The Business Flat Tax: How It Works, What It Means for the Economy

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The Business Flat Tax: How It Works, What It Means for the Economy

August 15, 2016 10 min read Download Report
David R. Burton
Senior Fellow in Economic Policy
David Burton focuses on tax matters, securities law, entrepreneurship, financial privacy and regulatory and administrative law issues.

Revised and updated November 8, 2016

Replacing the current income tax with a business flat tax would increase economic growth, productivity, and wages and dramatically simplify the tax system. A business flat tax, also called a business transfer tax or business activity tax, would be imposed on all businesses including corporations, partnerships, limited liability companies, and sole proprietorships. The business flat tax base[1] is gross receipts from the sale of goods and services by businesses less purchases from other businesses (including the purchase of capital goods). Financial receipts and disbursements (such as interest and dividends) would be disregarded.[2] Individuals, unless they were operating a business (that is, if they are self-employed or operating a business as a sole proprietor), would not be subject to the tax and would not be required to file a tax return.

History of Business Flat Tax Proposals

Most recently, Senators Rand Paul (R–KY)[3] and Ted Cruz (R–TX)[4] have proposed a business flat tax in their tax reform plans.[5] Representative Paul Ryan (R–WI) introduced a business flat tax as part of his Roadmap for America’s Future” in 2008 and 2010.[6] A national sales tax–business transfer tax plan (sometimes referred to as the BEST Tax) was introduced by Senator Jim DeMint (R–SC)[7] in 2005.[8] The “new business tax” in the USA Tax proposed by Senators Pete Domenici (R–NM) and Sam Nunn (D–GA) in 1995 was a business flat tax.[9] Senator William Roth (R–DE) introduced a business transfer tax in 1985.[10]

The Economic Impact of a Business Flat Tax

Replacing the corporate or individual income tax with a business flat tax would have a substantial positive economic impact because doing so would eliminate the double and treble taxation of savings and investment, eliminate unwarranted tax preferences, and reduce marginal tax rates substantially. Reducing the cost of capital would increase investment and the size of the capital stock, which would, in turn, make the economy more productive. Output per worker would grow and real wages would increase. Eliminating special preferences, exclusions, and deductions would reduce distortions in the marketplace, allowing taxpayers to make decisions for business and economic reasons, thereby improving economic efficiency. This will improve productivity and result in higher wages and lower prices. Reducing marginal tax rates would improve the incentive to work, save, and invest, increasing the amount of economic activity.

Both the Cruz and Paul plans would give the United States the lowest marginal tax rates in more than a century, combined with an improved tax base.[11] The Tax Foundation has estimated that the Cruz and Paul plans, which partially replace the current tax system with a business flat tax, would allow the size of the economy to increase by 13.9 percent and 12.9 percent, respectively, over 10 years.[12]

The Simplification Impact of a Business Flat Tax

The business flat tax would dramatically simplify the tax system. First, the financial transactions of businesses would no longer be relevant to determining their tax liability. Thus, interest income and expense, capital gains and losses, dividends paid or received, and other financial transactions would not matter for business tax purposes. Second, complex inventory accounting (including the uniform capitalization rules)[13] would be replaced by a simple deduction for the costs of inventory purchased. Current rules impose costly compliance costs on businesses that have inventories.[14] Third, the business flat tax would replace the existing complex capital-cost-recovery rules under which different types of assets are deducted using different methods over different periods—some as long as 39 years.[15] Instead, businesses would simply deduct the cost of acquiring machinery and equipment in the year purchased. This is called expensing. “Recapture” rules would also be unnecessary.[16] Fourth, the move to a territorial system would substantially reduce compliance costs and complexity. The international aspects of the U.S. tax system are monstrously complex.[17] They are also badly out of step with international norms, encourage businesses to leave the U.S., and make U.S. firms less competitive.[18]

The business flat tax would repeal the foreign tax credit provisions, the controlled foreign corporation provisions, the foreign currency transaction rules, and other rules. It would also substantially simplify the income-sourcing and expense-allocation rules because financial transactions would no longer be relevant for purposes of determining taxable income.

