Flat tax

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A flat tax (short for flat rate tax) is a tax system with a constant tax rate.^[1] Usually the term flat tax would refer to household income (and sometimes corporate profits) being taxed at one marginal rate, in contrast with progressive taxes that may vary according to such parameters as income or usage levels.

Flat taxes that include a tax exemption for household income below a level determined by statute are not a true proportional tax, as taxable income may not equal total income. Nomenclature regarding flat taxes has become increasingly lax, in that taxes that are described as flat sometimes have little to differentiate them from other tax regimes.

Contents 1 Tax effects 1.1 Distribution 1.2 Administration and enforcement 1.3 Economic efficiency 1.4 Revenues 1.5 Overall structure 1.6 Border adjustable 1.7 Race to the bottom 2 Around the world 2.1 Eastern Europe 2.2 Countries that have flat tax systems 2.3 Countries reputed to have a flat tax 2.4 Countries considering a flat tax system 3 Recent and current proposals 3.1 Flat tax with deductions 3.2 Hall-Rabushka flat tax 3.3 Negative income tax 3.4 True flat income tax 4 See also 5 Notes 6 References 7 External links

Tax effects

Distribution

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 point out first that it might not make sense for everyone to pay the same proportion when some get advantages of prosperity. Also, they note that for the state to raise the same amount of money under a flat rate tax (to the first order, that is, assuming people earn the same incomes as before) requires that the rich pay less and the poor pay more than they would under a more progressive tax system. Proponents respond to this argument by saying that second-order effects would compensate; a flat tax would remove economic disincentives and encourage economic growth, thus leading to higher incomes and more tax revenues. So taxpayers across income ranges could be paying at the same or lower rate than their old system. Economic models usually predict that flat tax will increase both output and inequality.^[2][3][4]

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.

The issue of removing deductions, exemptions and special treatments is also relevant to the tax burden, if those special treatments currently benefit the better off. As an example, the tax debate in the UK has recently (2007) focused on the fact that hedge fund managers, some with multi-million pound incomes, "pay less tax than a cleaning lady"^[5] (actually a lower tax rate rather than less tax), because the hedge fund manager's "income" qualifies as capital gains, taxable at 10%, rather than the cleaner's employment income taxable at 33% (22% income tax plus 11% social security charge). A flat tax that taxed both at the same rate is argued to be fairer than the current, supposedly progressive, system.

We must also consider fairness in relation to the broader concept of justice. Proponents argue that a flat tax would:

1. by its greater simplicity, reduce taxes for each person, rich and poor; and
2. by stimulating economic growth, produce more government revenue, directable to programs that benefit the poor.

Thus, even if a flat-rate taxation is less fair than graduated taxation as a concept, it could produce more social justice.

Administration and enforcement

A flat tax taxes all income once at its source. Hall and Rabushka (1995) includes a proposed amendment to the US Revenue Code implementing the variant of the flat tax they advocate.^[6] 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.^[7] 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.

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. The people freed from working in administering taxes will then be employed in jobs that are more productive. 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 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. Similarly, a nation could establish a flat tax rate while retaining inordinately complex rules defining the nature of income (such as the imputed interest rules in the US).

It is possible that a flat tax would not remain simple over time, given the realities of interest group politics. While all flat tax proposals propose to eliminate nearly all deductions and credits, some envision keeping the mortgage interest deduction and possibly some others (note that Hall and Rabushka 1995 do not).

Economic efficiency

A common approximation in economics is that the economic distortion or excess burden from a tax is proportional to the square of the tax rate.^[8] A 20 percent tax rate thus causes four times the excess burden or deadweight loss of a 10 percent tax, since it is twice the rate. Broadly speaking, this means that a low uniform rate on a broad tax base will be more economically efficient than a mix of high and low rates on a smaller tax base.

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.^[9] 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.^[10]

Overall 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. 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 seem to leave the wealthy better off. Modifying the tax base can change the effects. A flat tax could be targeted at income (rather than wages), which could place the tax burden equally on all earners, including those who earn income primarily from returns on investment. Tax systems could utilize a flat sales tax to target all consumption, which can be modified with rebates or exemptions to remove regressive effects (such as the proposed FairTax in the U.S.^[11]).

Border adjustable

A flat tax system and income taxes overall are not inherently border-adjustable; meaning the tax component embedded into products via taxes imposed on companies (including corporate taxes and payroll taxes) are not removed when exported to a foreign country (see Effect of taxes and subsidies on price). Taxation systems such as a sales tax or value added tax can 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. Though, it's possible that a flat tax system could be combined with tariffs and credits to act as border adjustments (the proposed Border Tax Equity Act in the U.S. attempts this). Implementing a income tax with a border adjustment tax credit is a violation of the World Trade Organization agreement.

Race to the bottom

Main article: Race to the bottom

An argument raised by opponents of the flat tax is that corporations or wealthy persons might move to countries with lower taxes, especially in a single country context. The argument states that this would lead to a race to the bottom in which countries compete to offer ever-lower taxes for the rich, so that the rich become even richer, while the poor and middle classes, unable to financially handle relocation to another country, 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 the flat tax 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. It is argued that in order to prevent this 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. In other words, making economic conditions too desirable in one country may have the effect of forcing other countries to compete by making their conditions equally desirable. It could however be argued that even in the absence of a flat tax, this situation in which the very wealthy relocate to lower tax jurisdictions already exists.

Around the world

Main article: Tax rates around the world

Eastern Europe

Advocates of the flat tax argue that the former-Communist states of Eastern Europe have benefited from the adoption of a flat tax. Most of these nations have experienced strong economic growth of 6% and higher in recent years, some of them, particularly the Baltic countries, experience exceptional GDP growth of around 10% yearly.

• Lithuania, which levies a flat tax rate of 24% (previously 27%) on its citizens, has experienced amongst the fastest growth in Europe. Advocates of flat tax speak 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 a non-progressive flat tax 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.^[12] However, the emigration trend has recently stopped as enormous real wage gains in Lithuania (presumably due to the shortage of workers) have caused a return of many migrants from Western Europe. In addition to that, it is clear that countries not levying a flat tax such as Poland also temporarily faced large waves of emigration after EU membership in 2004.

• 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.^[13]

• In Estonia, which has had a 26% (24% in 2005, 23% in 2006, 22% in 2007, 21% in 2008, planned 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.^[14] Moreover, Estonia and Slovakia have high social contributions, pegged to wage levels.^[14] 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" [33]. However, this did not happen, since after the 2007 elections a right-wing coalition was formed which has stated its will to keep the flat tax in existence.

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.

•  BIH [34]

•  Bulgaria ^[15]

•  Albania ^{[16] [17]}

• Czech Republic^[18]

•  Estonia ^[19][20][21]

•  Georgia ^[22][21]

•  Guernsey ^[23]

•  Kazakhstan ^[24]

•  Iraq ^{[25] [26] [27]} It is not clear how effectively the Iraqi tax is being collected in practice.

•  Jersey ^[28]

•  Kyrgyzstan ^[23]

•  Latvia ^[21]

•  Lithuania ^[29][21]

•  Macedonia ^{[30] [23]}

•  Mongolia ^[31]

•  Montenegro ^[32]

•  Mauritius ^[23]

•  Romania ^[21]

•  Russia ^[33][21]

•  Serbia ^[34]

•  Slovakia ^[21]

•  Ukraine ^[35][21]

Also:

• Transnistria, also known as Transnistrian Moldova or Pridnestrovie. ^[36] 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.