An earlier Working Paper of the flat tax alternative was released by AFPC in February 1996. The present report supersedes that report because earned income tax credits and alternative minimum taxes under the current income tax provisions were previously ignored.
The purpose of this Working Paper is to report the results of a simulation analysis for a flat tax on 70 representative crop, livestock, and dairy farms in major production regions. The flat tax analyzed in this study involved a single marginal tax rate of 18 percent, a $35,000 personal deduction for a family of four, tax exempt interest earnings, and elimination of all deductions under current tax law including interest payments. Immediate 100 percent expensing of capital purchases (machinery and land) is allowed as a deduction to replace depreciation. Self-employment and Medicare taxes are assumed to be computed the same as under current tax provisions.
Assuming the representative farms have moderate debt levels 56 percent (39 of 70) of the farms experienced higher total taxes (federal income and employment taxes) under the flat tax alternative. If one assumes the farms have high initial debt levels, then 71 percent (50 of 70) experience higher total taxes under the flat tax alternative. The representative farms with higher total taxes see their taxes increased largely due to increases in employment taxes. About one third (22 of 70) of the moderate debt farms had higher federal income taxes, while 56 of the 70 farms had higher self-employment and Medicare taxes. Starting the representative farms with high initial debt increases the number that have higher employment taxes to 67 of the 70.
A central issue in the flat tax debate is what tax rate is needed to generate a certain level of government revenue/spending. While a farm level study is not designed to answer this question it may shed some light on the direction. The results presented for 70 representative crop, livestock, and dairy farms suggest that an 18 percent flat tax would generate lower total federal tax revenues from the agricultural sector. Thus if these results are reflective of capital intensive businesses there would be a need to substantially downsize government spending or increase the flat tax rate to achieve a balanced budget.
An earlier Working Paper of the flat tax alternative was released by AFPC in February 1996. The present report supersedes that report because earned income tax credits and alternative minimum taxes under the current income tax provisions were previously ignored.
Although flat tax proposals have been discussed for a number of years, the Presidential election and the current tax reform debate has heightened interest in tax reform proposals. A common theme of the flat tax proposals is a single marginal income tax rate for all taxpayers and the elimination of most deductions (e.g., interest payments and charitable donations). Proponents of a flat tax cite studies which project significant benefits to the U.S. economy, such as: decreases in interest rates of 20-30 percent (Golob), reduced costs of complying with the current tax code of $200 billion per year (Hall), increases in the rate of public savings (Auerbach; Kotlikoff), new growth in the economy (Jorgenson), and an increase in efficiency of capital markets (Boskin; Auerbach).
Studies showing the impacts of a flat tax on agriculture have produced conflicting results. A preliminary analysis by AFPC in 1995 showed many farms could expect to pay less federal income tax under a flat tax, but did not analyze the impacts on self-employment taxes. Harl recently reported that many agricultural producers would not benefit from a flat tax because the loss of interest expenses as a tax deduction would substantially increase the taxable incomes for highly leveraged operators.
The purpose of this Working Paper is to report the results of a simulation analysis for a flat tax alternative on 70 representative crop, livestock, and dairy farms in major production regions.
Current federal income tax provisions are used as a base for comparison to an alternative flat tax. The provisions in the 1993 Tax Reform Act constitute the base tax policy for the present study. The study assumes net farm income and interest income are the only forms of taxable income on the farm, i.e., there is no off-farm income. Net farm income is computed based on the provisions in the IRS Schedule F form with interest deductions being taken for all farm liabilities.
All of the representative farms are assumed to be taxed as sole proprietors with four personal exemptions, resulting in a $10,000 personal exemption in 1995. (While the largest representative farms in the AFPC data base are actually organized as corporations, they are treated as sole proprietors for the present study to allow comparison across farm types.) The farm family is assumed to file a "Married Individuals Filing Jointly" federal income tax return. In addition, each farm is assumed to take the standard deduction ($6,550) in 1995. Adding the personal exemption and standard deduction results in a $16,500 exemption to taxable income under the current tax provision. It is assumed that half of the self-employment taxes qualify as a federal income tax deduction and that state income taxes are not deductible because the family elects to take the standard deduction. Both the personal exemption and standard deduction are indexed over the seven year (1996-2002) planning horizon to adjust for inflation.