Why a Business Flat Tax Is a Consumption Tax

Output is the value of all goods and services produced. In a business flat tax, output is measured by the gross receipts from the sale of goods and services by businesses. Final goods and services are either consumption goods and services or investment. Investment would be the purchase of capital goods, such as machinery, equipment, and structures. Intermediate goods and services used to produce final consumption or investment goods and services would be deductible, so what remain subject to tax are consumption goods or services. Financial receipts and disbursements (such as interest and dividends) would be disregarded. Thus, the business flat tax base is output (the value of all goods and services produced) less all intermediate and capital goods (investment) that produced that output (that is, consumption):

Business Flat Tax Base = Output – Investment = Consumption
= O – I
= C

Who Really Pays the Business Flat Tax

To determine the impact of replacing the existing corporate income tax with a business flat tax on the distribution of the tax burden, it is necessary to make an assessment of who bears the burden of both the existing corporate income tax and the proposed business flat tax. There is a great deal of uncertainty regarding this question. But one thing is certain: Corporations and other businesses will not bear the actual economic incidence (or “burden” of the business flat tax, just as they do not bear it for any other business tax, including the corporate income tax. Only people ultimately bear the burden of taxes. Legal fictions, such as corporations, limited liability companies, or partnerships cannot pay tax in the sense of bearing the actual economic incidence or burden of the tax. So the business flat tax, like the existing corporate income tax, is borne by the people who own the business, who buy goods and services from the business, or who work for the business or, perhaps, by workers, owners, or consumers in the non-corporate sector competing with workers, owners, or consumers in the corporate sector.[19]

In every market there is a buyer and a seller, regardless of the terms one uses. A store supplies goods to consumers who buy the goods. Employers “buy” the labor services of employees with wages and salaries. The “price” of labor services is the wage rate. Borrowers “buy” the capital that lenders provide by paying interest. The interest rate is the price of the borrowed capital. Firms “buy” the capital that investors provide by paying a return on the investment. The return is the price or cost of the invested capital.

Except in the rare case where buyers or sellers do not change their willingness to buy or sell when the price changes,[20] a tax is partially borne by the seller and partially borne by the buyer.[21] Furthermore, once those prices (goods, services, wages, interest rates, return on capital) have changed in the corporate sector, competition will tend to force prices in the non-corporate sector to the same levels as in the corporate sector. For example, in general, equally qualified workers performing the same job for a corporation and a non-corporate business will be paid the same (otherwise, workers will quit and move to the higher-paying sector). In general, the same good sold by a corporation and a non-corporate business will be sold at the same price (otherwise, consumers will tend to patronize the sector with the lower price).[22]

Government analysts still tend to assume that capital bears most of the burden of the corporate income tax. The Treasury Department assumes that capital bears 82 percent of the burden, while labor bears 18 percent.[23] The congressional Joint Committee on Taxation (JCT) staff distributes 100 percent of both types of taxes to owners of capital in the short run. JCT staff distributes 75 percent of corporate income taxes and 95 percent of taxes on pass-through business income to owners of capital in the long run.[24] The Congressional Budget Office allocates 75 percent of the corporate income tax to capital and 25 percent to labor.[25] More recent research that takes into account that capital is highly mobile and that goods, and increasingly services, are more and more traded internationally, finds that the existing corporate tax is probably primarily borne by workers.[26] Replacing the corporate tax with a business flat tax that taxes labor and capital equally would tend to increase wages because capital will flow into the U.S. and domestic capital formation will increase.

Comparison to the Traditional Flat Tax

The business flat tax is fundamentally similar to the flat tax proposed by Stanford University economists Robert Hall and Alvin Rabushka in 1985,[27] and supported by House Majority Leader Dick Armey (R–TX) and Senator Richard Shelby (R–AL).[28] This flat tax was also aggressively promoted by Forbes magazine editor in chief and two-time presidential candidate Steve Forbes.[29]

The only conceptual difference between the business flat tax and the Hall–Rabushka flat tax is the means by which wages are taxed. The Hall–Rabushka flat tax has the same tax base as the business flat tax, except that, in the Hall–Rabushka plan, businesses may deduct wages. Then wages, and only wages, are taxed at the individual level and an exemption is provided for the taxpayers and dependents. A business flat tax only allows business to deduct purchases from other business, so wages are not deductible. Thus wages are taxed at the business level.[30] This is similar in some respects to withholding under current law but individuals need not file tax returns and, as a result, may not be fully aware of the tax.

