Flat tax

For the term related to tax incidence regarding flat progressivity, see Proportional tax.

A flat tax (short for flat rate tax) taxes all household income, and possibly corporate profits as well, at the same marginal rate. A flat tax usually refers to the taxation of incomes but can be applied to consumption.

Flat taxes are uncommon in advanced economies, whose nationwide taxes typically include a graduated tax on household incomes and corporate profits, such that the marginal tax rate rises as the income or profit of the taxed entity rises. Flat taxes, implemented as well as proposed, usually exempt from taxation household income below a statutorily determined level that is a function of the type and size of the household. As a result, such a flat marginal rate is consistent with a progressive average tax rate. Otherwise, all income or consumption is taxed at the same marginal rate.

Countries that have flat tax systems

These are countries, as well as minor jurisdictions with the autonomous power to tax, that have adopted tax systems that are commonly described in the media and the professional economics literature as a flat tax.

• Albania

• Estonia

• Georgia

• Guernsey

• Kazakhstan

• Kyrgyzstan

• Latvia

• Lithuania

• North Macedonia

• Mongolia

• Montenegro

• Mauritius

• Romania

• Russia

• Serbia

• Slovakia

• Ukraine

Countries that have no income tax

No income tax can be considered as a trivial example of a flat tax, with a 0% rate. There are countries that have no income tax. Some of these countries have alternative sources of income (often natural resources), while others (in particular Somalia) lack a government apparatus to effectively collect taxes.

Countries that may have a flat tax

These are countries for which there are some rumors claiming that the country has a flat tax, but there are no reliable sources proving or disproving that statement, or the legal status of the government levying the tax is doubtful.

• Bosnia and Herzegovina This country is sometimes rumored on internet forums and the like to have a flat tax, but no reliable citation has yet been found confirming this fact.

• Hong Kong The flat nature of Hong Kong's taxes is disputed by one "D.B.B.", who says "Hong Kong's 'flat tax' is better described as an 'alternative maximum tax.'" Alan Reynolds clears up some of the misunderstanding in a detailed article, concluding "The Hong Kong tax system has one major advantage over even the most elegant theoretical alternatives. It has been tested for more than 50 years. It works."

• Iceland But note that "Iceland’s system is not a pure Hall-Rabushka flat tax. Not only is the rate high, but Iceland retains some double taxation of saving and investment, as well as a few special tax preferences."

• Transnistria, also known as Transnistrian Moldova or Pridnestrovie. This is a disputed territory, but the authority that seems to have de facto government power in the area claims to levy a flat tax.

Countries considering a flat tax system

These are countries where concrete flat tax proposals are currently being considered by influential politicians or political parties.

• Czech Republic
• Hungary
• Poland

Historical use of flat taxes

Historically, a flat tax was seen as an improvement over a status quo featuring lower, including zero, tax rates for the nobility and clergy. Such a situation in 18th century France was one of the causes of the French Revolution. Over the course of the 19th century, most European nations adopted flat taxes applicable to most or all incomes.

After World War I, a progressive income tax was introduced in most countries to fund increased government spending for social programmes and, in particular, large-scale wars. In more recent years, it has been argued that very high tax rates for the highest income classes are ineffective in that the rich and mobile taxpayers are often able to avoid them. Proponents of high taxes such as George Monbiot claim that they have worked quite well in, for example, Sweden.

Flat tax today

Flat tax proposals have made something of a "comeback" in recent years. In the USA, former House Majority Leader Dick Armey and FreedomWorks have sought grassroots support for the flat tax. In other countries flat tax systems have also been proposed, largely as a result of flat tax systems being introduced in several countries of the former Eastern Bloc, where it is generally thought to have been successful, although this assessment has been disputed (see below). This has elicited much interest from countries such as the US, where it has gone hand in hand with a general swing towards conservativism.

