Flat Tax System Benefits Progressivity,

Flat Tax System Benefits

Progressivity, Efficiency, and Simplicity

The Flat Tax: Why it Works

As a country's tax system becomes more complicated, it becomes easier for governments to make it more complex still, in a rapidly accelerating process of proliferating insanity -- until, perhaps, a limit of madness is reached and radical simplification is demanded (the Economist, 2005). In 2005, many of the world's largest and wealthiest countries seem far along this curve. The United States, which last simplified its tax code in 1986, and spent the next two decades making it more complicated, may soon reach a point of renewed fiscal catharsis. Other wealthy countries, with a tolerance for tax-code complexities even greater than the U.S., may not be so far behind.

Revenue naturally needs to be raised. However, many economists are left wondering whether a realistic alternative to tax codes exists. According to the Economist (2005): "The answer is yes: there is indeed an alternative, and experience is proving that it is an eminently realistic one. The experiment started in a small way in 1994, when Estonia became the first country in Europe to introduce a "flat tax" on personal and corporate income. Income is taxed at a single uniform rate of 26%: no schedule of rates, no deductions. The economy has flourished. Others followed: first, Latvia and Lithuania, Estonia's Baltic neighbors; later Russia (with a rate of 13% on personal income), then Slovakia (19% on personal and corporate income). One of Poland's centre-right opposition parties is campaigning for a similar code (with a rate of 15%). So far eight countries have followed Estonia's example. An old idea that for decades elicited the response, "Fine in theory, just not practical in the real world," seems to be working as well in practice as it does on the blackboard."

Many economist have argues that flat taxes cannot work because they are unfair (the Economist, 2005). Progressive countries, it is argued, have "progressive" tax systems, which require the rich to pay a bigger share of their incomes in tax than the poor. A flat tax appears to rule this out in concept.

However, this is not necessarily the case (the Economist, 2005). A flat tax on personal incomes combines a threshold (an exempt amount) with a single rate of tax on all income above it. The progressivity of this type of system may vary within great limits using just these two variables. Under systems such as the system in the U.S. Or systems seen in most of western Europe, the incentives for the rich to avoid tax (legally or otherwise) are great; and the opportunities to do so, which arise from the complexity of the codes, are enormous. Thus, the wealthy typically pay about as much tax under a flat-tax regime as they do under a progressive system.

In this light, the main objections to the flat tax are cancelled out (the Economist, 2005). In addition, the advantages of a simple tax system are enhanced. Simplicity is an advantage in its own right. The costs of administering a complex tax system are huge. Estimates for the United States, whose tax regime, despite government efforts, put the costs of compliance, administration and enforcement between 10% and 20% of revenue collected. This sum is equivalent to between one-quarter and one-half of the government's budget deficit. And many countries have even higher maintenance costs.

According to Hall and Rabushka (1995), the flat tax would save taxpayers hundreds of billions in direct and indirect compliance costs (Hall and Rabushka, 1995). It would also transfer billions of dollars from investments that reduce taxes to those that produce goods and services.

An effective flat tax could have many benefits (Branch, 2004). It could reduce compliance and administrative costs, as well as enhance productivity and work incentives. However, the majority of flat tax proposals that have been offered to date have been criticized for raising taxes on the middle class, increasing the deficit, or reducing the surplus.

However, just because previous flat tax proposals have been ineffective does not mean that the United States cannot implement a flat tax structure that, by integrating the Social Security (including Medicare) and income tax levies, has the advantages of other flat tax proposals without their faults (Branch, 2004).

For example, economist Ben Branch has proposed a combined 25% Social Security and income tax levy coupled with a $1,000 per exemption tax credit (Branch, 2004). "The working poor would be incentivised with subsidy payments based on the unutilized portion of their tax credits. Employer Social Security payments would continue as under the present system. Such a flat tax would neither shift the tax burden nor increase the deficit. It would, however, include all of the advantages of the other proposals."

