinefficiency of the current income taxsystem. This study shows that theproposal needs to reconsider some of itsprovisions in light of taxpayers’ propen-sity to engage in effective tax planning.Since modifications to the flat taxsystem may greatly change the complex-ity and the incidence of the proposal,failure to deal with these issues in aforthright manner would be a disserviceto the proposal and to tax reform.

ENDNOTES

This paper has benefited from comments andsuggestions made by Greg Geisler, Ernie Larkins,Alan Macnaughton, Brian Mayhew, Joel Slemrod,Terry Shevlin, Jim Smith, two anonymous referees,and workshop participants at Georgia StateUniversity.

1 Hall and Rabushka initially published thecomponents of their flat tax system in a December


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10, 1981 article in the Wall Street Journal. Theplan was later formalized in Hall and Rabushka(1983). Except for inflation mandated changes topersonal allowances, the proposal presented in Halland Rabushka (1995) is essentially the same as the1983 version.

2 The Hall–Rabushka flat tax proposal was firstintroduced as a bill in Congress by Senator DennisDeConcini on March 1, 1982. Since that time,various members of Congress have continuallyreintroduced the proposal as an alternative to thecurrent system. Representative Armey introducedhis most recent version of the Hall–Rabushkaproposal on March 12, 1997 as H.R. 1040. SenatorShelby’s companion bill, S. 1040, was introducedon July 21, 1997. A third bill, S. 593, introduced bySenator Arlen Specter on April 16, 1997, is alsobased on the Hall–Rabushka proposal, but wouldallow limited deductions for charitable contribu-tions and mortgage interest on personalresidences.

3 These principles are also discussed in Scholes andWolfson (1988, 1992).

4 The study does not cover tax-planning opportuni-ties that exist during the transition from an incometax system to a flat tax system. Instead, it examinestax planning in a steady-state flat tax system.Transition issues have been discussed in severalprevious studies (e.g., Staff of the Joint Committeeon Taxation, 1995; Pearlman, 1996).

5 Doernberg (1985) and Feld (1995) discuss someareas that are likely to be troublesome in a Hall–Rabushka flat tax system. Ginsburg (1995)describes some tax avoidance strategies that canbe used in a USA flat tax regime. Grubert andNewton (1995) analyze international implicationsof the Hall–Rabushka and USA flat tax proposals.

6 For example, Clotfelter and Schmalbeck (1996)estimate that the flat tax will reduce individualcharitable donations by 10–22 percent, corporatecontributions by 15–21 percent, and testamentarygifts by 24–44 percent.

7 Although the Armey–Shelby plan is based on theHall–Rabushka proposal, it differs from theproposal in both terminology and substance (seeFeld (1995) for a comparison of the twoproposals). I analyze the Hall–Rabushka proposalinstead of the Armey–Shelby plan because theArmey–Shelby plan contains more opportunitiesfor arbitrage than its more fully developedpredecessor. Consequently, the arbitrageopportunities described in this paper can beexploited by taxpayers in both flat tax regimes.

8 Under the Armey–Shelby plan, the tax rate is 20percent for two years and 17 percent thereafter.

9 The proposal does not provide any guidance onthe application of these rules. For example, therules do not indicate whether businesses withdifferent ownership structures or differentownership groups can file consolidated returns.

10 The Armey–Shelby plan also contains a symmetricrule that allows businesses to deduct the marketvalue of property or services provided in anexchange.

11 See Feld (1995) for a discussion of this issue.12 Explicit taxes are tax dollars that are paid directly to

taxing authorities. Implicit taxes refer to taxes thatare paid indirectly in the form of lower before-taxrates of return on tax-favored investments.

13 In the current system, the installment methodcannot be used to defer gains on sales ofinventory, gains on sales by dealers in personalproperty or real property, or gains attributable toprevious depreciation deductions.

14 See Doernberg (1985). Alternatively, the flat taxsystem could require businesses to deduct the costof the asset as principal payments are paid on thedebt. This alternative treatment would be muchmore complex than an immediate deduction,especially when the debt includes borrowed fundsand accrued interest.

