Review of Agricultural EconomicsVolume 24, Number 1Pages 160180

The Effects of a Federal Flat Tax on Agriculture

Christine A. Wilson, Allen M. Featherstone, and Del D. Elffner

This study examines the impact of a federal at tax on agriculture by determining the tax liability under the current and at tax systems using actual farm records. The study considers the linkages between agriculture and the rest of the economy by examining the impact of a at tax on interest rates and capital investment and how those changes would affect agriculture. Results indicate that roughly 63% of agricultural producers would benet from a at tax in terms of lowering taxes paid. Under the at tax, larger farms and more protable farms would be relatively better off.

axation and tax reform are subjects that receive a great deal of attention and discussion in Congressional and other political debates. Recent tax reform proposals have included the Flat Tax, the USA Tax, and the National Sales Tax (Carman). Much of the reason for tax reforms staying power as a topic for debate arises from continued public dissatisfaction with the current system. Most alternative tax proposals, therefore, concentrate on resolving the publics dissatisfaction by improving the simplicity, efciency, and equity of the current income tax system. The National Commission on Economic Growth and Tax Reform recommended the development of a new simplied income tax code based on six major policy points. The Commission suggested that any new tax code should: (1) have a single tax rate; (2) increase personal exemptions to remove the burden from those least able to pay; (3) lower tax rates for families; (4) allow payroll tax deductibility for workers; (5) end the biases against work, saving, and investment; and (6) make the new tax system difcult to change. In addition to its policy recommendations, Christine A. Wilson is an Assistant Professor in the Department of Agricultural Economics, Purdue University, West Lafayette, Indiana; Allen M. Featherstone is a Professor in the Department of Agricultural Economics, Kansas State University, Manhattan, Kansas; and Del D. Elffner is a Vice President with Stockgrowers State Bank, Maple Hill, Kansas.

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the Commission suggested six principles that should guide any new tax system. These principles are: (1) economic growth through incentives to work, save, and invest; (2) fairness for all taxpayers; (3) simplicity so that anyone can understand it; (4) neutrality that lets people and not the government make choices; (5) visibility to let people know the cost of government; and (6) stability so that people can plan for the future. Although the Commission did not endorse a specic tax proposal, some argue that current at tax proposals are consistent with these policies and principles. A at tax is one in which the marginal tax rate remains constant as taxable income increases. Marginal tax rates differ from average tax rates in that the marginal tax rate is the fraction of an additional dollar of income that must be paid in taxes, whereas average tax rates are the total amount of taxes paid divided by the individuals before-tax income. Robert Hall and Alvin Rabushka were the rst to formally propose a at tax, and most at tax proposals are derivatives of their proposal. The HallRabushka proposal draws heavily on the principle of a consumption tax, under which consumers are taxed on what they take out of the economy, not what they put in. Hall and Rabushka suggest that all income should be taxed only once, at the same rate, and taxed as close to the source as possible. These authors believe the poorest families should pay no tax, and lower-income individuals should pay a smaller fraction of their incomes in tax than those with higher incomes. Hall and Rabushka argue that a at tax would simplify tax returns for many wage earners. Their proposal has two classications of income, business income and individual wage income, both taxed at the same rate. On March 9, 1999, Representative Richard Armey (R-Texas) introduced H.R. 1040 to the 106th Congress.1 The bill is an update of The Freedom and Fairness Restoration Act of 1995, and is a pure at tax on income based on the at tax proposal put forth in the book by Hall and Rabushka. H.R. 1040 would replace the current progressive tax system with a 19% at tax that would have remained in effect until December 31, 2000, followed by a reduced tax rate of 17% thereafter.2 The rate reduction would occur provided revenues to the Treasury increase, federal spending falls, and the decit meets certain preestablished targets. Under Representative Armeys at tax, the Social Security tax would remain intact. Although Social Security payments would no longer be deductible, the employer would still be obligated to make one-half of the employees Social Security contribution, with the employee contributing the other half. Self-employed individuals could choose to have their entire business income taxed at the at tax rate, or pay themselves a salary that could be deducted from gross revenue, lowering their business income. The salary would then be taxed at the at tax rate and the Social Security tax rate (15.3%), after personal deductions were removed. The objective of this study is to evaluate the impact of a at tax on agriculture. Tax models are used to determine the tax liability under the current system and the at tax system, to analyze the shift in the tax burden using actual Kansas farm records, to evaluate the equity and progressivity of the current and at tax systems, and to determine the winners and losers resulting from a change in the tax system. The study also examines the impact of a at tax on interest rates and capital investment.

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Previous Studies
Several studies have examined the effects of a at tax on the economy and agriculture. Fellows concluded that a at tax system may not spur much economic growth since the work/leisure substitution and income effects would probably be nearly offsetting. Adams and Harl indicated that eliminating the deduction for interest paid under a at tax would signicantly impact young, highly leveraged farmers. The authors contend that without this deduction, many indebted farmers could have a negative net farm income, yet nd they still owe taxes at the end of the year. Adams and Harl also suggested higher land prices and land-lock as two additional effects of a at tax. Under most at tax proposals, capital gains taxation and the present scheme of depreciation for business assets are eliminated, allowing capital purchases to be deducted as business expenses in the year they are incurred and fully taxed in the year of sale. Adams and Harl suggested farmers will purchase additional land to reduce their tax liability during a high-income year, but that the large tax liability associated with the sale of the land will create a disincentive to sell, creating a lock-in effect, and potentially higher land prices. Adams and Harl concluded that increased land prices, coupled with the elimination of interest deductions, would create a barrier for individuals wanting to enter farming. Duncan, Koo, and Taylor estimated the effect of a at tax on representative farms in North Dakota for 19962003. They concluded that only large-size farms would experience tax savings under the at tax system; small- and medium-sized farms would pay higher federal taxes. Carman and Boehlje examined past studies of changes in income tax laws from which they suggested several consequences of a at tax. Some of the effects they offered were increased farmland prices, increased nonfarm investor interest, and decreased land availability. These effects could lead to greater nancial requirements and larger barriers to entry into farming. Carman and Boehlje also suggested that the reduced after-tax cost of capital purchases due to full expensing in the purchase year would encourage greater capital investment. They concluded that greater capital investment would increase the mechanization of agriculture, increase business activity in machinery and equipment industries, and reduce farm employment. They further concluded that increased tax-sheltering could lead to increased production over time. Richardson et al. simulated the impacts of a at tax on 70 representative crop, livestock, and dairy farms for a seven-year period. Their research indicated that highly leveraged farmers would face higher taxes under a at tax due to the loss of the interest expense deduction. They also suggested that farmers would adjust their equipment investment in order to capitalize on the ability to fully expense assets in the year they were purchased. Carman outlined several expected impacts of a at tax. He suggested that full taxation of land sales would discourage selling, leading to decreased land availability and increased land prices. He also suggested that the immediate deduction of land purchases would lead to increased demand for land and increased land prices. Carman further outlined that a reduction in land availability and higher land prices, as well as the lack of interest deductibility, would create larger barriers to entry into farming.