Hall and Rabushka (1995) have also created a flat tax plan. According to the authors: "Under our flat tax, all income would be taxed once and only once, at a uniform low rate of 19%. Our plan is fair to ordinary Americans because it would permit a tax-free allowance of $25,500 for a family of four. The family would pay a tax of 19% on its earnings above that allowance. Millions of U.S. residents would no longer pay any income taxes. All wage earners would pay less tax under our flat tax than under the current system. Our flat tax would eliminate the distortions of the present tax treatment of business. It would replace a hodgepodge of depreciation schedules with an effective investment incentive, a first-year write-off. It would reduce the current corporate tax of 35% to 19%. It would eliminate double taxation of business income by ending taxation of dividends and capital gains."

The authors point out that this flat tax system simply taxes people on what they take out of the economy, not on what they put in (Hall and Rabushka, 1995). While opponents argue that it would hurt homeowners and the real estate industry, reduce charitable contributions, and provide a windfall to the rich, proponents argue that this would not be the case. According to Hall and Rabushka (1995): "Adopting the flat tax would improve the overall performance of the economy. Housing and charitable giving would flourish. Everyone's after-tax income would rise. All designers of rival tax plans agree that the tax base must be broadened and that tax rates must be lowered. Our flat tax meets the tests of efficiency, equity, and simplicity better than every other plan that has been proposed." flat tax applied to personal income has numerous advantages over the progressive tax system (Branch, 2004). Administrative costs, compliance costs, and the marginal tax rate can be greatly reduced, while productivity, compliance with the tax laws, and work incentives can all increase. As a result, there would be a strengthened economy; thus enabling a still lower tax rate. However, opponents of the flat tax argue that to maintain current tax collections, the flat rate has to be set at a level that would increase the tax burden on the majority of the middle class (or at minimum increase the relative tax burden on the middle class).

The greater efficiencies that can exist under a flat tax system may permit the development of a revenue neutral flat tax that does not raise middle class taxes (Branch, 2004). Still, current flat tax proposals remain vulnerable to the criticism that they would reduce the relative tax burden on the wealthy, while increasing it on the middle class.

Because the United States is a democracy, today's present system's tax burden has a tendency to reflect the will of the electorate. To be politically viable, proposed tax reforms must be structured so that they neither increase the deficit nor the tax burden on the middle class. Compared to the existing tax system, flat tax reform should simultaneously accomplish each of the following objectives (Branch, 2004):

Reduce administrative costs.

Reduce compliance cost.

Reduce economic distortions.

Reduce marginal tax rates.

Not increase the middle class's relative tax burden.

Maintain current rates of tax collections.

This paper offers an in-depth look at the flat tax system, in an effort to present a clear argument as to why this system could be very beneficial to countries around the world.

Explaining the Flat Tax

When implementing a flat tax, it is best to have two separate tax forms -- one for business income (which includes corporate income and income from the ownership of unincorporated businesses) and the other for wages and salaries (Rabushka, 1997). However, it is crucial to view the two forms as a single integrated system. An integrated system allows for equal taxation of all types of income, although reporting of income is divided into two parts. The flat tax can be seen as a single tax on the cash flow of the economy, rather than two or more different taxes arising from different sources of income.

According to Rabushka (1997): "Expensing investment eliminates the double taxation of saving. Under an income tax, people pay tax once when they earn and save, and again when the savings earn a return. With expensing, the first tax is abolished. Saving is, in effect, deducted in computing the tax."

The following list summarizes the key aspects of the flat tax (Rabushka, 1997):

1. "The flat tax, in effect, removes the tax code from the economy. No individual, household, or firm needs to take into account any tax complications that arise from their economic decisions and activities. The tax system is designed for the sole purpose of collecting revenue, not for social manipulation of individuals or firms.

2. The flat tax is pro-investment because it permits 100%, first-year writeoff of all investment.

3. The flat tax is non-discriminatory, in that it treats every individual, household, and firm exactly the same. It is fair in this regard. This is an important point of principle, namely, that of enhancing individual economic freedom. The flat tax does not punish success.