15 The transaction costs are due to negotiating andmonitoring the contract. One potential problemwith this tax-planning technique is that thecontract, as described, does not prevent customersfrom purchasing the product at the new contractprice (S – Xb) and then refinancing the loan at themarket interest rate i < r. If the customer is able torefinance without penalty, the taxpayer will not beable to recover the price reduction through thehigher interest rates. In order to forestall thispossibility, the contract must include a disincentivefor using an outside source of funding. Thetaxpayer can achieve this objective by either (1)charging prepaid interest (i.e., “points”) of Xb atthe date of the contract, (2) making thediscounted price contingent upon the customer’sadherence to the terms of the original contract, or(3) inserting a prepayment penalty clause in thecontract. Since neither the Courts nor the IRS haveaddressed the consequences of using suchrestrictions in this context, tax planners shouldproceed with caution when forming the basiccontract.

16 In a Hall–Rabushka flat tax system, the cost ofpersonal-use assets does not have any tax impactbecause the sale of personal-use property is taxexempt. By contrast, in the current tax system, thecost of the personal-use asset becomes the basisfor determining the taxable gain from the sale ordisposition of the asset.

17 Although this tax strategy is couched in terms of alandlord-tenant relationship, it may also beextended to other lease arrangements. Forexample, this strategy may be available to leasecontracts involving automobiles or computers.

18 Costs associated with note foreclosures (or tenantevictions) are nontrivial when the tenant conteststhe proceedings. The proposed strategy assumesthat the tenant does not contest the foreclosure


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and that the costs associated with an amenableforeclosure are trivial for both parties.

19 See Doernberg (1985) for a discussion of this issue.20 Despite previous analysis (e.g., Doernberg, 1985;

Feld, 1995), the Armey–Shelby plan does notcontain any provisions that restrict the use of thissimple tax avoidance strategy.

21 See Hall and Rabushka (1995).22 Note that this strategy can also be used to make

contributions to “uncharitable” entities such aspolitical organizations or government officials.

23 In contrast, employee expenses are not deductibleunless the taxpayer is able to itemize herdeductions. Even then, certain employee expensesmust exceed two percent of adjusted grossincome. Furthermore, the employee will notreceive a tax benefit for itemized employeedeductions if she is subject to alternative minimumtax.

24 See Calegari, Key, and Smith (1996) for an in-depth analysis of this subject.

25 The personal allowance in the Armey–Shelby bill is$11,000 for unmarried taxpayers and $22,000 formarried taxpayers. Both proposals also provideunmarried heads of households with a personalallowance that is less than that for marriedtaxpayers but greater than that for unmarriedtaxpayers who are not heads of households.

26 Hall and Rabushka (1995) § 201(a). The additionalpersonal allowance in the Armey–Shelby bill is$5,000.

27 The Armey–Shelby bill requires taxpayers to includeany income earned by dependent children underage 14. To avoid double taxation, dependentchildren under age 14 do not file personal taxreturns.

28 Hall and Rabushka (1995) § 301(2).29 Hall and Rabushka (1995) § 203(a) requires

corporations and partnerships to pay businesstaxes even if they are wholly or partially owned byexempt organizations.

30 See Hall and Rabushka (1995).31 See Slemrod (1996) for a review of studies that

estimate the compliance cost of the currentincome tax system.

32 See Slemrod and Blumenthal (1996) for an analysisof components of business compliance costs.

33 See Armey (1996) and National Commission onEconomic Growth and Tax Reform (1996).

REFERENCES

Armey, Dick. The Flat Tax. New York: FawcettColumbine, 1996.

Asinof, Lynn, and Tom Herman. “TaxPackage: Double-Edged Sword forHomeowners.” Wall Street Journal (August 5,1997): C1–21.

Auerbach, Alan J., and Dale Jorgenson.“Inflation-Proof Depreciation of Assets.”Harvard Business Review (September–October,1980): 113–8.