See also Tax rates around the world

The countries that have recently reintroduced flat taxes have done so largely in the hope of boosting economic growth. The Baltic countries of Estonia, Latvia and Lithuania have had flat taxes of 24%, 25% and 33% respectively with a tax exempt amount, since the mid-1990s. On 1 January2001, a 13% flat tax on personal income took effect in Russia. Ukraine followed Russia with a 13% flat tax in 2003. Slovakia introduced a 19% flat tax on most taxes (that is, on corporate and personal income, for VAT etc., almost without exceptions) in 2004; Romania introduced a 16% flat tax on personal income and corporate profit on January 1 2005. Macedonia introduced a 12% flat tax on personal income and corporate profit on January 1 2007 and promissed to cut it to 10% in 2008.[24] Albania would be implementing 10% flat tax from 2008.

In the United States, while the Federal income tax is progressive, five states — Illinois, Indiana, Massachusetts, Michigan and Pennsylvania — tax household incomes at a single rate, ranging from 3% (Illinois) to 5.3% (Massachusetts). Pennsylvania even has a pure flat tax with no zero-bracket amount.

Recent and current proposals

Greece (25%) and Croatia are planning to introduce flat taxes. Paul Kirchhof, who was suggested as the next Finance minister of Germany in 2005, proposed introducing a flat tax rate of 25% in Germany as early as 2007, which sparked widespread controversy. Some claim the German tax system is the most complex one in the world.

On 27 September 2005, the Dutch Council of Economic Advisors recommended a high flat rate of 40% for income tax in the Netherlands. Some deductions would be allowed, and persons over 65 years of age would be taxed at a lower rate.

In the United States, proposals for a flat tax at the federal level have emerged repeatedly in recent decades during various political debates. Jerry Brown, former Democratic Governor of California, made the adoption of a flat tax part of his platform when running for President of the United States in 1992. At the time, rival Democratic candidate Tom Harkin ridiculed the proposal as having originated with the "Flat Earth Society". Four years later, Republican candidate Steve Forbes proposed a similar idea as part of his core platform. Although neither captured his party's nomination, their proposals prompted widespread debate about the current U.S. income tax system.

Flat tax plans that are presently being advanced in the United States also seek to redefine "sources of income"; current progressive taxes count interest, dividends and capital gains as income, for example, while Steve Forbes's variant of the flat tax would apply to wages only.

In 2005 Senator Sam Brownback, a Republican from Kansas, stated he had a plan to implement a flat tax in Washington DC. This version is one flat rate of 15% on all earned income, unearned income (in particular capital gains) would be exempt. Furthermore, his plan also calls for an exemption of $30,000 per family and $25,000 for singles. Mississippi Republican Senator Trent Lott stated he supports it and would add a $5,000 credit for first time home buyers and exemptions for out of town businesses. DC Delegate Eleanor Holmes Norton's position seems unclear, however DC mayor Anthony Williams has stated he is "open" to the idea.

Flat taxes have also been considered in the United Kingdom by the Conservative Party. However, it has been roundly rejected by Gordon Brown, Chancellor of the Exchequer for Britain's ruling Labour Party, who said that it was "An idea that they say is sweeping the world, well sweeping Estonia, well a wing of the neo-conservatives in Estonia", and criticised it thus: "The millionaire to pay exactly the same tax rate as the young nurse, the home help, the worker on the minimum wage".

Possible implementations

Flat tax proposals differ in how they define and measure what is subject to tax.

Flat tax with deductions

US Congressman Dick Armey has advocated a flat tax on all income in excess of an amount shielded by household type and size. For example, draft legislation proposed by Armey would allow married couples filing jointly to deduct $26,200, unmarried heads of household to deduct $17,200, and single adults, $13,100. $5,300 would be deducted for each dependent. A household would pay tax at a flat rate of 17% on the excess. Businesses would pay a flat 17% rate on all profits. Others have put forth similar proposals with various rates and deductions. Armey defined income to include only salary, wages, and pensions; capital gains and all other sources of wealth appreciation were excluded from taxation under his proposal.

While campaigning for the American presidency in 1996 and 2000, Steve Forbes called for replacing the income tax by a tax at the flat rate of 17% of consumption, defined as income minus savings, in excess of an amount determined by the type and size of the household. For example, the exempt amount for a family of four would be $42,000 per year.

Modified flat taxes have been proposed which would allow deductions for a very few items, while still eliminating the vast majority of existing deductions. Charitable deductions and home mortgage interest are the most discussed exceptions, as these are popular with voters and often used. However, according to "Flat tax fiasco" by economist Douglas Dunn, this is not a true flat tax.

