A flat tax is a system of taxation that would require every household to pay the same tax rate on their income, regardless of how much income they made during the year. At the time of writing, there are currently flat tax systems in place in 8 U.S. states.
Instead of using a progressive system of taxation, where higher income earners pay a greater percentage of tax at new income levels, a flat tax system guarantees a specific rate. That simplifies the tax code because it eliminates deductions, exemptions, and credits. Only earned income is taxed, which would theoretically encourage economic growth.
As with any system of taxation, there are several advantages and disadvantages which must be considered. Here are the essential flat tax pros and cons to examine.
List of the Pros of a Flat Tax
1. It eliminates confusion.
When there is a system of progressive taxation, tax filers must have access to the current income brackets to accurately file their taxes. In the United States, there were 7 different tax brackets enforced for the 2017 tax year. Every household works their way up the tax bracket until their income level is reached. That means they’d pay 10% on their first $9,325 of income, then 15% from that point up to $37,950, and so forth. With a flat tax system, there would only be one tax bracket.
2. It would reduce tax preparation costs.
CBS News reports that 50% of tax filers pay a professional to prepare their taxes and file their return. About 7 in 10 Americans worry about preparing their taxes, with the top concern being that a mistake could trigger an audit. The average cost to file a simple Form 1040 with no itemized deductions and a state tax return was $176 in 2017. If itemized deductions were required, the average cost to file was $273. With a flat tax, a simple calculation would be required to determine tax responsibilities.
3. It would eliminate supplemental taxes.
Because a progressive system of taxation creates income gaps, there are several other taxes in place to generate the income the government requires for operations. There are estate taxes, capital gains taxes, and some forms of income are even taxed twice. Under a flat tax system, only earned income is subjected to the annual tax. That means dividends, interest, and other forms of wealth generation can be excluded.
4. It may encourage economic growth.
One of the primary arguments against a progressive taxation system is that it penalizes people for earning more income. If you reach the top tax bracket in 2017, for example, then your income would be taxed at 39.6%. That’s a lot higher than the first bracket, at 10%. By moving to a flat tax rate, people would theoretically be encouraged to work more because they’d be able to save more of their money. That would increase overall revenues, provide economic stability, and even attract business investments in a best-case scenario.
5. It would eliminate the self-employment tax.
If you are self-employed in the United States, then you actually pay more in taxes than someone who is more traditionally employed. That is because you must pay the Medicare and Social Security taxes that are required to be withheld. Although the employer-equivalent portion of this tax can be deducted from your income, it does not affect your net earnings. A flat tax would eliminate this penalty for those who are self-employed.
6. It is a system that has been proven to work at a national level.
In Hungary, a progressive taxation system with rates from 17% to 32% was replaced with a flat tax of 16% on income and a 2% boost on sales tax. In the first year of this change, the total tax revenues received by the government increased by more than 7%. Much of the income boost came through increases in consume consumption. By 2015, total government revenues were almost 24% higher than the last year before the flat tax.
7. It promotes local spending.
Local spending helps to boost the economic viability of everyone. For every $100 that is spent at a local store that is not owned by a national chain, 68% of the money stays in the community. That means the value of local spending is the equivalent of $1.68 for every dollar. If that money is spent at a national chain or outside of the community, then the money that stays in the local economy is halved. With the potential for more disposable income, a flat tax encourages local growth.
8. It could create a trickle-down effect for each class.
With greater wealth comes a greater ability to invest. By promoting incentives to earn income through interest and dividends, people with means are encouraged to create new opportunities that expand this income source. That creates new opportunities to earn income for many households across the country, in theory, as more investments are sought. Although the working-class would still potentially pay more in such a scenario, everyone would be potentially better off if they were willing to join the labor force.
9. It would encourage more compliance with tax laws.
Under the current system of taxation in the United States, the laws governing the process are over 70,000 pages in length. That makes it difficult for people to stay in compliance, even if that is their purpose. The flat tax would possibly encourage more offshore funds to come back into the national economy because of the potentially lower tax rate on it. Both options encourage better compliance, which ultimately means more revenues at the government’s disposal.