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Friedman suggested that a at tax system would benet taxpayers and the economy. Friedman stated that, A low at rateless than 20%on all income above personal exemptions with no deductions except for strict occupational expenses would yield more revenue than the present unwieldy structure. Taxpayers would be better off because they would be spared the costs of sheltering income from taxes; the economy would be better off because tax considerations would play a smaller role in the allocation of resources (p. 306). One issue that some previous studies have neglected is the effect that a at tax could have on interest rates. John Golob, a Kansas City Federal Reserve Bank economist, estimated that the elimination of the taxation of interest would cause interest rates to drop 25% to 35%. With the consideration of secondary factors, he concluded the drop would likely be closer to 25% than 35%.

Data
Data used in this study are from the Kansas Farm Management Data Bank and a tax survey sent to members of the Kansas Farm Management Association. The Farm Management Data Bank contains all the necessary information for determining the tax liability under the current federal tax system for each association member, except for the cost basis of livestock and other items purchased for resale, and capital or ordinary gains or losses. Because these gures are not explicitly included in the data bank, a survey to ascertain these data was sent to all members enrolled in the Farm Management Association. The tax survey asked association members for the cost basis of livestock and other items purchased for resale, found on line 2 of the Schedule F; the capital gains gure, found on line 13 of the 1040 (taken from Schedule D); and the other gains gure, found on line 14 of the 1040 (taken from Form 4797), for 1990 through 1994. The survey data were combined with the Farm Management Data to complete this study. The tax survey was sent to 2,071 members of the Farm Management Association. Survey data for 653 producers were received. Of those, 593 were sole proprietorships, 27 were partnerships and 33 were corporations. Only the results for the sole proprietorships are reported in this study since not enough nonfarm information was available to construct a complete nancial picture for those individuals involved in partnerships and corporations.

Empirical Tax Models

Tax models were developed to analyze the tax liability under the current federal tax system and a federal at tax. The models account for both income and selfemployment taxes.

Current Tax Model The Current Tax Model (CTM) was developed using the Schedule F to calculate farm income and expenses for sole proprietorships.3 Net farm income or loss was used to calculate self-employment taxes and Federal income taxes owed. Schedule SE and Form 1040 were used to determine self-employment taxes, Social Security taxes for wages paid, and Federal income taxes.

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All farm expenses were broken into four classes of operating expense, depreciation, interest paid, and real estate taxes, for comparison among tax plans. Depreciation is determined on a market-value basis instead of a tax basis. Farm expenses were subtracted from farm income, resulting in net taxable farm prot in the CTM. Once net taxable farm income, capital gains, other gains, and self-employment taxes were determined, then total income and adjusted gross income were calculated. Total income was determined by adding net taxable farm income, capital gains, ordinary gains, and any net operating losses carried forward from previous years. Adjusted gross income was calculated by subtracting one-half of the self-employment tax value from total income. Adjusted gross income was then used to determine taxable income.4 The CTM calculated taxes due by using ve income brackets ranging from 15% to 39.6%. Taxes due were combined with the full value of self-employment, Social Security, and Medicare taxes, where applicable, to arrive at the nal tax amount owed and paid by the operator. Table 1 provides sample tax calculations and a summary of the breakdown of income and expenses used in calculating the total tax liability under each tax plan.

Flat Tax Model The Flat Tax Model (FTM) calculates the tax liability a Kansas farmer operating as a sole proprietor could expect to face under a at tax plan. Representative Armeys original at tax proposal placed a 20% tax on the difference between revenue and expenses (if positive) for all business enterprises. Even though H.R. 1040 uses a 19% tax rate, we continue to use the rate of the original proposal to somewhat alleviate critics concerns regarding revenue neutrality. The proposal subtracts purchases of goods and services, capital equipment, structures, and land from gross revenue to arrive at a base taxable income. Gross revenue for the FTM was found by combining income variables from the Farm Management Data Bank (Elffner). With only a few exceptions, all income variables included in the FTM are identical to the variables included in the CTM. Motor vehicle and machinery sales, building sales, land sales, and sales of breeding livestock are included as income in the FTM, but are not included in the CTM. Additionally, in the FTM, all capital assets are expensed at the time of purchase, and they are not depreciable, which differs from their treatment in the CTM. Expenses used in the FTM are similar to the CTM except that interest paid, motor vehicle, machinery-equipment, and building depreciation are no longer deducted. The change in deduction status of these items reects Representative Armeys proposal to eliminate the interest and depreciation deductions and to expense all capital purchases the year that they are placed in service. Income5 in the FTM was determined by subtracting the purchases of goods and services, capital equipment, structures, and land and livestock from gross revenue. If income was negative, then a net operating loss occurred, and the loss was carried forward to the next year. Under the Armey plan, a loss would earn interest equal to the three-month Treasury rate for the last month of that next year, at which time the loss plus the interest earned would be deducted from that years net income. If the net income for that year was again negative, then the combined loss would be carried forward again, until the loss is offset by income.

