President Bush appears serious about tackling "fundamental tax reform" within the next four years, although enhancing alternatives to Social Security and Medicare may well deserve his first turn at bat.

 Whenever we do get down to talking seriously about serious changes to the tax system, one question that will inevitably arise is whether there should be one individual tax rate or several. Smart people often form hasty opinions on this topic. Some may be surprised to learn that the most rigorous case for a single tax rate did not come from proponents of various "flat tax" proposals, who treat the topic as self-evident, but from President Clinton's chief economist Joe Stiglitz in his "Economics of the Public Sector."

 The main economic reason for a single, low marginal tax rate is that graduated tax rates impose rising penalties on additions to income, and therefore on additions to national output. Punish added income and you punish added output -- economic growth. A single tax rate puts a lid on marginal tax rates -- on the share of added earnings a worker, saver or entrepreneur gets to keep.

 In terms of incentives, however, there is no clear reason to prefer a flat tax of 25 percent to progressive rates of 15, 20 and 25 percent. A flat tax is not necessarily better than a low tax. Yet there are at least seven technical reasons for preferring a single tax rate, regardless how the tax base is defined (consumption, income or both). These reasons have to do with making the tax system simpler, fairer, more efficient, less vulnerable to political manipulation, and less prone to tax avoidance and evasion.

 First, a single tax rate makes it much easier to integrate business and individual taxes. Income originating in business (and used to pay interest and dividends to investors) can be taxed at the business source, rather than distributed to individuals and taxed at different rates depending on what their annual salaries happen to be that year.

 As Stiglitz explained, "the uniformity of (flat) marginal tax rates means that income can be taxed at its source; taxing income at its source will reduce compliance costs and increase compliance rates."

 If we all paid the same tax rate on interest income and dividends, there would be no need for individuals to report every detail about dividend or interest income -- the tax could simply be withheld by banks, brokers and mutual funds. If business and personal tax rates were the same, then interest expense would be deducted from corporate income at the same tax rate that interest income was taxed to individuals who own corporate bonds. These simplifications would plug notorious leaks in the tax system, raising more revenues at lower tax rates.

 Second, a single tax rate makes tax deductions equally valuable to all taxpayers with taxable income, not most attractive to those with the most income. Ironically, this eliminates a common argument against deductions -- that they mainly benefit those in high brackets.

 Third, a single tax rate avoids imposing a brutal tax rate on second earners. The current system taxes the first dollar of the second earner's income at the same tax rate as the last dollar of the first earner's income, regardless how modest the second earner's income may be.

 Eliminating the whole idea of "tax brackets" that rise with income would eliminate the most egregious "marriage penalty" (actually a work penalty). It makes it unnecessary to have different tax schedules for married couples who benefit from a joint return and gay couples who do not. And it would greatly improve lifetime work incentives for second earners, expanding employment and therefore enlarging the tax base for all federal, state and local taxes.

 Fourth, a single tax rate eliminates arbitrary legal distinction between Subchapter C corporations and other businesses, such as partnerships and proprietorships. This does away with tax avoidance strategies that involve setting up legal entities to create tax losses (shelters), or to take deductions not allowed on individual forms, or to defer taxes on savings. A single tax on all individuals and businesses ends such loopholes, raising greater revenues and thus allowing a lower tax rate.

 Fifth, a single tax rate eliminates possibilities of "tax arbitrage" designed to shift the tax base from taxpayers in high tax brackets to those in low tax brackets. In a system with high and low tax rates, tax arbitrage can involve people and firms in higher tax brackets borrowing from those in lower tax brackets, while the latter deposit the interest they receive in low-yield money market funds and end up paying low tax rates on low interest.

 Tax deductions for mortgage, business and investment interest thus lose more revenue from taxpayers in higher tax brackets than the government can possibly collect from the other side of the transaction -- interest income received by those in lower tax brackets. Arbitrage strategies also involve shifting income and assets toward family members in lower tax brackets, particularly in small businesses. Continued...