The best known of these [consumption tax] proposals is the one put forth by Hall and Rabushka (H&R) [1995], which they call a flat tax. The H&R proposal, a version of which was the centerpiece of the 1996 presidential candidate Steve Forbes' campaign, has two tax-collecting vehicles, a business tax and an individual compensation tax. The coordinated use of these two instruments allows the government to levy a progressive tax.
The calculation of the business tax base begins with a computation like that of a consumption-type VAT--sales less purchases from other firms. The key difference is that the firm also deducts payments to its workers. Firms then pay a flat rate of tax on the final amount.
The base for the individual tax is the payments received by individuals for their labor services. No capital income is taxed at the individual level. [i.e., no cap gains tax] In principle, any tax schedule could be applied to this base--the tax rate could be flat or increasing, and an exemption might or might not be allowed. H&R propose only one rate (19 percent), and it is the same as the rate that applies to cash flow at the business level. H&R build progressivity into the system by allowing an exemption of $25,000 (for a family of four). No other deductions are allowed. This is what permits the rate to be so low.
At this point you might be wondering why the H&R [flat] tax is a consumption tax. To see why, consider that a VAT that taxes all goods and services at the same rate, say, 19 percent. It has already been shown that this is economically equivalent to a 19 percent retail sales tax. Now consider an H&R-type flat tax that taxes both individuals and firms at 19 percent and that has no exemptions or deductions at the personal level. Recall that under the VAT, the firm's tax base is sales minus purchases from other firms. Wage payments are not deductible. In effect, then, wage payments are subject to a 19 percent tax. Under the H&R tax, wage payments are deductible at the firm level, but they are taxed at the individual level. The amount of tax is exactly the same as under a VAT; all that changes is the point of collection for part of the tax. The personal exemption simply builds some progressivity into the system. [solving heleny's dilemma posed in post 75] In short, the H&R flat tax is essentially equivalent to a VAT or a retail sales tax. Hence, any results pertaining to the economic effects of one apply to all.
MY COMMENT: Since a flat tax and other consumption taxes are mathematically equivalent and are better than the current awful tax system, choosing the best one to support need only be a matter of implementation, transitional, and political considerations. I, for one, am not opposed to some progressivity, so I prefer a flat tax over a VAT or sales tax scheme. However, I'm not totally opposed to the other two. The most important reason to move away from the current system to any of the three is to eliminate abuses and economic distortions caused by loopholes, most of which come from the presence of multiple tax brackets. Social engineering by the government also derives from the bracket structure. For instance, with a single ("flat") bracket, the marriage penalty (which for some, though few, families you might be surprised to know is a marriage reward) goes 'poof'. I would respectfully disagree with Chuckster (post 57) that the flat tax is a productivity tax from a mathematical perspective, although from a perceptual perspective I see his point. Indeed, taking net present value into effect, if you take away the brackets, everything you earn (INCOME) you eventually spend, or CONSUME, whether you do so today or tomorrow (or, with the elimination of the estate tax, by your children). The problem with the current income tax is that (1) you can't possibly capture all instantaneous changes in income to make it mathematically equivalent to the VAT/sales/flat tax [baseball cards value is the stock example] and (2) it DOES punish savings because savings are more likely to be taxed at a higher bracket in period two. With a flat tax, the savings punishment disappears b/c, once again, the existence higher brackets is responsible for the punishment. I took a semester of public finance with a professor who has lent his academic support to the group that advocates the "Fair Tax" that Free the USA mentions in post 49, so I hope I don't sound like I'm spouting total b.s. :-)