One advantage of a business flat tax over the Hall–Rabushka flat tax is that it is virtually impossible to make the business flat tax a graduated rate tax system where rates increase as individual income increases. Since there is no reporting or taxation of individuals’ taxable income in a business flat tax, the rates cannot be varied as a function of individual income. A graduated-rate “flat tax” was proposed by President George W. Bush’s Advisory Panel on Federal Tax Reform in November 2005, based on Princeton economist David Bradford’s “X Tax” plan.[31] This plan had the same tax base and structure as Hall–Rabushka but with graduated tax rates.[32]

Important Secondary Design Choices

Any tax plan, including the business flat tax, must address a wide variety of secondary design issues, including whether the tax is an origin-principle tax or a destination-principle tax, how to treat tax-exempt organizations, the tax treatment of owner-occupied housing, the tax treatment of government consumption, the size of family and personal allowances if any, the tax treatment of financial intermediation services, the tax treatment of health insurance and health services, the tax treatment of insurance and risk intermediation, the tax treatment of educational and job-training expenses, the tax treatment of mixed-use property or previously used property, and transition issues. Various business flat tax plans address these secondary design issues differently.

For example, the original Hall–Rabushka tax proposal and all of the bills introduced in Congress based on the proposal were origin-principle taxes. This means that they included income from exports in the tax base and imposed no tax on imports. The tax was based on the origin or source of the capital and labor incomes being taxed. The graduated-rate Hall–Rabushka plan proposed by President Bush’s tax panel, however, was a destination-principle (or border-adjusted) plan. Income from exports would not be in the tax base, and a tax would be imposed on imports equal to the tax paid by U.S.-produced goods sold in the U.S. Some economists argue that border tax adjustments would add a significant amount of complexity, be difficult to administer and likely invite retaliatory tariffs from other countries. Other economists argue that replacing the existing origin principle income tax with a destination principle tax would eliminate the current system’s bias against production in the U.S. and is consistent with WTO principles allowing other countries to have border-adjusted value added taxes.[33]

Business Flat Tax Criticisms

Some free-market advocates are critical of the business flat tax. They are concerned that taxing wages at the business level could make the tax less visible or transparent, and that it would therefore be easier for politicians to increase this tax. The Cruz plan would address this concern by requiring a statement from employers to employees that reports the tax paid on wages.[34] An allied concern is that if, as in the Cruz and Paul plans, the business flat tax is used to replace some existing taxes (the corporate income tax and payroll taxes), while an improved and lower-rate individual income tax is retained, the income tax will grow back to something resembling the current income tax.[35]

This concern is reasonable, but all tax reform plans involve judgments and trade-offs. As discussed, it is easy to make a Hall–Rabushka-type flat tax a graduated-rate plan, and there is no guarantee that this will not happen in a future Congress or as the proposal works its way through Congress. It is difficult to tax government consumption with a business flat tax or sales tax.[36] Some regard a sales tax as highly visible (consumers would pay it on every transaction), while others fear that without an annual tallying of the total tax burden, it does not fully convey the true cost of government. And so on.


Replacing the current income tax with the business flat tax would substantially improve economic growth and increase real wages by eliminating multiple taxation of savings and investment, reducing marginal tax rates, and eliminating special tax preferences. It would dramatically simplify the tax system. Individuals would no longer need to file tax returns. It is one possible path to fundamentally improving the U.S. tax system.

—David R. Burton is Senior Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.

[1] The “tax base” is what the tax rate is multiplied by to determine the tax due. In the current income tax system, the tax base is “taxable income.”