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Table 1. Sample tax calculations for the current and at tax systemsa
Current Tax System Without nonfarm wages Gross farm income (Schedule F) Plus: Sales of breeding livestock Plus: Sales of capital assets Plus: Sales of land Less: Cost basis of livestock sold Less: Operating expenses Less: Depreciation Less: Interest paid Less: Real estate taxes Less: Purchases of livestock for resale Less: Purchases of breeding livestock Less: Purchases of capital assets Less: Purchases of land Net taxable farm income Less: Capital loss Plus: Other gains Less: Net operating losses Total income Less: Half of self-employment tax Adjusted gross income Less: Standard deduction Less: Personal exemptions Taxable income Federal income tax Self-employment tax (15.3%) Total income tax & self-employment tax With nonfarm wages Nonfarm wages Taxable income Federal income tax Self-employment tax (15.3%) Total income tax & self-employment tax
a Sample

Flat Tax System $392,923.00 3,519.00 5,800.00 0 96,747.00

$392,923.00

214,266.00 96,747.00 18,591.00 2,553.00 1,056.00

59,710.00 (3,000.00) 1,310.00 0 58,020.00 3,924.45 54,095.55 5,450.00 12,300.00 36,345.55 5,958.25 7,848.90 $13,807.15 $2,890.00 39,235.55 6,767.45 7,848.90 $14,616.35

1,056.00 221,402.00 1,200.00 19,549.00 0 62,288.00

0 62,288.00

18,370.00 17,160.00 26,758.00 5,351.60 5,436.09 $10,787.69 $2,890.00 29,648.00 5,929.60 5,436.09 $11,365.69

calculations use 1990 tax provisions.

The Armey at tax would eliminate the current self-employment tax, but leave the Social Security tax untouched. Self-employed individuals could choose to have their entire business income taxed at the at tax rate, or they could choose to pay themselves a salary, which would be deducted from gross income, and would thus lower their business income. The salary would be taxed at the 20% at tax rate and at the 15.3% Social Security tax rate after personal deductions were removed. This study assumed that producers, acting as rational individuals, would deduct a salary that would be exempt from the at tax for business income. A 15.3%

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Table 2. Taxes for sole proprietors in the current and at tax models (19901994)
Standard Deviation $10,318.01 $3,115.80 $1,096.12 $12,622.18 $9,543.74 $1,797.37 $1,096.12 $10,528.02

Mean Current tax model with nonfarm wages Federal income tax Self-employment tax (15.3%) Social Security tax Total tax $5,945.48 $3,736.74 $640.57 $10,322.79

Flat tax model with nonfarm wages and land transactions Federal income tax $5,257.76 Self-employment tax (15.3%)a $2,283.11 Social Security tax $640.57 Total tax $8,181.44
a Assumes

that producers choose to pay themselves a salary that is deducted from gross income, and lowers business income. The salary is taxed at the 20% at tax rate as personal income, but is exempt from the at tax for business purposes. The tax amount stops when the maximum deductible income is reached. The salary is taxed at the 15.3% Social Security tax rate after personal deductions are removed.

Social Security tax was calculated on the salary, compared to a 20% at tax rate for the business purposes. Table 1 presents the tax calculations for both tax models for a sample observation for 1990, using 1990 tax provisions. Under the FTM, the total tax liability for the sample observation is $10,787.69, which is $3,019.46 less than the tax liability of the CTM. The lower taxable income of the FTM decreased taxes by 22% for the sample observation.

Tax Model Results Table 2 reports the mean tax results for both the CTM and the FTM. Nonfarm wages are included in both models and land transactions are included in the FTM. The at tax plan assumes the complete expensing of land in the year of purchase, and it taxes the total sale price of the land when sold. The mean Federal income tax for the CTM was $5,945.48 with a standard deviation of $10,318.01, while that for the FTM was $5,257.76 with a standard deviation of $9,543.74. The mean total tax for the CTM, which included income tax, self-employment tax, and Social Security tax, was $10,322.79 with a standard deviation of $12,622.18, while that for the FTM was $8,181.44 with a standard deviation of $10,528.02. The mean total tax for the study indicate that average total taxes decline by 21% ($2,141.35) and have less variability under the at tax system investigated.

Regression Analysis
Ordinary least squares regression was used to determine how farm and personal characteristics inuence the equity and progressivity of the tax burden under

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the current and at tax systems and to determine the winners and losers as measured by tax payments resulting from a change in tax systems. The regression analysis examined the effect that debt, income, size of farm, type of farm, age of the operator, and family size had on Federal taxes owed. Models were estimated using annual data from 1990 through 1994. The dependent variables in the models were Federal tax liability and the difference in the total tax liability of the two tax systems. The independent variables included in the models were the debt-to-asset ratio, the net farm income-to-total asset ratio, total assets, the age of the operator, the number of dependents, the type of farm operation, net farm income, and net farm income squared.