4. The flat tax is the essence of tax simplification. It is completely transparent. Everything you need to know to understand the system is contained on the two proposed forms for reporting individual and business tax liabilities.

5. The flat tax promotes economic growth. The consensus of scholarly studies is that a low flat tax would result in higher growth in those countries which now have graduated income tax systems.

6. The flat tax is easy to administer. Revenue from business cash flow is collected at source, except for wages, which is withheld at source and directly transmitted to the government.

7. The flat tax increases individual incentives to work, save, invest, and take entrepreneurial risks. The rate of tax in a flat tax system is lower than the top rate in graduated tax systems.

8. The flat tax eliminates political lobbying on the part of special interest groups."

Case for the Flat Tax System

The majority of citizens in various areas across the world accept that they must contribute to the cost of public goods and services, such as the police and social services (Kerr, 2004). Most agree that taxation is the best way to do so. However, there is a great deal of disagreement when it comes to how people should be taxed.

There are three basic ways taxes can be collected (Kerr, 2004). The first is a head or poll tax, which is a fixed exaction upon individuals of an amount that does not correlate to one's income. Under this system, a janitor and a stockbroker pay the same level of tax.

The second basic type of taxation is a progressive tax (Kerr, 2004). Under this system, the rate of taxation increases as the amount of money subject to the tax increases. For example, New Zealand's income tax is a progressive tax. The rate of tax applied to the first dollar of income is 15% while that applied to each dollar of income over $60,000 is 39%. The rate of tax may start at zero and rise to 100%.

The third option is a flat tax (Kerr, 2004). Under this system, the rate of tax remains the same regardless of the amount of income earned. The janitor and stockbroker would pay the same rate of tax. However, the stockbroker would still pay more total tax than the janitor because he earns more money.

Head taxes are not popular in many areas of the world. According to Kerr (2004): "At first sight they may seem bizarre. Yet we accept a somewhat similar approach every day when we belong to a gym, society or club: membership generally means flat dues for everybody. Similarly, prices charged by supermarkets do not depend on the income of the shopper. The head tax, however, runs into serious problems if the tax is more than trivial. If taxpayers earned little income relative to the level of the head tax, they would face severe hardship. The government might decide to remit the head tax on people who do not earn a minimum level of income, but this would create problems. It would need to raise additional tax from other people to compensate for the revenue forgone. The head tax has gone out the window."

Thus, it is important to ask whether a flat tax or progressive income tax is a more desirable option (Kerr, 2004). A flat tax appears to be a more robust option than a progressive tax. It is fairly easy to set the rate of tax and calculate the amount of tax paid by each taxpayer with a flat tax. It does not matter whether income is earned through a company or fund, or as a fringe benefit. All income is taxed at the flat rate. Because every taxpayer pays the same rate of tax, there is less room for the level of tax payable by various groups to be changed simply for political reasons.

The progressive tax is a more complicated system (Kerr, 2004). The government needs to figure out which particular progressive tax scale it supports out of the vast number that could be created. This choice is a political question. There is no principle to resolve it in an objective fashion.

Many people claim that an increase in the progressiveness of the tax scale is justified on fairness grounds (Kerr, 2004). There is no limit to these arguments. A little more progressivity is always seen as fair.

The flat tax is commonly perceived as a benefit to the rich (Kerr, 2004). People who make more money initially benefit more than those who earn less. However, over long periods of time, higher productivity may be better for everyone. A progressive tax scale discourages productivity and negatively affects living standards more than an equivalent flat tax.

Richard Epstein, a leading legal scholar at the University of Chicago, claims that the shape of a progressive tax scale leads to what he called the Goldilocks problem (Kerr, 2004). This is the constant search for a schedule of tax rates that is 'just right'.

