What is a flat tax? Categories and Criticism

A flat tax, is a tax system that applies a single tax rate to all levels of income. It has been proposed as a replacement for the federal income tax in the United States, which was based on a system of progressive tax rates in which the percentage of tax taken increases as income rises.

flat tax

What is a flat tax?

A flat-tax system is one in which everyone pays the same rate, regardless of income. Although proponents suggest that flat taxes would simplify the tax system and make both payment and enforcement easier, flat taxes generally reduce the proportional tax burden of high-income earners while increasing it on low-income earners. While the U.S. federal tax system is progressive, meaning that a worker’s income is taxed according to her level of income, some states have flat taxes on income as well.

Flat tax example

One of the most prominent supporters of the flat tax is the publishing executive Steve Forbes, the editor-in-chief of Forbes magazine. Forbes has run for office on several occasions, and he frequently makes the flat tax one of his policy proposals while championing it in his magazine. Forbes’ plan calls for a 17 percent flat tax assessed just once on individual and business incomes, with exemptions for people and families earning below a certain amount.

Understanding a Flat Tax

Supporters of a flat tax system propose that it gives taxpayers an incentive to earn more because they are not penalized with a higher tax bracket. Also, flat tax systems make filing easier. Critics of flat taxes argue that the system places an unfair burden on low-wage earners in exchange for lowering tax rates on the wealthy. Critics believe a progressive tax system is fairer than a flat tax system.

Major categories of a Flat Tax

Flat tax proposals differ in how the subject of the tax is defined.

True flat-rate income tax

A true flat-rate tax is a system of taxation where one tax rate is applied to all personal income with no deductions.

Marginal flat tax

Where deductions are allowed, a ‘flat tax’ is a progressive tax with the special characteristic that, above the maximum deduction, the marginal rate on all further income is constant. Such a tax is said to be marginally flat above that point. The difference between a true flat tax and a marginally flat tax can be reconciled by recognizing that the latter simply excludes certain types of income from being defined as taxable income; hence, both kinds of tax are flat on taxable income.

A flat tax with limited deductions

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 examples of deductions that would be retained, as these deductions are popular with voters and are often used.

Another common theme is a single, large, fixed deduction. This large fixed deduction would compensate for the elimination of various existing deductions and would simplify taxes, having the side-effect that many (mostly low income) households will not have to file tax returns.

Hall–Rabushka flat tax

Designed by economists at the Hoover Institution, Hall–Rabushka is a flat tax on consumption. Principally, 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.

Major categories of a Flat Tax

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” that the government would owe to the household—unlike the usual “positive” income tax, which the household owes the government.

Criticism of the flat tax

The main criticism leveled against the flat tax is that it is unfair. Such a system, say, opponents of the tax, would result in a windfall for the rich and higher tax burdens for the poor and the middle class, who are less able to afford them. Defenders of a flat tax argue that the beneficial effects of a progressive tax system could be maintained through generous personal exemptions.

A second criticism is that a flat tax would cause shortfalls in the government’s budget by lowering the taxes paid by the wealthy. Flat tax supporters counter that the economic growth resulting from a flat tax would generate additional tax revenue that would more than makeup for the revenue lost from lower tax rates.

Criticisms of the flat tax

Flat Tax vs. Progressive Tax

The progressive tax system – In this tax system, a high tax rate is charged on high-income earners while the low-income earners are charged a lower tax rate. The progressive tax system is used in most countries, including the United States, and it is considered a more just tax system.

In the US (as of 2018), a person earning an annual taxable income under $9,275 pays a 10% income tax, while those earning above $500,000 are charged 37% income tax. The progressive tax system is designed to ease the tax burden on low-income earners; the burden is shifted to high-income earners with a large amount of disposable income.

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