Hall-Rabushka flat tax

Designed by economists at the Hoover Institution, Hall-Rabushka is a fully developed flat tax on consumption (taxing consumption is thought by economists to be more efficient than taxing income). Loosely speaking, Hall-Rabushka accomplishes this by taxing income and then excluding investment. An individual could file a Hall-Rabushka tax return on a postcard. Robert Hall and Alvin Rabushka have consulted extensively in designing the flat tax systems in Eastern Europe.

Negative income tax

Main article: Negative income tax

The Negative Income Tax (NIT) which Milton Friedman proposed in his 1962 book Capitalism and Freedom is a type of flat tax. The basic idea is the same as a flat tax with personal deductions, except that when deductions exceed income, the taxable income is allowed to become negative rather than being set to zero. The flat tax rate is then applied to the resulting "negative income," resulting in a "negative income tax" the government owes the household, unlike the usual "positive" income tax, which the household owes the government.

For example, let the flat rate be 20%, and let the deductions be $20,000 per adult and $7,000 per dependent. Under such a system, a family of four making $54,000 a year would owe no tax. A family of four making $74,000 a year would owe tax amounting to 0.2(74,000-54,000) = $4,000, as under a flat tax with deductions. But families of four earning less than $54,000 per year would owe a "negative" amount of tax (that is, it would receive money from the government). E.g., if it earned $34,000 a year, it would receive a check for $4,000.

The NIT is intended to replace not just the USA's income tax, but also many benefits low income American households receive, such as food stamps and Medicaid. The NIT is designed to avoid the welfare trap—effective high marginal tax rates arising from the rules reducing benefits as market income rises. An objection to the NIT is that it is welfare without a work requirement. Those who would owe negative tax would be receiving a form of welfare without having to make a try to obtain employment. Another objection is that the NIT subsidizes industries employing low cost labour, this objection can also be made against current systems of benefits for the working poor.

True flat tax

A system where one tax rate is applied to all taxable income with no exceptions.

In an article titled The flat-tax revolution, dated April 14, 2005, The Economist argued as follows: If the goals are to reduce corporate welfare and to enable household tax returns to fit on a postcard, then a true flat tax best achieves those goals. The flat rate would be applied to all taxable income and profits without exception or exemption. It could be argued that under such an arrangement, no one is subject to a preferential or "unfair" tax treatment. No industry receives special treatment, large households are not advantaged at the expense of small ones, etc. Moreover, the cost of tax filing for citizens and the cost of tax administration for the government would be further reduced, as under a true flat tax only businesses and the self-employed would need to interact with the tax authorities.

Fairness

This is a hotly debated aspect of flat taxes. Real and perceived fairness hinges crucially on what tax deductions are abolished when a flat tax is introduced, and who profits the most from those deductions.

Proponents of the flat tax claim it is fairer than progressive taxation, since everybody pays the same. Opponents point out that for the state to raise the same amount of money under a flat rate tax requires that the rich pay less and the poor pay more than they would under a progressive tax system. The issue comes down to how one defines "fair". Proponents claim that since everybody pays the same rate, it treats everyone equally and thus is fair to everyone. Opponents of the flat tax, on the other hand, claim that since the marginal value of income declines with the amount of income (the last $100 of income of a family living near poverty being considerably more valuable than the last $100 of income of a millionaire), taxing that last $100 of income the same amount despite vast differences in the marginal value of money is unfair. Many flat-tax proponents actually concede this premise since most proposals are not truly totally flat but have a threshold below which income is not taxed at all. Therefore, with the exception of flat-tax proponents who argue for no deductions and taxation of all income at one flat rate, both proponents and opponents agree in principle if not in degree with the basic premise of this concept.

However, the sizable exemptions provided under most flat tax proposals go far in restoring effective progressivity. As income for an individual increases, the exempt income becomes an ever smaller percentage of total income.

Arguments in favor

In addition to the controversy over which kind of tax system is fairest to both high and low income earners, there are other arguments favouring or opposing a flat tax.