List of the Cons of a Flat Tax
1. It requires low-income earners to bear a greater portion of tax responsibilities.
Although a flat tax seems fair from a percentage standpoint, as a 20% tax would be applied to all incomes, a greater share of a low-income household’s disposable income is affected. At $20,000 per year, a $4,000 tax bill would allow for just $16,000 (less any state taxes) for expenses. At $200,000, there would be $160,000 available to meet needs. It may incentivize some families to earn more, though not every individual is capable of such an action. And for some ultra-low-income earners, they would start paying taxes when they haven’t before, which creates an even greater burden on them.
Under a progressive system of taxation, the effective tax rate is what must be considered. Most low-income households that earn $40,000 or less in the U.S. have an effective tax rate around 13%. For a household earning $100,000, the effective tax rate is around 21%. If the proposed 14.5% flat tax is approved, the wealthier households get an effective tax cut, while the poor households get an effective tax increase.
2. It would eliminate multiple layers of government bureaucracy.
With a simplified tax system like the flat tax, there would be fewer bureaucratic requirements to review submitted tax returns. As long as the income was verified in some way, the mandated flat tax percentage would need to be calculated from that income to determine if the filing was accurate.
3. It ignores income resources that the wealthy generally own.
Most flat tax systems propose to tax only earned income. For the wealthy class, much of their income may come from dividends and interest. That means someone could earn enough money through interest and dividend payments where they would owe $0 in taxes because they didn’t work a formal job to create earned income. People in low-income households would not likely have this option, which would shift even more of the responsibility to fund the government onto their shoulders.
4. It removes certain incentives from the tax code.
Incentives are included in modern tax codes to encourage people to behave in certain ways. Offering an income credit for money donated to charitable causes encourages people to donate to charity. An allowed deduction for an electrical vehicle purchase gives people an incentive to lower their carbon footprint. If a flat tax system is implemented, there is an immediate loss of these incentives.
5. It would change the financial profile of millions of households.
Many people invested into homes because there was an advantage in deducting their interest payments from their income. Changes to the tax code for the 2018 filing year in the United States have already altered the financial profiles of many families, expanding the amount of income that is eligible for taxation. A flat tax would further this issue. Many homes are owned through a 30-year mortgage, which means an immediate change to how finances are calculated could have a long-term negative effect on the housing market.
6. It would change how people save for a retirement.
A flat tax eliminates other benefits in society as well. Businesses are often allowed to deduct matching funds that are contributed to an employee’s retirement plan. These matching funds are treated as pre-tax funds, which means they’re not taxable until they are withdrawn. Under a flat tax system, these matches could be considered earned income, which would push tax responsibilities higher for many households. That could impact the amount people are able to save for retirement, which is already an area of struggle for over 40% of U.S. households.
7. It would potentially decrease the GDP.
Although Hungary saw revenue advantages come through the passing of a flat tax, they also experienced an immediate drop in their gross domestic product. During the first year of the flat tax, the GDP in Hungary reclined by 1.6%. That happened because consumers put any extra funds they had into items they need anyway or toward debts they were carrying. In time, the GDP may increase at a similar rate as income, though that has not occurred as of yet.
8. It creates the potential for a massive deficit.
In the United States, a flat tax proposal of 14.5% has often been floated when discussing this subject. At that rate of taxation, it would create the potential of an annual revenue deficit of $300 billion. That is the equivalent of 50% of the current defense spending budget in the U.S. each year.
9. It enhances the changes felt at all economic levels.
When an economy is growing and strong, then the effects on wealth with a flat tax system are also strong. That helps households potentially grow their incomes, pay off debt, save more, and increase their spending. The opposite is also true. If there are fewer opportunities available, then there are fewer jobs available with this simplified system. That means less people in the labor force, which ultimately reduces the income of everyone, including the government.
These flat tax pros and cons create a new set of benefits which could promote economic growth. If households are unable to make financial adjustments to this new system right away, however, it could also promote economic hardships. Although the taxed percentage would be equal, there could be disparity in responsibility, which would create possible socioeconomic cliques within a society. That would lead to even more division, all in the name of fairness, and it may not even generate the same amount of money.