By Kyle Pomerleau, The Tax Foundation
Several Republican presidential hopefuls have stated their support of the “Flat Tax.” Ted Cruz, Ben Carson, and Rand Paul have all expressed interest in a tax reform plan that moves our current code to a new “Flat Tax.” As a result, there is renewed interest in what a Flat Tax is, what its pros and cons are, and how it could impact different taxpayers.
What is a Flat Tax?
When most people hear “Flat Tax,” they usually think a tax system with one, flat tax rate on all income. They also imagine a tax system with little or no deductions or credits. While this is a possible way to design a flat tax, it is not what makes a flat tax a flat tax. The key to a flat tax goes beyond its rates. The key is that it is a consumption tax. You would not call a low-rate tax on all transactions in an economy a flat tax, even though it had one, flat rate.
A consumption tax is a tax on what people spend, rather than what people earn. Economists like consumption taxes because they are what is called “temporally neutral.” They are neutral with respect to consumption today and consumption tomorrow (saving). Another way to think about a consumption tax is that it taxes, one-time, all the money people spend today plus the money people save, either when they save it, or when they spend it in the future.
Types of Flat Taxes or Consumption Taxes
When you think about a flat tax as being a consumption tax, there are actually multiple different tax systems that fit the description of a flat tax. All of these systems tax the same exact economic activity at some point. What differs between them is how they tax that activity or the legal incidence of the tax (on whom the tax is actually levied).
The “Flat Tax”
The system that is typically referred to as the “Flat Tax” arrives at a consumption base by taxing wages and salaries, but exempts investment income from taxation. You can think of it as a tax on all current consumption and saving, with no further tax on that what people saved in the future. It is close to the current income tax, but with Roth IRAs for all saving (and with no restrictions or penalties).
The retail sales tax
The retail sales tax taxes consumption by levying a tax directly on what people purchase at the cash register. Thus it is a tax on what people spend today. Any money that people save and thus spend later will be taxed in the future when they spend it.
The value-added tax
The value-added tax is similar to the retail sales tax, but instead of being levied once at the cash register, it is levied on the business at each stage of production. For example, assume a 10 percent VAT. A woodworking business may purchase lumber from a mill for $110. $100 for the price plus $10 for the VAT. The woodworking business then makes a chair and sells it for $132. It charges $120 plus $12 for the VAT. Before it submits the VAT payment to the government, it deducts the $10 in VAT it paid on the lumber. Thus it only pays $2 in VAT. When an individual purchases the chair, the value of the tax ($12) is built into the price of the product. This tax is very popular throughout the world.
There is also a variant of the value-added tax. Instead of levying a tax on the expenditures of a business, the tax is levied on a business’s payments to the factors of production (capital and labor): wages and salaries, rent, and profits. The value of all of these payments is equal to a business’s value added. New Hampshire’s Business Enterprise Tax is an example of an income-side value-added tax.
The cash-flow tax
The cash-flow tax taxes all income earned by an individual: salaries, wages, dividends, capital gains. All businesses are treated similarly to pass-through businesses: a business’s income is only taxed when it is passed to their owners in the form of dividends (retained earnings are exempt from taxation). Any money that individuals save is deductible against their taxable income. Another way to think about this type of tax system is you take our current income tax and extend unlimited traditional IRAs with no restrictions or penalties to all saving.
Why do Economists Like Flat Taxes?
Economists like flat taxes or consumption taxes because they are efficient: they raise revenue while doing little damage to the economy.
Our current income tax system is inefficient from an economic perspective. It places a significant amount of double-taxation on saving and investment. If a person earns $100 they have a choice: should they spend it now or save it and spend it later? If the individual decides to spend that $100 now, our tax code has just taxed the income once through the individual income tax. However, if the individual decides to save that $100, it will be taxed twice: once through the individual income tax when he earned it and again when that saving nets a return and is spent in the future.
This double taxation creates tax bias against saving and investment. It makes people less likely to save. This leads to lower levels of investment in the economy and a smaller capital stock, or less productive stuff in the economy. As a result the economy will be smaller in the future.
A consumption tax does not create this bias against saving because it taxes all consumption once, whether it is today or in the future. As a result, a consumption tax does not lead to a smaller capital stock, and thus allows the economy to grow less inhibited.
Do Flat Taxes Raise Taxes on the Poor?
Many are concerned that a flat tax will significantly raise taxes on low-income taxpayers. This is because our current income system heavily taxes high-income individuals. According to the CBO, the lowest quintile households in the United States pay an average effective federal tax rate of 2 percent and the top quintile pays an average rate of 21 percent. If you were to replace all federal tax revenue with a flat tax that made everyone pay the same tax rate, the lowest income households would certainly see a large tax increase.
However, a flat tax, or any other consumption tax does not necessarily need to be structured in a way that increases taxes on low-income taxpayers. As discussed above, the key to what makes a flat tax is its consumption base. There is room to alter the tax system in order to define some level of progressivity in a consumption tax.
In fact, many flat taxes come with a large standard deduction, which create 0 percent tax brackets for a large number of taxpayers. Rubio-Lee’s recent tax proposal was also a consumption tax, but with two tax brackets, 15 percent and 35 percent. It also provided a large refundable personal credit, which made their plan a large tax cut for low-income taxpayers. Even the Fair Tax, which is a national retail sales tax, has a level of progressivity by providing a “prebate,” which is a large cash transfer from the government to offset the impact of the retail sales tax on low-income households.
Does a Flat Tax Reduce Tax Revenue?
Again, it depends. The most basic structure of any flat tax is the consumption base. Once you get the base correct, lawmakers can adjust the rate to arrive at the level of revenue they want.
Many proponents of the Flat tax or other consumption taxes are also proponents of lower tax revenue in general. The Rubio-Lee tax reform plan, which moves to a progressive flat tax, also reduces revenue for the government. consumption taxes, tend to raise a lot of revenue.
Conversely, European countries that have flat taxes, value-added taxes, or other consumption taxes, tend to raise a lot of revenue. For example, Estonia for all intents and purposes has a perfect consumption tax, yet raises more than 30 percent of its GDP in taxes.
Can a Flat Tax Abolish the IRS?
Some politicians sell the flat tax as a way to eliminate the IRS. While this does buy political points (who doesn’t like to pick on the government agency that collects taxes?), it isn’t realistic. At its core, the IRS is the agency that collects taxes. As long as the government collects taxes, some agency will exist to carry out that task.
It is true that moving to some types of flat taxes vastly simplifies the tax code. With a flat tax, the IRS would be responsible for less, but it would still be there.