Pros and Cons for the U.S. of Flat vs. Progressive Taxes
Flat tax success stories are fairly easy to find. A number of countries have seen impressive economic growth after adopting the flat tax idea. This is especially true since the fall of the Soviet Union. As countries formerly under Soviet communist control adapted to capitalism, many of them made the flat tax part of their system and saw great economic growth. Would a flat tax be equally successful in the United States?
This article will discuss the definitions of flat and progressive taxation, looking at the pros and cons of each, and then speculate as to the effectiveness of the flat tax for the US.
Flat Tax Definition
At first glance, the flat tax idea seems simple enough: one tax rate, which applies to everyone, regardless of income. No deductions, loopholes or tax shelters - you multiply your income times the tax rate, and your taxes are done. Nothing could be easier!
In reality, it's not quite that simple. What constitutes income, for example? In the US, long-term capital gains are taxed at a lower rate than regular income, in part to encourage long-term investment. Should this continue under a flat tax plan?
Business income also complicates things, and not only for large corporations. If you have income from a small part-time business, for example, you currently deduct your expenses to determine the taxable amount. How would that work on a tax form that has no place to enter deductions? Clearly, business income requires additional rules.
Modified Flat Tax
A flat tax, applied across the board, would also increase the tax burden on those with lower incomes, many of whom currently pay little or no income tax. For all of these reasons, most current flat tax proposals are actually modified flat tax proposals. These modified plans usually include some variation of these elements:
- an income level beneath which no taxes are paid.
- a small number of allowable deductions - charitable contributions and home mortgage deductions are among the most common
- different rules, or at least different rates, for business income
Some "flat tax" plans also have a small number of tax brackets. Technically, this makes them progressive tax plans, although they are far "flatter" than our current system.
Flat Tax Pros and Cons
easy to understand and comply with, thereby reducing errors and tax fraud
may shift tax burden away from the rich, to the middle and lower class
professional tax preparers and advisors no longer needed, saving money for taxpayer
elimination of deductions may have negative impact on taxpayers with lower income
lawmakers can no longer create tax loopholes in exchange for campaign contributions or other personal favors
government cannot use the tax code to encourage desirable activities, such as giving tax credits for making a home more energy-efficient
businesses can make decisions designed to better serve the marketplace and their stockholders, instead of trying to beat the tax code
thousands of government employees and tax professionals would lose their jobs, or suffer a large decrease in business
may encourage investment and expansion, as additional profit is not taxed at a higher rate
effects on government revenue of converting to a flat tax are difficult to predict accurately
Progressive Tax Definition
A progressive tax is one in which the tax rate increases as income increases. In the US, this is done using tax brackets, in which income is divided into ranges, with each range taxed at a higher rate than the range below.
As a taxpayer's income enters a higher tax bracket, only the portion of income that falls into that bracket is taxed at the higher rate, with the remaining amount taxed according to the lower tax bracket(s) that it falls into. Otherwise, it would be theoretically possible for a person to earn more money but actually end up with less, due to the entire amount being taxed at the higher rate.
Progressive tax systems often allow for a number of adjustments to taxable income, such as exemptions, deductions, and tax credits. These can be used to provide additional relief to low-income citizens, or to encourage certain types of behavior, such as business investment or higher education.
Progressive Tax Pros and Cons
shifts tax burden to those most able to pay
"bracket creep" - inflation can push taxpayer into a higher tax bracket, with no real increase in income after adjusting for inflation
those with greater influence in society pay more
can be used in corrupt manner by politicians
prevents political and social instability by limiting the gap between classes (at least in theory)
"brain drain" - individuals with high earning potential (often a nation's brightest and most talented people) leave to avoid high taxes
protects taxpayer during hard times - when income goes down, the tax rate also goes down
may discourage business investment and expansion, as additional profit is taxed at higher rates
many economists suggest that governments can get the most revenue from a progressive tax system
progressive taxation is arguably unconstitutional, in that it does not treat all citizens equally
Would Flat Tax Work in the US?
I've tried to accurately present the pros and cons of both flat and progressive taxation in an objective way. There are advantages to both philosophies, and neither should be dismissed out of hand. In my opinion, however, the flat tax is not the answer for the US.
First, there's no way of knowing how much of the economic growth seen in flat tax success stories are actually due to the flat tax. Because of political changes and other economic reforms, many of these nations would have seen growth under almost any tax plan.
In addition, I'm not sure that a flat tax in the US could provide the same amount of revenue as the current tax system without increasing the tax burden on the middle class. Nor do I believe than anyone can predict the effects on the US economy of switching to a flat tax.
Flat Tax - What do You Think?
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The workings of both the US economy and the current 11,000-page US tax code are extremely complicated. Anyone who says that they understand both well enough to accurately make predictions about the flat tax is, in my opinion, simply mistaken.
That uncertainty alone is reason enough not to switch to a flat tax - but this is not to say that there shouldn't be changes made. The current US tax code is 3.8 million words. Compliance is difficult even for those who want to. Callers to the IRS with tax questions receive the wrong answer more than 20% of the time, according to the US Treasury.
Clearly, the US tax code needs to be vastly simplified. Progressive taxation is fine, but it should meet these criteria:
- everyone should actually pay the tax rate for their tax bracket - no loopholes, tax shelters, or other ways to avoid having to pay.
- it needs to be simple - an average citizen should not have to pay a professional to figure out how much he owes the government in taxes.
- the top tax rates should be low enough that they neither encourage "brain drain" nor stifle business investment.
- it should not be open to tinkering by politicians to use for their own ends.
It's also important to realize that taxes are only part of the equation. In the long run, no tax plan, flat or progressive, can help the US until the government learns not to spend more than it takes in.