Santorum 20/20 Flat Tax Might Be Hard On Many Small Businesses

This post was originally published on Forbes Oct 15, 2015

Rick Santorum rolled out his tax plan with a piece in The Wall Street Journal-A Flat Tax Is The Best Path To Prosperity– . I have to say that the Republicans are doing a much better job of providing me with material than the Democrats.  Getting specific tax proposals from the Dems is like pulling teeth. There is Bernie Sanders with about 90% of a plan still holding back on the rates and the rest of the bunch don’t even have that much all put together, except for Chafee who thinks the Code is OK as is and just wants to add a new top rate and increase exemptions a bit.  Santorum’s plan has significant substance to it, although, as always there are devilish details I’d like to know more about.  The most detailed version I could find is here.

The Tax Foundation scored Santorum’s plan .  Over ten years it gives up $3.2 trillion in revenue scored statically – $1.1 trillion scored dynamically. (Dynamic scoring accounts for the positive effect the cuts have on the economy) Santorum has a “piece of cake method for taking”care of the revenue loss – Repeal Obamacare – Huzzah!! At any rate, if you care about the deficit, this plan compares very favorably to Trump and Jindal who are both in the neighborhood of $10 trillion in lost revenue with their plans.

Santorum calls for a 20% flat rate for both individual and corporations.  Individuals get a $2,750 per person refundable credit plus retention of the Child Tax Credit.  I’m reading that to work out to $7,500 for a family of 4. So you would have zero tax till you got to $37,500.  Personal exemptions, dependency deductions and most itemized deductions are blown away as is the Alternative Minimum Tax and the Estate Tax.

There is an uncapped itemized deduction for charity and a residence mortgage interest deduction capped at $25,000 (That’s a lot simpler than the current cap which is based on mortgage balance).  It is getting tough to keep track but blowing away all itemized deductions except charity and mortgage interest is a pervasive feature of the Republican plans. It is getting so I would really like to have some candidate come out and say that they want to leave everything in the tax code just like it is except that the mortgage interest and charitable deductions will be eliminated and every man woman and child in the country will get a check for $300 around Christmas time.  I have a request in to the Tax Foundation to score that, but I’m not real optimistic about getting an answer.

Business Provisions

It is not crystal clear to me that the business provisions apply to flow throughs that will be taxed to individuals.  I’m going to go with that assumption, though.  The big new benefit is “expensing of all capital investments in plant and equipment including inventories”.  I don’t recall seeing inventory expensing in other plans.  Before getting too excited, we have to note the big takeaway – no more deductions for business interest.  This coupling of expensing with eliminating interest deductibility is something that you will see economists arguing for.  It is part of the Bush plan. I find it very troubling.

Simplistically put, big companies with access to Wall Street can raise equity.  The little guys – Main Street so to speak – tend to be fueled by bank debt.  Think about somebody who owns a small shopping mall that is pretty well depreciated. Say it is worth $5,000,0000 and has net operating income of $300,000 and a $3,000,000 5% mortgage.  Instead of being taxed on $150,000, the owners will now be taxed on $300,000 which takes all the fun out of the rate decrease.  More dire is the situation of a small business that generates just enough operating income in a year to cover its debt service.  Under this plan a company like that could still have a big income tax bill and no net income to pay it.

The Bush plan has a similar provision which I discussed here.   Bush’s plan, which is not flat, scores similarly to Santorum’s .

I don’t understand why there does not seem to be more excitement about the elimination of business interest deductions.   Based on anecdotal evidence there are quite a few small business people who would be devastated by the change and the lower rates and expensing would not offset it.  If I was cynical, I would think that this is a plot for people who can tap the equity markets to snap up small businesses at a discount

I’m willing to give on the “eliminate a culture of corruption and taxpayer abuse” as a kind of faith-based rendering of the interminable IRS Scandal – now on Day 888 by TaxProf count.  It is the “dramatically downsize” that I have a hard time with.  Most of the complexity and most of the controversy around the income tax, turns on the definition of income and also people simply omitting income or entirely fabricating business deductions.  The IRS also spends time and energy, probably not enough, collecting from people and businesses who have not paid taxes about which there is no controversy.  This new system does not eliminate those issues.  Expensing of capital items and inventory will simplify business returns, but there will still be issues.

It would be easier to take these proposals more seriously in their simplification claims, if they were accompanied by a copy of the proposed Internal Revenue Code of 2017.  The emoting about the 70,000 pages or 4 million words that are a part of these proposals misses a couple or realities.  One is that there is inherent complexity in defining income.  That is why there is, for example, a section for insurance companies, which need to be providing for claims that might not be paid for a really long time.  The other is that statutes need to be devised to squash obvious and not so obvious ways that people will use to game the system.

A progressive rate table may be a good or bad idea, but it is really not that complicated.  Even if you are doing a return by hand figuring out the tax on a progressive table once you have gotten to taxable income could be turned over to a bright fourth grader.  Boiling the 29 line Schedule A down to 2 lines might seem like a massive reduction in complexity, but all the various Code Sections that address potentially abusive transaction will need to stay in some form or other and you will still need special provisions for insurance companies and financial institutions.  So the page count will not come down all that much, but the page count is not a real problem, since nobody is affected by all the pages and regular people only have to worry about a few of them

It is worth noting that the core IRS Scandal was about the processing of exempt applications, something which would continue to be required under Santorum’s plan.