Equity One major principle for evaluating a tax system is equity. Equity is generally used to refer to fairness in the tax system, especially fairness of the distribution of the tax burden. Due and Friedlaender indicate that equity or fairness in taxation is ultimately a value judgment, since a scientic specication of an equitable distribution pattern is not possible. Thus, they contend that the only way an equitable distribution can be devised is by a consensus of attitudes of people in the contemporary society. The regression used in this study to examine fairness or equity summarizes the tax liability across farms. The dependent variable modeled was federal taxes owed (in four scenarios) and the independent variables were the debt-to-asset ratio (DTA), net-farm-income-to-total-assets ratio (NTA), total assets (ASSET), the age of the operator (AGE), the number of dependents (DEPD), and binary variables for the type of farm operation (ICROP, BEEF, DAIRY, HOG, OTHER). The results reported in table 3 indicate that the net farm income-to-total assets ratio and total assets were positive and signicant in both the CTM and the FTM (no change in interest rates). This suggests that more protable and larger farms pay more in federal taxes under both tax systems than relatively smaller and/or less protable farms. Results also show that the debt-to-asset ratio was negative and signicant in the CTM, but positive and signicant in the FTM, implying that increasing leverage reduces taxes under the current tax system and increases taxes in the at tax system. This result suggests that relatively higherleveraged farms pay less tax in the current tax system and more tax in the at tax system than lower-leveraged rms. Additionally, results indicate that in the CTM, a beef producer pays lower taxes than a nonirrigated crop farmer. The number of dependents was not statistically signicant in either model. Comparison of the regression results for the two tax plans indicates that the FTM reduces the effect of protability (NTA) and size (ASSET) on the tax burden. Under the FTM, more protable farms, as measured by the net-income-to-totalassets ratio, and larger farms, as measured by total assets in dollars, pay relatively lower taxes than under the CTM. However, under the at tax system, farms with relatively higher leverage ratios pay higher taxes than in the current tax system.

Progressivity Vertical equity, or the unequal treatment of unequals, addresses the issue of how to appropriately tax households with different levels of well-being. The terms

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Table 3. Estimated regression coefcients of tax plans for evaluating equity

Flat Tax Model Current Tax Model 0.3264 10,379.53 2,079.61 (1,446.50) 1,627.04 (678.05) 53,933 (1,999.48) 0.013724 (0.0006) 34.51 (20.20) 55.48 (165.60) 474.34 (770.04) 1005.19 (495.05) 1,035.55 (992.98) 68.55 (1,334.54) 523.58 (861.12) No Change in Pretax Interest Rates 0.3179 8,712.31 2,621.23 (1,183.74) 2,304.87* (571.27) 29,848 (1,002.67) 0.00816 (0.0005) 23.00 (16.84) 123.06 (139.17) 249.38 (646.29) 366.75 (414.96) 1,117.62 (833.72) 1,664.64 (1,120.23) 456.04 (722.38) 12.5% Drop in Pretax Interest Rates 0.2725 8,687.46 3,592.24 (1,180.37) 1,594.11 (569.64) 29,637 (999.81) 0.004547 (0.0005) 11.70 (16.80) 104.81 (138.77) 396.70 (644.45) 665.92 (413.78) 1,221.83 (831.34) 1,512.27 (1,117.04) 216.24 (720.32) 25% Drop in Pretax Interest Rates 0.2555 8,948.25 4,563.26 (1,215.80) 5,493.10 (586.74) 29,425 (1,029.82) 0.000934 (0.0005) 0.40 (17.30) 86.57 (142.94) 544.02 (663.80) 965.09 (426.20) 1,326.04 (856.30) 1,359.90 (1,150.57) 23.56 (741.95)

Variablea R-squared RMSE Intercept DTA NTA ASSET AGE DEPD ICROP BEEF DAIRY HOG OTHER

Variables that are signicant at the 5% level. Standard errors are in parentheses. a The dependent variable is Federal taxes owed. Independent variables are the

debt-to-asset ratio (DTA), net-farm-income-to-total-assets ratio (NTA), total assets in dollars (ASSET), age of the operator (AGE), number of dependents (DEPD), and binary variables for the type of farm operation: irrigated crop, beef, dairy, hog, and other production (ICROP, BEEF, DAIRY, HOG, OTHER), where nonirrigated crop production is the base.

progressive, proportional, and regressive are typically associated with vertical equity. A progressive tax is one in which the tax liability as a percentage of income rises with income. A proportional tax is one in which all people pay the same percentage of income in tax, regardless of the level of income. Finally, a regressive tax is one in which the tax liability is a smaller percentage of income for people with higher income levels. According to Slemrod and Bakija, the question of vertical equity generally focuses on whether or not the tax burden should be distributed in a progressive manner, and if so, then how progressive should the tax be.

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The amount of federal taxes owed was the dependent variable modeled in examining the progressivity of each tax plan in this study. The independent variables included were the debt-to-asset ratio (DTA), net farm income (NET), net farm income squared (NET2), the age of the operator (AGE), the number of dependents (DEPD), and binary variables for the type of farm operation (ICROP, BEEF, DAIRY, HOG, OTHER). Regression results for progressivity in the CTM indicate that age, net farm income, and net farm income squared were positive and signicant in explaining the federal tax owed, which suggests that increases in these variables increase the tax owed (table 4). The net farm income squared variable indicates that the tax paid increases at an increasing rate as income increases in the CTM. The debt-to-asset ratio, net farm income, and net farm income squared

Table 4. Estimated regression coefcients of tax plans for examining progressivity

Variablea R-squared RMSE Intercept DTA NET NET2 AGE DEPD ICROP BEEF DAIRY HOG OTHER Current Tax Model 0.7473 6,357.16 2,582.71 (877.14) 809.50 (419.26) 0.2049 (0.0044) 4.1E07 (2E08) 24.63 (11.85) 146.19 (101.49) 344.64 (463.35) 32.12 (300.15) 160.50 (608.04) 168.89 (817.23) 207.02 (527.09) Flat Tax Model 0.7362 5,417.86 3,619.30 (736.56) 1,880.79 (351.90) 0.0927 (0.0016) 1.8E07 (1E09) 2.07 (10.12) 4.72 (86.50) 17.19 (394.50) 613.50 (255.77) 670.80 (518.42) 771.85 (696.25) 365.40 (448.86)

Variables that are signicant at the 5% level. Standard errors are in parentheses. a The dependent variable is Federal taxes owed. Independent variables are the

debt-to-asset ratio (DTA), net farm income (NET), net farm income squared (NET2), age of the operator (AGE), number of dependents (DEPD), and binary variables for the type of farm operation: irrigated crop production, beef production, dairy production, hog production, and other production (ICROP, BEEF, DAIRY, HOG, OTHER), where nonirrigated crop production is the base.