Federal income taxes are computed using the tax tables provided in the IRS code. The tax table for 1996 is currently known. Tax tables for subsequent years are estimated by indexing the income values in the 1996 table for inflation. The federal income tax table used for 1996 is summarized in Table 1. The alternative minimum tax for each farm is computed and income tax is the greater of regular taxes or the alternative minimum tax. Once income taxes are determined the earned income credit, if the farm qualified, is computed. (The formula for computing earned income credits is outlined in the CCH Tax Law Editors' Tax Handbook.) Earned income credits are subtracted from income taxes to determine the final federal income tax payment.
Self-employment and Medicare taxes are computed as provided for under current law. In
particular, the self-employment tax is 12.4 percent on the lower of: self-employment income or the
legislated maximum income subject to self-employment ($61,300 in 1995). The Medicare tax is 2.9
percent of self-employment income. In the case of the representative farms, the income subject to the
self-employment tax is the same as net farm income from schedule F. The flat tax proposals being
debated do not call for a modification to self-employment and Medicare taxes, so the current
provisions are used for both the current and the alternative flat tax provisions.
Rather than analyze each of the flat tax proposals currently in the political arena, a generic flat tax alternative, based on the various proposals, was used for the farm level analysis. Each of the representative farms was simulated for seven years (1996-2002) under the current income tax provisions and a flat tax alternative. The farm program provisions, crop and livestock prices, and macroeconomic variables (interest rates and rates of inflation) were held constant for both income tax alternatives.
It was assumed the flat tax alternative would use a marginal income tax rate of 18 percent each year. This marginal tax rate lies within the range of proposed tax rates in the Armey-Shelby bill (20 percent for the first two years and 17 percent thereafter) and the Forbes proposal (17 percent each year). All of the farms are taxed as sole proprietors, who are assumed to be married and filing jointly with two dependents. The assumed personal deduction for a family of four is $35,000 per year. A personal exemption for two dependents of $10,000 and a family allowance deduction of $25,000 for a family of four lies within the range of deductions for a family of four in the Armey-Shelby bill ($33,300) and the Forbes proposal ($36,000). Other itemized deductions claimed under the current income tax provisions are set at zero for the flat tax. Interest earnings are assumed to be tax exempt while business interest payments are no longer treated as an income tax deduction.
The farms are assumed to use an accelerated cost recovery schedule for computing depreciation deductions under the current federal income tax provisions. For the flat tax alternative the depreciation deductions are eliminated and replaced with a deduction for capital purchases, which allows farms to deduct 100 percent of the purchase price, net of trade in value, in the year purchased. The rules for replacing machinery on the representative farms were held constant across the two tax scenarios, although farmers will likely adjust the rate of machinery replacement under a flat tax. Negative income taxes under the alternative flat tax can result from allowable deductions exceeding gross revenue. When this occurs it is assumed the negative tax is carried forward as tax benefits in subsequent years. Carry forward benefits are inflated 4 percent each year in an effort to maintain their real (adjusted for inflation) value in subsequent years. Most flat tax proposals are vague as to how the transition from the current system would be accomplished. For this analysis it was assumed that the farms' total un-used depreciation (basis) for existing machinery is treated as an expensing deduction in the first year.
Self-employment and Medicare taxes are computed using the same tax codes (tax rate and maximum income subject to the tax) under both the current tax provisions and the flat tax alternative. However, differences exist in the calculation of income subject to employment taxes. Under the flat tax the cost of expensing capital purchases is used in place of the current depreciation deduction, and the interest expense deductions are eliminated when calculating income subject to employment taxes for the flat tax alternative. In addition, income subject to employment taxes for the flat tax alternative is not reduced by the excess deduction carry forward. The taxable income base used to calculate employment taxes for the flat tax alternative was assumed to not be reduced by excess tax deductions carried forward, consistent with current provisions for dealing with net operating loss carry forward.
Annual income taxes (1996-2002) for a representative farm are calculated in Tables 2 and 3 to demonstrate the differences between the current income tax provisions (Table 2) and the alternative flat tax (Table 3). The annual receipts for the farm are identical across the two income tax provisions. The two tables demonstrate how the two tax alternatives compute the farm's annual taxable income and federal income taxes. Self-employment and Medicare taxes are computed under each provision to show how their values can differ even though the alternative flat tax does not explicitly change the method for computing these taxes. Below is a list of noteworthy differences found in Tables 2 and 3.
AFPC has developed and maintains data to simulate 70 representative crop, livestock, and dairy farms in major production areas across the United States (Figure 1). Characteristics for each of the farms in terms of size, crop mix, assets, and average receipts are summarized in Appendix A. The location of these farms was the result of discussions with staffers for the House and Senate Agriculture Committees.