[2] Financial transactions are disregarded because the tax is based on transactions involving “real” goods and services, not financial transactions. In this sense, it is conceptually similar to the national income and product accounts (NIPA), and the overall tax base is output or gross domestic product (GDP) minus investment, which equals consumption. For more on NIPA, see Bureau of Economic Analysis, “Measuring the Economy: A Primer on GDP and the National Income and Product Accounts,” December 2015, (accessed February 29, 2016). In Meade Report terminology, the tax has an R (real) base rather than an R+F (real plus financial) base. See Institute for Fiscal Studies, The Structure and Reform of Direct Taxation: Report of a Committee Chaired by Professor J. E. Meade (London: Allen and Unwin, 1978), (accessed February 29, 2016).

[3] Rand Paul, “Blow Up the Tax Code and Start Over,” The Wall Street Journal, June 17, 2015 (accessed February 29, 2016). Senator Paul refers to the tax as a business activity tax.

[4] Ted Cruz, “A Simple Flat Tax for Economic Growth,” The Wall Street Journal, October 28, 2015, (accessed February 29, 2016), and Ted Cruz 2016, “The Simple Flat Tax Plan,” (accessed February 29, 2016).

[5] Both of these plans would replace the corporate income tax, as well as employer and employee payroll taxes, with a business flat tax (16 percent in the Cruz plan, and 14.5 percent in the Paul plan) but retain a simplified personal income tax (at a 10 percent rate in the Cruz plan, and a 14.5 percent rate in the Paul plan).

[6] The business flat tax was incorporated into the “Roadmap for America’s Future Act” as Title VI of H.R. 6110, 110th Cong., 2nd Sess. (2008), (accessed February 29, 2016), and as Title VI of H.R. 4529, 111th Cong., 2nd Sess. (2010), (accessed February 29, 2016). The business tax reform title in this legislation was the “Competitive American Business Tax,” and the bill enacts a “business consumption tax.”

[7] Former Senator DeMint is now president of The Heritage Foundation.

[8] S. 1921, 109th Cong., 1st Session (2005). See David R. Burton, “The BEST Tax,” testimony before the President’s Advisory Panel on Federal Tax Reform, May 11–12, 2005, (accessed February 29, 2016).

[9] The USA Tax Act, Title III, S. 722, 104th Congress (1995), (accessed March 1, 2016). See also Lawrence Seidman, The USA Tax: A Progressive Consumption Tax (Cambridge, MA: MIT Press, 1997).

[10] Business Transfer Tax Act of 1985, S. 1102, 99th Cong.

[11] The top individual tax rate was 7 percent with the advent of the income tax in 1913; it was raised to 77 percent during World War I. It was reduced to 25 percent in 1925, and then stayed at that level until it was raised to 63 percent in 1932. Tax Foundation, “Federal Individual Income Tax Rates History, Nominal Dollars, Income Years 1913–2013,” (accessed February 29, 2016). The corporate tax was 1 percent in 1913, increasing to 12 percent during World War I. Between 1925 and 1931, the corporate tax rate varied between 11 percent and 13 percent. Tax Foundation, “Federal Corporate Income Tax Rates, Income Years 1909–2012,” (accessed February 29, 2016). Thus, the lowest combined corporate and individual rate in the late 1920s was 36 percent (as compared to 26 percent for the Cruz plan, and 29 percent for the Paul plan). 1916 was the last year to have lower combined tax rates. In 1916, the top individual tax rate was 15 percent, and the top corporate tax rate was 2 percent, for a combined rate of 17 percent.

[12] Andrew Lundeen and Michael Schuyler, “The Economic Effects of Rand Paul’s Tax Reform Plan,” Tax Foundation, June 18, 2015, (accessed February 29, 2016), and Kyle Pomerleau and Michael Schuyler, “Details and Analysis of Senator Ted Cruz’s Tax Plan,” Tax Foundation, October 29, 2015, (accessed February 29, 2016). The primary reason for the difference in the Tax Foundation estimates is that the Paul plan relies more heavily on the income tax (a 14.5 percent rate) and less heavily on the business flat tax (a 14.5 percent rate) than does the Cruz plan, which has a 10 percent income tax paired with a 16 percent business flat tax, and the Paul plan has a somewhat higher combined tax rate (29 percent) compared to 26 percent for the Cruz plan. On a dynamic basis (taking into account economic growth effects), the Tax Foundation estimates that the Paul plan increases revenues by $737 billion over 10 years, while the Cruz plan reduces revenues by $768 billion over 10 years. This represents an increase or reduction, respectively, in federal revenues of less than 2 percent over the 10-year period.