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Figure 1. Federal tax liability

50,000

Current system
40,000

Flat tax system

Federal taxes owed (dollars)

30,000

20,000

10,000

0 0 10,000 30,000 50,000 70,000 90,000 110,000 130,000 150,000

Net farm income (dollars)

were also positive and statistically signicant in the FTM. Results also indicate that the tax liability for beef operations was statistically less than that for crop farms in the FTM. Use of the squared net farm income term in the regression equations allowed the models to take a nonlinear form so that the progressivity of both systems could be evaluated. Progressivity of the tax systems was examined by using the estimated equation to determine the expected Federal tax liability for a range of net farm income levels, while holding the other variables constant at their sample means. As shown in gure 1, results indicate that as net farm income increases, the tax liability increases at an increasing rate for both tax plans, which implies that both the current tax system and the at tax are progressive. However, the at tax liability is lower when compared to the current system at all income levels greater than $6,497. Winners and Losers Regression analysis was used to determine the winners and losers caused by a move from the CTM to Armeys FTM. Much like the term fairness, the term winners and losers may ultimately be considered a value judgment. In this study, winners and losers are measured in terms of the amount of tax paid. Winners from a change in tax systems are dened as those whose tax liability is lower (or after-tax income is higher) under the at tax system compared with the current system; losers are dened as those individuals whose tax liability is higher (or after-tax income is lower) under the at tax system. The dependent variable estimated in this regression analysis was the difference in total federal and self-employment tax (or the negative of the difference in after-tax income) between the two tax systems, that is, the tax savings of the

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FTM over the CTM. The difference was determined by subtracting the total tax liability under the FTM from the total tax liability under the CTM. The independent variables were the debt-to-asset ratio (DTA), net-farm-income-to-totalassets ratio (NTA), total assets (ASSET), the age of the operator (AGE), the number of dependents (DEPD), and binary variables for the type of farm operation (ICROP, BEEF, DAIRY, HOG, OTHER). Regression results indicate the net-income-to-total-assets ratio and the debt-toasset ratio were negative and statistically signicant in explaining the difference in total taxes between the two plans (table 5). Thus, increases in protability or in debt load decrease the tax difference between the current tax system and the at tax system. Hence, farms with higher debt loads or higher prots will pay Table 5. Estimated regression coefcients for examining the winners and losers of a at tax
Variablea R-squared RMSE Intercept DTA NTA ASSET AGE DEPD ICROP BEEF DAIRY HOG OTHER
Variables that are signicant at a The dependent variable is the

Current System vs. Flat Tax 0.1140 10,640.57 8,458.83* (1445.73) 6,796.53* (697.71) 13,169* (1224.58) 0.0040* (0.0006) 97.95* (20.57) 195.94 (169.97) 10.80 (789.33) 1,343.39* (506.80) 1,270.90 (1018.24) 2,184.45 (1368.17) 1,726.82 (882.27)

the 5% level. Standard errors are in parentheses. savings in total Federal tax and self-employment tax of the Flat Tax System over the Current Tax System. Independent variables are the debt-to-asset ratio (DTA), netfarm-income-to-total-assets ratio (NTA), total assets in dollars (ASSET), age of the operator (AGE), number of dependents (DEPD), and binary variables for the type of farm operation: irrigated crop, beef, dairy, hog, and other production (ICROP, BEEF, DAIRY, HOG, OTHER), where nonirrigated crop production is the base.

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relatively more tax under a at tax than lower-leveraged rms. These results support some of the economic reasoning given by proponents and opponents of a at tax. Results suggest that a producer who has relatively higher prots would be better off under a at tax than under the current graduated tax system because of the constant marginal tax rate. However, producers with higher leverage ratios would be relatively worse off with the at tax than with the current tax system, under a no-change-in-interest-rate scenario. Further examination of the difference between the two models (FTM savings) indicates that roughly 63% of the producers would have paid less tax under the 20% at tax than with the current tax system. Based upon the historical information for the 593 sole proprietors and the tax results generated by the models, if the at tax had been in effect during the 19901994 period, 376 producers would have experienced an average total tax decrease of $100 or more over the 5-year period, with a mean total tax savings of $5,502 for this group. A total of 199 of the sole proprietors would have experienced an average total tax increase of $100 or more during the 5-year period, with a mean total tax increase of $4,199 for the group. The nal 18 sole proprietors realized either an increase or a decrease in average total taxes of $100 or less, with a mean total tax of negative $22.98.

Effects on Interest Rates

Schuh has argued that a sectoral emphasis has caused neglect of the linkages of agriculture with the rest of the economy and underestimation (or underemphasization) of the interrelationships between agriculture and the larger economy (p. 810). Thus, the total effects of a at tax cannot be determined solely by changing the tax rate faced by individual farmers and recalculating their tax liability. A at tax would have signicant effects on many factors in the economy, including interest rates, and understanding the difference between pretax and after-tax interest rates can provide some insight on the potential interest rate changes expected under a at tax. A comparison of the average interest rate earned on Moodys Aaa-rated state and local bonds, which are tax exempt from Federal taxes, and Moodys Aaa-rated corporate bonds, which are taxable, illustrates how taxes affect interest rates. Although these bonds are secured by different assets, they are roughly in the same risk and return class. The major difference between the two bonds is that state and local bonds are Federally tax exempt, while corporate bonds are taxable, implying that corporate bond rates have accounted for the effects of taxes. Historical bond rates are listed in table 6, along with the implied tax rate, which is the tax rate that equalizes the corporate bond yield with the taxfree state and local bond yield. The state and local bond yield is determined by subtracting the product of the corporate bond rate and the implied tax rate from the corporate bond rate. An investor with the implied tax rate will be indifferent between investing in a corporate bond and investing in a state and local bond. Table 6 indicates that the average Moodys Aaa state and local bond rate over the last 20-year period was 7.11%. The average Moodys Aaa corporate bond rate during the same 20-year period was 9.53%; thus the average implied tax rate