Simplicity

A flat tax taxes all income once at its source. From this fact huge gains in simplicity flow. Hall and Rabushka (1995) includes a proposed amendment to the US Revenue Code implementing the variant of the flat tax they advocate. This amendment, only a few pages long, would replace hundreds of pages of statutory language (although it is important to note that much statutory language in taxation statutes is not directed at specifying graduated tax rates; see Conflating concepts in Arguments against below). As it now stands, the USA Revenue Code is over 9 million words long and contains many loopholes, deductions, and exemptions which, advocates of flat taxes claim, render the collection of taxes and the enforcement of tax law complicated and inefficient. It is further argued that current tax law retards economic growth by distorting economic incentives, and by allowing, even encouraging, tax avoidance. With a flat tax, there are fewer incentives to create tax shelters and to engage in other forms of tax avoidance.

Under a pure flat tax without deductions, companies could simply, every period, make a single payment to the government covering the flat tax liabilities of their employees and the taxes owed on their business income. For example, suppose that in a given year, ACME earns a profit of $3 million, pays $2 million in salaries, and spends an added $1 million on other expenses the IRS deems to be taxable income, such as stock options, bonuses, and certain executive privileges. Given a flat rate of 15%, ACME would then owe the IRS (3M + 2M + 1M) x0.15 = $900,000. This payment would, in one fell swoop, settle the tax liabilities of ACME's employees as well as taxes it owed by being a firm. Most employees throughout the economy would never need to interact with the IRS, as all tax owed on wages, interest, dividends, royalties, etc. would be withheld at the source. The main exceptions would be employees with incomes from personal ventures. The Economist claims that such a system would reduce the number of entities required to file returns from about 130 million individuals, households, and businesses, as at present, to a mere 8 million businesses and self-employed.

This simplicity would remain even if realized capital gains were subject to the flat tax. In that case, the law would require brokers and mutual funds to calculate the realized capital gain on all sales and redemptions. If there were a gain, 15% of the gain would be withheld and sent to the IRS. If there were a loss, the amount would be reported to the IRS, which would offset gains with losses and settle up with taxpayers at the end of the period.

Economic efficiency

A simple but powerful result in economics is that the economic distortion from a tax is proportional to the square of the tax rate. A 20 percent tax rate doesn't cause twice the deadweight loss of a 10 percent tax, but 4 times the deadweight loss. Broadly speaking, this means that a low uniform rate on a broad tax base will be more economically efficient than a mix mash of high and low rates on a smaller tax base. This leads to the idea of a flat tax.

Dividend taxation

Some opponents of the dividend tax support a flat tax, since this would eliminate taxation on income in the form of cash dividends on corporate stock and realized capital gains. Under the flat tax, dividends and interest paid by businesses would be taxed only at the business level, and not at the shareholder level.

Other taxes

A flat tax might also serve as a substitute for taxes of Social Security benefits, if FICA tax liabilities are not a deductible expense for employers. It may also enable the reduction or elimination of estate or bequest taxes, though income tax reform does not necessarily entail the reform of other types of taxes. The corparations outside of america (that mainly relate to NAFTA) will have to pay the same amount of taxes that will be issued on Income tax because the money made in America will be Taxed in America.

Increased tax revenues

Some claim the flat tax will increase tax revenues, by simplifying the tax code and removing the many loopholes corporations and the rich currently exploit to pay less tax. The Russian Federation is a claimed case in point; the real revenues from its Personal Income Tax rose by 25.2% in the first year after the Federation introduced a flat tax, followed by a 24.6% increase in the second year, and a 15.2% increase in the third year. The Laffer curve predicts such an outcome, but attributes the primary reason for the greater revenue to higher levels of economic growth. The Russian example is often used as proof of this, although an IMF study in 2006 found that there was no sign "of Laffer-type behavioral responses generating revenue increases from the tax cut elements of these reforms" in Russia or in other countries.

Minor matters

Under a flat tax, the government's cost of processing tax returns would become much smaller, and the relevant tax bodies could be abolished or massively downsized. If combined with a provision to allow for negative taxation, the flat tax itself can be implemented in an even simpler way. In addition, such a tax reduces the cost of welfare administration significantly.

It is also argued that a flat tax will help lessen outsourcing, a growing problem in recent years, because under a flat tax, businesses will be able to pay taxes more easily and to deal with fewer regulations.