[13] Internal Revenue Code §263A.

[14] For a short discussion of these rules, see Internal Revenue Service, “Accounting Periods and Methods: Inventories,” Publication 538, December 2012, (accessed February 29, 2016).

[15] The recovery period for non-residential property is 39 years. For a summary of these rules, see Internal Revenue Service, “How to Depreciate Property,” Publication 946, February 27, 2015, (accessed February 29, 2016).

[16] For a short discussion of these rules, see Internal Revenue Service, “Sales and Other Dispositions of Assets: Depreciation Recapture,” Publication 544, February 2, 2016, (accessed February 29, 2016).

[17] Richard L. Doernberg, International Taxation in a Nutshell, 9th Edition (West Academic Publishing, 2012). This 654-page introduction meant for law students just touches the surface.

[18] Curtis S. Dubay, “A Territorial Tax System Would Create Jobs and Raise Wages for U.S. Workers,” Heritage Foundation Backgrounder No. 2843, September 12, 2013,, and Curtis S. Dubay, “Business Inversions: Tax Reform Is the Only Way to Curb Them,” Heritage Foundation Backgrounder No. 2950, September 4, 2014,

[19] The non-corporate sector can be affected because competition will eventually cause wages, prices, and after-tax returns in the corporate and non-corporate sectors to be the same. For a more detailed explanation, see Arnold C. Harberger, “The Incidence of the Corporation Income Tax Revisited,” National Tax Journal, Vol. 61, No. 2, June 2008, pp. 303–312, (accessed February 29, 2016).

[20] Economists refer to the case where supply or demand does not change when the price changes as inelastic supply or demand. The case where demand will entirely disappear in response to a small price increase, or supply will entirely disappear in response to a small price decline, is perfectly elastic demand or supply.

[21] For a detailed yet accessible discussion of these issues, see Stephen J. Entin, “Tax Incidence, Tax Burden, and Tax Shifting: Who Really Pays the Tax?” Institute for Research on the Economics of Taxation Policy Bulletin No. 88, September 10, 2004, (accessed February 29, 2016).

[22] Obviously, companies selling the same product can compete on the basis of something other than price (customer service, convenience, or financing, for example). For a discussion of the economics of the impact of the corporate tax on the non-corporate sector, among other issues, see Alan J. Auerbach, “Who Bears the Corporate Tax? A Review of What We Know,” National Bureau of Economic Research Working Paper No. 11686, October 2005, (accessed February 29, 2016).

[23] Julie-Anne Cronin et al., “Distributing the Corporate Income Tax: Revised U.S. Treasury Methodology,” U.S. Department of the Treasury, Office of Tax Analysis Technical Paper No. 5, May 17, 2012, (accessed February 29, 2016).

[24] Joint Committee on Taxation, “Modeling the Distribution of Taxes on Business Income,” JCX-14-13, October 16, 2013, (accessed February 29, 2016).

[25] Kevin Perese, “The Distribution of Household Income and Federal Taxes, 2011,” Congressional Budget Office, November, 2014, (accessed February 29, 2016).

[26] Harberger, “The Incidence of the Corporation Income Tax Revisited.” (“So we end up with labor bearing a large burden …”); William M. Gentry, “A Review of the Evidence on the Incidence of the Corporate Income Tax,” U.S. Department of the Treasury, Office of Tax Analysis Paper No. 101, December 2007, (accessed February 29, 2016). (“[L]abor may actually bear a substantial burden from the corporate income tax.”).

