From the June 2006 issue of Wealth Manager Web • Subscribe!

June 1, 2006

Going Flat

Maybe vampire chronicler Anne Rice should write her next piece about the flat tax: It also never lives yet never dies.

One of its main advocates has been Steve Forbes, the publisher and presidential contender who made the flat tax the centerpiece of his campaign when he ran in 1996 and 2000. If his plan or one similar, became reality, its effect on high-net-worth individuals--those with $1 million or more of investable assets--would be significant. In particular, it would mean major revisions in their investment strategies. But Forbes looks at the situation another way: "The only thing you have to lose with the flat tax is painful conversations with your tax lawyer," he says. In general, flat-tax supporters are looking to make filing federal taxes as simple as filling out a form the size of a postcard.

In addition to the well-known Forbes Flat Tax plan, is the Hall-Rabushka plan, named after its creators, Robert E. Hall and Alvin Rabushka, economists at the Stanford, Calif.-based Hoover Institution.

Hall-Rabushka (and some other flat-tax plans), which outwardly appears to tax income, actually taxes consumption. With this plan there are no deductions for mortgage interest and charitable contributions; no tax credits and the only exemptions are for adults and children. No tax would be imposed on savings or investments. Under a consumption tax, high net worth individuals would not pay any tax, for example, on the million dollars they have in the bank until it is spent. Also, eliminated would be the so-called death tax and the Alternative Minimum Tax.

A flat tax may grant certain limited, fixed deductions. For example, under the Forbes proposal, high-net-worth individuals would pay a single-rate federal income tax of 17 percent that would kick in after exemptions for adults and children. A standard adult exemption would be $13,200; double the amount for married couples and families would get a $4,000 exemption for each child. A family of four would pay no federal income tax on its first $46,165 of income, says Forbes.

The number of high-net-worth individuals has grown steadily in this country, according to data from a 2005 study. In 2005, there were 8.9 millionaire households or 8 percent of total U.S. households. Most high-net-worth individuals get more of a benefit from itemized deductions to bring down their tax bill, so would there really be advantages for a flat tax?

"People with a million or more of investable assets would be helped by the flat tax because the value of their portfolios is likely to rise considerably" says Patrick Fleenor, chief economist at The Tax Foundation, a nonprofit, nonpartisan research organization in Washington, D.C. "For example, the average person at that level holds a lot of stock, and the value of those stocks will likely rise if there would be a flat tax."

With deductions gone under a flat-tax plan, wealthy individuals will make weighty changes in their investment portfolios, says one money manager.

"There will be a huge change, to the extent investment decisions are now made on the basis of the tax difference between capital gains and dividends versus interest," says Alan Kral, a managing director at Trevor Stewart Burton & Jacobsen Inc. an investment management company in New York City. "Investors will be less attracted to equities and will be become more attracted to the fixed-income market when they are taxed the same." He adds there will likely be a sell-off in the municipal bond market with people increasing their commitments to taxable fixed income.

Another substantial change would be the second home market. "If you can no longer deduct the mortgage interest or property taxes, people will face a greater disincentive to buy second homes," he says.

Talk about a flat tax to simplify the U.S. tax code is speculative for now. Last November, the President's Advisory Panel on Federal Tax Reform issued a report on proposals to fix America's tax system. One reform plan that was much like a flat tax which would not tax families or businesses on savings and investments, landed with a thud. The Panel was disbanded following the report's release. The Treasury Department said it plans to outline its own tax reform proposals, but there are no deadlines for when that may be forthcoming.

Still, Forbes says the flat tax idea is being embraced by the rest of the world and is making its way here to the U.S. "In the next few years it will happen [here] in part because of the growing competition from the Indias and the Chinas of the world. Already a number of eastern and central European nations have adapted it," says Forbes. "Now Western Europe is starting to debate the issue, and when it comes to Western Europe, it is going to make a quick journey across the ocean."

Sandra Lea Abrams is a freelance writer based in Washington, D.C.

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