Information necessary to simulate the economic activity on these representative farms was developed by interviewing panels of producers using a consensus building process. Names of producers and local Land Grant scientists who acted as facilitators are listed in Appendix B. Normally two farms are developed in each region using separate panels of producers; one is representative of moderate size full-time farm operations, while the second panel represents farms that are two to three times larger. Following the panel interview, producers are asked to examine pro forma financial statements for their representative farm. Changes in the input data are made until the panel members are satisfied that the model simulates observed economic activity on the farm.
The data collected from the producer panels are analyzed in a whole farm simulation model (FLIPSIM) that was developed by AFPC and has been refined and used for more than a decade. Projections of prices and yields for the seven year study period (1996-2002) are from the Food and Agricultural Policy Research Institute's (FAPRI) December 1995 Baseline. The December 1995 Baseline assumes the Agricultural Market Transition Program (AMTP) passed by Congress in 1995 is fully implemented. The macroeconomic variables (interest rates and rates of inflation) underlying the Baseline are from the WEFA Group's October 1995 projections, assuming a near balanced budget by 2000.
The representative farms are simulated using two initial debt to asset ratios, namely, moderate and high debts. The crop farms with moderate debt are assumed to begin with intermediate- and long-term debt to asset ratios of 20 percent. This level of debt is considered to be a moderate level of debt for commercial size farms, based on information developed from the USDA-ERS and NASS Cost and Returns Survey and the producer panels. Moderate initial debt to asset ratios for dairy, hog, and beef cattle farms are 30, 30, and 5 percent, respectively. For the high debt levels the crop, dairy, hog and beef cattle farms have debt to asset ratios of 40, 60, 60, and 10 percent, respectively.
The results of simulating 70 representative crop, livestock, and dairy farms are summarized in Figures 2-10 and Tables C1-C8 in Appendix C. The simulation results are presented in terms of the projected average annual federal income taxes for 1996-2002, the average annual self-employment and Medicare taxes for 1996-2002, and the average annual total federal taxes paid by the farms for 1996-2002. The three scenarios reported in Figures 2-10 are: (1) current federal income tax provisions (Base) with moderate debt, (2) current federal income tax provisions (Base) with high debt, and (3) the flat tax alternative. A sensitivity analysis which assumed a 20 percent decrease in interest rates is not presented because the federal income and employment tax results, under the flat tax alternative, for the farms are the same as those presented here for baseline interest rates. Lower interest rates, however, increase net cash farm incomes for all of the representative farms.
Feed Grain Farms
All ten of the moderate debt feed grain farms would pay lower average annual federal income taxes under the flat tax alternative, while eight of the ten farms pay lower income taxes assuming high initial debt levels (Figure 2 and Table C1). For example, under the base income tax provisions the large Iowa grain farm (IAG1500) has average annual federal income taxes of about $12,120 and $10,500 assuming moderate and high debt levels, respectively; and about $9,480 under the flat tax alternative (Table C1). In contrast to the current tax provisions, the loss of interest expenses as an income tax deduction for the flat tax alternative causes farmers to pay the same federal income taxes, regardless of their debt position (Table C1).
Relative to the base tax provisions, federal income tax savings for the flat tax alternative range from $80 to $32,800 per year for the moderate debt feed grain farms. Assuming high initial debt levels, the moderate size Nebraska (NEG800) and Texas High Plains (TXNP1600) feed grain farms would have higher federal income taxes under the flat tax of $1,420 and $220, respectively. These two farms had higher federal income taxes under the flat tax alternative in part because they lost the benefits of the earned income tax credit under the flat tax alternative.
The flat tax alternative generally results in lower federal income taxes, because it has a higher nontaxable base, in other words, it allows farmers to expense 100 percent of the net cost of machinery (purchase price less trade in value) in the year purchased, and it allows for inflation adjusted tax benefits (excess deductions) to be carried forward. Also the flat tax alternative results in a lower marginal income tax rate for the larger, more profitable, feed grain farms. On average, the combination of lower taxable income base and the carry-forward tax benefit more than offsets the loss of interest expense and depreciation deductions for the representative feed grain farms analyzed.
Self-employment and Medicare taxes for six of the ten representative feed grain farms (IAG760, MOG1250, NEG800, TXNP1600, TXNP4500, and SCG1500) are higher for the flat tax alternative under the moderate debt scenario (Figure 2 and Table C1). Four of the farms (IAG1500, MOG2400, NEG1575, and SCG3500) experience lower employment taxes under the flat tax alternative, assuming a moderate initial debt level. Employment taxes computed under the flat tax alternative exceed current employment taxes when the interest expense and depreciation exemptions under the current provisions exceed the expensing deductions under the flat tax alternative. The taxable income base used to calculate employment taxes for the flat tax alternative was assumed to not be reduced by excess tax deductions carried forward.