[27] Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed. (Stanford, CA: Hoover Institution Press, 1995). See also Daniel J. Mitchell, “Make Taxes Simple and Fair: Enact the Flat Tax,” in The IRS v. the People, Ken Blackwell and Jack Kemp, eds. (Washington, DC: The Heritage Foundation, 2005). It was first introduced in Congress by Senators Dennis DeConcini (D–AZ) and Steven Symms (R–ID) as The Flat Tax, S. 321, 99th Cong., 1st Sess. (1985).

[28] H.R. 1040, 105th Cong., 1st Sess. (1997), S. 1040, 105th Cong., 1st Sess. (1997). In the current (114th) Congress, Senator Richard Shelby (R–AL) has introduced S. 929.

[29] Steve Forbes, “The Moral Case for the Flat Tax,” Imprimis, Vol. 25, No. 10 (October 1996), (accessed February 29, 2016), and Steve Forbes, Flat Tax Revolution: Using a Postcard to Abolish the IRS (Washington, DC: Regnery Publishing, 2005). Steve Forbes is a trustee of The Heritage Foundation.

[30] For a discussion of why the business flat tax, the Hall–Rabushka flat tax, a consumed-income tax, and a national sales tax are economically equivalent, see David R. Burton, “Four Conservative Tax Plans with Equivalent Economic Results,” Heritage Foundation Backgrounder No. 2978, December 15, 2014,

[31] President’s Advisory Panel on Federal Tax Reform, “Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System,” November 2005, (accessed February 29, 2016). See also David F. Bradford, Untangling the Income Tax (Cambridge, MA: Harvard University Press, 1986) for a discussion of Bradford’s “X Tax” which is a graduated rate version of the Hall–Rabushka tax.

[32] Steve Forbes, for example, is critical of plans that have lower, but multiple, tax rates: “And when you put two tax rates together, it’s like putting two rabbits together—they will multiply. We should have learned that from 1986 when we got it down to two rates. Within a few years, the weeds were growing again. So you’ve gotta do one.” See Nick Gillespie and Paul Detrick, “Steve Forbes on the Flat Tax, Trump, and Election 2016,” Reason TV, July 24, 2015, (accessed February 29, 2016).

[33] Free market economists differ about whether replacing the origin principle income tax with a border tax adjusted destination principle consumption tax would have a material economic impact. See, e.g., Kyle Pomerleau, “Senator Ted Cruz’s Comment About His Border-Adjusted Tax, Explained,” Tax Foundation, November 11, 2015, (accessed November 8, 2016); Martin Feldstein and Paul Krugman, “International Trade Effects of Value Added Taxation,” in Taxation in the Global Economy, eds. Assaf Razin and Joel Slemrod (Cambridge, Mass.: National Bureau of Economic Research, 1990), pp. 263-282, (accessed November 8, 2016); David G. Raboy, “International Implications of Value Added Taxes,” in Value Added Tax: Orthodoxy and New Thinking, eds. Murray Weidenbaum, David G. Raboy, and Ernest S. Christian Jr. (St. Louis: Center for Study of American Business/Kluwer, 1989), pp. 131-162; and Dan Mitchell, “Shocker: Paul Krugman Makes a Sensible and Accurate Observation about Tax Policy,” International Liberty, September 28, 2016, (accessed November 8, 2016).

[34] Author conversation with Senator Cruz’s staff.

[35] See, for instance, Daniel J. Mitchell, “Ted Cruz’s Tax Plan Is Pro-Growth and Reins in the IRS, But There Is One Worrisome Feature,” Forbes, October 29, 2015; Daniel J. Mitchell, “Senator Rand Paul’s Very Good Tax Plan Needs One Important Tweak,” Forbes, June 18, 2015; and Heritage Foundation panel discussion, “The Great Flat Tax Debate,” February 8, 2016,

[36] Taxing government consumption in a business flat tax or sales tax requires a separate excise tax on government because government does not usually sell the consumption it provides to consumers. Such a tax is largely unnecessary in Hall–Rabushka because all government wages are taxed by the wage tax.


David R. Burton
David Burton

Senior Fellow in Economic Policy