The effect of a shift to flat taxation on charitable giving is unclear. Those whose after-tax incomes will rise under a flat tax may give more. On the other hand, the net of tax "price" of donating to charity will rise, which would discourage giving. A survey ranked tax deductibility #7 among the reasons people give for donating money to worthy causes.

Arguments against

Overall tax structure

Some taxes other than the income tax (for example, taxes on sales and payrolls) tend to be regressive. Hence making the income tax flat could result in a regressive overall tax structure. Under such a structure, those with lower incomes tend to pay a higher proportion of their income in total taxes than the affluent do. It is a fact that the fraction of household income that is a return to capital (dividends, interest, royalties, profits of unincorporated businesses) is positively correlated with total household income. Hence a flat tax limited to wages would leave the wealthy much better off. Similarly, the loss of deductions will adversely affect some middle income households. The upshot could be a regressive shift in the tax burden. Hence opponents of the flat tax conclude that it is deceptive to advertise that tax as fair, when in fact it shifts the tax burden from the well off to the middle class. The real issues are deductions and what money counts as taxable income, not the flatness of the tax rate schedule.

Conflating Concepts

It is invariably argued that a flat tax will greatly simplify tax compliance and administration. In fact, simplicity does not so much stem from the structure of tax rates (a progressive rate structure is nothing more than a look-up table filling at most one page) as from the definition of what is subject to tax. Tax simplification - getting rid of all the deductions, exemptions, and special rules added over the years - is an issue wholly separable from that of the rate structure. A nation can vastly simplify its tax code while keeping its rate structure progressive: New Zealand is a case in point.

Ensuring simplification

Adopting a flat tax with its attendant simplicity may be all well and good, but it is unlikely that it will remain simple over time, given the realities of interest group politics. While all flat tax proposals propose to eliminate nearly all deductions and credits, most envision keeping the mortgage interest deduction and possibly some others (note that Hall and Rabushka 1995 do not). Legislators will be unable to resist the annual temptation to tinker with the tax code in order to advance certain policy objectives and to buy votes. Eventually, the tax code will become bloated and complex again.

Influence on particular investments

Through tax deductions and credits, the government can stimulate investments in activities it deems worthy, for example, renewable energies. Under a flat tax without deductions, the government loses this option.

Border adjustable

A flat tax system and income taxes overall are not border-adjustable; meaning the tax component embedded into products via taxes imposed on companies (including corporate taxes and payroll taxes) can not be removed when exported to a foreign country (see Effect of taxes and subsidies on price). Taxation systems such as a national sales tax or value added tax remove the tax component when goods are exported and apply the tax component on imports. Under a flat tax, domestic products are at a disadvantage to foreign products (at home and abroad). Such a system greatly impacts the global competitiveness of a country. For example, the United States is the only one of 30 OECD countries with no border adjustment element in its tax system. Due to this tax structure, it is estimated that U.S. goods are at a 17% competitive disadvantage, on average, to foreign producers.

Race to the bottom

Main article: Race to the bottom

The argument that corporations or wealthy persons might move to countries with lower taxes may seem irresistible at first blush, especially in a single country context. Yet how many wealthy people would gladly uproot their lives just to pay slightly less tax? Still, some claim it might lead to a race to the bottom in which countries compete to offer ever-lower taxes for the rich, so that the rich become ever richer, while the poor and middle classes, less mobile by assumption, are left to shoulder the entire cost of all government services. A consequence would be an ever-worsening under-funding and neglect of the public sector.

Opponents of lower taxes for the rich argue that the end result of this race to the bottom is social disintegration (see also failed state), a situation from which even the richest cannot benefit. In order to prevent this, it is argued, it is the responsibility of local and national governments everywhere to ensure that the rich pay a fair share of the tax burden. Concepts such as flat rate taxes are therefore said to be irresponsible at a global level, even if they may seem to grant a temporary advantage at a national level.

Inequality

Social democrats in particular oppose flat tax schemes since they weaken the redistributive effect of progressive taxation. Irrespective of economic growth, a rise in inequality is seen as undesirable in developed nations as it is linked to poorer health, higher crime and more social unrest (See economic inequality). Since the health of a population, for instance, takes many years to respond to economic realities, the negative effects of a flat tax may not be immediately observable.

