Removed flat head and found exhaust valve is always open about 1/8 inch. It moves up and down when I rotate the crankshaft but never closes any lower than 1/8 inch. It rotates freely and appears to be in time. The intake operates normal. Could this be a problem with the compression release?

Hi,
In a word no. It is something else. Look for something obstructing it. Spray some lubricant at valve stem to make sure that it is not sticking. Try easing it into different positions and tapping it lightly with a wooden hammer handle (in direction of stem.)
Peace,
Clarke