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Table 6. Historical Moodys Aaa bond averages and implied tax rates
State and Local Bonds 7.85% 10.43 10.88 8.80 9.61 8.60 6.95 7.14 7.36 7.00 6.96 6.56 6.09 5.38 5.77 5.80 5.52 5.32 4.93 5.28 7.11% Corporate Bonds 11.94% 14.17 13.79 12.04 12.71 11.37 9.02 9.38 9.71 9.26 9.32 8.77 8.14 7.22 7.97 7.59 7.37 7.27 6.53 7.05 9.53% Implied Tax Rate 34.25% 26.39 21.10 26.91 24.39 24.36 22.95 23.88 24.20 24.41 25.32 25.20 25.18 25.48 27.60 23.58 25.10 26.82 24.50 25.10 25.39%

Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Mean

Source: Federal Reserve Bulletin.

was 25.39%. The relationship between the interest rates provides some indication of the interest rate changes that could occur under a at tax. Under a at tax, all interest rates will be on an after-tax basis. A at tax would eliminate both the deduction for interest paid on debt and the taxability of interest earned on savings, thereby placing all interest rates on a tax exempt (after-tax) basis. The removal of the deduction for interest paid would likely cause interest rates to drop close to 25% (Golob). This study examined the possible consequences of interest rate changes by considering three possible interest rate scenarios: (1) no change in pretax rates (an increase of 33% in after-tax rates), (2) a 25% decrease in pretax rates (no change in after-tax rates), and (3) a 12.5% decrease in pretax interest rates (an increase of 17% in after-tax rates). Regression analysis was used to examine the equity and the total tax liability, net of alternative interest savings assumptions, of the at tax system under the three interest rate scenarios, including any interest savings resulting from decreases in pretax interest rates. Table 3 provides the regression results for the current tax system and for the at tax system under the three interest rate scenarios. Results indicate that net farm income as a percentage of total assets was positive and signicant in the three interest rate scenarios, implying that the tax liability,

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net of interest savings, increases as protability increases. Results also show that the coefcient on total assets was positive and signicant when pretax interest rates remain constant or drop 12.5%, suggesting that as farm size grows, the tax liability increases. However, the magnitude of this parameter estimate decreases as interest rates fall, and it is not signicantly different from zero at a 25% interest rate drop. The debt-to-asset ratio was positive and signicant when the pretax interest rate did not change, but was negative and signicant when rates declined by 12.5% and 25%. These results suggest that highly leveraged farms will pay higher taxes if pretax interest rates remain constant under a at tax system. However, if interest rates decline by more than 12.5%, then farmers with relatively higher debt-to-asset ratios will have higher after-tax income than under the current tax system. An examination of the parameter estimates of both tax models indicates that the movement from the current tax system to a at tax decreases the effect of the netincome-to-total-assets ratio on total taxes by approximately 45%. As interest rates decline, the effect remains fairly stable, implying that the effect of the net-incometo-total-assets ratio on total taxes changes very little as interest rates change under the at tax. The effect of total assets on total tax liability decreases by 41% when moving from the current system to the at tax system. The parameter estimate for total assets decreases another 45% as interest rates decline by 12.5%, implying a change in total assets is associated with a smaller change in total taxes as pretax interest rates decline. The effect of a change in the debt-to-asset ratio on the total tax liability changes substantially when switching from the current tax system to a at tax if interest rates change under a at tax system. When switching from the current system to the at tax, the effect of a change in the debt-to-asset ratio more than doubles as it changes from a negative effect to a positive effect. As interest rates decline under the at tax system, the debt-to-asset ratio becomes inversely related to total taxes, net of interest savings, with the effect of a change in the debtto-asset ratio when pretax interest rates drop 12.5% being very close to the effect under the current system. When pretax interest rates decline by 25%, the magnitude of the negative parameter estimate more than triples from its value at a 12.5% decrease in pretax interest rates. This result indicates that as pretax interest rates decline, the effect of an increase in the debt-to-asset ratio causes total taxes to decline by greater and greater amounts. With a decline in interest rates of 12.5%, 77% of producers would have paid lower taxes under the 20% at tax. If rates fell by 25%, roughly 90% of this set of producers would have paid less in taxes.

Effects on Capital Investment

A at tax may signicantly impact land and equipment investment patterns. Changes in investment patterns may occur because of the ability to fully expense capital assets in the year they were purchased, because assets are fully taxed when sold, or because of the removal of the deduction for interest. A at tax could also impact land prices, especially under alternative interest rate scenarios. This section of this paper examines the probable effects of a at tax on capital investment.

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Land Investment The effects of a at tax on land investments were examined under the current tax system and under the at tax system. Land purchases under the current tax system were evaluated using both a 18% (15% federal and 3% state) and a 34% (28% federal and 6% state) marginal tax rate, with a pretax interest rate of 9%, a 3% ination rate, and a 30-year holding period. The land was assumed to have a $35 per acre pretax return, which was an average cash rent for Kansas (U.S. Department of Agriculture, 1996a). Property tax expenses were assumed to be 0.75%, which was the average rate in the United States during 1994 (U.S. Department of Agriculture, 1996b). Land purchases for the at tax plan were evaluated using a 20% at tax and the three previously discussed interest rate scenarios. Additionally, land purchases were fully expensed in year 0 and the full sale price was taxed at 20% in year 30. The same ination rate, holding period, and $35 return per acre were used for the at tax evaluation. Finally, all land investors were assumed active, and therefore, were treated equally under the at tax scenario. Previous work by Featherstone in deriving a maximum bid model for agricultural land under a at tax system indicated that changes in land values under a at tax scenario critically depend on how pretax interest rates change. Table 7 presents the results for the land investment analysis. Results indicate the break-even or maximum bid price under the current tax system was $611 per acre, using the 34% marginal tax rate (28% Federal) assumption. With a 18% marginal tax rate (15% Federal), the break-even land price is $569 per acre, roughly a 7% reduction. Because of the change in tax rates, the nominal after-tax cost of capital increased from 5.94% to 7.38%, causing land prices to decrease by $42 per acre. Any time income tax rates decrease and pretax rates remain constant, the cost of Table 7. Capital investment scenarios under the current and at tax systems
Land Investment Tax System, Interest Rate Assumption Current 15% Federal income tax Current 28% Federal income tax 20% Flat tax, no change in pretax interest rates 20% Flat tax, 12.5% decrease in pretax rates 20% Flat tax, 25% decrease in pretax rates Break-Even Land Price $569 $611 $532 $638 $797 Nominal After-Tax Interest Rate 7.38% 5.94% 9.00% 7.875% 6.75%