Blumenthal, Marsha, and Joel Slemrod. “TheCompliance Cost of the U.S. Individual IncomeTax System: A Second Look After Tax Reform.”National Tax Journal 45 No. 2 (June, 1992): 185–202.

Brown, E. Cary. “Business-Income Taxation andInvestment Incentives.” In Income, Employmentand Public Policy: Essays in Honor of Alvin E.Hansen. New York: W. W. Norton & Company,1948.

Calegari, Michael J., Kimberly G. Key, andJames K. Smith. “Flat Tax Ramifications forSelf-Employed Taxpayers.” Tax Notes 72 No. 5(July 23, 1996): 641–6.

Clotfelter, Charles, and Richard Schmalbeck.“The Impact of Fundamental Tax Reform onNonprofit Organizations.” In Economic Effects ofFundamental Tax Reform, edited by Henry J.Aaron and William G. Gale, 211–43. Washing-ton, D.C.: Brookings Institution Press, 1996.

Doernberg, Richard L. “A Workable Flat RateConsumption Tax.” Iowa Law Review 70 No. 2(January, 1985): 425–85.

Dunbar, Amy, and Thomas Pogue. “Estimat-ing Flat Tax Incidence and Yield.” National TaxJournal 51 No. 2 (June, 1998): 303–24.

Feld, Alan L. “Living with the Flat Tax.” NationalTax Journal 48 No. 4 (December, 1995): 603–17.

Gale, William G., Scott Hauser, and John KarlScholz. “Distributional Effects of FundamentalTax Reform.” In Economic Effects of Fundamen-tal Tax Reform, edited by Henry J. Aaron andWilliam G. Gale, 281–320. Washington, D.C.:Brookings Institution Press, 1996.

Ginsburg, Martin D. “Life Under a PersonalConsumption Tax: Some Thoughts on Working,Saving, and Consuming in Nunn–Domenici’s TaxWorld.” National Tax Journal 48 No. 4(December, 1995): 585–602.

Graetz, Michael J. The Decline (and Fall?) of theIncome Tax. New York: W. W. Norton &Company, 1997.

Gravelle, Jane G. “The Flat Tax and OtherProposals: Who Will Bear the Tax Burden?” TaxNotes (December 18, 1995): 1517–27.

Grubert, Harry, and T. Scott Newlon. “TheImplications of Consumption Tax Proposals.”National Tax Journal 48 No. 4 (December, 1995):619–47.

Hall, Robert E., and Alvin Rabushka. LowTax, Simple Tax, Flat Tax. New York: McGraw-Hill, 1983.


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Hall, Robert E., and Alvin Rabushka. The FlatTax. Stanford: Hoover Institution Press, 1995.

Hoven, Vernon. “Flat Tax as Seen By a TaxPreparer.” Tax Notes 68 (August 7, 1995): 747–55.

Mason, J. David. “Independent Contractor orEmployee: The Continuing Controversy.” Taxes(February, 1997): 99–112.

National Commission on Economic Growthand Tax Reform. Unleashing America’sPotential: A Pro-Growth, Pro-Family Tax Systemfor the Twenty-First Century. New York: St.Martin’s Press, 1996.

Pearlman, Ronald A. “Transition Issues inMoving to a Consumption Tax: A Tax Lawyer’sPerspective.” In Economic Effects of Fundamen-tal Tax Reform, edited by Henry J. Aaron andWilliam G. Gale, 393–434. Washington, D.C.:Brookings Institution Press, 1996.

Scholes, Myron S., and Mark A. Wolfson.“The Cost of Capital and Changes in TaxRegimes.” In Uneasy Compromise: Problems ofa Hybrid Income-Consumption Tax, edited byHenry J. Aaron, Harvey Galper, and Joseph A.Pechman, 157–90. Washington, D.C.:Brookings Institution Press, 1988.

