Term Paper on "Why a Flat Income Tax Is Preferable to a Progressive"

Term Paper 16 pages (5234 words) Sources: 1+

[EXCERPT] . . . .

Flat Tax System Benefits

Progressivity, Efficiency, and Simplicity

The Flat Tax: Why it Works

As a country's tax system becomes more complicated, it becomes easier for governments to make it more complex still, in a rapidly accelerating process of proliferating insanity -- until, perhaps, a limit of madness is reached and radical simplification is demanded (the Economist, 2005). In 2005, many of the world's largest and wealthiest countries seem far along this curve. The United States, which last simplified its tax code in 1986, and spent the next two decades making it more complicated, may soon reach a point of renewed fiscal catharsis. Other wealthy countries, with a tolerance for tax-code complexities even greater than the U.S., may not be so far behind.

Revenue naturally needs to be raised. However, many economists are left wondering whether a realistic alternative to tax codes exists. According to the Economist (2005): "The answer is yes: there is indeed an alternative, and experience is proving that it is an eminently realistic one. The experiment started in a small way in 1994, when Estonia became the first country in Europe to introduce a "flat tax" on personal and corporate income. Income is taxed at a single uniform rate of 26%: no schedule of rates, no deductions. The economy has flourished. Others followed: first, Latvia and Lithuania, Estonia's Baltic neighbors; later Russia (with a rate of 13% on personal income), then Slovakia (19% on personal and corporate income). One of Poland's centre-right opposition parties is campaigning for a similar code (with a rate of 15%). So far eight countries have followed Estonia's example. An old idea that for decades elicited the response, "Fine in theory, just not practical in the real world," seems to be working as well in practice as it does on the blackboard."

Many economist have argues that flat taxes cannot work because they are unfair (the Economist, 2005). Progressive countries, it is argued, have "progressive" tax systems, which require the rich to pay a bigger share of their incomes in tax than the poor. A flat tax appears to rule this out in concept.

However, this is not necessarily the case (the Economist, 2005). A flat tax on personal incomes combines a threshold (an exempt amount) with a single rate of tax on all income above it. The progressivity of this type of system may vary within great limits using just these two variables. Under systems such as the system in the U.S. Or systems seen in most of western Europe, the incentives for the rich to avoid tax (legally or otherwise) are great; and the opportunities to do so, which arise from the complexity of the codes, are enormous. Thus, the wealthy typically pay about as much tax under a flat-tax regime as they do under a progressive system.

In this light, the main objections to the flat tax are cancelled out (the Economist, 2005). In addition, the advantages of a simple tax system are enhanced. Simplicity is an advantage in its own right. The costs of administering a complex tax system are huge. Estimates for the United States, whose tax regime, despite government efforts, put the costs of compliance, administration and enforcement between 10% and 20% of revenue collected. This sum is equivalent to between one-quarter and one-half of the government's budget deficit. And many countries have even higher maintenance costs.

According to Hall and Rabushka (1995), the flat tax would save taxpayers hundreds of billions in direct and indirect compliance costs (Hall and Rabushka, 1995). It would also transfer billions of dollars from investments that reduce taxes to those that produce goods and services.

An effective flat tax could have many benefits (Branch, 2004). It could reduce compliance and administrative costs, as well as enhance productivity and work incentives. However, the majority of flat tax proposals that have been offered to date have been criticized for raising taxes on the middle class, increasing the deficit, or reducing the surplus.

However, just because previous flat tax proposals have been ineffective does not mean that the United States cannot implement a flat tax structure that, by integrating the Social Security (including Medicare) and income tax levies, has the advantages of other flat tax proposals without their faults (Branch, 2004).

For example, economist Ben Branch has proposed a combined 25% Social Security and income tax levy coupled with a $1,000 per exemption tax credit (Branch, 2004). "The working poor would be incentivised with subsidy payments based on the unutilized portion of their tax credits. Employer Social Security payments would continue as under the present system. Such a flat tax would neither shift the tax burden nor increase the deficit. It would, however, include all of the advantages of the other proposals."

Hall and Rabushka (1995) have also created a flat tax plan. According to the authors: "Under our flat tax, all income would be taxed once and only once, at a uniform low rate of 19%. Our plan is fair to ordinary Americans because it would permit a tax-free allowance of $25,500 for a family of four. The family would pay a tax of 19% on its earnings above that allowance. Millions of U.S. residents would no longer pay any income taxes. All wage earners would pay less tax under our flat tax than under the current system. Our flat tax would eliminate the distortions of the present tax treatment of business. It would replace a hodgepodge of depreciation schedules with an effective investment incentive, a first-year write-off. It would reduce the current corporate tax of 35% to 19%. It would eliminate double taxation of business income by ending taxation of dividends and capital gains."

The authors point out that this flat tax system simply taxes people on what they take out of the economy, not on what they put in (Hall and Rabushka, 1995). While opponents argue that it would hurt homeowners and the real estate industry, reduce charitable contributions, and provide a windfall to the rich, proponents argue that this would not be the case. According to Hall and Rabushka (1995): "Adopting the flat tax would improve the overall performance of the economy. Housing and charitable giving would flourish. Everyone's after-tax income would rise. All designers of rival tax plans agree that the tax base must be broadened and that tax rates must be lowered. Our flat tax meets the tests of efficiency, equity, and simplicity better than every other plan that has been proposed." flat tax applied to personal income has numerous advantages over the progressive tax system (Branch, 2004). Administrative costs, compliance costs, and the marginal tax rate can be greatly reduced, while productivity, compliance with the tax laws, and work incentives can all increase. As a result, there would be a strengthened economy; thus enabling a still lower tax rate. However, opponents of the flat tax argue that to maintain current tax collections, the flat rate has to be set at a level that would increase the tax burden on the majority of the middle class (or at minimum increase the relative tax burden on the middle class).

The greater efficiencies that can exist under a flat tax system may permit the development of a revenue neutral flat tax that does not raise middle class taxes (Branch, 2004). Still, current flat tax proposals remain vulnerable to the criticism that they would reduce the relative tax burden on the wealthy, while increasing it on the middle class.

Because the United States is a democracy, today's present system's tax burden has a tendency to reflect the will of the electorate. To be politically viable, proposed tax reforms must be structured so that they neither increase the deficit nor the tax burden on the middle class. Compared to the existing tax system, flat tax reform should simultaneously accomplish each of the following objectives (Branch, 2004):

Reduce administrative costs.

Reduce compliance cost.

Reduce economic distortions.

Reduce marginal tax rates.

Not increase the middle class's relative tax burden.

Maintain current rates of tax collections.

This paper offers an in-depth look at the flat tax system, in an effort to present a clear argument as to why this system could be very beneficial to countries around the world.

Explaining the Flat Tax

When implementing a flat tax, it is best to have two separate tax forms -- one for business income (which includes corporate income and income from the ownership of unincorporated businesses) and the other for wages and salaries (Rabushka, 1997). However, it is crucial to view the two forms as a single integrated system. An integrated system allows for equal taxation of all types of income, although reporting of income is divided into two parts. The flat tax can be seen as a single tax on the cash flow of the economy, rather than two or more different taxes arising from different sources of income.

According to Rabushka (1997): "Expensing investment eliminates the double taxation of saving. Under an income tax, people pay tax once when they earn and save, and… READ MORE

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