Equipment Investment Tax System, Interest Rate Assumption Current 15% Federal tax bracket Current 28% Federal tax bracket 20% at tax, no change in pretax interest rates 20% at tax, 12.5% decrease in pretax rates 20% at tax, 25% decrease in pretax rates
a CRC

After-Tax CRCa $2,283 $1,778 $2,345 $2,106 $1,875

Pretax CRC $2,685 $2,470 $2,931 $2,632 $2,343

is captial recovery cost.

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debt nancing is higher for the individual in the lower tax bracket, thus reducing the value of capital assets. These results illustrate inequities that are built into a graduated tax code. Under a 20% at tax system with no change in pretax interest rates (a 33.3% increase in the after-tax rate), the break-even land price falls to $532 per acre. This is a $79 or 12.9% decrease in land prices below those of the current 34% tax bracket and is the result of a higher after-tax interest rate. Under the at tax proposal, the after-tax interest rate is equal to the pretax interest rate because interest paid is no longer deductible. An increase in the after-tax interest rate increases the cost of borrowing, thus pushing the price of land down. If pretax interest rates decline by 12.5%, effectively making the nominal aftertax interest rate equal to 7.875%, then the break-even land price is $638 per acre, 4.4% higher than that of the current 34% tax bracket. Increases in land prices become even more pronounced if the pretax interest rate falls by 25%. If the interest rate declines to a nominal after-tax rate of 6.75%, then the break-even land price becomes $797 per acre, that is, an increase in land prices of 30.4% for a producer currently in the 34% tax bracket.

Equipment Investment The at tax plan will not only affect land prices, it will also have an effect on equipment investment decisions. To examine the at taxs effect on equipment investment, the purchase of an irrigation sprinkler system was evaluated using information obtained from the Kansas State Universitys Kansas Farm Management Marketing Handbook. The assumptions used to evaluate this investment under the current tax code include a purchase cost of $36,450 for the sprinkler system,6 a 20-year asset life, and a 20% salvage value for the system at the end of 20 years. Additionally, a seven-year Modied Accelerated Cost Recovery System (MACRS) was used, with a $0 terminal value for depreciation. The sprinkler system investment was evaluated using 15% and 28% federal marginal tax rates, with a 9% nominal pretax interest rate and a 3% ination rate. The at tax system was evaluated using a 20% at tax rate, the three interest rate scenarios previously examined, and the same sprinkler cost, ination rate, life of the investment, and salvage value as used for the current tax system. The at tax scenarios did not include depreciation since the Armey at tax plan eliminates this deduction. Additionally, the sprinkler was fully expensed in year 0 under the at tax, and the sale price was fully taxed when the sprinkler was sold in year 20. Table 7 reports the results of the equipment investment analysis (for a complete discussion of the methods, see Elffner). Under the current tax system, using a 28% marginal tax rate, the after-tax capital recovery charge for the sprinkler system is $1,778 per year. This result implies that the sprinkler investment would cost the producer $1,778 after taxes per year to own, given the above assumptions. The $1,778 after-tax capital recovery charge is equivalent to a $2,470 pretax capital recovery charge. In other words, $2,470 in pretax income needs to be generated per year to pay for the sprinkler system. Using a 15% marginal tax rate, the aftertax capital recovery charge increases to $2,283 per year. The additional $505 rise in cost is the result of an increase in the nominal after-tax cost of capital. The pretax

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difference of the marginal tax brackets is $215. A farmer in the lower tax bracket still needs to generate more income in order to pay for the equipment. Evaluation of the same sprinkler investment using a 20% at tax and no change in the pretax interest rate results in an after-tax capital recovery charge of $2,345, suggesting that the investment will cost the producer $567 more after taxes per year to own the sprinkler under a at tax system than under the current marginal tax rate of 28%. The pretax capital recovery charge of owning the sprinkler increases by $461 per year to $2,931 for a 20% at tax relative to the current marginal tax rate of 28%. The producer would also pay more on both an after-tax and a pretax basis under a at tax than under the current 15% marginal tax bracket if pretax interest rates remain constant. If pretax interest rates fall by 12.5%, then under the at tax, the after-tax capital recovery charge is $2,106 for the sprinkler investment, effectively raising aftertax expenses by $328 per year for those producers in the current 28% tax bracket and decreasing the after-tax expense by $177 per year for those producers in the current 15% tax bracket. These results suggest that producers currently in the 15% tax bracket would see a benet in moving to a at tax system relative to remaining in the current system. Results are the same for the pretax capital recovery costs of the two tax systems. The sprinkler would cost producers in the 28% marginal tax bracket $162 more pretax per year, and it would cost the producer in the 15% tax bracket $53 less per year relative to the costs in a 20% at tax system. When pretax interest rates decline by 25%, to 6.75%, the after-tax capital recovery charge for the sprinkler becomes $1,875 using a 20% at tax. Under this scenario, the current 28% tax system still saves the producer $97 per year in aftertax capital recovery charges. The at tax benets the producer currently in the 15% marginal tax rate on both an after-tax and a pretax basis. Overall, results of the equipment investment analysis indicate that producers currently operating in the 15% tax bracket would invest more under a at tax if the pretax interest rate declines by 12.5% or more. Producers in the 15% tax bracket face a higher after-tax capital recovery charge under the at tax than under the current system if pretax interest rates do not change or decline by at least 12.5%, suggesting that producers under these circumstances would invest in less capital equipment. When pretax interest rates drop by 12.5% or more, the after-tax capital recovery charge falls below what it is for the current 15% tax bracket, encouraging producers to invest in more capital equipment. Producers in the current 28% tax bracket face higher after-tax capital recovery charges under a at tax unless interest rates decline by roughly 25%. This higher cost will lead producers to invest in less capital equipment under a at tax system than under the current system. For producers in the current 28% tax bracket, a switch from the current tax system to a at tax system, even with a decline in pretax interest rates up to nearly 25%, causes capital investment to decline primarily because of the removal of the interest deduction and because assets are fully taxed when sold.7