Total average annual taxes (federal income, self-employment and Medicare taxes) are higher for three of the ten moderate debt, representative feed grain farms under the flat tax alternative and for half of the high debt feed grain farms (Table C1). At the high initial debt level, total taxes for the TXNP1600 farm are $2,140 per year higher under the flat tax alternative (Table C1). The other four high debt feed grain farms which pay higher total taxes under the flat tax alternative, experience average increases of $530 to $4,550 per year.
Wheat Farms
Six of the eight moderate debt representative wheat farms would experience lower average annual federal income taxes under the flat tax alternative (Figure 3 and Table C2). For these farms, the average annual reduction in federal income taxes ranges from $640 to more than $10,500. Assuming the eight representative wheat farms had high initial debt levels, five of the eight farms would have higher federal income taxes under the flat tax alternative. Note that the moderate Kansas wheat farm (KSW1175) would see an increase in federal income taxes under the flat tax alternative (regardless of the debt assumption) due to the loss of earned income tax credits. The farm is projected to have a negative average annual income tax under the current tax provisions due to the earned income tax credit.
Employment taxes for seven of the eight moderate debt representative wheat farms under the flat tax alternative exceed the employment taxes under the current tax provisions (Table C2 and Figure 3). These wheat farms experience an increase in self-employment taxes because the loss of interest expenses and depreciation as tax deductions is greater than benefits from expensing capital purchases. Wheat farms tend to have low capital purchases which are consistent with the machinery replacement strategies observed for the representative wheat farms. At higher debt levels all eight of the representative wheat farms pay more employment taxes under the flat tax (Figure 3).
Total federal income and employment taxes for three of the eight representative wheat farms with moderate debt are higher under the flat tax alternative, and seven of the eight high debt wheat farms have higher total taxes. These farms experience increases in total taxes due to increases in self-employment taxes out pacing the decline in federal income taxes and due to the loss of the earned income tax credit.
Cotton Farms
Eight of the nine moderate debt representative cotton farms would experience a decrease in federal income taxes and seven of the nine high debt cotton farms have lower federal income taxes under the flat tax alternative (Figure 4 and Table C3). Federal income tax savings range from about $130 to $21,320, assuming a moderate initial debt position. Assuming the cotton farms have high initial debts, the federal income tax savings would range from $900 to $17,200. The two high debt cotton farms that pay higher federal income taxes (CAC900 and MSC1635) pay an average of $1,000 to $6,700 per year in higher federal income taxes under the flat tax alternative.
Self-employment and Medicare taxes for seven of the nine moderate debt, representative cotton farms are higher under the flat tax alternative. The average annual tax increases for these moderate debt farms is about $880 per year. All of the high debt cotton farms pay higher average annual employment taxes under the flat tax alternative due to the loss of interest as an income tax deduction. The average increase in employment taxes for the high debt producers is about $1,300 per year.
Total federal taxes for all but two of the moderate debt representative cotton farms are reduced under the flat tax alternative. All but three of the high debt farms (TXBL1200, CAC900, and MSC1635) experience a decrease in total taxes under the flat tax.
Rice Farms
Like the other crop farms, most (five of eight) of the moderate debt representative rice farms experience a decrease in federal income taxes under the flat tax alternative (Figure 5 and Table C4). Seven of the eight high debt representative rice farms, however, have higher federal income taxes under the flat tax alternative. Average annual income tax savings under the flat tax alternative for the moderate debt rice farms range from $60 to $6,500. The high debt farms that pay higher federal income taxes under the flat tax have increases ranging from $330 to $3,860 annually (Table C4).
Self-employment and Medicare taxes for seven of the eight moderate debt rice farms would increase an average of about $2,000 per year. All eight of the farms would experience higher employment taxes if they had high initial debts. Similar to wheat farms, this result is consistent with a production agriculture system which is experiencing a low capital turnover due to economic pressure within the sector.
Total federal taxes for five of the eight moderate debt rice farms increase under the flat tax alternative and total taxes increase for seven of the eight high debt farms. For the moderate debt farms the increase in total taxes occurs because increases in employment taxes more than offset reductions in federal income taxes under the flat tax. Seven of the high debt farms pay higher total taxes under the flat tax alternative due to a combination of higher federal income taxes and higher employment taxes. Two of the farms presently benefit from earned income tax credits (ARR1260 and LAR1100) and lose this benefit under the flat tax alternative.