Scholes, Myron S., and Mark A. Wolfson.Taxes and Business Strategy: A PlanningApproach. Englewood Cliffs, NJ: Prentice-Hall,1992.

Sease, Douglas R., and Tom Herman. TheFlat-Tax Primer. New York: Viking, 1996.

Slemrod, Joel. “Which Is the Simplest TaxSystem of Them All?” In Economic Effects ofFundamental Tax Reform, edited by Henry J.Aaron and William G. Gale, 355–91. Washing-ton, D.C.: Brookings Institution Press, 1996.

Slemrod, Joel, and Marsha Blumenthal. “TheIncome Tax Compliance Cost of Big Business.”Public Finance Quarterly 24 No. 4 (October,1996): 411–38.

Staff of the Joint Committee on Taxation.Description and Analysis of Proposals to Replacethe Federal Income Tax. Washington, D.C.:Government Printing Office, 1995.

Stiglitz, Joseph E. “The General Theory of TaxAvoidance.” National Tax Journal 38 No. 3(September, 1985): 325–37.

U.S. Department of the Treasury. Blueprintsfor Basic Tax Reform. Washington, D.C.:Government Printing Office, 1977.

U.S. Department of the Treasury. Office ofTax Analysis. “’New’ Armey–Shelby Flat TaxWould Still Lose Money, Treasury Finds.” TaxNotes (January 22, 1996): 451–61.

APPENDIX: DETERMINATION OF DEDUC-TION ALLOWED ON CONVERSION OFPERSONAL-USE PROPERTY INTO BUSINESS-USE PROPERTY

In the Hall–Rabushka proposal, the cost of businessinputs is the actual cost of purchases of goods,services, and materials required for business purposes.If a taxpayer wishes to convert personal use propertyto business use, it is uncertain whether the flat taxproposal allows the taxpayer to deduct the cost orvalue of the property as a business input. Feld (1995)suggests that it may be possible for taxpayers todeduct an amount on the date of conversion as a“deemed purchase of a business input,” which raisesthe question of whether to base the deduction on theproperty’s cost basis or on its fair market value on thedate of conversion. In this Appendix, I show thattaxpayers will be able to deduct the fair market valueof the property (not the lower of cost or market) as abusiness expense.

Suppose that an individual taxpayer wishes to convertproperty worth V (original cost of C) when the flat taxrate is τ. The taxpayer can sell the property to anunrelated party (U) for V – ξ and later repurchase theproperty for V + ξ, where Vτ > 2ξ > 0 is the pricecharged by U to effect the transaction and Vτ > 2ξ (1– τ ) –1. Since the taxpayer did not use the property forbusiness purposes at the time of the original sale, shedoes not recognize income on the sale to U. U willresell the property to the taxpayer because no oneelse is willing to pay more than V for the property.When the taxpayer repurchases the property, she isable to deduct the entire cost of the property, V + ξ,as a business deduction. In this scenario, the taxpayeris able to deduct the value of the property regardlessof whether the taxpayer originally acquired theproperty through purchase, exchange, gift, orinheritance.

The taxpayer can obtain a similar result by using awholly-owned corporation to effect the transaction. Inthis scenario, the taxpayer borrows the value of theproperty, V, by using the property as collateral for aloan, and then transfers the borrowed money to awholly-owned corporation in return for thecorporation’s stock. The corporation then purchasesthe property from the taxpayer for price V. Thetaxpayer uses the proceeds of the sale to repay theloan. The taxpayer does not recognize income on thesale to the corporation and the corporation receives adeduction equal to V. The difference between the twostrategies is that the taxpayer’s business deducts thevalue of the property in the first scenario, while thetaxpayer’s corporation obtains the deduction in thesecond scenario. In both instances, however, thetaxpayer is able to deduct the value of the convertedproperty against business income.

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FLAT TAXES AND EFFECTIVE TAX PLANNING - NTA ... TAXES AND EFFECTIVE TAX PLANNING 691 individual and business taxable income.8 The tax is administered at two levels. First, an individual