Conclusions
This study evaluated the effect that a at tax system would have on agriculture by comparing the tax liability under the current federal system to the tax

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liability under a at tax system. The study examined the shift in the tax burden on Kansas farmers occurring from a switch in tax systems, and it evaluated the equity, the progressivity, and the winners and losers of a at tax system. The study also assessed the impact of the at tax on interest rates and capital investment. Results indicate that the at tax is progressive since it increased the federal tax liability at an increasing rate as farm protability and farm size increased. Results also indicate that the average federal tax paid by farm families would drop from $10,323 to $8,181, or approximately 21%, under the at tax proposal and that 63% of the producers would benetin the form of lower taxesfrom a movement to the at tax system. Under the at tax, larger farms and more protable farms would be relatively better off, while farms with higher leverage ratios would be relatively worse off. If interest rates fall, as would be expected in order for real after-tax rates to remain nearly constant, the percentage of producers benetting from a 20% at tax increases to 90% as the decline in interest rates approaches 25%. The study examined the effects of a at tax on interest rates and capital investment by considering three interest rate scenarios: (1) no change, (2) a 12.5% decline, and (3) a 25% decline in pretax interest rates. Results indicate that land values decline by 12.9% if pretax interest rates remain unchanged. Land values increase by 4.4% under a 12.5% decline in pretax interest rates, and land values increase by 30.4% in response to a 25% decline in pretax rates. Results also suggest that producers in the 28% marginal tax bracket reduce their investment in equipment, on an after-tax basis, in response to the three interest rate scenarios. Producers in the 15% tax bracket also decrease investment unless pretax interest rates decline by 12.5% or more; these producers will increase investment if pretax rates fall by at least 12.5%. Finally, economic analysis of fundamental tax reform is not complete without full consideration of the macroeconomic consequences of that tax reform. Simply calculating tax liability changes and surmising changes that may occur without a consistent analysis can lead to misleading conclusions. Previous studies have suggested that land prices will increase due to the ability to expense items while interest rates will remain unchanged. These arguments are not internally consistent when one looks at capital asset pricing models. If businesses lose the ability to expense interest, interest rates will readjust to a new equilibrium or capital asset values will fall dramatically. With the downward adjustment in interest rates, those producers who currently have debt will benet, therefore mitigating the adverse effects from the loss of that interest deduction. When evaluating fundamental tax reform, agricultural economists would be wise to remember Schuhs warning that a sectoral emphasis has caused neglect of the linkages of agriculture with the rest of the economy and underestimation (or underemphasization) of the interrelationships between agriculture and the larger economy (p. 810).

Acknowledgments
Helpful comments from Terry Kastens and three anonymous journal reviewers are greatly appreciated.

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Endnotes
1 This was a modied version of H.R. 2060 introduced in the 104th Congress (Armey, 1995). The tax rate was modied from 20% to 19%. 2 The 19% at tax is argued by proponents as the implied tax rate that results in tax-revenue neutrality. We have not empirically established the actual implied tax rate that results in tax-revenue neutrality; doing so is beyond the scope of this study. We have used a 20% at tax rate. Additionally, we ignore the decline to a 17% at tax rate and only examine a 20% rate in this study. 3 Taxes were calculated using the tax law provisions corresponding with the years of data used in the study, 19901994. 4 Because depreciation was calculated on a management (market) basis rather than a tax basis, the adjusted accrual income is likely above what would be in place if depreciation was calculated on a tax basis. Thus, the current tax liability is overstated. However, contingent tax liabilities arising from the overdepreciation of assets will offset any tax differences except for a time value of money adjustment. 5 It should be noted that this income is for taxation purposes. This income is not the same as net taxable farm income as under the current tax model. Neither measure is equivalent to net farm income that is often used as a measure of sectorial health. However, under a at tax regime, the agricultural economics profession will need to dene a measure of net farm income. We argue that the income measure used for taxation does not necessarily constitute the well-being of the farm sector especially under a at tax. We propose that net farm income be calculated as it is currently with the exception that depreciation should be determined on a management (market) basis rather than use tax depreciation. Because the Kansas Farm Management Associations already use management depreciation in the calculation of net farm income, the net farm income used in this study is unaffected by a change in tax regime, although this would not be the case if tax depreciation was used to determine net farm income. Because net farm income is a pretax measure of the well-being of the sector, it is desirable that net farm income would be unaffected by tax policy. 6 It is assumed in the analysis that the capital investment price will be unaffected by the tax policy change. Aggregate demand and supply could change the price of the investment (the center pivot in this case). In addition, changes in investment policy due to tax effects will also result in feedback effects. 7 Under a 25% reduction in interest rate scenario, it becomes unclear whether the aggregate demand for capital investment will increase or decrease in that those producers in the lower tax bracket would demand more capital and those in the higher bracket would demand less. Therefore, the estimation of feedback effects becomes difcult. Because the overall economy will ultimately pay roughly the same tax under a at tax system and the current tax system, substantial feedback effects would be unlikely. Homma, Shigeno, and Fukushige found that when Japan shifted to a consumption tax in April 1989, a one-time 1.1% increase in consumer prices occurred. Thus, it can be deduced from their study that the feedback effects (major changes in prices) are not large. To fully examine this issue, a computable general equilibrium approach would be needed.

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