The Free-Market Case Against the "Flat Tax"

As President George W. Bush continues to push for health-care tax credits, private tax-free accounts within Social Security, expanding educational savings accounts, and other policies, many free-market advocates are starting to complain. Whatever happened to the Holy Grail of the conservative movement, the flat tax? Or the national sales tax beloved by many libertarians?

Since the mid-1990s, the two factions have debated the proper means of fundamental tax reform. The dispute gained its greatest prominence during the 1996 presidential campaign, when flat-taxer Steve Forbes first put the issue on the national media's agenda.

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But increasingly, conservative politicians and public policy experts, seeking to offer market-oriented alternatives to government provision of education and health care, have championed tax credits and tax-free savings accounts despite their apparent conflict with fundamental tax reform. Unlike the tax-simplification folks, tax-credit and savings-account advocates have seen their ideas embodied in recent state and federal legislation and in serious presidential proposals in health care and Social Security.

The resulting rhetoric has tended toward the apologetic. In a recent editorial praising the latest progress on tuition tax credits, for example, The Wall Street Journal stated that its "own preference is for tax systems that are clear, have low marginal rates at their core, and don't clutter the tax code with social engineering." But if teacher unions continue to block parental choice, the editorial allowed, "they shouldn't be surprised if the pent-up demand for reform comes in through the back door of tax credits."

For those seeking a little more intellectual tidiness, the good news is that there is no real tension between tax breaks for education and health care on the one hand and tax reform on the other. Properly conceptualized, any tax reform worth its salt will include tax deductions or credits for these expenditures. They constitute a form of capital formation indistinguishable from building factories or buying stocks-both investments that everyone agrees should be either expensed at the front end or exempted from tax when they pay off.

Both the flat tax and the national sales tax seek to create a consumption-based tax that excludes investment (which is nothing more than deferred consumption) from double-taxation. The reasoning is straightforward. Investments that generate future taxable income (in the form of wages, dividends, or capital gains) should not themselves be taxed. Otherwise, the stream of future income is reduced by the same amount, resulting in double-taxation. While many understand and embrace this concept for financial assets such as stocks, it applies equally well to human capital formation.

The notion that education is an investment that pays future returns in the form of higher wages should be a familiar one. If you tax an investment in education, then, you are inherently reducing the return on that investment by the same amount. Since future earnings will also be taxable at that time, a tax bias against human capital is created.

The application of the principle to health care may seem less straightforward, but in fact the idea is hardly new. When economists Theodore W. Schultz and Gary Becker were developing modern theories of human capital in the 1950s, they included health care as one of the investments that pays off in future wages. A worker or future worker getting needed health care can be analogized to the maintenance and repair of any capital asset.

Of course, distinguishing between the consumption and investment components of education and health care is extremely difficult. Spending four years at college in pursuit of an engineering degree will likely prove to be a profitable investment. The same amount of time and expense devoted to a degree in art history will not likely yield so healthy a return.

Such complexity does not argue against tax breaks for education and health care in a flat-tax world. They argue for limitation. Parents should be allowed to deduct a fixed amount of spending on education or health care for their children. Adults should receive a similar, though probably smaller, annual deduction for human capital formation. In my book "Investor Politics," I propose a system in which these tax exclusions are linked to ESAs, MSAs, and other personal investment vehicles, which offers a number of other practical advantages.

Using this human capital argument, one can even defend proposals from free-market think tanks and politicians for refundable tax credits for private school tuition or health insurance-since these credits, for most taxpayers, will merely offset payroll and other taxes levied on such investments by Washington, the states, and local governments.

In this case, there is no need to invent rationalizations for policies such as MSAs that are popular with free-market conservatives who also seek tax reform. Properly understood, tax neutrality does not preclude tax breaks for education and health care expenses. It requires them.

Mackinac Center Adjunct Scholar John Hood is president of the John Locke Foundation, a public policy think tank in North Carolina, and author of "Investor Politics: The New Force That Will Transform American Business, Government, and Politics in the 21st Century," available from Templeton Foundation Press.

"There is no real tension between tax breaks for education and health care on the one hand and tax reform on the other."