I n t h I s c h a p t e r y o u w I l L

People pay all taxes.
When the government levies a tax on a cor-
poration, the corporation is more like a tax collector than a taxpayer. The bur-
den of the tax ultimately falls on people—the owners, customers, or workers of
the corporation.
Many economists believe that workers and customers bear much of the
burden of the corporate income tax. To see why, consider an example. Suppose
that the U.S. government decides to raise the tax on the income earned by car
companies. At first, this tax hurts the owners of the car companies, who receive
less profit. But, over time, these owners will respond to the tax. Because pro-
ducing cars is less profitable, they invest less in building new car factories. In-
stead, they invest their wealth in other ways—for example, by buying larger
houses or by building factories in other industries or other countries. With
fewer car factories, the supply of cars declines, as does the demand for auto-
workers. Thus, a tax on corporations making cars causes the price of cars to rise
and the wages of autoworkers to fall.
The corporate income tax shows how dangerous the flypaper theory of tax
incidence can be. The corporate income tax is popular in part because it appears
to be paid by rich corporations. Yet those who bear the ultimate burden of the
tax—the customers and workers of corporations—are often not rich. If the true
incidence of the corporate tax were more widely known, this tax might be less
popular among voters.
C A S E S T U D Y
THE FLAT TAX
A recurring topic of debate is whether the U.S. federal government should com-
pletely scrap the current tax system and replace it with a much simpler system
evaluating the vertical and horizontal equity of any tax, it is important to take ac-
count of these indirect effects.
Many discussions of tax equity ignore the indirect effects of taxes and are
based on what economists mockingly call the 
flypaper theory
of tax incidence. Ac-
cording to this theory, the burden of a tax, like a fly on flypaper, sticks wherever it
first lands. This assumption, however, is rarely valid.
For example, a person not trained in economics might argue that a tax on ex-
pensive fur coats is vertically equitable because most buyers of furs are wealthy.
Yet if these buyers can easily substitute other luxuries for furs, then a tax on furs
might only reduce the sale of furs. In the end, the burden of the tax will fall more
on those who make and sell furs than on those who buy them. Because most work-
ers who make furs are not wealthy, the equity of a fur tax could be quite different
from what the flypaper theory indicates.
T
HIS WORKER PAYS PART OF THE
CORPORATE INCOME TAX
.

---

C H A P T E R 1 2
T H E D E S I G N O F T H E TA X S Y S T E M
2 6 1
called the 
flat tax.
The flat tax was proposed in the early 1980s by economist
Robert Hall and political scientist Alvin Rabushka. Since then, it has from time
to time caught the attention of politicians on both the political left (such as Jerry
Brown, former governor of California and sometime candidate in the Demo-
cratic presidential primaries) and the political right (such as Steve Forbes, multi-
millionaire publisher and sometime candidate in the Republican presidential
primaries).
Although flat-tax advocates have proposed various plans that differ in de-
tail, the essence of all the plans is a single, low tax rate that would apply to all
income in the economy. If the tax rate were set at 19 percent, for example, then
every taxpayer in the economy would face a marginal tax rate of 19 percent.
Most of the plans allow a certain amount of income to be excluded from the
tax. If the income exclusion were $10,000, for instance, then a person’s tax bill
would be
Tax 
⫽
0.19 
⫻
(Income 
⫺
$10,000).
Because of the income exclusion, a flat tax can be progressive: Average tax rates
rise with income, even though the marginal tax rate is constant. Some of the
plans even allow a person with very low income (in this example, less than
$10,000) to pay a “negative tax” by receiving a check from the government.
Because the flat-tax proposal calls for a major overhaul of the tax system,
it raises almost every issue discussed in this chapter, especially the tradeoff
between efficiency and equity. Here are some of the points made by flat-tax
advocates:
◆
The flat tax would eliminate many of the deductions allowed under the
current income tax, such as deductions for mortgage interest payments
and charitable giving. By broadening the tax base in this way, the flat tax is
able to reduce the marginal tax rates that most people face. Lower tax
rates mean greater economic efficiency. Thus, flat-tax advocates claim that
this change would expand the size of the economic pie.
◆
Because the flat tax is so simple, the administrative burden of taxation
would be greatly reduced. Flat-tax advocates claim that many taxpayers
could file their returns on a postcard. Because all taxpayers would pay
the same low tax rate on all forms of income, people would have less
incentive to hire tax lawyers and accountants to take advantage of
loopholes.
◆
Because all taxpayers would face the same marginal tax rate, the tax
could be collected at the source of income rather than from the person
who receives the income. Income from corporate profit, for instance,
would be taxed at the corporate level rather than at the personal level.
This additional simplification also reduces administrative costs.
◆
The flat tax would replace both the personal income tax and the corporate
income tax. All income, whether from working at a job or from owning
shares in a corporation, would be taxed once at the same marginal rate.
The flat tax would eliminate the current double taxation of corporate
profits, which now discourages corporations from investing in new plants
and equipment.

---

2 6 2
PA R T F O U R
T H E E C O N O M I C S O F T H E P U B L I C S E C T O R
◆
In computing income for tax purposes, businesses would be allowed to
deduct all legitimate business expenses, including expenses on new
investment goods. This deduction for investment makes the flat tax more
like a consumption tax than an income tax. As a result, a change to a flat
tax would increase the incentive to save (or, more precisely, would
eliminate the current tax system’s disincentive to save).
In short, advocates of the flat tax claim that there is a strong efficiency argument
for this dramatic tax reform.
Critics of the flat tax are sympathetic with the goal of a simpler and more ef-
ficient tax system, but they oppose the flat tax because they believe that it gives
too little weight to the goal of vertical equity. They claim that a flat tax would be
less progressive than the current tax system and, in particular, would shift some
of the tax burden from the wealthy to the middle class. This concern may well
be justified, but no one knows for sure. Our study of tax incidence shows that
the burden of a tax is not necessarily borne by the person who sends the check
to the government. If the flat tax did encourage greater saving, as advocates
claim, it would lead to more rapid economic growth, which would benefit all
taxpayers. No one can be certain, however, about how large the impact on eco-
nomic growth would be.
Q U I C K Q U I Z :
Explain the