Dairy Farms
Eight out of 22 of the moderate debt, and 17 of the 22 high debt, representative dairy farms have higher federal income taxes under the flat tax alternative than the current tax provisions (Tables C5 and C6 and Figures 6, 7, and 8). Five of the dairy farms are projected to have negative average annual income taxes (TXED300, TXED200, NYCD110, VTD70, and VTD186) under the current income tax provisions due to earned income tax credits. The flat tax is assumed to eliminate this provision so these three farms see a net increase in their federal income taxes at both debt levels. Loss of interest expenses as a income tax deduction explains why federal income taxes are higher under the flat tax alternative for 14 of the dairy farms, when one assumes the farms start with a high debt level. Dairy operations, in general, can currently carry more debt than crop farms due to more consistent cash flows throughout the year.
Self-employment and Medicare taxes are increased by the flat tax alternative for 19 of the 22 moderate debt dairy farms. If the representative dairy farms start with high debt levels, all of the representative dairy farms experience higher employment taxes. The capital replacement deduction, on the dairy farms, is not sufficient to offset the loss of the interest and depreciation deductions; thus causing an increase in employment taxes for most all of the dairy farms.
The sum of total taxes (federal income and employment) increases for 9 of the 22 moderate debt farms and 17 of the 22 high debt representative dairy farms under the flat tax alternative. Higher total taxes for the 17 high debt farms are a result of increases in both employment taxes and federal income taxes. The loss of interest expenses as an income tax deduction largely explains the increase in taxes for the 17 high debt dairy farms.
Beef Cattle Ranches
Average annual federal income taxes for five of the six moderate and high debt representative beef cattle operations would increase for the flat tax alternative (Figure 9 and Table C7). The flat tax alternative is assumed to eliminate the earned income tax credit which is responsible for increasing federal income taxes for these five ranches. Under the current tax provisions the WYB300, COB250, STB400, MOSB150, and MONB150 ranches all have negative average annual income taxes due to the benefits of earned income tax credits. The increase in federal income taxes under the flat tax for these moderate debt ranches ranges from about $340 to $980 per year. One of the representative ranches (MTB400) has a decrease in federal income taxes of about $1,000 per year under the flat tax, largely due to the fact the ranch seldom benefits from earned income tax credits under the current tax provisions.
Employment taxes would be expected to increase for all six representative cattle ranches, regardless of their initial debt to asset ratio. The only ranch with a decrease in federal income taxes (Montana), under the flat tax alternative, would have an increase in total taxes because employment tax increases exceed the decrease in federal income taxes. The annual total tax burden, across the six representative cattle operations, increases an average of $1,670 for the moderate debt ranches and $2,400 for the high debt ranches.
Hog Farms
Three of the seven moderate debt representative hog farms can expect an increase in federal income taxes under the flat tax alternative (Figure 10 and Table C8). At a high initial debt to asset ratio, five of the seven representative hog farms would pay higher federal income taxes under the flat tax alternative. The two Illinois grain-hog farms (ILH200 and ILH450) pay lower income taxes, regardless of their initial debt position, under the flat tax because the farms benefit from the lower marginal income tax rate of 18 percent assumed for the flat tax. Three of the farms are projected to benefit from earned income tax credits under the current tax provision (NCH350, MOH225, and MOH75) so the flat tax alternative would increase their average annual federal income taxes, particularly at the high debt assumption.
Self-employment and Medicare taxes increase under the flat tax alternative for four of the seven moderate debt representative hog farms. At the high initial debt level only one of the farms (ILH450) experiences a reduction in employment taxes under the flat tax alternative.
Total federal taxes for three of the seven moderate debt hog farms increase under the flat tax alternative. The total tax bill for these three farms increases an average of $6,600 per year under the flat tax alternative. At high initial debt levels total taxes would increase for five of the seven representative hog farms.
Auerbach, A. J. "Tax Reform, Capital Allocation, Efficiency and Growth," Paper presented at the Brookings Conference on Fundamental Tax Reform, February 15-16, 1996.
Food and Agricultural Policy Research Institute (FAPRI). "December 1995 Summary of the FAPRI Baseline: The Rainbow Book," University of Missouri-Columbia and Iowa State University, December 1995.
Golob, J. E. "How Would Tax Reform Affect Financial Markets?" Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter (1995):19-39.
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