If there is little difference between the bottom and top tax rates, what is the point of greater complexity and costs entailed in implementing a progressive tax? However, if the tax scale is highly progressive, people who generate wealth and jobs are encouraged to participate in wasteful tax avoidance activities and some might move to other countries (Kerr, 2004).

Epstein observes that there is great reluctance in the United States to have progressive tax systems at the state level because, "the folks who live in California can happily relocate to Nevada with a lower tax base (Kerr, 2004)." Tax competition is a major restraint on the level of taxes and the progressivity of tax scales. Thus, it seems that a flat tax is generally better than a progressive one. Paying taxes is not considered a pleasurable activity for most, but it could become somewhat less painful for many citizens if flatter income tax systems are implemented.

Benefits of the Flat Tax System

There are many types of proposals for tax reform and one of the strongest is the flat tax reform proposal, which promises to simplify income tax preparation and reduce the opportunity for cheating (Bradley, 1984). The concept is simple. Individuals and corporations are taxed at the same rate. Savings and investments are exempt from tax, eliminating double taxation and promoting savings and investments necessary for economic growth. The preparation of tax returns is simplified by allowing for just four types of personal deductions. Tax credits and other deductions will no longer be available, which is a benefit as this simplifies the calculation of net income and taxes. Corporations will no longer be able to deduct interest payments on debt. This proposal may also result in an increase of collections from companies. For individuals it stands to significantly reduce the tax rate for many, increasing the tax base, encouraging more people to file, and discouraging cheating.

With a flat tax system, Hall and Rabushka (1995) argue that tax forms could fit on postcards. A simple tax system takes only a few easy calculations, as opposed to the complexity of today's progressive income taxes.

The flat tax would reduce the negative twist in the progressive tax system (Auerbach, 1997). The flat tax has a single, uniform incentive for all investments. Basically, businesses report all purchases of equipment and buildings as expenses. Auerbach observes that using a flat-rate consumption tax in place of an income tax would raise the ratio of capital stock to GDP from 5.0 to 6.2.

Like that of many other countries, the United States' federal income tax system needs a great deal of improvement (Carroll et al., 1998). The process of filing should not be complicated and time-consuming. This is important because it will deter taxpayers from taking shortcuts, cheating and choosing not to report income. Thus, an improved tax system would result in higher tax collections. When it comes to corporations, legislators need to realize that they have enjoyed paying less than half of the statutory 35% federal corporation tax rate for many years. Companies like Target and Microsoft have taken advantage of millions of dollars in tax giveaways and rebates.

In addition, tax loopholes and abusive tax shelters should be eliminated (Bradley, 1984). Loopholes interrupt the tax dollars destined for the United States treasury and that money is often funneled instead to sources outside the U.S.

The benefits of a flat tax system for the United States are great (Hall and Rabushka, 1995). Because the system utilizes a broad base, a low 19% tax rate would raise the same revenue as the current tax system. The tax on families is fair and progressive: the poor do not pay tax at all, and the fraction of income that a family pays increases with income. The flat tax system is simple and easy to comprehend. And the tax operates on the consumption tax principle -- families are taxed on what they take out of the economy, rather than what they put into it.

The flat tax system is based on a basic administrative principle: income should be taxed just once as close as possible to its source (Hall and Rabushka, 1995). Today's tax system violates this concept in many ways. Some kinds of income -- like fringe benefits -- are not taxed at all. Other types, like dividends and capital gains, are taxed twice. And interest income, which should only be taxed once, avoids taxation altogether when clever taxpayers arrange to receive interest beyond the reach of the Internal Revenue Service (IRS).

The flat tax system proposes that all income is taxed at the same rate (Hall and Rabushka, 1995). Equality of tax rates is a basic concept of the flat tax. Its logic is more complex than just the simplicity of calculation with a single tax rate. Whenever various types of income are taxed at different rates or different taxpayers face different rates, the public determines how to take advantage of the differential. The main goal is to take deductions at the highest available rate and to report income at the lowest rate. Here are some of the ways that this goal can be reached (Hall and Rabushka, 1995):

company pays its workers partly in the form of stock options because the options will eventually be taxed at lower capital gains rates.

