Flat Tax

fair flat

flat tax by slug signorino

A flat tax is a tax system with a constant tax rate. A flat tax may also be called a tax in rem (‘against the thing’), such as an excise tax on gasoline of three cents per gallon. Usually the term flat tax refers to household income (and sometimes corporate profits) being taxed at one marginal rate, in contrast with progressive or regressive taxes that vary according to parameters such as income or usage levels. Flat taxes offer simplicity in the tax code, which has been reported to increase compliance and decrease administration costs. Proposals differ in how they define and measure what is subject to tax. A ‘true flat rate tax’ is a system of taxation where one tax rate is applied to all income with no exceptions. 

Critics of the flat tax argue that the marginal dollar to low income individuals is vastly more vital than that of the high income earner, especially around the poverty level. In their view this justifies a progressive taxation system as the added income gained from a flat tax rate to the rich would not be spent on vital goods and services for survival as they might at the poverty level with reduced taxation. However, true Flat tax proponents necessarily contest the concept of the diminishing marginal utility of money and that a marginal dollar should be taxed differently.

Proponents argue that under a flat tax 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.

When deductions are allowed a ‘flat tax’ is a progressive tax with the special characteristic that above the maximum deduction, the rate on all further income is constant. Thus it is said to be marginally flat above that point. To reconcile the difference between a true flat tax and a marginally flat tax it is argued that the latter simply excludes certain kinds of funds from being defined as income.

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. Designed by economists at Stanford’s Hoover Institution, the Hall–Rabushka tax is  flat tax on consumption. Hall–Rabushka accomplishes a consumption tax effect by taxing income and then excluding investment. Robert Hall and Alvin Rabushka have consulted extensively in designing the flat tax systems in Eastern Europe.

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.

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 an effort to obtain employment. Another objection is that the NIT subsidizes industries employing low cost labor, but this objection can also be made against current systems of benefits for the working poor.

Since a central philosophy of the flat tax is to minimize the compartmentalization of incomes into myriad special or sheltered cases, a vexing problem is deciding when income occurs. This is demonstrated by the taxation of interest income and stock dividends. The shareholders own the company and so the company’s profits belong to them. If a company is taxed on its profits, then the funds paid out as dividends have already been taxed. It’s a debatable question if they should subsequently be treated as income to the shareholders and thus subject to further tax. A similar philosophical issue arises in deciding if interest paid on loans should be deductible from the taxable income since that interest is in-turn taxed as income to the loan provider. There is no universally agreed answer to what is fair. For example, in the United States, dividends are not deductible but mortgage interest is deductible. Thus a Flat Tax proposal is not fully defined until it differentiates new untaxed income from a pass-through of already taxed income.

Taxes are often used as instruments of policy. For example, it is common for governments to encourage social policy such as home insulation or low income housing with tax credits rather than constituting a ministry to implement these policies. In a true flat tax system (i.e. one without deductions) such policy mechanisms may be curtailed. In addition to social policy, flat taxes can remove tools for adjusting economic policy as well. For example, in the US short term gains are taxed at a higher rate than long term gains as means to promote long term investment horizons and damp speculative fluctuation. Thus claims that flat taxes are cheaper/simpler to administer than others may need to factor in costs for alternative policy administration.

In general, the question of how to eliminate deductions is fundamental to the flat tax design: deductions dramatically affect the effective ‘flatness’ in the tax rate. Perhaps the single biggest necessary deduction is for business expenses. If businesses were not allowed to deduct expenses then businesses with a profit margin below the flat tax rate could never earn any money since the tax on revenues would always exceed the earnings.

Thus corporations must be able to deduct operating expenses even if individual citizens cannot. A practical difficulty now arises as to identifying what is an expense for a business. For example, if a peanut butter maker purchases a jar manufacturer, is that an expense (since they have to purchase jars somehow) or a sheltering of their income through investment. How deductions are implemented will dramatically change the effective total tax, and thus flatness, of the tax. Thus a Flat Tax proposal is not fully defined until it differentiates deductible and non-deductible expenses.

Perhaps the largest logical issue is that if the flat tax system has a large per-citizen deductible, then it is effectively a progressive tax since the total income tax rate is increasing with increasing income. Any flat tax with an initial threshold deduction is inherently a progressive tax. The admission that such a flat tax is not actually flat at all, would seem to undermine the notion that the ‘flatness’ of the tax is itself a desirable feature. As a result, sometimes the term Flat Tax is actually a shorthand for the more proper ‘marginally flat tax.’

Tax distribution is a hotly debated aspect of flat taxes. The relative 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 stepped marginal tax rates, since everybody pays the same proportion. 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.

Proponents of the flat tax system point out that there is a strong likelihood that another positive effect would be to discourage increased spending by government. The reason for this would be that any tax increase would affect all taxpayers. In the current tax system, government officials are able to win the approval of the public by raising taxes on certain groups to pay for new spending. If everyone’s taxes had to go up with any new spending, every new government program would have to be carefully scrutinized. In the long run, the hope would be that government would become more efficient.

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