However, proponents argue that this does not consider the effects of the sizable exemptions included in most flat tax proposals. Further it is possible to envision a scenario in which all parties are better off under a flat tax than without, despite inequality; in this case, according to utility theory, the flat tax scenario dominates the status quo (meaning it is preferred in all cases); the 'inequity' becomes a mere abstract consideration, as contrasted with the tangible economic benefit achieved by each individual. This assumes, of course, that there is not some third alternative which benefits each individual in a more equitable way.

Flat taxation effects in Eastern Europe

Advocates of the flat tax point to the former-Communist states of Eastern Europe as examples favourable to the adoption of a flat tax. Some of these nations, particularly the Baltic countries, have experienced exceptional economic growth in recent years. However, there is a growing concern over the effect that flat rates of taxation are having on these countries, both socially and politically, and arguments have been made that flat tax has had less influence on economic growth than previously thought.

• Lithuania has experienced amongst the fastest growth in Europe, and levies a flat tax rate of 27% (previously 33%) on its citizens. Advocates of flat tax talk of this country's declining unemployment and rising standard of living. They also state that tax revenues have increased following the adoption of the flat tax, due to a subsequent decline in tax evasion and the Laffer curve effect. Others point out, however, that Lithuanian unemployment is falling at least partly as a result of mass emigration to Western Europe. The argument is that Lithuania's comparatively very low wages, on which an overly regressive flat tax regime is levied, combined with the possibility now to work legally in Western Europe since accession to the European Union, is forcing people to leave the country en masse. The Ministry of Labour estimated in 2004 that as many as 360,000 workers may have left the country by the end of that year, a prediction that is now thought to have been broadly accurate. The impact is already evident: in September 2004, the Lithuanian Trucking Association reported a shortage of 3,000-4,000 truck drivers. Large retail stores have also reported some difficulty in filling positions.

• Again in Lithuania, it has been argued that whilst a new urban elite is certainly emerging in the country, poverty remains rife, average salaries pitifully low and that for the vast majority of people things have not markedly improved. According to a report published by the US Department of State in October 2005, the minimum wage increased in 2005 to $197.50 per month (the first rise since June 1998), well below the poverty threshold. The average wage stands at $458 per month.

• Whilst in most countries the introduction of a flat tax has coincided with strong increases in growth and tax revenue, there is no proven causal link between the two. For example, it is also possible that both are due to a third factor, such as new government that may institute other reforms along with the flat tax. A study by the IMF showed that sharp increases in Russian GDP growth and tax revenue around the time of the introduction of a 13% flat tax were not the result of the tax reform, but of a sharp increase in oil prices, strong real wage growth, and intensification in the prosecution of tax evasion.

• In Estonia, which has had a 26% (24% in 2005, 23% in 2006, 22% in 2007, 21% in 2008, 20% in 2009, 19% in 2010, 18% in 2011) flat tax rate since 1994, studies have shown that the significant increase in tax revenue experienced was caused partly by a disproportionately rising VAT revenue. Moreover, Estonia and Slovakia have high social contributions, pegged to wage levels. Both matters raise questions regarding the justice of the flat tax system, and thus its long-term viability. The Estonian economist and former chairman of his country's parliamentary budget committee Olev Raju, stated in September 2005 that "income disparities are rising and calls for a progressive system of taxation are getting louder - this could put an end to the flat tax after the next election" [25].

See also

• Negative income tax
• consumption tax
• Progressive tax
• Regressive tax
• Income tax
• Value added tax
• Sales tax
• FairTax
• Taxable income elasticity (also known as Laffer Curve)
• Fiscal drag (also known as Bracket creep)

Notes

References

• Steve Forbes, 2005. Flat Tax Revolution. Washington: Regnery Publishing. ISBN 0-89526-040-9
• Robert Hall and Alvin Rabushka, 1995 (1985). The Flat Tax. Hoover Institution Press.

External links

• The Laffer Curve: Past, Present and Future: A detailed examination of the theory behind the Laffer curve, and many case studies of tax cuts on government revenue in the United States