A real estate operator borrows from a bank and deducts the interest at his 40% marginal rate; the interest received by the depositors at the bank is taxed at their lower rates.

An author arranges for royalties to be deferred to next year because she knows that she will be in a lower tax bracket next year.

A corporation pays its shareholders exaggerated salaries as officers because salaries are taxed only once but dividends are taxed twice.

A company gives its workers prepaid legal services as a nontaxable fringe benefit, in place of cash that would be taxed.

The flat tax would eliminate all these inequities and inefficiencies. None of these opportunities to avoid taxes by distorting economic choices would survive this reform.

Boessenkool (et al., 1995) uses Alberta, Canada as an example of how flat tax can benefit economies. Albertans demanded that the government get its spending under control, meaning they wanted the deficit eliminated, the debt paid down, and their taxes reduced. The government reduced provincial spending, eliminating its deficit in three years, and paid down the debt. Having paid down the debt, the province introduced a 10% flat tax on personal income, which meant a 20% reduction in personal taxes. The payoff was great. The population is working hard; Alberta has the greatest proportion of people working of any province in Canada.

Progressivity, Efficiency, and Simplicity

Limiting tax burdens on the poor is a main principle of tax reform (Hall and Rabushka, 1995). Some ideas for tax simplification and reform ignore this principle -- neither a federal sales tax nor a value-added tax is progressive. Instead, all citizens, rich and poor alike, pay essentially the same portion of their spending in taxes. For this reason, the flat tax rejects sales and value-added taxes. The current U.S. federal tax system avoids taxing the poor, and this is a positive effort.

One of the greatest benefits of the flat tax is its simplicity and this cannot be understated (Hall and Rabushka, 1995). The main idea is to start over, eliminating all the present incentives and replacing them with a simple, uniform principle -- treating the total amount of investment as an expense in the year that it is made. The entire incentive for capital formation is on the investment side, instead of the existing split in the tax system between investment incentives and saving incentives. According to Hall and Rabushka (1995): "The first virtue of this reform is simplicity. Businesses and government need not quarrel, as they do now, over what is an investment and what is a current expense. The distinction doesn't matter for the flat tax. Complicated depreciation calculations, carrying over from one year to the next and driving the small-business owner to distraction, will vanish from the tax form. The even more complicated provisions for recapturing depreciation when a piece of equipment or a building is sold will vanish as well, to everyone's relief."

Every act of investment in the economy can be traced back to an act of saving (Hall and Rabushka, 1995). A tax on income with an exemption for saving is actually a tax on consumption, as consumption is the difference between income and saving. Consumption is what people take out of the economy; income is what people put into it. A consumption tax is an example of the concept that people should be taxed on what they take out, not what they put in. The flat tax, by expensing investment, is essentially a consumption tax.

Expensing investment takes away the double taxation of saving, another way to articulate the most economically significant feature of expensing (Hall and Rabushka, 1995). Under an income tax, people pay tax once when they earn and save and again when their savings earn a return. With expensing, the first tax is eliminated. Saving is deducted in computing the tax, then the return to the saving is taxed through the business tax. While economists have proposed numerous ways to eliminate double taxation of saving (involving complicated record keeping and reporting by individuals), the flat tax method is the least complex.

For instance, expensing investment is a consumption tax comes up when a person invests directly in a personally owned business (Hall and Rabushka, 1995). If a taxpayer receives $1,000 in earnings and turns around and purchases business equipment for $1,000, there would be a tax of $190 on the earnings in addition to a deduction worth $190 in reduced taxes for the equipment purchase. On net, there would be no tax. The taxpayer did not consume any of the original $1,000. Later the taxpayer receives business income representing the earnings of the machine, which will be taxed at 19%. If the taxpayer decides to consume rather than invest again, there will be a 19% tax on the consumption. As a result, he would pay a 19% consumption tax.